Practical Aspects of Fair Value Measurements The Impact of FAS 157 on Credit Unions

Practical Aspects of Fair Value Measurements

The Impact of FAS 157 on Credit Unions

October 21, 2008

Fair Value Measurements and Disclosures

Presenter:

Douglas Winn, Wilary Winn, LLC


Agenda

Summary of Principles – FAS 157 and 159

Fair Value Hierarchy

Significant Changes from Existing Standards

Implementation Process and Challenges

Required Disclosures

Questions and Answers


Objective of FAS 157

To define fair value, establish a framework for measuring fair value

and expand disclosures about fair value.

Scope

Applies to other accounting pronouncements that require or permit

fair value measurements except:

Share-based transactions

Practicality exceptions

Pronouncements requiring measurements similar to fair value


Timing

Effective for years after 11/15/07 for financial assets and

liabilities

Implementation for nonfinancial assets and liabilities has

been deferred for one year, except for those that are

recognized or disclosed at fair value in the financial

statements on a recurring basis (at least annually).


Examples of Items Deferred

Nonfinancial assets and liabilities initially measured at

fair value in a business combination that are not subject

to fair value measurement subsequently

Indefinite-lived intangible assets


Examples of Items Not Deferred

Financial assets and liabilities measured at fair value under a

business combination

Instruments within the scope of FAS 107

Impaired-collateral dependent loans measured for impairment under

FAS 114

Servicing assets and liabilities

Eligible items under FAS 159 including:

Financial and nonfinancial derivatives

Written loan commitments and best efforts forwards


Implementation Steps

Determine assets and liabilities that will be required to be measured and

reported at fair value – remember that FAS 157 is “principles” based not

“rule” based like FAS 133

Identify the principal or most advantageous market

Identify the valuation premise

Identify market participants

Determine the appropriate valuation techniques

Prepare appropriate disclosures


Implementation Discussion Items

Investments

Loans receivable

Impaired Loans

Mortgage Servicing Rights – FAS156

Mortgage Lending Derivatives

Shares


FAS 157 Key Terms

Fair Value: The price that would be received to sell an asset or transfer a

liability in an orderly transaction between market participants at the

measurement date (exit price).

Asset or Liability: The measurement is for a particular asset or liability.

Orderly transaction: A transaction that assumes exposure to the market for a

period prior to the measurement date to allow for marketing activities that

are usual and customary for transactions involving such assets and

liabilities; it is not a forced transaction.

Market participants: Buyers and sellers in the principal (or most

advantageous) market


Principal vs. Most Advantageous

Principal – The market in which the reporting entity would sell the

asset or transfer the liability with the greatest volume and level of

activity for the asset or liability.

Most Advantageous – The market in which the reporting entity would

sell the asset or transfer the liability with the price that maximizes

the amount that would be received for asset or minimizes the

amount paid to transfer the liability, considering transaction costs.


Valuation Techniques

Market Approach – Quoted prices in active markets for identical or

comparable assets or liabilities

Can include matrix pricing

Income Approach – Techniques to convert future amounts to a single

present amount.

Can include present value, option-pricing, and multi-period excess

earnings

Cost – replacement cost – does not apply to financial assets and liabilities


Valuation Inputs

Observable inputs – inputs from independent sources on what

market participants would use

Unobservable inputs – entity’s own assumptions about the

assumptions market participants would use


FAS 157 Fair Value Hierarchy

Level 1 – Quoted prices in active markets for identical assets or

liabilities

Level 2 – Observable inputs other than quoted prices

Level 3 – Unobservable inputs



Level 1 – Quoted prices in active markets for identical assets or

liabilities.

Most reliable measure and should be used whenever possible



Level 2 – Observable Inputs

Quoted prices for similar assets or liabilities in active markets.

Quoted prices in markets that are not active (e.g. few transactions, prices

not current, price quotations vary, little public information, etc.)

Observable inputs such as interest rates and yield curves observable at

commonly quoted intervals, volatilities, prepayment speeds, credit risks,

default rates, etc.

Market-corroborated inputs


FAS 157 FSP 157-c Measuring Liabilities

Clarifies FAS 157

Issue – Potential lack of observable markets or observable inputs for

the transfer of a liability because in most cases an entity

extinguishes a liability by settling it.

FSP states that in the absence of a quoted price in an active market,

an entity may measure the fair value at the amount it would receive

if it were to issue the liability at the measurement date.


FAS 157 Significant Changes

Use of an exit price versus an entry price.

Transaction costs are expensed if initial measurement is at fair value.

Entity’s own credit risk must be considered when measuring the fair value of

liabilities – nonperformance risk.

Fair value of a block of financial instruments traded in an active market is

“price X quantity”. No block adjustments.


FAS 159 – Fair Value Option for Financial Assets and Liabilities

Permits entities to elect to measure eligible items at fair value

May be applied instrument by instrument, with certain exceptions

Election is irrevocable

May not be applied to portions of instruments

Effective for fiscal years beginning after November 15, 2007


FAS 159 – Eligible Items

Financial assets and financial liabilities

A firm commitment involving only financial instruments (e.g. best efforts

forward sales contract)

Written loan commitments

Insurance contracts, warranty agreements and host financial instruments

resulting from the separation of a nonfinancial derivative from a nonfinancial

hybrid instrument


FAS 159 – Ineligible Items

Consolidated investments in subsidiaries

Consolidated interests in variable interest entities

Employers’ and plans’ obligations for employee benefit obligations,

employees stock options and other deferred benefit compensation

arrangements

Financial assets and liabilities recognized under leases

Deposit liabilities, withdrawable on demand

Financial assets classified under shareholder’s equity


FAS 159 – Election Dates

When the entity first recognizes the eligible item

When the entity enters into an eligible firm commitment

Specialized accounting principles for a financial asset cease to apply

The accounting treatment for an investment in another entity changes and

ceases to apply (e.g. an investment must now be accounted for on the

equity method)

An event that requires fair value accounting at inception but does not

require re-measurement at each subsequent reporting date (e.g. business

combination – FAS 141R)


FAS 157 Effect on Existing Standards – Relevant Changes

EITF 02-03 Initial measurement of derivatives

APB 21 Interest on Receivables and Payables

FAS 15 Troubled Debt Restructurings

FAS 65 Mortgage Banking Activities

FAS 107 Fair Value Disclosures

FAS 114 Impaired Loans

FAS 115 Investments in Debt and Equity Securities

FAS 133 Derivatives

FAS 140 Transfers and Servicing

FAS 141 Business Combinations

FAS 142 Goodwill

FAS 156 Servicing


Summary of Credit Union Assets

Cash 9%AFS investments 8%Other investments 11%1st mortgages 22%Other real estate loans 12%New car loans 11%Used car loans 11%Other loans 11%Other assets 5%

100%


Investments

Equity securities with a “readily determinable fair

value” under FAS 115 must be recorded at fair

value as either a “trading security” or as available

for sale

Debt securities can also be recorded at fair value

as a “trading security”, as an “available for sale”

security or as “held to maturity”


Investments

Trading or AFS securities are subject the measurement

and disclosure requirements of FAS 157

Held to maturity securities are not within the scope of the

FAS 157 disclosure requirements. However, the fair

value and unrealized gains and losses for disclosures

required under FAS 115 must be measured in

accordance with FAS 157


Impaired Investment Securities

An investment security is considered impaired if its fair

value is less than its cost.

If a security is impaired, the institution must determine if

the impairment is temporary or other than temporary

Important to determine if the security is to be evaluated

for OTTI under FAS 115 (generally) or EITF 99-20

(below AA rated securities in ABS transactions)



A security is temporarily impaired under FAS 115 if the

institution determines that:

The security will recover its fair value;

The recovery period can be reasonably estimated; and

The recovery period will not adversely affect the

institution’s ability to manage liquidity risk



A security is other than temporarily impaired if the

institution determines that:

The institution will be unable to collect all of the interest

payments and outstanding principal owed or

The required recovery period will adversely affect the

institution’s ability to manage liquidity risk



To determine if a security is temporarily or other than temporarily

impaired the institution must consider:

The severity and duration of impairment

The historical and implied volatility of the security

Recoveries or additional declines in fair value

The financial condition and near-term prospects of the issuer

Whether the market decline was security specific or caused by

macroeconomic conditions


Loans Receivable

Real estate loans

Auto loans

Mortgage loans held for sale


Real Estate Loans – Key Valuation Assumptions

Interest rate – fixed or variable

Contract term – balloons, hybrids, etc.

Lien position

Closed or open ended

Source – retail versus wholesale

Underwriting – including credit score and advance rate

Prepayment rate

Default rate

Loss severity


Auto Loans – Key Valuation Inputs

Interest rate

Contract term

Source – direct versus indirect

Underwriting – including credit score and advance rate

Prepayment rate

Default rate

Loss severity


Troubled Debt Restructurings – Measuring Impairment

Present value of expected future cash flows discounted

at the loan’s effective interest rate

Loan’s observable market price

Fair value of collateral if loan is collateral dependent

The latter two alternatives are viewed as practical

expedients


Mortgage Loans Held for Sale

FAS 65 amended – loans are to be measured at the lower of cost or

fair value (not market)

Can elect under FAS 159 to account for loans at fair value, which

we generally recommend – level 2 in hierarchy

Entity could also elect FAS 133 fair value hedge, which we believe

is unnecessarily complex to accomplish same purpose


Mortgage Servicing Rights (MSRs)

Servicing is inherent in all financial assets and becomes a

distinct asset or liability in one of three circumstances:

Results from a transfer of assets that meets “sale”

accounting

Results from a transfer to a QSPE

Is acquired or assumed and not related to the

financial assets of the servicer


MSR Asset vs. MSR Liability

Benefits of servicing are expected to exceed “adequate compensation” as

determined by the marketplace – if they do not then a “servicing liability”

exists

Adequate compensation is based on the specified servicing fees and other

benefits demanded in the marketplace to perform the servicing

Servicing assets and liabilities are initially recorded at their fair value

Servicing assets and liabilities must be reported separately

An servicing asset can become a servicing liability over its life and vice

versa


Mortgage Servicing Rights

FAS 156 requires that servicing rights be initially recorded

at their fair value (not relative fair value) in accordance

with FAS 157

Industry believes MSRs are Level 2 or Level 3 assets

based on a discounted cash flow model


How to account for the MSR after initial recording?

The ongoing accounting depends on the methodology selected to

measure the asset. FAS 156 allows the asset to measured in one of two

ways:

1) Amortization Method

2) Fair Value Method

An institution may select either method, but cannot switch methodologies

unless it moves to the Fair Value method at the beginning of the fiscal year.

It cannot go back to the Amortization method after it has elected Fair Value.


Required disclosures under FAS 156

1) Management’s basis for determining classes of servicing assets and

liabilities

2) Description of risks inherent in the servicing asset and liabilities and

instruments used to mitigate this risk in the income statement

3) The amount of servicing fees, late fees, and ancillary fees earned,

including a description of where each item is reported on the income

statement


Additional disclosures for Fair Value Methodology under FAS 156

The change in the carry amount of the asset including:

1. Beginning and ending balances

2. Additions to the asset

3. Disposals

4. Changes in fair value resulting from:

a. Changes in valuation inputs or assumptions used in the model

b. Other changes in fair value and a description of those changes

5. Other changes that impact the balance and a description of those changes

A description of the valuation techniques used to estimate the fair value


Mortgage Banking Commitments

Interest Rate Lock Commitments (IRLCs)

Forward Loan Sales Commitments


IRLCs

Agreements under which a lender agrees to extend credit to a borrower under certain

terms and conditions in which the interest rate and maximum amount of the loan are

set prior to funding.

IRLCs for mortgage loans to be held for sale are derivatives

Three accounting changes:

Prior guidance required initial valuation to be zero – FAS 157 requires fair value

Prior guidance required that the value not include the value of the servicing right

– the opposite is now required

Origination revenues and costs were capitalized – they are now recognized as

generated or incurred


Valuation of IRLCs

Primary components:

Projected sales price of the loan based on market

interest rates

Projected fallout rate

Decay in the value of the borrowers option due to the

passage of time

Remaining origination costs to be incurred


IRLCs Valuation Example

Rates up Loan at Rates down Loan Loan at

Inception 50 bp Processing 100 bp Approved Close

Loan amount A 100,000$ 100,000$ 100,000$ 100,000$ 100,000$ 100,000$

Lock in interest rate 6.375% 6.375% 6.375% 6.375% 6.375% 6.375%

Market interest rate 6.375% 6.875% 6.875% 5.875% 5.875% 5.875%

Market value w ith servicing B 102.75% 100.75% 100.75% 104.75% 104.75% 104.75%

Servicing Value 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%

Origination costs to be incurred C 1.00% 1.00% 0.50% 0.50% 0.00% 0.00%

Price to borrow er D 100.50% 100.50% 100.50% 100.50% 100.50% 100.50%

Value as percent of loan (1) E 1.25% -0.75% -0.25% 3.75% 4.25% 4.25%

Dollar value A * E F 1,250.00$ (750.00)$ (250.00)$ 3,750.00$ 4,250.00$ 4,250.00$

Pull through percentage G 30.00% 45.00% 60.00% 60.00% 80.00% 100.00%

Derivative Value F * G 375.00$ (337.50)$ (150.00)$ 2,250.00$ 3,400.00$ 4,250.00$

Amount recorded 375.00$ (712.50)$ 187.50$ 2,400.00$ 1,150.00$ 850.00$


IRLC Journal Entries Income

Description Debit Credit Statement IRLC Cash Warehouse

IRLC A 375$ 375$

Origination income 375$ (375)$

Record initial value

Origination expense B 500$ 500$

Cash 500$ (500)$

Record origination costs

IRLC C 3,875$ 3,875$

Gain on IRLC 3,875$ (3,875)$

Record changes in value

Origination expense D 500$ 500$

Cash 500$ (500)$

Record origination costs

Warehouse loan E 104,750$ 104,750$

IRLC 4,250$ (4,250)$

Cash 100,500$ (100,500)$

Record loan funding

110,000$ 110,000$ (3,250)$ -$ (101,500)$ 104,750$

Journal Entries


IRLCs

Derivative asset and derivative liability

In general, cannot be offset for accounting purposes

Level 3 in hierarchy


Forward Sales Commitments

Mandatory forward sales commitments are derivatives

and are accounted for at fair value

Best efforts sales commitments are not derivatives

Can elect to account for them at fair value


Forward Sales Commitments

Derivative asset and derivative liability

In general, cannot be offset for accounting purposes

Level 2 in hierarchy


Summary of Credit Union Liabilities and Equity

Interest payable 4%Share drafts 9%Regular shares 23%Money market shares 14%Share certificates 28%Other shares 10%Other liabilities 1%Equity 11%

100%


Share drafts, regular shares, money market shares

Fair value is the amount payable on the reporting date

Core deposit intangibles are not included, it is a

separate asset the recognition of which has been

deferred under FAS 157


Share Certificates

Interest rate

Term

Early redemption

Discount rate


FAS 157 Required Disclosures for Each Major Category of Assets and

Liabilities The fair value at the reporting date

The level within the fair value hierarchy

For level 3 items, a reconciliation of beginning and ending balances attributable to the following:

Total gains or losses for the period (realized and unrealized) segregating those gains and

losses included in earnings, and a description of where they are reported in the income

statement

Purchases, sales, issuances and settlements (net)

Transfers in or out of Level 3

The amount of gains and losses from level 3 items that are still held and where they are reported

on the income statement

Valuation techniques used and discussion of changes if any


Total Carrying

Amount in Statement

of Financial

Position at 12/31/08

Statement 107 Fair Value

Estimate

Assets / Liabilities Measured

at Fair Value at 12/31/08

Quoted Prices in

Active Markets

for Identical

Assets Level 1

Significant Other

Observable Inputs Level

2

Significant Other Un-

observable Inouts Level 3

Available for Sale Securities 75 75 75 60 15 -

Securities Held for Investment 125 135 50 - 50 -

Auto Loans 100 110 - - - -

Mortgage Loans Held for Sale (a) 165 165 165 - 165 -

IRLCs 20 20 20 - - 20

B/E Forward Sales Commitments (a) (15) (15) (15) - (15) -

Long Term Debt (50) (55) (40) - (40) -

(a) Elected to measure and report at fair value

Disclosures Example for Items Measured and Reported on a Recurring Basis


IRLCs - Level 3

Beginning Balance 10

Total gains or losses (realized/unrealized) 1

Issuances and Settlements 9

Tranfers in and/or out of Level 3 -

Ending Balance 20

Unrealized gains or losses for items still outstanding at December 31, 2008 1


Required Disclosures for Assets and Liabilities Measured at Fair Value

on a Nonrecurring Basis (e.g. impaired assets)

The fair value at the reporting date and the reasons for the measurements

The level within the fair value hierarchy

For level 3 items, a description of the inputs used and the information used

to develop them

Valuation techniques used and discussion of changes if any


Required Disclosures – FAS 157-2

The fact that the entity has only partially adopted FAS

157 as a result of electing the deferral

Each major category of assets and liabilities recognized

or disclosed at fair value amounts that were not

measured in accordance with FAS 157


Required Balance Sheet Disclosures – FAS 159

Must separately report items measured at fair value

Reasons for electing fair value

Reasons for not electing fair value for similar items

For each line item on the balance sheet that includes fair value items:

Information to show how the line item relates to FAS 157 and 107 disclosures

The aggregate carrying amount of items included in the line item ineligible for the fair value

option

The difference between the aggregate fair value and aggregate unpaid principal balance of:

Loans and long-term receivables (except FAS 115 securities) for which the option has been

elected

Long-term debt instruments for which the fair value option has been elected

Certain additional information for instruments that would have been reported under the equity

method and loans that are 90 days or more past due


Required Income Statement Disclosures – FAS 159

Gains and losses from changes in fair value included in earnings

Description of how dividends and interest are measured and where they are

reported

For loans and other receivables – gains and losses arising from changes in

instrument specific credit risk and how the credit risk gains and losses were

determined

For liabilities with fair values that significantly changed – gains and losses

arising from changes in instrument specific credit risk, qualitative information

about the reasons for the changes, and how the credit risk gains and losses

were determined


Implementation Challenges

Process capabilities – especially re capture of recurring

level 3 data

Determining level 1, 2 or 3 – discuss with your auditors

FASB’s Valuation Resource Group is working on issues

but does not release minutes


Auditing Fair Value

PCAOB Staff Audit Practice Alert No. 2 – Auditing Fair

Value Measurements and the Use of Specialists

Four major areas:

1. Auditing fair value measurements

2. Fair value hierarchy classifications

3. Use of specialists

4. Use of pricing services


Auditing Fair Value Measurements

Obtain understanding of client’s fair value processes

Evaluate reasonableness of assumptions, including

consistency with market information

Consider whether reliance on historical information is

justified – be especially careful re level 3 inputs

Determine if client has applied methodologies

consistently


Auditing Fair Value Hierarchy

Consider incentives to inappropriately classify – level 2

when it should be level 1 thereby allowing more

discretion or judgment


Auditing Fair Value

Use of specialists – when to use

Does auditor have necessary skill and knowledge Significant use of unobservable inputs Complexity of the valuation technique Materiality of the fair value measurement


Auditing Fair Value

Using the work of a specialist

Obtain understanding of the methods and

assumptions used

Make appropriate tests of data provided to specialist

Evaluate whether the specialist’s findings support the

assertions in the financial statements

Evaluate the specialist’s qualifications


Auditing Fair Value

Use of pricing services

Determine nature of information provided

Active market, observable inputs, mark to a model

Adjust audit procedures accordingly including gaining an

understanding of the model and input assumptions

Price based on principal or most advantageous market

Is the price provided by the service realizable?


Questions?

Practical Aspects of Fair Value Measurements The Impact of FAS 157 on Credit Unions

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