March 18, 2008
R. Larry Johnson
Veris Consulting, LLC
Subprime Lending
Issues of Valuation
Summary Questions
• What and how GAAP should be applied?
• Were the valuation methods appropriate?
• Were the assumptions about the future
reasonable?
• Was the need for loss recognition a result
of new information or changed
circumstances?
2
Valuation Measurements
Valuation/Impairment measurements vary
under US GAAP based on type of asset
3
The Assets and Holders
• Mortgage loans
• MBS, CDO and other
structured securities
• Sale transactions
– Servicing Rights
– Residual Interests
– Repurchase Obligations
• Municipal Bonds
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•
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Lenders
Originators
Servicers
Investors
– Banks
– Insurance Companies
– Mutual Funds
• Insurers
4
Traditional Lending Without
Securitization
Lends money secured by real estate
BANK
HOMEOWNER
Pays principal and interest
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Valuation of Mortgage Loans
• Investment
– Ability and Intent
• Impairment
– FAS 65, Accounting for Certain Mortgage
Banking Activities
• Loan loss reserves
– FAS 5, Accounting for Contingencies
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Valuation of Mortgage Loans
• FAS 5, Accounting for Contingencies:
– An estimated loss from a loss contingency
shall be accrued by a charge to income if
both of the following conditions are met:
a. It is probable that an asset has been impaired or
a liability has been incurred at the date of the
financial statements
b. The amount of loss can be reasonably estimated
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Valuation of Mortgage Loans
•
AICPA Audit and Accounting Guide, Depository
and Lending Institutions: Banks and Savings
Institutions, Credit Unions, Finance Companies
and Mortgage Companies:
–
–
FAS 5 prohibits loss recognition when events causing losses
have not yet occurred
Future losses should not be provided for at the time loans are
made
•
–
Events causing losses or impairment have not yet occurred
Generally, a loan would be impaired at origination only if a
faulty credit granting decision has been made or loan credit
review procedures are inadequate or overly aggressive, in
which case, the loss should be recognized at the date of
origination
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Valuation of Mortgage Loans
• Held for Sale
• FAS 65, Accounting for Certain Mortgage
Banking Activities:
– Shall be reported at the lower of cost or fair value,
determined as of the balance sheet date
– The amount of the reduction shall be reported as a
loss
– The carrying amount of the loan shall be reduced to
its expected collectible amount, which becomes the
new cost basis
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Valuation becomes more complex when
securitization is involved…
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The Impact of Securitization
Homeowner
Mortgage
Servicer
$$
Lender/Conduit
Mortgages
Trustee
$$
Trust (SPE)
ABS/MBS
Rating Agency
Mortgage Broker
$$
Underwriter/
Placement Agent
$$
ABS/MBS/PMI
Individuals, Pension Funds, Insurance
Companies, Mutual Funds, Hedge Funds
Financial Interests
$$
Individuals
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Insurer
Example of Calculation Model to
Value Structured Securities
•
Since the default event of each asset is uncorrelated, the probability of J
defaults in the portfolio simply follows binomial distribution
(DS: diversity score. PD: probability of default for each asset)
•
With this distribution, the expected loss (EL) for each CDO tranche can now
be calculated:
(Lj: loss for a given tranche with J defaults)
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MBS/CDO/Other Structured
Securities
• FAS 115, Accounting for Certain Investments
in Debt and Equity Securities:
– Held to maturity
• Investment carried at amortized cost: subject to
permanent impairment
– Trading
• Investment carried at fair value
• Change in value recorded in income statement
– Available for sale
• Investment carried at fair value
• Change in value recorded in equity
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Sale of Mortgages
• “True” Sale
– Gain on Sale if:
• Transferred assets isolated from transferor (SPE)
• Transferee has right to pledge or exchange the
assets
• Transferor does not retain effective control
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Sale of Mortgages
• “True” Sale
– Derecognize assets sold
– Measure assets and liabilities at fair value
– Recognize gain or loss
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New Assets/Liabilities
•
•
•
•
Servicing
Residual Interests
Repurchase Obligations
All at Fair Value
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FASB’s Road to Fair Value
Accounting
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SFAS 107 – Disclosures about Fair Value of Financial Instruments (12/91)
SFAS 115 – Accounting for Certain Investments in Debt and Equity Securities (5/93)
SFAS 119 – Disclosure about Derivative Financial Instruments and Fair Value of
Financial Instruments (10/94)
SFAS 133 – Accounting for Derivative Instruments and Hedging Activities (6/98)
SFAS 137 – Accounting for Derivative Instruments and Hedging Activities-Deferral of
the Effective Date of FASB Statement No. 133 (6/99)
SFAS 138 – Accounting for Certain Derivative Instruments and Certain Hedging
Activities (6/00)
SFAS 149 – Amendment of Statement 133 on Derivative Instruments and Hedging
Activities (4/03)
SFAS 157 – Fair Value Measurements (9/06)
SFAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities (2/07)
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FAS 157, Fair Value Measurements
• Issued September 2006
• Effective years beginning after November 15, 2007
– Early adoption permitted
•
•
•
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Defines fair value
Establishes a framework for measuring fair value
Expands disclosures about fair value measurements
FASB recognized:
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Different definitions of fair value in existing guidance
Limited guidance for applying those definitions
Guidance dispersed among many accounting pronouncements
Differences in guidance created inconsistencies that added to
the complexity in applying GAAP
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FAS 157, Fair Value Measurements
• Price that would be received to sell an asset or
paid to transfer a liability in an orderly
transaction between market participants
• Illiquid Assets
– Present value techniques
– Pricing models
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FAS 159, The Fair Value Option for
Financial Assets and Financial
Liabilities
• Permits entities to choose to measure many financial
instruments and certain other items at fair value
• Expected to expand the use of fair value measurement
• Unrealized gains and losses on items for which the fair
value option has been elected are reported in earnings
20
Valuation Requires Specialized
Knowledge
• Due to the complexity of many of the securities,
it is likely that companies and auditors will utilize
valuation experts to determine the value of the
securities
• SAS 73 provides guidance to the auditor who
uses the work of a specialist in performing an
audit in accordance with GAAS
• Provides, as an example, the valuation of
complex financial instruments
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The Limitations of Financial
Statements
• Significant estimates
• Historical in nature
• Limited ability to assess the future
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The Limitations of Financial
Statements
“Those who use financial information for business and
economic decisions need to combine information provided
by financial reporting with pertinent information from other
sources, for example, information about general economic
conditions or expectations, political events and political
climate, or industry outlook.”
“Financial information is a tool and, like most tools, cannot
be of much direct help to those who are unable or unwilling
to use it or who misuse it.”
FASB Statement of Financial Accounting Concepts No. 1, Objectives of
Financial Reporting by Business Enterprises
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The Limitations of Financial
Statements
“Changes in estimates used in accounting are necessary
consequences of periodic presentations of financial statements.
Preparing financial statements requires estimating the effects of future
events. Examples of items for which estimates are necessary are
uncollectible receivables…Future events and their effects cannot be
perceived with certainty; estimating, therefore, requires the exercise of
judgment. Thus accounting estimates change as new events occur, as
more experience is acquired, or as additional information is obtained…”
“A change in an estimate should not be accounted for by restating
amounts reported in financial statements of prior periods or by reporting
pro forma results for prior periods.”
APB Opinion 20, Accounting Changes
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Summary Questions
• What and how GAAP should be applied?
• Were the valuation methods appropriate?
• Were the assumptions about the future
reasonable?
• Was the need for loss recognition a result
of new information or changed
circumstances?
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