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New Accounting & Reporting Standards - Do They Help Our Understanding Of Recent Market Disruptions? May 6, 2009 . Dina Maher Head of US Accounting Research Credit Policy Group. Agenda. Fair Value. Derivatives. Impairments. Securitizations. Agenda. Fair Value. Derivatives. Impairments.

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New Accounting & Reporting Standards -Do They Help Our Understanding Of Recent Market Disruptions?May 6, 2009

Dina Maher

Head of US Accounting Research

Credit Policy Group


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Agenda

Fair Value

Derivatives

Impairments

Securitizations


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Agenda

Fair Value

Derivatives

Impairments

Securitizations


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SFAS 157 Definition

  • “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

  • Exit price: Not necessarily the price paid for an asset (for example), which is an entry price

  • Market participants: Buyers and sellers that are independent, knowledgeable, able, and willing

    • Scepticism of a risk averse buyer

    • Fair value should reflect how market participants would value the asset/liability, even if market participants would use it differently from the owner’s intended use



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Citigroup Disclosure of Fair Value Hierarchy

Compare to Total Assets = $1.9T

Source: Citigroup December 31, 2008 Form 10-K


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Valuation Issues: Illiquid Markets

  • SFAS 157 allow for non-current market data if “distressed” or “forced” sale

  • Center for Audit Quality (CAQ) and Global Public Policy Committee:

    • Significantly lower transaction volume does not mean that there are forced or distressed sales. Not appropriate to disregard observable prices.

  • Issuers forced to take whatever market prices are out there and input into models and valuations.

CAQ paper issued Oct 2007- set the tone from beginning of credit crisis


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Fair Value in Inactive Markets

  • SEC / FASB Clarifications- September 30, 2008

    • Suggests that if observable Level 2 inputs need significant adjustment (such as the CMBX), may be more appropriate to use Level 3 measures.

    • This does not imply that issuers can just mark to their own models. Reinforces need to incorporate current market participant expectations of future cash flows and appropriate risk premiums.

    • Allows more use of judgment to determine whether a sale is distressed. Refutes CAQ guidance issued in 3Q2007 that forced many issuers to mark to highly illiquid markets.

No material observed changes to valuation after this clarification was released-

Still taking a hard line?


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SEC Study on Fair Value

  • Findings of Congressionally mandated SEC study on Mark To Market Accounting issued on December 30, 2008:

    • The effects of FV accounting standards on a financial institution's balance sheet

      • FV was used to measure 45% of assets and 15% of liabilities

      • 25% of FV assets were MTM to P&L and did affect reported net income

    • FV accounting did not play a meaningful role in bank failures

    • The impact of such standards on the quality of financial information available to investors

      • Investors supported FV, but many indicated need for improvement in application, disclosures

    • Staff supported FASB as independent accounting standard setter but made recommendations to enhance timeliness and transparency of process


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SEC Study on Fair Value (continued)

  • Findings of Congressionally mandated SEC study on MTM:

    • Alternative accounting standards to those provided in SFAS 157

      • Did not advise the suspension of FAS 157, but had recommendations

    • The advisability and feasibility of modifications to such standards

      • Recommended actions to improve application and understanding

        • Additional guidance for determining FV in inactive markets

        • Assessing whether the incorporation of credit risk in FV measurement of liabilities is useful for investors

        • Enhancing presentation and disclosure

      • Readdress accounting for financial asset impairments (OTTI)

        • Develop a single method for addressing impairments to reduce complexity

        • Consider the ability to “write-up” upon recovery

      • Accounting standards should continue to meet needs of investors

FASB/IASB already working on this

Next on the agenda


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April 2 FASB Decisions on FV in Inactive Markets

  • Affirmed objective of FV in inactive market is the price that would be received to sell the asset in an orderly transaction

  • Eliminated proposed presumption that all transactions in inactive markets are distressed unless proven otherwise

  • Clarify and identify factors for determining inactive markets and distressed transactions

  • Requirement to disclose a change in valuation technique (and related inputs) resulting from application of the FSP and to quantify its effects, if practicable.

Disclosures will help identify impact of new FV guidance


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FASB Modified Proposal Based on Comment Letters

  • “Those comments arrived by the hundreds, including bitter reactions from investors. ‘Market value is market value. Stop letting the financial industry call a duck a whale,’ stated an e-mail message signed by Diane Walser.”

Source: NYT March 31, 2009


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More Fair Value Disclosures, More Frequently

  • FASB also made mandatory INTERIM FV disclosures for any financial instruments that are not currently reflected on the balance sheet at FV

    • Currently only required in annual financial statements

    • Banks will have to disclose FV of loans each quarter

  • Only required for public entities

  • Effective for interim periods ending after June 15, 2009 (second quarter filings). May early adopt for 1st quarter, if also adopted new FV and OTTI proposals for 1st quarter.


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Credit Analysis and Fair Value

  • May have more Level 3 fair value measures than previously

    • If not, issuer may have concluded that illiquid market not “distressed” - still utilizing market quotes or inputs to determine FV

  • How can we tell if FV under new guidance represents a better indication of expected cash flows?

    • Compare to Fitch stress analysis of portfolio

    • For structured finance, see if FV in range of Fitch recovery rating

    • Look at interest rate assumptions on FV measures, compare to cash flows

  • Many financial assets such as loans and HTM investments are NOT measured at FV

    • Will now have quarterly disclosures for FV for these financial instruments


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IASB Discussion Paper

  • IASB discussion paper on “Reducing Complexity in Reporting Financial Instruments” FASB also released for comment.

  • Identify sources of complexity and recommend intermediate and long term solutions

  • Multiple measurement bases is source (MTM, LOCOM, AFS)

  • Intermediate approach

    • Reduce categories of financial instruments

    • Replace existing requirements with fair value principle- with some optimal exceptions

    • Simplify hedge accounting

  • Long term solution- Fair value all financial instruments


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Fitch Response to IASB and FASB

  • Fitch is not convinced that measuring more instruments at fair value will reduce complexity.

  • Fitch believes that the measurement basis for all non-trading financial liabilities and for financial assets held to maturity should reflect the actual cash amount the company expects to pay to settle a liability or to receive in settlement of an asset at its expected maturity.

  • Do not believe that all hedge accounting should be eliminated- but advocated for better overall risk management disclosures.

  • Emphasize need to complete joint projects on how to measure fair value and expand disclosure requirements before contemplate further expansion of fair value.


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New Fair Value Measures This Year

  • New Acquisition Method for business combinations (SFAS 141(R)), focuses on fair value of assets and liabilities at acquisition date

  • Expiration of one-year deferral of application of SFAS 157 on non-financial assets and liabilities

    • Asset retirement obligations initially measured at FV

    • Non-financial liabilities for exit or disposal activities initially measured at FV

    • Non-financial assets, such as goodwill, other intangibles and long-lived assets, measured at fair value for purposes of impairment testing


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Agenda

Fair Value

Derivatives

Impairments

Securitizations


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Overview of Fair Value of Liabilities in US GAAP

  • Any financial liability may be recorded at FV (SFAS 159) at recognition.

  • All financial derivatives are recorded at FV (SFAS 133)

  • Changes in credit risk will produce counterintuitive results

    • Increase in credit risk → higher discount rate → lower FV of liability

      • Will result in gains reported in the income statement.

    • Lower credit risk→ lower discount rate → higher FV of liability

      • Will result in losses reported in the income statement.


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Fair Value of Derivative Liabilities

  • FV measurement includes entity’s own credit risk

  • Credit Perspective

    • For derivatives in the liability position, (or for those that are disclosed net of all positions), liabilities may be understated.

    • Equity will be overstated to the extent that derivatives liabilities are reduced due to increased credit risk.

  • FV changes due to credit spread widening will result in gains in net income or in OCI depending on where derivative marks are flowing.

  • Disclosures are not required to quantify the impact.

  • If credit spreads have widened for the issuer, should evaluate.


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Recovery Analysis

Recovery values may be impacted

  • Out of the money derivatives will be a liability on winding-up

    • Credit analysis focus is on cash commitment

    • May impact unsecured credit recovery values

  • In the money derivatives are unlikely to be readily recoverable - but may be in some cases

  • Derivatives to the same counterparty are likely to be netted


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General Criteria Methodology

  • Key Take-Away-Focus on Cash Commitments

  • On assumption company is going concern

    • Work back to cash principal outstanding for debt

  • Interest

    • Use cash interest when computing coverage ratios

    • Including net amounts paid on interest rate derivatives

  • Need to consider materiality

    • These movements and impacts will often be small, and can therefore be ignored


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New Disclosures

  • FAS 161, Disclosures about Derivatives Instruments and Hedging Activities

  • How and why an entity uses derivative instruments

    • Speculation or risk management?

    • What risks are they hedging and with what instruments?

      • Interest rate, Currency, Commodity, Credit, Equity

    • What new risks are they now exposed to (e.g. counterparty)?

    • What is the volume of their derivative activity?

  • How derivative instruments and related hedged items are accounted for under SFAS 133

    • Fair value hedges, Cash flow hedges, No hedge accounting

  • How derivative instruments and related hedged items affect an entity’s I/S, BS, CFS:

    • Location and fair value amounts of derivatives on a gross basis (even if qualify for net presentation).

    • Must be presented separately by asset and liability position

    • Must also segregate by derivatives designated in and qualifying as hedges


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New Disclosures

FAS 161, Disclosures about Derivatives Instruments and Hedging Activities

Sample FAS 161 Disclosure


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New Disclosures

FAS 161, Disclosures about Derivatives Instruments and Hedging Activities

Sample FAS 161 Disclosure


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New Disclosures

  • FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees

  • Requires more information about potential adverse effects of changes in credit risk on the financial position and performance of sellers of credit derivatives.

    • Nature of credit derivative

    • Events or circumstances that would require seller to perform under the credit derivative

    • Approximate term of the credit derivative

    • Current credit risk of the referenced entity or obligation (based on either internal or external credit ratings, depending on how seller manages risk).

    • Fair value of the credit derivative

    • Maximum potential amount of future payments (undiscounted)


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New Disclosures

  • FSP FAS 133-1 and FIN 45-4, Disclosures about Credit Derivatives and Certain Guarantees


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Agenda

Fair Value

Derivatives

Impairments

Securitizations



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Flow Chart of Historical OTTI Guidance for AFS and HTM Investments

No OTTI Determination Needed

Is Fair Value (FV) Less Than Cost Basis?

No

Yes

Evaluate the Duration and Extent of FV Decline. Is it Other Than Temporary?

Yes

Write-down Security to FV through Earnings

No

Does Issuer have the Ability and Intent to Hold to Recovery?

No

Yes

Available-for-Sale (AFS) or Held-to-Maturity (HTM)?

HTM

AFS

No Adjustment to Cost Basis

Write-Down Security to FV through OCI

Source: Fitch.


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Debt and Equity Investments – Investments Other Than Temporary Impairments

  • Issuer ramifications

    • MTM changes in AFS securities

      • Impact a bank’s total capital but not Tier 1 capital

      • Does not impact statutory capital for insurance companies

    • OTTI hits P&L

      • Impacts a bank’s Tier 1 capital

      • Most statutory accounts pick up OTTI as reduction to capital

    • Investors cannot reclassify or sell securities out of HTM without penalty

      • Many financial institutions in past year reclassified AFS investments to HTM to “prove” intent to hold to recovery and avoid OTTI


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Changing Income Statement Recognition for OTTI** Investments

These are not the impairments you are looking for…

**But only for debt securities


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Changing Income Statement Recognition for OTTI Investments

  • New proposal changes 2 key parts of OTTI guidance

  • Modifies “Ability and intent to hold impaired security to recovery” to “No intent to sell, and more likely than not (changes >50%) it will not sell prior to recovery”

  • For those securities where the issuer is able to make the above assertion, will recognize in P&L only the portion of FV decline due to “credit losses” with the remainder being allocated to OCI

    • For those securities that it cannot assert “no intent to sell, more likely than not will not sell,” will have to take full FV decline to P&L

    • Credit losses will be based on management’s estimate of the decrease in expected cash flows


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Flow Chart of Newly Adopted OTTI Guidance for InvestmentsAFS and HTM Debt Investments

No OTTI Determination Needed

Is Fair Value (FV) Less Than Cost Basis?

No

Yes

Does the Issuer Intend to Sell the Security Before Recovery of its Cost Basis?

Yes

Recognize Impairment Equal to Full Difference of FV and Amortized Cost Basis of Security Through Earnings.

No

Is It More Likely than Not that the Issuer Will Sell the Security Before Recovery of the Cost Basis?

Yes

No

Recognize in Earnings the Amount of FV Decline Related to Credit Losses. Record the Remaining Difference Between FV and Amortized Cost in OCI.

Is It Probable that the Issuer Will be Unable to Collect All Amounts Due for the Security?

Yes

No

Available-for-Sale (AFS) or Held-to-Maturity (HTM)?

HTM

AFS

No Adjustment to Amortized Cost

Write-Down Security to FV through OCI

Source: Fitch.


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Arguments FOR Change Investments

Forcing write-down to current asset prices does not reflect ongoing “economic value”

Preference for only recognizing credit losses since there is an inability to “write-up” recoveries in FV

Change of “intent” language more operational

Arguments AGAINST Change

Separating credit losses from total FV decline will increase financial statement complexity

Having full FV decline recognized for some investments, but not for others will also increase complexity

Change in “intent” language would delay recognition of OTTI

Will decrease comparability within and between issuers

Credit loss estimates too arbitrary

Changing Income Statement Recognition for OTTI


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Industry Unrealized Losses On Investments Investments

Source: Credit Suisse "Still Searching for OTTI" Apirl 1, 2009


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Disclosures Expanded Investments

  • Require disaggregation based on nature and risks of the security and include additional types of securities in the list of major types

    • For example, separate RMBS, CMBS, and CDOs

  • Include cost basis of AFS and HTM debt by security type

  • Rollforward of amounts recognized in earnings for debt securities that have OTTI and the noncredit portion of the OTTI recognized in OCI

  • Require, by security type, methodology and key inputs used to measure portion of OTTI related to credit losses

Disclosures for investments, previously provided annually, will now be provided in interim financial statements


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Transition Adjustment Investments

  • Issuer will record a cumulative-effect adjustment to reclassify the non-credit component of a previously recognized OTTI from retained earnings to accumulated other comprehensive income if it does not intend to sell before recovery and it is more likely than not that it would be required to sell before recovery

  • Tier 1 Capital will be positively adjusted by AOIC reclassification

  • The cost basis used to calculate the accretable yield will also be adjusted

    • No longer accrete non-credit portion through earnings

Will insurance regulators follow suit and allow for only credit losses to reduce statutory capital?


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Credit Analysis & OTTI- Now What? Investments

  • Need to understand how issuer developed credit loss estimates and whether we agree with them

    • Do we think the fair value prices reflect real losses of future cash flows, regardless of accounting recognition?

    • Compare to portfolio stresses, recovery data and FV

  • Determine if regulatory relief may be available due to accounting changes (as long as credit loss estimates hold up)


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Impairments- Goodwill and Other Intangibles Investments

  • Even though “non-cash”, goodwill impairment should not be ignored

  • An indicator that future cash flow projections have declined

  • How will it affect equity based covenants? Macy’s had to renegotiate

  • Focus on

    • Actual triggering event & reason leading to impairment charge

    • Reasonable sensitivity analysis showing how changes in assumptions would affect future valuation

    • Early warning of future impairment


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Agenda Investments

Fair Value

Derivatives

Impairments

Securitizations


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Proposed changes to SFAS 140 InvestmentsAccounting for Transfers of Financial Assets

  • Provides guidance for what securitization transactions would qualify as true sales and allow for derecognition from the balance sheet.

  • Proposed changes to standard constrict conditions by which a securitization transaction qualifies for a sale. Cannot be a “sale” if:

    • transferor or its consolidated entities retain “effective control”

    • transferor limits purchaser in any way with respect to assets and the transferor benefits from the constraint.

  • Eliminates the QSPE concept

  • Stronger disclosure requirements

  • Effective for fiscal years beginning after Nov 15, 2009


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FIN 46(R) is now FIN 46(R) Investments²-- Its all about POWER

Current Requirements

  • Determine whether to consolidate a variable interest entity (VIE) based on who is primary beneficiary.

  • Primary beneficiary is based on quantitative analysis of who is expected to receive gains and absorb losses.

Proposed Requirements

  • Qualitative control analysis determine if a VIE is consolidated

  • Control based on decision making power or right/ obligation to obtain/absorb a majority of benefits/risks.

  • Quantitative analysis eliminated (The end of first-loss notes?)

  • Recently reversed need to evaluate each quarter- should have less on and off than previous expectations

  • Still deliberating disclosure needs


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Implications…. Investments

  • Most structured asset sales will be evaluated for consolidation as a VIE.

  • New structures may be designed to share “power” to keep off balance sheet.

  • Issuers may not have CONTROL or RISK OF ASSETS of VIE, yet still consolidate. Must determine whether appropriate to include in credit analysis.

  • Some previously consolidated entities may be deconsolidated.

  • Bank and insurance regulators have not yet determined how this will impact regulatory capital.


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Securitized Receivables Investments

  • Securitization of receivables effectively represents super-senior debt ranking above group debt

  • Often higher quality, less concentrated receivables are sold in securitization transactions

    • Lower quality, higher concentrated retained by parent

    • Typically there is an over-collateralization to protect the securitization’s creditors. Varies by asset type

  • Credit questions- may or may not be disclosed

    • Are there cross-default provisions between securitizations and other debt?

    • Are there asset performance triggers to the securitization?

    • What are the liquidity needs in absence of securitization market?

    • What happens in a distressed environment to securitization availability?


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Securitized Receivables- Credit Considerations Investments

  • Need to look at financial statements without the effects of securitization accounting

    • Add back assets and debt onto balance sheet

    • Eliminate securitization gains from income statement

    • Include cash flows from securitization in operating cash flow

  • Retained Interests

    • Servicing asset- the amount of “excess” benefits of servicing that would fairly compensate a substitute servicer

    • Retained interests typically have valuation issues when securitizations have issues, such as covenant, liquidity matters

    • When putting securitizations back on balance sheet, ensure book value of retained interests are removed from equity to avoid double counting


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New Disclosures Investments

  • FSP FAS 140-4 and Fin 46(R)-8, Disclosures about Transfers of Financial Assets and Interests in Variable Interest Entities

    • Improve disclosures until pending amendment to FAS 140 & FIN 46R are effective

    • FAS 140

      • A transferor’s continuing involvement in assets that have been transferred

      • Nature of any restrictions on assets reported on B/S

      • How a transfer to an SPE affects an entity’s B/S, I/S & CFS

    • FIN 46(R)

      • Judgments & assumption made in determining whether the entity must consolidate a VIE

      • The nature of restrictions on a consolidated VIE’s assets

      • The nature of, and changes in, the risks associated with continuing involvement

      • The potential financial impact from an entity’s involvement with a VIE on the entity’s B/S, I/S, & CFS


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New Disclosures Investments

  • FSP FAS 140-4 and Fin 46(R)-8, Disclosures about Transfers of Financial Assets and Interests in Variable Interest Entities

Hartford’s FYE 2008 disclosures on unconsolidated VIE’s


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