Publications & Resources
July/August 2009
Focus: Risk Management
This Year’s Battle over Mark-to-Market Versus Mark-to-Model Accounting Was Worth the Fight
By Douglas Wilding
It’s rare to see tempers flair on television news programs over arcane accounting issues, but that happened this year. As the credit crisis created panic selling in debt securities markets, banks and other financial institutions saw the value of their asset-backed securities, such as mortgage bonds, plummet in an unprecedented illiquid market. And as the liquidity crisis continued well past one year, it became clear that the banking industry would have to deal with serious accounting issues related to how to determine the fair value of these securities. Without some changes or at least clarification in the interpretation of these rules, the health of many banks and insurance companies across the country was seriously at risk, given the impact these market value declines had on their capital.
The fight became known in some circles as mark-to-market versus mark-to-model and was taken to Washington D.C., where many voices were heard during hearings on Capitol Hill. Following an eight-month industry campaign to raise public awareness over the serious impact of these accounting issues, the Financial Accounting Standards Board (FASB) issued new guidance in April 2009 for fair value accounting rules.
The key issue in this battle was how to value securities whose market prices had plummeted, but the underlying assets – the loans themselves such as mortgage loans – were often still performing by delivering expected cash flows. The mark-to-market theorists wanted banks to value these securities at fair value, defining fair value as the current market price, while the mark-to-model advocates said fair value should be based upon documented analysis of expected future cash flows, or economic value.
In the middle of the mark-to-market vs. mark-to-model battle was yet another debate on how to determine whether a security was Other Than Temporarily Impaired (OTTI). To clarify, a security was marked to market (or marked to model as some were arguing), only after it was determined to be OTTI, which would then directly reduce earnings and reduce Tier 1 capital. If a security was not considered to be OTTI, then mark-to-market did not apply and no write-down was necessary.
Accordingly, the first step was to determine whether a security was OTTI, and the accounting literature on this stated that an OTTI charge should be based on whether it was probable the investor will receive the cash flows they expected at purchase. Despite this language, many accountants were relying on current market price fair value, rather than expected cash flows, to determine whether a security was OTTI. By using fair value based on the historically high liquidity spreads of the distressed and illiquid market, many accountants misapplied the accounting guidance and forced institutions to unnecessarily write down performing securities. To address all of this, we sought to clarify that fair value should be based on orderly transactions in active markets and that OTTI is based on the probability of receiving expected cash flows – an approach that would actually improve the consistency in financial reporting.
FASB heard the debate and amended its guidance in April, addressing some of
these key issues. FASB said it made these changes to make the guidance more
operational and improve the presentation and disclosure of OTTI in debt and
equity securities in the financial statements.
FSP FAS 157-4 relates to determining fair values when there is no active market or where the prices being used represent distressed sales. It reaffirms that the objective of fair value measurement is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced sale).
FSP FAS 115-2 and FAS 124-2 provide additional guidance on how to determine OTTI and changes how the OTTI charge is recorded in the financial statements. The changes provide a way to separate the credit and noncredit components of impaired debt securities once OTTI is determined. Only the charge related to credit is recorded in earnings and Tier 1 capital.
The new guidance from FASB is welcomed support for banks, but more than ever, banks now need to be especially prepared to provide documented analysis for their decision making. That means they will need to document the intent and ability to hold these instruments until fair value recovers or cash is received (maturity). They also must develop a detailed model for measuring the expected cash flows of debt securities and determine a method to assess OTTI and support their conclusions.
FASB appeared to accept the argument that while financial statements must maintain a high level of transparency, they also must show that financial performance is being measured consistently and delivers a fully accurate picture of financial conditions. Valuation methods such as mark-to-model are not asking regulators to “go easy” on banks, but rather report real economic value without penalizing long-term investors (banks) in this current illiquid market.
This article is for general information only and does not represent any legal, financial or accounting advice. Please contact your legal representative and/or tax accountant for specific application to your investments.
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