Recent proposals by the Financial Accounting Standards Board (FASB) give holders of illiquid assets more flexibility in disclosing their fair values but also establish stricter guidelines for how to achieve those values, likely resulting in greater operational burdens and a step back on the road toward fair value accounting.
Technically FASB staff positions (FSPs), one proposal would affect disclosures by amending two existing accounting statements and an Emerging Issues Task Force (EITF) issue. Only credit-related losses would be reported in earnings, while losses related to other factors would appear in other comprehensive income.
The change could soften the steep charges financial institutions following generally accepted accounting principles (GAAP) have taken over the last year and are expected to face in coming quarters.
However, the other FSP, amending FASB Statement No. 157 (FAS 157), Fair Value Measurements, proposes a new paradigm to determining fair values that could end up being operationally burdensome for firms and difficult to implement under the proposed timeframe.
In its request for comments, due April 1, FASB asks whether the proposed effective date of interim and annual periods ending after March 15, 2009, is operational. Several credit unions that submitted comments within days after the FSP's March 16 issuance actually request the amendments to become effective a quarter earlier, for interim and annual periods ending after last Dec. 15.
"Making this change for year-end December 31, 2008, would be beneficial for many companies to reduce panic in the markets," wrote Rex Hochstedler, CFO of Goshen, IN-based Interra Credit Union.
Either way, the current proposal would require asset holders to substantially change their policies and procedures to measure the values of illiquid assets, such as MBS, CDOs and even auction-rate securities (ARSs). The FSP proposes a two-step process to arrive at fair values. The first determines whether the market for a security is active or not, and the FSP offers seven factors to consider, such as whether quotes are stale or the bid/ask spread is abnormally wide.
If a firm determines that there is no active market for its asset, step 2 requires it to presume that a quoted price is for a distressed transaction - perhaps stemming from a forced sale of the asset. The FSP does allow the asset holder to avoid the distressed designation if it shows evidence that there was enough time before the measurement date to allow for typical marketing activities to sell the asset, and there were multiple bidders for the asset.
However, said Gene Phillips, director at PF2 Securities Evaluations, a year-old firm specializing in valuing illiquid assets, "Those burdens of proof are cumbersome and may be infeasible."
Phillips added that knowledge about the number of bidders is not always readily available, and that such an assessment may be difficult to support. Plus, since the asset holder wants bids for valuation purposes, rather than to actually sell the asset, potential bidders are likely to grow weary of providing labor-intensive bids for hard-to-value assets. "It becomes difficult to get someone to give you a value if you're not even interested in selling the asset," Phillips said.
Other complications may also arise. "In practice, this will certainly be an area of contention between management and external auditors, and some specific guidance would be helpful," wrote Doug Listman, chief account officer at Cohen & Co., an institutional broker-dealer and fund manager. He added, "Please realize in practice it will be difficult to do 'due diligence' on every trade in an inactive market."
Phillips said the FSP may prompt reporting entities to assume that a sale is forced and therefore distressed, unless proven otherwise, and that essentially reverses the assumptions in existing accounting language. He added that given the dearth of activity in the CDO market, for example, the new assumption may be a more realistic approach, since participants in that market tend to be wary of trading unless they absolutely have to.
Espen Robak, president of Pluris Valuation Advisors, said true "fire sales" or distressed transactions - when the asset is sold below fair value - are likely less common than popularly assumed. Hedge funds, for example, can suspend redemptions for enough time to find multiple bidders. "FASB seems to be setting up a dynamic where almost anything selling off an exchange would be considered a fire sale," Robak said.
The FSP, according to Robak, calls for disregarding prices associated with a distressed transaction - typically from brokers - and instead resorting to models, such as a present-value technique, to estimate fair value.
However, he added, that language appears contrary to existing language in FAS 157, which says to include such prices, even if sporadic, as inputs in the fair value analysis.
"If the new FSP takes away good inputs, then the quality of the analysis for fair value coming out of the models would necessarily have to be reduced," Robak said, adding, "In many ways the FSP seems to represent a step back from fair value because it could take us further away from true market values."
Ambiguity Over Distress
Nevertheless, since there's always been some ambiguity about whether assets should be viewed as distressed under FAS 157, clearer guidelines - even if weighted toward distressed territory - may benefit a market in which participants are wary about one another's valuations. "If everybody is doing the same thing, then it's probably better. It could have a positive impact," Phillips said, adding, "Clarity, consistency and transparency calm the markets."
Once a transaction is designated as distressed, however, the asset holders will have to adjust the price.
The FSP notes that the firm would have to disclose the "input and the effect of using other reasonably possible discount rate estimates" in the cash-flow model it chooses. Phillips noted that the FSP doesn't require a specific number of additional disclosure values, but depending on the asset in question, it could be several.
Since a market participant would likely see many more assets designated as distressed under the FSP, and there's little automation in many markets for currently illiquid assets, firms may have to beef up internal manpower and relationships with third-party valuation firms such as Pluris or FSP.
"New policies and procedures will have to be adopted, and for each security there will be more work to do to its price," Phillips said, adding, "It may prove operationally expensive - at least at first - to employ these measures, but if more transparency and consistency are the result, it may have a positive impact."
The FSP does not specify the models to adjust the broker's quote. Robak noted that ultimately the quality of the inputs is more important than the specific model. So far, market participants likely have found many current present-value models, using parameters such as interest rates and quotes from comparable assets, to be unsatisfactory, providing an opening to newcomers.
Response Analytics, for example, captures data at the individual mortgage loan level, including loan servicing data, borrower creditworthiness and collateral value, to determine the likelihood of default and the loan portfolio's present value, as well as how the loans can be adjusted to optimize that value.
"We're doing these calculations so we can come back and tell the owner of the portfolio what it's worth and what can be done to improve its value," said Brent Lippman, CEO of the Scottsdale, AZ-based firm.
Lippman said that a "top-10 servicer" and a "probably top-20 investor" are using the technology, respectively, to value current mortgage assets and to purchase assets. Lippman said the service could also be used to value MBS, assuming historical servicing data on the typically tens of thousands of loans in an MBS security is available. And since MBS is often a major component of CDOs, presumably it could be used to help value those assets as well.
The federal government also has a major stake in properly valuing illiquid assets, as it launches programs to purchase or aid private investors in purchasing them. Lippman said his firm's efforts to garner federal interest have been frustrating. "We can't get anybody's attention," he said.
Lippman sees private market participants as strong prospects, given that their lack of understanding about the loans comprising MBS and CDO securities and what they're worth has been a major impediment to rejuvenating those markets. "Our philosophy is that by understanding the individual loan and then rolling it up, you have very valid valuation for the portfolio," Lippman said.
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