FASB Votes To Propose Additional Guidance on Fair Value In Inactive Markets, Distressed Transactions
March 16, 2009
FEI Summary
At its board meeting on March 16, 2009, the Financial Accounting Standards Board voted to release Proposed FSP FAS 157-x (‘x’ will be assigned a letter by FASB when released) on Determining Whether a Market is Not Active and a Transaction is Not Distressed. Following is a detailed summary of the board meeting. NOTE: FEI's detailed summaries are normally available only to FEI members; this summary is being made available to demonstrate one of the benefits of FEI membership, along with our networking, education, and advocacy activities. Join FEI by April 6 and you can attend our Summit Conference May 4-6 at the Gaylord Texan Resort in Grapevine, Texas for free. See contact info at the bottom of this summary if you'd like to request more information.
Two-Step Model Proposed
To address the concern - which FASB noted it heard anecdotally it heard from its Valuation Resource Group and others - that there is a bias to use last transaction price, or to use an imputed liquidity discount derived from a last transaction price, potentially due to a belief that it is difficult to affirmatively ‘evidence’ that a transaction is ‘distressed,’ FASB decided today to effectively ‘flip’ the thought process to presume that transactions in inactive markets are distressed, unless two factors are met that indicate the transaction is not distressed.
The two step model being proposed by FASB to determine first, whether a transaction is taking place in an inactive market, and second to determine whether it is a distressed transactions is:
Step One: Determine whether there are factors present that indicate that the market for the asset is not active at the measurement date [factors listed below] If the answer to this question is yes (i.e. inactive market, then go to step two.
Step Two: Evaluate the quoted price (that is, a recent transaction or broker price quotation) to determine whether the quoted price is not associated with a distressed transaction. The reporting entity shall presume that the quoted price is associated with a distressed transaction unless the reporting entity has evidence that indicates that both of the following factors are present for a given quoted price [see factors listed below].
Factors to consider in determining if market is not active (step one)
The list of factors to be considered in step one, taken from the board handout, is as follows:
- Few recent transactions (based on volume and level of activity in the market). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
- Price quotations are not based on current information.
- Price quotations vary substantially either over time or among market makers (for example, some brokered markets).’
- Indices that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.
- Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared to reasonable estimates of credit and other nonperformance risk for the asset class.
- Significant widening of the bid-ask spread.
- Little information is released publicly (for example, a principal-to-principal market).
During the meeting, board members noted the list above is not necessarily all inclusive. In a change from the board handout, when considering the above factors, FASB board members agreed to remove the words “sum of” which had appeared immediately before the words “the evidence” in a sentence immediately below the list of factors in paragraph 10 of the board handout. With the change agreed to at the FASB meeting, the sentence now says: “If after evaluating all the factors the evidence indicates that the market is not active, the reporting entity shall apply step 2.”
Factors to consider in determining if a transaction is NOT distressed (step two)
FASB agreed that transactions taking place in inactive markets (as determined under step one above) are assumed to be distressed, unless both of the factors below are present, (as shown in the board handout):
a. There was a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities (for example, there was not a regulatory requirement to sell), and
b. There were multiple bidders for the asset.
Proposed Effective Date
The proposed effective date will be interim and annual periods ending after March 15, 2009. Board members debated whether some constituents may say it is not practicable to adopt the new standards that quickly, and considered as an alternative whether to propose an effective date further out, such as second quarter 2009, with earlier adoption permitted. The board agreed to propose the March 15 effective date (interim and annual periods ending after March 15), and to include a question in the Notice to Recipients section of the proposal as to the practicability of that effective date.
Additional Highlights From FASB Discussion of Proposed FSP FAS 157-x
Background:
FASB board and staff members noted they have heard anecdotally, from their Valuation Resource Group and others, that in implementing the three level hierarchy in FAS 157, Fair Value Measurement – even in distressed markets – that there is a bias in practice to use the ‘last transaction price’ as an indicator of a market-participants exit price, to determine fair value.
As noted in the board handout, “Constituents have indicated that this … has resulted in the significant write downs in asset values that are not grounded in economic reality.”
Additionally, FASB board members noted their intent in issuing FSP FAS 157-3 last fall (Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active) was not fully met, because, as noted in the board handout, “the FSP [157-3] indicates that market participant liquidity risk must be considered [and] … many have interpreted that to mean that entities must use the liquidity risk implied in the last transaction price, since it is argued that there is no better indicator of market participant liquidity risk.”
Today’s Proposal Consistent with FAS 157
FASB Board Member Leslie Seidman noted that the objective of the Proposed FSP being discussed today was: “To emphasize that FAS 157 already says, right now, a price from a forced sale or distressed transaction does not represent fair value. What we are talking about here is, how do I know if I have one of those, and if I do have one of those, what do I do. So, what we are talking about is consistent with the standard, we are trying to provide [operational] guidance.” She continued, “Even after you have identified a distressed transaction, your objective is still to estimate a fair value that represents exit price… your objective should not be to derive a fair value [using] a transaction price that we just decided is distressed… to estimate an exit price.” FASB Board Member Tom Linsmeier added, “And to emphasize, exit price in an orderly market, not in a market that is distressed.”
Adjustments To Quoted Prices Should Be Considered In Certain Circumstances, Even if Not Meeting the Two-Step ‘Distressed’ Test
In accordance with FAS 157 (as explained at the board meeting), as detailed in paragraph 11 of the board handout, just because a transaction is not deemed ‘distressed’ under the two step model above does not necessarily mean that some adjustment to a quoted price should not be made. Specifically, para. 11 of the board handout states (board members pointed out it is stated as a double negative in the board handout; we have reformatted with bullets and highlighting, but words are from the board handout)
- If the reporting entity has evidence that both of the factors are present for a given quoted price, then that quoted price is presumed not to be associated with a distressed transaction.
- In that case, the quoted price may be a relevant observable input that shall be considered in estimating fair value.
- However, the reporting entity should consider whether any other factors or conditions warrant making an adjustment to the quoted price (see [FAS 157] paragraph 29).
- For example, if a quoted price that is not associated with a distressed transaction is not current or is a consequence of a trade with an insignificant volume relative to the total market for that asset, the reporting entity should consider whether that quoted price is a relevant observable input (that is, whether the quoted price requires adjustment).
‘An Observed Distressed Price Is Not Level 2,’ Proportion of Level 3 Assets May Increase
Board member Tom Linsmeier noted, “In some respects, I was frustrated by what happened in Congress last Thursday, [my] frustration was an assertion [made that] we had done nothing in recognition of these issues over time, and that is absolutely not the case, in October we issued guidance that reminded people fair value was the amount in an orderly transaction, not a distressed transaction/circumstance.” He added, “What I think has happened in that time period [since October when FSP 157-3 was issued] is the ability to do that was challenged partly by ability to prove transaction was distressed, I also believe there were factors in the system that people [did not] want to do the work to estimate an orderly transaction price… it is easier to use [market price] or broker quote… [and] for.. maybe auditing, liability issues. .. some factors caused people not to do the work,” [i.e., to rely on a last transaction price or dealer quote as easier or as better evidence as it represented a third party quote.]. He continued, “What we are doing is reiterating what we said last October, provide evidence, in which you do not have to do work if you can prove transaction is not distressed, otherwise you have to do an adjustment, so this is consistent with what we did last October.. .and forcing [people] to think about orderly transactions more thoroughly.”
Board member Mark Siegel said, “One surprising thing in the SEC study [SEC’s report to Congress on mark-to-market accounting, published Dec. 30, 2008], [was that in spite of] all the inactivity/illiquidity of the markets, yet a [relatively small] proportion of fair value was coming on at Level 3 [i.e. assets for which pricing inputs are determined more by methods other than just a market price, if there is no active market for the same or similar assets].” He continued, “If we are successful, [in] help[ing] identify when [transactions are] distressed, maybe more of those will be Level 3, [and we’ll] get a better expectation of cash flows.”
Board member Larry Smith noted, “There is a stigma in Level 3, therefore people are grabbing for any Level 2 quote they can find, hopefully this will make people feel better.”
Linsmeier added, “A good Level 3 is better than an observed quoted price that people might say is Level 2, but really isn’t Level 2; an observed distressed price is not Level 2.”
FASB Board member Leslie Seidman observed that she noticed the American Securitization Forum has posted some proposed best practices for disclosures, but they would not be effective until 2010. She said, It seems to me, if we are being asked to turn on the dime, it seems the only way for there to become price discovery is for market participants to have cash flow information so they have the same information as the banks… and we remove some of the uncertainty from the system, so I’d like to encourage people [i.e. the ASF] to think about a time line closer than 2010.”
FASB Chairman Robert Herz said, “I agree, I’ve been saying, part of problem is… large exploding markets, and no infrastructure that allows good price discovery, [or] clearing mechanisms.”
Linsmeier added, “Part of the thought process I went through this weekend, was trying to figure out, how can Congress and the banks and investors, with different points of view - could it be both are right?” He stated, “I actually came to the conclusion they can be. Congress and the banks telling us fair value has exacerbated the problem, investors tell us fair value is [necessary/useful].” He added that he saw Fed Chairman Ben Bernanke interviewed on 60 Minutes last night, and that Bernanke had observed the need to get private equity investing in banks. Linsmeier described how investors are currently not confident in banks’ reported Tier One capital levels, although those levels (over 11%) suggest the banks are currently well capitalized. He added, “So, what are investors doing? They are using tangible common equity.. for our largest banks, 3%, .. [which] assumes all the losses in Available for Sale (AFS) securities are real, so, there is a possibility if our fair values are too low, investors are thinking things are worse then they are, investors are not going to want to come into those banks if they believe the fair values are too low, so what we are doing now is elevating fair value to a more reasonable point, so [investors can come in there].”
However, Linsmeier added, he read a Goldman Sachs’ report last night, which talked about how long it could take to go from a peak to trough in an economic cycle, noting, “Japan took 161 months, that dragged down Main St. for a really long time… interestingly enough, Goldman Sacs said it took Sweden 39 months to get peak to trough, and we know [there was] intervention in there… The question is, in this next issue for me [looking ahead to the OTTI issue discussed separately], what do we need to do to get information out so the housing bubble bursts as quickly as possible … the question is, if we dribble and drabble the impairments out in the second one [i.e. in the OTTI proposal discussed separately], are we going to dribble and drab out…”[i.e. the impairment and the time to go through the cycle.]
Linsmeier closed: “I think we have to think about public policy as we are doing this.”
Board member Larry Smith said, “The only thing I want to add, or slightly disagree with, this goes both ways, depending where you are in a market cycle, the goal is a better calculation of fair value, and perhaps in this market, it might elevate [the value].” He added, “In inactive markets, you shouldn’t just automatically assume a transaction is a good transaction.”
The board then discussed the next agenda item, agreeing to issue a proposed FSP on other-than-temporary impairment (OTTI). Details follow.
At the end of the board meeting, as noted above, FASB Chairman Robert Herz said, “[We should] encourage people to write in, and staff should be reaching out” for additional feedback.”
Prepared March 16, 2009 by Edith Orenstein, Director, Accounting Policy Analysis, Financial Executives International. This summary is unedited, and does not represent FEI opinion unless specifically noted below. For further information about this summary or the benefits of FEI membership, contact Edith Orenstein at eorenstein@financialexecutives.org .