A few comments about mark-to-market

Because I received a message via e-mail that my previous post on mark-to-market was misleading, I thought I would clarify what is happening with FAS 157 and provide some good links.

The long and short of the rule is it gives more specific guidance as to when a market is distressed and an asset must not be marked-to-market as a result.  Moreover, it allows assets which are not permanently impaired to be excluded from mark-to-market and defines the reporting requirement of how to do so.

You should note that only a small percentage of assets on financial companies’ balance sheets are actually marked-to-market, even for money center banks that have written down the greatest amount of assets.  Nevertheless, I do project this rule will reduce the number of writedowns, particularly from residential real estate where bankruptcy and default is not a factor (i.e. temporary impairment).

One other point, I have mentioned before that banks are hiding impaired and distressed assets in Level 3 assets.  This change gives them the ability to do so legally under the current accounting rules (see Buiter’s piece).  You can bet the IASB will soon follow.

The rule change passed by one vote.

Here is what the new rule states (I have highlighted some of the important parts in the beginning):

April 2, 2009 Board Meeting

Determining whether a market is not active and a transaction is not distressed. The Board discussed comment letters received on proposed FSP FAS 157-e, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. In response to comment letters and additional feedback received, the Board decided to make significant revisions to the proposed FSP. The Board decided that the final FSP would

1. Affirm that the objective of fair value when the market for an asset is not active is the price that would be received to sell the asset in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions (that is, in the inactive market).
2. Clarify and include additional factors for determining whether there has been a significant decrease in market activity for an asset when the market for that asset is not active.
3. Eliminate the proposed presumption that all transactions are distressed (not orderly) unless proven otherwise. The FSP will instead require an entity to base its conclusion about whether a transaction was not orderly on the weight of the evidence.
4. Include an example that provides additional explanation on estimating fair value when the market activity for an asset has declined significantly.
5. Require an entity to disclose a change in valuation technique (and the related inputs) resulting from the application of the FSP and to quantify its effects, if practicable.
6. Apply to all fair value measurements when appropriate.

The Board also affirmed its previous decision that the FSP would be applied prospectively and that retrospective application would not be permitted. The Board decided that the FSP would be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity early adopting this FSP must also early adopt FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, Recognition and Presentation of Other-Than-Temporary Impairments. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, it must also elect to early adopt this FSP and FSP FAS 115-2, FAS 124-2, and EITF 99-20-2.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Recognition and presentation of other-than-temporary impairments. The Board discussed comment letters received on proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, Recognition and Presentation of Other-Than-Temporary Impairments. The Board made the following decisions in response to comment letters and additional feedback received:

1. 1. The Board decided that the change to existing guidance for determining whether an impairment is other than temporary should be limited to debt securities.
   1. The Board decided to replace the existing requirement that the entity’s management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert
      1. It does not have the intent to sell the security; and
      2. It is more likely than not it will not have to sell the security before recovery of its costs basis.
   2. The guidance will incorporate examples of factors from existing literature that should be considered in determining whether a debt security is other-than-temporarily impaired and how those factors interact with the requirement to assert that the entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis.
   3. When an entity does not intend to sell the security and it is more likely than not that the entity will not have to sell the security before recovery of its cost basis, it will recognize the credit component of an other-than-temporary impairment of a debt security in earnings and the remaining portion in other comprehensive income.
   4. An entity will be required to recognize noncredit losses on held-to-maturity debt securities in other comprehensive income and amortize that amount over the remaining life of the security in a prospective manner by offsetting the recorded value of the asset unless the security is subsequently sold or there are additional credit losses.
   5. The FSP will include guidance stipulating that credit losses should be measured on the basis of an entity’s estimate of the decrease in expected cash flows, including those that result from an increase in expected prepayments.
   6. The guidance will clarify that existing premiums or discounts and subsequent changes in estimated cash flows or fair value should continue to be accounted for in accordance with existing guidance (for example, EITF Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets”).
   1. An entity will be required to present the total other-than-temporary impairment in the statement of earnings with an offset for the amount recognized in other comprehensive income.
   2. An entity will be required to present separately in the financial statement where the components of other comprehensive income are reported, amounts recognized in accumulated other comprehensive income related to the noncredit portion of other-than-temporary impairments recognized for available-for-sale and held-to-maturity debt securities.
   1. The disclosure requirements of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, and FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, will be modified to require an entity to provide the following:
      1. The cost basis of available-for-sale and held-to maturity debt securities by major security type
      2. The methodology and key inputs, such as performance indicators of the underlying assets in the security, loan to collateral value ratios, third-party guarantees, levels of subordination, and vintage, used to measure the portion of an other-than-temporary impairment related to credit losses by major security type
      3. A rollforward of amounts recognized in earnings for debt securities for which an other-than-temporary impairment has been recognized and the noncredit portion of the other-than-temporary impairment that has been recognized in other comprehensive income.
   2. Statement 115 and FSP FAS 115-1 and FAS 124-1 will also be modified to require that major security classes be based on the nature and risks of the security and additional types of securities will be included in the list of major security types listed in Statement 115.
   3. The above additional disclosures, as well as all existing Statement 115 and FSP FAS 115-1 and FAS 124-1 disclosures, will be required for interim periods

Scope

Recognition

Presentation

Disclosures

When adopting the new guidance, an entity will be required to record a cumulative-effect adjustment as of the beginning of the period of adoption to reclassify the noncredit component of a previously recognized other-temporary impairment from retained earnings to accumulated other comprehensive income if the entity does not intend to sell the security and it is not more likely than not that the entity will be required to sell the security before recovery. The cost basis used to calculate accretable yield will also be adjusted to reflect this adjustment (that is, the entity will no longer accrete the noncredit component of a previously recognized other-than-temporary impairment through earnings).

The Board decided that the FSP will be effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. The Board decided that an entity may early adopt this FSP only if it also elects to early adopt FSP FAS 157-4, Determining Whether a Market Is Not Active and a Transaction Is Not Distressed. Additionally, if the entity elects to early adopt FSP FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments, or FSP FAS 157-4, it must also elect to early adopt this FSP.

The Board directed the staff to proceed to a draft of the final FSP for vote by written ballot.

Related articles
More Mark-to-Market Myths – Paul Kedrosky
How the FASB aids and abets obfuscation by wonky zombie banks – Willem Buiter