CFA Institute Centre for Financial Market Integrity

Remarks byMatthew Waldron, CPA

CFA Society of MinnesotaMay 28, 2009

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Discussion Outline

► Key Fair Value Messages from CFA Institute

► The Need For Fair Value Measurement Guidance

► Fair Value Measurements in Inactive Markets

► Other-Than-Temporary Impairment (OTTI) for Debt Securities

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►Provides an early warning system and is the only accounting regime that can facilitate the timely correction from previous bad

decisions.

►Investors are opposed to the suspension of fair value and believe fair value contributes to transparency in financial institutions.

►The pro-cyclical effects of fair value accounting arise because of the failure to delink information required for overall

transparency from that applied in the determination of capital adequacy.

►Rather than reducing the application of fair value, focus should be on improving and expanding its application/ disclosure/ recognition and measurement.

Key Messages from CFA Institute

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Integrated Survey Analysis Findings

► Fair value considered by 79 percent as contributing to transparency and also as enhancing market integrity

► 72 percent said that companies should not be permitted to choose among alternative methods for measuring and recognizing similar assets and liabilities

► When asked “What is the overall impact of fair value requirements on market integrity?” 74 percent improved.

► Fair value measurement and recognition of assets and liabilities is ranked higher than historical cost consistently in surveys.

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Survey Fair Value Disclosure Needs

► Key qualitative and quantitative assumptions (e.g., interest or discount rate used to determine value) (81 percent)

► Description of the underlying method and policy for each measurement basis used (75 percent)

► Description of changes in measurement bases from prior reported periods including the reasons for the changes and the effects of making the changes (74 percent)

► Disclosures of the fair value (current or market valuations) of assets and liabilities on the balance sheet are rated high in importance but show gaps in the quality of the information provided

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Opponents Views of Fair Value

► Not relevant if can’t or do not intend to sell asset/lay-off liability

► Too subjective

► Difficult and expensive to develop

► Difficult to audit

► Re-measurements result in “misleading” volatility in earnings

► Fear of second guessing/litigation

► Exacerbates the credit crisis

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The Need for Fair Value Measurement Guidance

►There was no single, consistent concept for just what really is a fair value measurement.

►Statement 157 provides a definition of fair value measurement .

►Describes the general methods preparers should follow when they present fair values for assets and

liabilities.

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Fair Value Explained

► Clarifies that the fair value estimate is intended to convey to investors—the value of an asset or liability at the measurement date —not the potential value at some future date.

► Fair value determined by reference to the price that would be received in an orderly transaction for the asset at the measurement date (an exchange price notion).

► Not the price that would be received in a fire sale or forced liquidation transaction.

► A fire sale is one that compels market participants to transact under duress with little or no exposure to the market.

► Orderly transaction is one that involves market participants that are willing to transact and allows for adequate market exposure.

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FASB Statement No. 157 Explained

Level 1 inputs – Quoted prices from active markets for identical assets or liabilities.►Ideal: such inputs are objectively determined and verifiable, like a closing stock price listed in the WSJ.

►It’s the most reliable evidence of fair value and should be used whenever available.

Firms disclose information about the quality of the fair values reported according to the fair value hierarchy

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FASB Statement No. 157 Explained

Level 2 inputs – Observable inputs other than Level I quoted prices:

►Quoted prices in active markets for similar assets or liabilities.

►Quoted prices for identical or similar assets or liabilities in markets that are not active, (i.e., markets with little liquidity, stale prices, wide variations in quoted prices among market makers, or little public information).

►Observable inputs other than quoted prices (such as yield curves, volatility measures, or prepayment speeds).

►Inputs derived principally from observable market data by correlation or other means.

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FASB Statement No. 157 Explained

Level 3 inputs –Unobservable inputs for an asset or liability to be measured at fair value. These are to be used when observable inputs aren’t available; they are the bottom of the fair value hierarchy. Often referred to as “mark-to-model” valuation inputs:

►To be used on the best information available; may be the reporting firm’s own data.

►Whenever possible, should be adjusted to reflect assumptions of a market participant.

►Significant judgments involved.

FASB Statement No. 157 Explained

The fair values used must reflect the point of view of market participants.

►The principal market is the one with the greatest volume and level of activity for the item.

►The most advantageous market is the one where the reporting firm would maximize the amount received for an asset or minimize the amount paid to transfer a liability, taking into account transaction costs.

►Market participants are presumed to be:

- Independent of the reporting entity (no related parties) - Knowledgeable, having a reasonable understanding

about the asset or liability

- Able to transact for the asset or liability

- Willing to transact for the asset or liability; no force or compulsion on their part

“Market Participants”

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FASB FSP 157-4 Fair Value Measurement and Disclosures

►Clarifies the approach to, measuring fair value when there has been a significant decrease in market activity and quoted prices are associated with transactions are not orderly.

►Retains the existing “exit price” concept under FAS 157 and therefore does not change the objective of a fair value measurement, even when there has been a significant decrease in market activity.

►Increases the required frequency (from annual to quarterly) of disclosures of the fair values of financial instruments that are not carried on the balance sheet at fair value.

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Fair Value when Volumes and Levels of Activity has Significantly Decreased

►Should consider the volume and level of activity in the market which the input is observed.

►Provides further guidance in identifying whether the volume and level of activity have significantly decreases, in relation to normal market activity.

►When the entity concludes there has been a significant decrease, the guidance indicates that a single transaction or quoted price may not be determinative of fair value.

►Further analysis is needed and a significant adjustment to a quoted price may be necessary to estimate fair value in accordance with FAS 157.

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Factors to Consider in Determining Significant Decreases

►There are few recent transactions

►Price quotations are not based on current information

►Indices previously correlated are demonstrably uncorrelated

►Significant increase in implied liquidity risk premiums, yields, or performance indicators for observed transactions or quoted prices when compared with the entity’s estimates of expected cash flows

►Significant decline or absence of a market for new issuances

►Little information released publically

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Identifying Transactions that are not Orderly

► Even when an entity determines that there has been a significant decrease in the volume and level of activity, it is not appropriate to conclude that all transactions are not orderly.

► Circumstances that may indicate a transaction is not orderly:

- Not adequate exposure to the market for a period before the measurement date to allow marketing activities

- There was a usual and customary marketing period, but the seller marketed the asset or liability to a single market participant

- The seller is in near bankruptcy or receivership or the seller was required to sell to meet regulatory or legal requirements (forced)

- The transaction price is an outlier when compared with other recent transactions

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Evaluating Observable Transaction Prices

► Transaction is not orderly —If the weight of evidence indicates the transaction is not orderly, an entity is required to place little, if any, weight (compared with other indications of fair value) on that observable transaction price

► Transaction is orderly —If the weight of evidence indicates the transaction is orderly, an entity is required to consider that observable transaction price when estimating fair value. Amount of weight depends on the facts and circumstances of the transactions, such as the:

- Volume of the transaction

- Comparability of the transaction to the asset or liability being measured

- Proximity of the transaction to the measurement date

► Insufficient information to conclude - Required to consider that transaction price when estimating fair value. Less weight placed on these transactions

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New Guidance for Other-Than-Temporary Impairments FSP 115-2

►Revises the recognition and reporting requirements for other-than-temporary impairments of debt securities

►Expands and increases the frequency of disclosures for debt and equity securities

►Calendar-year companies can apply the new guidance in the first quarter 2009, and are required to apply it no later than the second quarter 2009

►Some financial institutions may receive regulatory capital relief as a result of recognizing only the credit-related component of OTTI charges through earnings

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Key Provisions and Changes 115-2

►Prior to issuance of FSP 115-2, impairments of investments in debt and equity securities classified as available-for-sale (AFS) or held-to-maturity (HTM) were evaluated on the basis of whether the entity could assert the ability and intent to hold the investment until a recovery of fair value.

►If an entity was unable to make the assertion of holding, the impairment was considered to other-than-temporarily impaired and the cost basis was written down to fair value through earnings.

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Changes to Existing Guidance 115-2

►“Ability and intent to hold” provision is eliminated.

►Impairment is now considered to be OTTI if an entity:

- Intends to sell the security- More likely than not will be required to sell the security

before recovering its cost- Does not expect to recover the security’s entire

amortized cost basis (even if the entity does not intend to sell).

►The “probability” standard relating to the collectibility of cash flows is eliminated. Impairment is now considered to be other than temporary if the present value of cash flows expected to be collected from the debt security is less than amortized cost.

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Changes to Existing Guidance 115-2

► If intend to sell an impaired debt security or more likely than not will be required to sell—the impairment is other than temporary and the difference between cost and fair value written down through earnings.

► If a credit loss exists, but the entity does not intend to sell or is not more likely than not to be required to sell, the impairment is other than temporary and is separated into:

- The estimated amount related to the credit loss- The amount relating to all other factors

Only the estimated credit loss amount is recognized in earnings, with the remainder of the loss recognized in other comprehensive income

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Changes to Existing Guidance 115-2

► For held-to-maturity securities, the portion of OTTI not related to credit loss will be in a new category of other comprehensive income and amortized over the remaining life of the debt security as an increase in the security’s carrying amount.

► Disclosures are expanded:

- Amortized cost basis of AFS and HTM securities by type

- Methodology and key inputs used to measure the credit portion of OTTI by major type of security

- Roll forward of amounts recognized in earnings for debt securities for which an OTTI has been recognized and the non-credit portion of the OTTI that has been recognized in other comprehensive income

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OTTI Working Example

CostBasis

FairValue

EstimatedCreditLosses

InvestmentClassification

Ability andIntent to

Hold UntilRecovery

Intend toSell BeforeRecovery

More LikelyThan Not to

Sell PriorTo Recovery

BalanceSheet

OCI Earnings BalanceSheet

OCI Earnings

Debt SecurityU 100.0 70.0 - AFS Yes No No 70.0 (30.0) - 70.0 (30.0) -V 100.0 70.0 - AFS No No No 70.0 - (30.0) 70.0 (30.0) -W 100.0 70.0 - HTM Yes No No 100.0 - - 100.0 - -X 100.0 70.0 (10.0) AFS No No Yes 70.0 - (30.0) 70.0 - (30.0)Y 100.0 70.0 (10.0) AFS Yes No No 70.0 - (30.0) 70.0 (20.0) (10.0)Z 100.0 70.0 (10.0) HTM Yes No No 70.0 - (30.0) 70.0 (20.0) (10.0)

Total 700.0 490.0 (30.0) 450.0 (30.0) (120.0) 450.0 (100.0) (50.0)

Prior Basis New Basis

Source: Fitch

Questions

Questions/Comments