New Accounting

1
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

2
Agenda
Fair Value
Derivatives
Impairments
Securitizations
3
Agenda
Fair Value
Derivatives
Impairments
Securitizations
4
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
  owners intended use

5
Fair Value Hierarchy Levels 1, 2, and 3
6
Citigroup Disclosure of Fair Value Hierarchy
Compare to Total Assets 1.9T
Source Citigroup December 31, 2008 Form 10-K
7
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
8
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?
9
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 PL 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

10
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
11
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
12
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.

13
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.

14
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

15
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

16
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.

17
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

18
Agenda
Fair Value
Derivatives
Impairments
Securitizations
19
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.

20
Fair Value of Derivative Liabilities

• FV measurement includes entitys 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.

21
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

22
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

23
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 entitys 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

24
New Disclosures

• FAS 161, Disclosures about Derivatives
  Instruments and Hedging Activities

Sample FAS 161 Disclosure
25
New Disclosures

• FAS 161, Disclosures about Derivatives
  Instruments and Hedging Activities

Sample FAS 161 Disclosure
26
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)

27
New Disclosures

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

28
Agenda
Fair Value
Derivatives
Impairments
Securitizations
29
Brief Overview of Accounting for Debt Securities
30
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)?
AFS
HTM
Write-Down Security to FV through OCI
No Adjustment to Cost Basis
Source Fitch.
31
Debt and Equity Investments Other Than
Temporary Impairments

• Issuer ramifications
• MTM changes in AFS securities
• Impact a banks total capital but not Tier 1
  capital
• Does not impact statutory capital for insurance
  companies
• OTTI hits PL
• Impacts a banks 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

32
Changing Income Statement Recognition for OTTI
These are not the impairments you are looking for
But only for debt securities
33
Changing Income Statement Recognition for OTTI

• 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 PL
  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 PL
• Credit losses will be based on managements
  estimate of the decrease in expected cash flows

34
Flow Chart of Newly Adopted OTTI Guidance for
AFS 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)?
AFS
HTM
Write-Down Security to FV through OCI
No Adjustment to Amortized Cost
Source Fitch.
35
Changing Income Statement Recognition for OTTI

• 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

• Arguments FOR Change
• 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

36
Industry Unrealized Losses On Investments
37
Disclosures Expanded

• 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
38
Transition Adjustment

• 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?
39
Credit Analysis OTTI- Now What?

• 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)

40
Impairments- Goodwill and Other Intangibles

• 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?
  Macys 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

41
Agenda
Fair Value
Derivatives
Impairments
Securitizations
42
Proposed changes to SFAS 140Accounting 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

43
FIN 46(R) is now FIN 46(R)²-- 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

44
Implications.

• 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.

45
Securitized Receivables

• 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 securitizations 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?

46
Securitized Receivables- Credit Considerations

• 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

47
New Disclosures

• 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 transferors 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 entitys 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
  VIEs assets
• The nature of, and changes in, the risks
  associated with continuing involvement
• The potential financial impact from an entitys
  involvement with a VIE on the entitys B/S, I/S,
  CFS

48
New Disclosures

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

Hartfords FYE 2008 disclosures on unconsolidated
VIEs
49
(No Transcript)