Late last week, following an extensive outcry and aggressive write-in campaign by bankers, the Financial Accounting Standards Board (FASB) finally modified its rules on "other than temporary impairment" (OTTI). All hail the bean counters.
There are two key aspects to the modifications worthy of discussion at this point related to OTTI and "fair value." The first, OTTI, states that securities need to be marked to market and that continues under the modified rule. In addition, if the bank has the intent to sell a security, then the bank should record the full market loss in earnings. If, however, the bank has no intent (or requirement) to sell the security, then it should record the estimated credit loss portion in earnings and the noncredit portion in "other comprehensive income" (OCI). This change allows banks to split credit losses from non-credit losses (such as a decline in value due to interest rates or low liquidity). By booking the difference between credit losses and mark to market losses in OCI, the income statement only includes the amount of impairment that is likely to be realized. In short, changes were designed to better reflect the difference between the fair value and the carrying value of impaired assets.
The change to OTTI is a mostly a good one for bankers, since it should serve to stabilize earnings and boost capital. The rules will have the most significant positive impact on larger banks (because they have a plethora of toxic assets) who will now be able to revalue the carrying amount of their toxic securities. The changes essentially eliminate the need for banks to write down assets they intend to hold to maturity, so that in turn, should help stabilize regulatory capital (since it is also supported by earnings). Experts predict the all-in impact of the change on large banks could be as much as a 10% increase in capital. In addition, banks that made purchase-accounting acquisitions and marked assets/liabilities very conservatively could also benefit.
The second key aspect to the rule change relates to "fair value." As part of the change, banks can use judgment in estimating market values when markets are illiquid or inactive. This allows banks to use modeled cashflows (such as present value of future cash flows) to estimate value, instead of relying solely on market price quotes during a stressed period. This change should also help banks since it eliminates the impact of being forced to use "fire sale" values when the market is under strain. Bankers should be sure they incorporate additional procedures, document evaluation processes, conduct model testing and improve disclosures as may be needed, to ensure compliance is adequate.
A few other important things bankers should know as a result of these modifications are: the rules are effective in the 2Q, but can be adopted in the 1Q if the bank so chooses; market losses are still required to be calculated and reported as they always have been for Held to Maturity securities (i.e. the new rule does not apply to HTM securities); fair value disclosures under SFAS 107 (disclosures about fair value of financial instruments) that were required on an annual basis must now be reported quarterly.
We consider this a "win" and it should raise the prestige of bean counters everywhere.