Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Answer to: Question 1
The objective of amortised cost measurement as stated in the exposure draft reads somewhat
confusingly as being: ‘to provide information about the effective return on a financial asset or
financial liability . . . ‘!
I recommend that the stated objective for this Exposure Draft should be described as relating to:
“The Impairment in Value of Financial Instruments measured on the basis of Amortised Cost”.
In this context, perhaps the objective of this section of the full version of the IFRS could more
usefully be re-written as:
‘to recommend how best to calculate impairment in the value of a financial instrument measured
on the basis of Amortised Cost, whether it be a financial asset or a financial liability’.
This objective, as stated, could then be helpfully supplemented by reference to the secondary
objective of using the effective return methodology as the recommended approach for measuring
the value of such financial instruments (i.e. those to be measured at amortised cost) – perhaps along
the lines of the text already incorporated into existing paragraph 1 and paragraphs 3-to-5.
Nevertheless, while the exposure draft got carried away by concentrating on the proposed
methodology rather than remaining focussed upon measurement of the impairment itself, the
proposed effective return methodology as described is unfortunately inadequate – as addressed
later in these Comments in answer to Question 4 (b) below.
Answer to: Question 2
The objective of amortised cost measurement as set out in the exposure draft again refers almost
exclusively to the effective return methodology, rather than to the value of a financial instrument as
measured using the effective return methodology.
Again, somewhat confusingly, the objective of amortised cost measurement in paragraph 3 is stated
to be to provide information about the effective return on a financial asset or financial liability –
whereas, surely, the objective of amortised cost measurement in this exposure draft should be:
‘to provide information about the value (and/or impairment in value) of a financial asset or
financial liability, as measured using the effective return methodology’.
The above re-written objective is more likely to be clear to both the layman and to the accounting
professional than that proposed in the exposure draft. This re-written objective also directly
addresses the expectations of anyone looking for guidance on how to measure the impairment in
value of financial instruments measured on an amortised cost basis.
Date: 2 June 2010
Page 1 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Answer to: Question 3
There is no objection to the underlying way in which the exposure draft emphasises measurement
principles accompanied by application guidance. There is a question, however, with the way in
which the exposure draft appears to concentrate exclusively on the methodology for measuring the
impairment of financial instruments rather than focussing upon the desired objective of the
proposed methodology – which is to determine the impairment in value of the said instruments!
Answer to: Question 4
(a) Q.4 (a) asks: “Do you agree with the measurement principles set out in the exposure draft?”
The principle is sound that with the effective return method, the amortised cost of a financial
instrument is the present value of the expected cash flows over the remaining life of the
financial instrument, discounted using the effective interest rate.
It does not necessarily follow, however, that the estimates of the cash flows should only be
expected values at each date. Similarly, the statement that the estimates of amounts and
timing of cash flows should necessarily be only the probability-weighted possible outcomes
at each measurement date is also not correct. In fact, such a provision is plainly daft when
specified as a requirement – as in the exposure draft – as it can have some potentially highly
dysfunctional consequences.
This entirely unnecessary stipulation restricts any analysis of prospective cash flows
attaching to financial instruments, as it specifies only ‘single-line’ probability-weighted cash
flows should be calculated even for those instruments which can be considered as complex.
Principal among the potentially dysfunctional consequences of this stipulation is to obscure
vital information pertaining to the inherent risks attaching to such financial instruments,
namely the probability of often potentially significant losses being incurred should the
financial instruments be held to maturity.
The current fair value standards are based on the premise that the financial markets are
both efficient and liquid and, in particular, that they are not subject to occasional significant
distortions – other than those attributable to those (supposedly few) occasions when the
markets can be considered to be illiquid. The FASB staff paper FSP 157-4, moreover, even
emphasised that when markets are illiquid, the values at which financial instruments trade
are not necessarily “not fair”, and could indeed be judged to be ‘fair’.
Regrettably, the joint SEC/FASB staff team which produced FSP 157-4, flunked the main task
set them - which was to examine the whole issue of the origins of the liquidity crisis during
Date: 2 June 2010
Page 2 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
2007 (and the subsequent financial crash in 2008), in response to a request from the
Financial Stability Forum. The SEC/FASB staff team merely confirmed the concept of fair
value as being the realisable exit price in liquid market conditions – which of course had the
effect of letting the entire banking industry ‘off the hook’ by implying that the whole crisis
could be blamed on illiquid market conditions.
As evidence of how badly wide of the mark were the conclusions of the above joint
FASB/SEC staff team, a poll of the members attending the CFA Institute’s Conference on
Efficient Markets in London during June 2009, indicated that a high proportion of these
investment professionals disagreed with the motion that the financial markets could be
regarded as “efficient” – though most acknowledged that the markets could at least be
regarded as “adaptable”. Documented in CFA UK’s magazine Professional Investor, Autumn
2009 edition, the CFA UK survey reported low levels of belief in market efficiency - with
more than two thirds of the 438 respondents believing that the markets behave irrationally.
The same proportion (67%) disagreed with the statement that market prices fully reflect all
available information.
(b) Q.4 (b) asks: “Other measurement principles that should be added, and why?”
The other measurement principle which should be added is the computationally much
simpler approach of probability-weighting the calculated final values for the large number
of possible cash flow ‘paths’.
By adopting this principle, one can preserve the information inherent within this multiplicity
of paths which then allows one to estimate the probability of experiencing, in practice, any
particular deviation from the final ‘expected’ values. Doing so, moreover, does not mean
that one must necessarily abandon calculating the expected values of the cash-flows at
every time-interval. Modern sophisticated stochastic modelling techniques enable both
approaches to be undertaken in a reproducible manner for even some of the most complex
financial instruments – with one approach helping to verify the results obtained by the other
approach.
In paragraph 8 of the exposure draft, it is stated that because the cash flow inputs are
expected values, the estimates of the amounts and timing of cash flows are the probabilityweighted possible outcomes. The fundamental flaw in this argument lies in its initial
premise, namely that the cash flow inputs are the expected values. Instead, the expected
values for each time interval are themselves comprised of the values taken from a large
Date: 2 June 2010
Page 3 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
number of different cash flows, which are the true inputs giving rise to the probabilityweighted possible outcomes!
Answer to: Question 5
(a) The exposure draft’s description of the objective of presentation and disclosure in relation to
financial instruments measured at amortised cost is not clear.
Surely the objective of presentation should relate to presenting information on the assessed
impairment losses themselves? The objective should not relate exclusively to some illdefined and confusing reference to the “information” that enables users of financial
statements to evaluate the financial effect of interest revenue and expense (which
presumably means that the users should evaluate this aspect for themselves).
Similarly, and in the above context, the objective of disclosure should relate to disclosing the
assessed credit losses. The objective of disclosure should not only refer to disclosing the
information that enables users of the financial statements to evaluate the “quality” of
financial assets, including credit risk, for themselves.
In the light of the above comments, paragraph 11 could usefully be re-written to replace the
existing text with: “An entity should present the assessed value of impairment losses
attaching to financial instruments measured at amortised cost.”
(b) Note that the replacement text recommended for paragraph 11, above, specifically excludes
reference to revaluation of financial instruments measured at amortised cost. The reason
for this is that the introduction of the possibility revaluing financial instruments measured at
amortized cost – as intimated in the following sub-paragraph 13 (d) – constitutes a
potentially dysfunctional and inappropriate recommendation.
On the other hand, for those financial instruments which are explicitly measured at fair value
under the current IFRS 9: Financial Instruments, it would be inappropriate to introduce a
restriction on their revaluation – though this consideration is outside the scope of the
exposure draft being addressed here.
Date: 2 June 2010
Page 4 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Answer to: Question 6
Whereas the line items addressed in Paragraph 13 of this exposure draft may be “nice to know”, it
does seem to be rather “over the top” to specify that they should be separately presented in the
statement of comprehensive income.
Including all these line items in the statement of
comprehensive income merely ends up obscuring the changes in value of the principal due to credit
losses.
Although changes in the value of the principal due to credit losses are specified to be shown in
paragraph 13 (d), all the other items would be better addressed in supplementary documents –
including any indication of potential gains in the value of the financial instruments were they to have
been effectively “marked to market” (in line with the recommendation which has ill-advisably been
embodied within the current exposure draft, via the current paragraph 13 (d)).
To restate: the only line item from the list contained within paragraph 13 which needs to be
included in the statement of comprehensive income is: “Losses resulting from changes in estimates
in relation to financial assets and liabilities that are measured at amortised cost”.
Answer to: Question 7
(a) Q.7 (a) asks: “Do you agree with the proposed disclosure requirements?”
The specification in paragraph 15 of mandatory use of an allowance account to account for
credit losses is a sensible requirement.
With regard to a number of the other requirements included within paragraphs 16-thro’-22,
however, there appears to be a tendency to specify information for which it is difficult to
identify its purpose (i.e. other than that the information may be “nice to know”) but which is
likely to end up merely “making work” for the preparers of the accounts, and also for their
auditors. In this context, the requirement for disaggregation of gains and losses resulting
from changes in estimates and an explanation of those changes – see paragraph 17 – could
be regarded as being “overkill”.
Similarly, paragraph 20 addresses stress testing but goes on to require the disclosure of
much information which has very little to do with establishing impairment per se.
Nevertheless it is appropriate to address why information regarding stress tests happens to
be relevant in the context of this Exposure Draft. It is relevant because the effective interest
rate method, as proposed, is based wholly upon the presumption of probability-weighted
Date: 2 June 2010
Page 5 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
cash flows – which implies that one is ending up with a single cash flow forecast and have
lost or discarded the rich source of data pertaining to all the other cash flows making up the
said probability-weighted cash flow. In this context, of course, had this rich source of data
been retained, there would be a dramatically reduced need for stress testing, in the first
place.
A second powerful reason why reference to stress testing is relevant in this context,
moreover, is that it is clear that many investors and potential investors in complex financial
instruments – particularly those investors who are not themselves hedge funds or the
investment arms of investment banks – are unlikely to create (or possess) comprehensive
stochastic models of these instruments. Instead many investors are likely avail themselves of
much more simplified commercially available software models which do indeed consist of
(or produce) essentially static cash-flow forecasts for the (groups of) components making up
the asset pools. The resulting essentially ‘single-path’ cash-flows of interest and principal
repayments are then fed down through the waterfall structures of these financial
instruments into the various tranches on the liabilities side of the said instruments (which
are the tranches into which many of these investors may invest). In this context, the more
senior tranches have first call on any interest payment flows, while any losses due to
defaults in the asset pools are absorbed first by the equity tranches and then, successively,
by the most junior remaining tranches.
Such ‘less sophisticated’ models, as referred to above, handle the uncertainty implicit within
their forecast cash flows by allowing the users to postulate deviations from the ‘central’
forecasts in the form of ‘scenarios’ to which, regrettably, there is almost no way to attach
credible probabilities of occurrence.
Stress-testing models compared with the more powerful ‘rating-based’ stochastic models1:
Perhaps one of the better known examples of the ‘stress-testing based models’ referred to
above is provided by ABSXchange© which is marketed by the non-rating side of Standard and
Poor’s. The other major competitor in this field is, I believe, Investec which offers an
essentially similar product. These models are nevertheless formidable and complex models
in their own right, though they are an order of magnitude less complex than the models
used by the rating agencies themselves to rate such financial instruments, in the first place.
1
In this context, the rating-based stochastic models referred to here are those used by the rating agencies and
more sophisticated investors (such as many of the hedge funds and the investment banks themselves).
Date: 2 June 2010
Page 6 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
These latter models are generally based upon stochastic modelling principles (i.e. Monte
Carlo simulation modelling) combined with extensive stress testing of the senior tranches to
confirm the robustness of the resulting recommended ratings. Critically, moreover, these
rating models are made available to the investing community – subject to those investors
who do sign up being subject to relatively stringent confidentiality agreements.
The key point regarding these rating models (such as Moody’s CDOROM© suite and Standard
& Poor’s Evaluator© suite) is that they only award single-point ratings to the various tranches
of the complex financial products (such as CDOs, CLOs, CBOs, etc.) – though this is balanced
by these rating agencies also publishing extensive information regarding the propensity for
such ratings for the various different types of instruments to transition to other ratings
(including ‘to default’) over time – which data is itself integral to the structure of these rating
models themselves, in the first place.
There can often be an important limitation on the usefulness and transparency of the
models which we have referred to as ‘the stress testing modes’, above, especially outside of
North America. This is that there can be quite high percentages of the asset pools of the
complex financial instruments which are not formally rated by the designated rating
agencies (such as Moody’s, Standard & Poor’s and Fitch). Instead such assets are accorded
‘advisory ratings’ (or ‘in-house ratings’), which are obtained by the managers and/or
administrators of the said ‘complex financial instruments’, and which advisory ratings are
only made available to investors in the said instruments (and, presumably, also to ‘serious’
potential investors in these instruments) – which, in turn, lies at the root of the reputation
for ‘lack of transparency’ that many of these complex financial instruments deservedly suffer
from.
(b) Q.7 (b) asks: “What other disclosures would you prefer (whether in addition to or instead of
the proposed disclosures) and why?
Addressed in the following paragraphs are some potentially very important considerations
which also partially fall under the scope of the section on ‘Practical expedients’ (paragraphs
B15-B17), but which otherwise appear to have been side-stepped by this exposure draft.
These considerations were raised by delegates who attended a workshop on “Practical
Approaches to Estimating Impairment in Complex Financial Instruments”, which delegates
included senior investment bankers and executives of certain national and international
regulatory authorities. Regrettably, neither the IASB nor the FSA were represented at the
workshop, though representatives of these two organisations did attend the Infoline
Date: 2 June 2010
Page 7 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Conference on “Accounting, Regulatory & Market Insights into Impairment of Financial
Assets” held in London on 8th December 2009, which was held the day before the abovementioned workshop.
Importantly, there would appear to be significantly different views even within the IASB
concerning the applicability of the exposure draft on “Financial Instruments: Amortised Cost
and Impairment” to different types of financial instruments.
Significantly, in the IASB
Webinar held on Thursday 12 November 2009, the IASB’s Director of Capital Markets, Gavin
Francis, emphasized that the amortized cost approach only applied to vanilla-type debt
instruments where it is relatively easy to predict the cash flows. Somewhat unfortunately,
however, his statement was comprehensively contradicted by IFRS 9: Financial Instruments:
Classification and Measurement published the same day, which had been specifically drafted
to allow certain complex financial instruments to qualify for holding on the Amortised Cost
basis, as addressed below:
1. With static CDOs (collateralised debt obligations), no trading is allowed. Therefore static
Cashflow CDOs, particularly those backed by cash instruments, appear likely to qualify to
be held on the Amortised Cost basis.
2. Whether Market Value CDOs qualify following the end of any reinvestment periods, will
tend to be a function of the nature of the collateral pool, as follows:
2.1.
Some collateral pools consist of defaulted bonds or loans, and the market value
structure has been used because the assets do not generate predictable cash flow
streams but do have significant market value upside potential.
2.2.
Such Market Value CDOs would therefore definitely not satisfy the conditions of
paragraph 4.2 (b) in IFRS 9, which is necessary to be measured at amortised costs.
In this context, paragraph 4.2 specifies that a financial asset shall be measured at
amortised cost if (a) the objective is to hold it to collect contractual cash flows, and
which (b) give rise on specified dates to cash flows that are solely payments of principal
and interest on the principal amount outstanding.
2.3.
On the other hand, those Market Value CDOs which are held to collect contractual cash
flows on specified dates (following the end of any reinvestment period) will qualify
where the cash flows are solely payments of principal and interest on the principal
amount outstanding.
3. Static synthetic CDOs are backed by static pools of credit default swaps. These should not
normally qualify for measurement under amortised cost owing to the contractual payment
Date: 2 June 2010
Page 8 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
of credit insurance premiums. But the condition set out in paragraph 4.2 (b) of IFRS 9 is
met if the contractual terms of the financial asset give rise on specified dates to cash flows
that are solely payments of principal and interest on the principal amount outstanding, as
follows:
Paragraph B4.21 of IFRS 9 allows the contractual terms for the tranche of a contractually
linked instrument (such as a CDO) to give rise to cash flows that are solely payments of
principal and interest on the principal amount outstand without looking through to the
underlying pool of financial instruments, provided:
3.1.
The exposure to credit risk in the underlying asset pool inherent in the tranche is equal
to or lower than the exposure to credit risk of the underlying pool of financial
instruments, and:
3.2.
The underlying pool contains one or more instruments that have qualifying contractual
payments (that are solely payment of principal and interest on the principal amount
outstanding; i.e. a hybrid pool?)
4. Qualifying RMBS (residential mortgage-backed securities) with Prepayments satisfying the
provisions of B4.10 of IFRS 9: i.e. which qualify as solely payments of principal and interest.
To the extent that many US-based RMBS have been held to lie at the heart of the recent
sub-prime crisis which, in turn, triggered the credit crunch in August 2007, one could
indeed anticipate some expressions of surprise that such instruments can qualify for
measurement under the amortised cost basis, as explained below:
Usually RMBS are themselves merely passing through cash flows from an underlying
mortgage pool. To determine if these cash flows qualify under provision B4.10, one
continues “looking through” to the underlying mortgage loans which are creating the cash
flows, per B4.22:
4.1.
The rights of many US mortgage holders to pay off their mortgages are not contingent
on future events – even although one would normally only expect the householders
concerned to only do so in order to refinance their mortgage loans in the event of
interest rates falling substantially;
4.2.
The required prepayment amounts, moreover, could be interpreted as substantially
representing unpaid amounts of principal and interest on the principal amount
outstanding, even although the interest payable is likely to represent not much more
than that payable on the principal over a relatively short notice period (i.e. not the “full
Date: 2 June 2010
Page 9 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
compensation” often required under many mortgage loans with fixed terms, as found in
the UK and Europe).
To continue with the answer to Q7 (b): the above-mentioned evidence makes it crystal-clear
that it is not only the organisations of those delegates who attended the workshop on
“Practical Approaches to Estimating Impairment in Complex Financial Instruments” on 9 th
December 2009 which believe that the exposure draft applies to complex financial
instruments, but IFRS 9: Financial Instruments: Classification and Measurement has itself been
specifically drafted to allow certain complex financial instruments to qualify to be held on the
Amortised Cost basis.
An important consideration that was raised not only by the above-mentioned delegates but
also by two delegates from a Spanish savings bank involved in mortgage loans (who had
attended the immediately preceding Conference), was that they were adamant that: “the
lending institutions involved should (be allowed to) account for their loans on the Amortised
Cost basis even although almost all these mortgage loans invariably had interest rates that
reset from time to time during their life.”
This consideration is similar to some other potentially very important considerations which
partially fall under the scope of the section on ‘Practical expedients’ (paragraphs B15-B17).
For this reason, these considerations have been addressed in connection with the answers to
Questions 11 and 12, below.
Questions 8, 9 and 10:
No formal answers are being submitted here to these three questions, which concern the transition
to the proposed IFRS. The reason is simply that the issues involved are outside the scope of my
competence.
Just as a comment, however, three years does seem to be a rather long time to wait before those
provisions which are agreed by the IASB are made mandatory. On the other hand, as noted above in
the answer to Question 7 (b), there are clearly differences of opinion or interpretation within the
IASB itself concerning the scope of this Exposure Draft, which need to be resolved first. In addition,
in the USA, and as intimated above under the answer to Question 4 (a) above, there are strong
indications that the FASB favours confirming fair value as being the appropriate standard to apply in
accounting for all financial instruments, where fair value is defined as the realisable exit price in
liquid market conditions. Particularly in the context of efforts to resolve this latter consideration,
perhaps three years may, after all, appear an appropriate time to specify for full implementation.
Date: 2 June 2010
Page 10 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Answer to: Question 11
The Practical Expedients outlined in paragraphs B15-B17 of the Exposure Draft do not address the
most important Practical Expedient which will be necessary in order to allow this standard to be
implementable (and realizable) in practice. This is: the practical expedient relevant to the complex
financial products, already considered in the Answer to Question 7 (b), of generating a large
number of cash-flows based upon the ratings (whether internal or external) of the components of
the asset pool(s) being checked for impairment, and which recognise and utilize the probabilities
inherent in those rating of those ratings ‘transitioning over time’ to other ratings, including ‘to
default’.
Properly analysed, the results of such an approach allow the identification of the associated
‘probability risk profiles’ in both the asset pool(s) as well as of any associated tranches which result
from feeding these cash flows through a “waterfall” in order to allocate them to ‘second-order’
financial instruments like the stand-alone tranches of a CDO.
The IASB staff‘s three website examples are very helpful in introducing how the recommended
effective interest rate method is expected to be implemented in practice, despite these three
examples not being formally part of the Exposure Draft.
As already commented upon earlier, the Exposure Draft for Financial Instruments: Amortised Cost
and Impairment introduces as its objective not the determination of the cost-based measurement of
the impairment in value of a financial instrument, as one might have expected, but instead: “to
provide information about the effective return on a financial asset or financial liability by allocating
interest revenue or interest expense over the expected life of the financial instrument.”
The reason for adopting the above objective appears not to have been linked to the stipulation that
the amortised cost shall be calculated using the effective interest rate method, but rather to the
IASB staffs’ understanding and interpretation as to how this method could be implemented in
practice. Fortunately the exposure draft leaves the door open for an expert advisory panel to help
the Board identify other practical expedients as to how the initial estimate of expected credit losses
can be allocated over the expected life of a financial asset.
Date: 2 June 2010
Page 11 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Answer to: Question 12
In the context that IFRS 9: Financial Instruments: Classification and Measurement has been
specifically drafted to allow certain complex financial instruments to qualify for holding on the
Amortised Cost basis, a ‘practical expedient’ is introduced below which addresses the main issues
necessary to provide a credible solution to the current dilemma. Unfortunately, it is difficult to
discuss such a ‘practical expedient’ without illustrating it by referring to a working, albeit simplified,
model of a complex financial instrument which qualifies under the specified criteria discussed in the
answer to Question 7 (b), for which an example of a ‘Cashflow CDO (collateralised debt obligations)’
has been selected. This model is, nevertheless, is available in Excel format to anyone who would
appreciate a copy of it, to achieve greater clarity. (Please send any requests for a copy, by e-mail, to:
hjo@adopttraining.co.uk and by referencing these comments.)
12.0 “Practical Expedient”:
Applying the Original Discount Rates and Ratings-related Interest Margins
Firstly, revise the cash flow forecasts for financial instruments held at amortised cost, in the
light of changes in their credit status (or ratings).
The “practical expedient” is then to apply those discount rates and ratings-related interest
margins which were originally derived when the financial instruments’ fair values were first
established, to the realised and revised forecast cash flows.
In this context, note that the financial instruments’ fair values will have been first
established when the investor acquired them, or else subsequently upon determining that
the instruments were to be held at amortised cost rather than at fair value.
The above step is done in conjunction with determining the underlying probability risk
profiles of the instruments – as illustrated below for a simplified CDO with just three
tranches: Senior Debt, Sub-Loan (i.e. Mezzanine Debt), and Equity.
Note that in the example shown here, referred to as “Scenario 1”, all interest payments in
excess of those contracted to be allocated to the Senior Debt, Sub-Loan and Equity tranches
were used to pay down the most senior remaining tranches rather than being allocated to
the Equity tranche itself (which is quite an popular, alternative, stipulation).
Also please note that owing to the limitations of the functions included within the standard
Microsoft Excel software, the random distribution of the 2,000 different scenarios generated
to produce the result summarised below was modelled as though conforming to the bellDate: 2 June 2010
Page 12 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
shaped Normal distribution rather than to one with the ‘fat-tails’, such as the Student-t
distribution. (There are special software packages, such as those supplied by the Numerical
Algorithms Group [NAG], which can provide such more appropriate distributions, like the
Student-t, and functions to use with and within Excel.)
SCENARIO 1 : Key Inputs/Settings:
Principal Allocation:
Pro-rata
Capture All Excess Spread for Senior Debt reduction
Liability Interest Curve:
Floating (Swap Interest rates)
Summary of Monte Carlo simulation runs with 2,000 iterations
Asset
Pool
£'000s
Senior
Debt
£'000s
12,009
10,887
48%
27%
12,186
11,250
582
-
Probability <=MODE
55%
83%
91%
36%
Upper Q
Median
Lower Q
Standard Deviation
12,808
12,041
11,246
1,055
11,230
11,195
10,829
644
559
467
348
110
852
287
578
8.8%
5.8%
23.5%
201.5%
9.4%
14,521
9,115
13,336
11,492
7,952
12,669
630
208
667
2,645
0
14,425
8,219
13,336
MEAN +/or AVG
VALUE:
Probability <= MEAN
MODE
Coeff. of Variation
Maximum Values
Minimum Values
Initial Principal Allocn
Sub
Loan
£'000s
Equity
£'000s
All
Tranches
£'000s
452
499
11,838
49%
60%
12,631
12,012
11,144
1,132
The standard error of the estimate with a Monte Carlo run = std dev/sqrt(n), where n = number of iterations
The corresponding 95% confidence limits = mean ± 1.96 x std dev/sqrt(n)
For n = 2,000 the 95% confidence limits = ± 1.96 x std dev/sqrt(2,000) or ± 4.4% of standard deviation
To halve the size of the 95% confidence limits to ± 2.2%, need to quadruple the number of runs to 8,000 - and so on
Date: 2 June 2010
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Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Date: 2 June 2010
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Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Date: 2 June 2010
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Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Probability-weighted cash flows for CDO Structure in Scenario 1
Assessed Fair Value
Effective Return (=> discount rate used)
Bond Equivalent Yield
Modified Duration
Sum of Discounted Cash Flows (£)
(with mid-point discounting convention)
Asset Pool
£12,008,996
Senior Debt
£10,887,101
6.86%
6.75%
7.27
5.04%
4.98%
6.78
5.83%
5.75%
13.78
10.57%
10.30%
17.05
12,008,996
10,887,101
451,734
498,800
Undiscounted Cash Flows:
Period
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Terminal Value
Sub Loan
Equity
£451,734 £498,800
ANNUAL (£)
Asset Pool
914,944
879,799
911,987
1,226,688
904,698
952,495
1,793,282
1,324,305
4,747,405
683,714
574,637
530,189
516,709
503,969
491,919
521,578
552,659
414,813
478,722
360,417
1,264,490
Senior Debt
800,664
719,458
740,693
1,018,426
776,556
820,556
1,578,037
1,239,707
4,235,590
639,516
562,932
540,163
538,950
538,269
538,387
18,644
-
Sub Loan
Equity
23,342
28,004
31,609
15,420
2,866
3,919
19,083
9,457
73,820
6,339
4,287
3,384
3,232
3,093
2,968
48,122
41,734
37,480
43,856
35,186
650,421
325,801
441,971
424,287
457,491
370,554
1,170,503
With regard to the cash flows from the asset pool generally being greater than those flowing
into the tranches, there are expenses and fees to be deducted, in addition to which there
are also income taxes to be paid which can be offset by capital losses (with the latter arising
in a number of the scenarios contributing to the resulting probability-weighted cash-flows).
Note that the practical expedient as described above is applicable to fixed rate instruments,
to also include those instruments where their managers have entered into swap agreements
to reduce the cash flow variability of the underlying pool (i.e. owing to the inclusion of
floating rate securities and/or securities designated in another currency).
In the case of floating rate instruments where the investors are seeking exposure to marketrelated interest rates, it may be inappropriate for such investments to be measured at
amortised cost; instead it is recommended that such investments be held at Fair Value.
Date: 2 June 2010
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Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
However, a number of banking and financial institutions are strongly of the opinion that
floating rate instruments should also be possible to measure at amortised cost. To
accommodate this requirement, the above-described practical expedient needs to be
extended to also allow the impact of changes in market interest rates to be identified,
quantified and then excluded.
Because floating rate instruments are quoted in terms of margins above benchmark interest
rates, moreover, any calculation of impairment needs to be performed after adjusting for
changes in market interest rates. (Note this order of calculation could be construed as
contrary to the current Exposure Draft’s declared intention of valuing credit losses/gains at
the originally determined effective interest rates.
The recommended method does,
however, also reflect commonly accepted financial analysis procedures.)
Note that in addition to the above “market interest rate” (or “price”) adjustment, which is
calculated using the benchmark interest rates, there will also be a “mix” effect identified.
This “mix” effect is attributable to the interest rates on the individual debt securities held in
the underlying asset pools resetting at various times during the year, and for varying “fixed”
terms.
Importantly, the above identified adjustments for “market interest rates” and “mix” result in
changes in the holding values of the financial instruments concerned, which are then taken
to the Profit & Loss account.
Taking the complex example of a floating rate CDO (collateralised debt obligation) as the
instrument to be measured at amortized cost, the following steps need to be taken:
12.1
Within the CDO Valuation Model, change the interest rates of the assets (i.e. debt
securities) held in the asset pool to reflect those current as of period-end;
12.2
Change the forecast interest rates of these “pool assets” to reflect the impact of
currently forecast changes in interest rates to the end of the assets’ lives (based
upon forward yield curves - such as reflected in published swap interest rates [e.g.
per the table provided by ICAP plc in the Financial Times newspaper]), together with
the impact of any “fixed interest” re-set periods.
12.2.1 Run the CDO Valuation Model to produce an interim probability-weighted cash flow
forecast, keeping the previous ratings and ratings-related interest-rate margins
constant. The resulting change in value (i.e. from the value at the previous
Date: 2 June 2010
Page 17 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
period-end) represents the adjustment for changes in market interest rates,
which is then carried to the Profit and Loss account.
12.2.2 Now amend the ratings of the separate assets held within the underlying asset
pool(s) to reflect their status as of the period-end;
12.2.3 Then identify the actual payments of principal and interest flowing into the CDO (i.e.
into the Special Purpose Vehicle for re-allocation to the tranches), together with
all actual prepayments of principal and any accompanying payments of interest
penalties. These actual payments are inserted as historical values into the CDO
Valuation Model’s calculation schedules, to replace the formulae held in the
model for the appropriate periods.
12.2.4 Run the CDO Valuation Model a second time, to produce the final probabilityweighted cash flow forecast for the particular period-end in question. The
resulting change in value from the interim cash flow forecast (at 11.2.3 above)
represents the credit-related impairment (or gain). The current Exposure Draft
states that this impairment (and/or gain) should also be carried to the Profit and
Loss account.
12.2.5 As well as producing the final probability-weighted cash flow forecast, the CDO
Valuation Model should also be used to produce the probability distribution
profiles for the asset pool(s) and for the separate tranches.
Note: the two adjustments recommended above, namely that for market-related interest
rate changes (which includes the formerly mentioned “mix” effect) and that for creditrelated impairments (or gains) are, together, essentially equivalent to measuring the floating
rate financial instrument at fair value, at each period-end.
Date: 2 June 2010
Page 18 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
Addendum
Fundamental concepts in the valuation of complex financial instruments
 The “single-point” ratings assigned to an instrument, or to its tranches (whether
by an external rating agency or internal model) has quantifiable probabilities of
“transitioning” to other ratings, including “to default”, over time.
 A properly probability-weighted forecast cash flow does not impose high data
storage requirements for a “single-line” cash flow forecast, on any technique
utilizing stochastic modelling techniques (Monte Carlo simulation) involving
even possibly hundreds of thousands of iterations. However, if the results of the
individual runs were also stored, then the storage requirement could be huge.
In practice, what one actually gets is just a “best estimate” of the forecast cash
flows which results in a “single-point” Mean (or average) value for the instrument
at a given point in time, i.e. on the valuation date.
Difference between valuation model and rating model
It is important to distinguish between the valuation model proposed here and the far
more complex ratings models, the “single-point” outputs from which form the inputs
into the valuation model.
Calculation of Impairment in subsequent periods
To implement the “practical expedient” described in section 12.0, above, the valuation
date remains unchanged. Any changes in the ratings of the component securities
within the underlying asset pool, including “to default”, are substituted into the CDO
valuation model together with the actual cash flows from the asset pool (i.e. payments
of interest and principal, including any prepayments and recovered amounts) plus any
net payments on any qualifying interest rate or currency swap agreements (ref. B4.24
of IFRS 9) entered into by the CDO manager.
One then runs the valuation model as before, analysing the outputs of the simulation
run to provide the revised mean values for the individual tranches together with their
revised probability distribution profiles.
Incidentally, comparing the actual cash flows to the individual tranches to those
calculated by the model, above, gives a useful check of the accuracy of the modelling
of the waterfall within the overall model (or of the CDO manager’s integrity!)
Risk Profiles of Holdings in Financial Instruments
For decision-making purposes in respect to impairments, proper awareness of the risk
profiles of the holdings in financial instruments is important - particularly when there
may be evidence that the markets may not longer be functioning efficiently, i.e. when
they are showing signs of illiquidity.
It is important to calculate and present probability distribution curves for financial
instruments. This contrasts with the single-point “exit prices” taken as the fair values
for the financial instruments under present practice.
Date: 2 June 2010
Page 19 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
In the context of the “practical expedient” referred to in section 11.0 above, the
corresponding probability-weighted cash flows can be derived by an iterative process
resulting in a “single-line” cash flow forecast, and without retaining the data for all
the component iterations. The probability distribution profiles of the output values,
for the various tranches involved, however, are far more important than the
probability-weighted cash flow forecast itself in the valuation, and calculation of
impairment, of such complex financial products.
The structure of the simplified valuation model for CDOs (collateralised debt
obligations) referred to above accommodates a fairly wide variation in the different
types of waterfalls for allocating cash-flows to the investors’ notes/tranches. The
above review was relatively short owing to space and time constraints.
 Frequency risk profiling of outcomes: producing probability distribution curves;
 Identifying the likelihood of any particular range of values being experienced within
the remaining life of a financial instrument.
 This, in turn, enables much greater consistency (i.e. lower volatility) to be achieved in
the determination of the appropriate levels of impairment to recognize in the P&L
account at the end of each reporting period.
Reviewing the Types of Models Currently in Use
Whichever models are being employed, it is anticipated that these models are “tuned” to
provide outputs which are reconciled to market prices. Such tuning reflects the
assumption embodied within the current accounting framework that the “fair value” of a
security is the current realisable exit price assuming liquid markets.
 Outline of basic forms of models anticipated:
o Structural models: Merton framework/KMV (extended Merton) models, etc.
o Reduced form (or intensity) models
Producing Probability Distribution Curves from In-house Pricing
Models
Analysing the outputs from in-house pricing models where stochastic pricing models are
used (i.e. using Monte Carlo simulation techniques), either:
 valuation models for CDOs, CLOs, etc. using ratings provided by the rating agencies
and generating scenarios through rating transition matrices, or:
 path-dependent option pricing models where one is “sampling through the binomial
(or trinomial) lattice” and/or effectively sampling through a decision tree.
Alternatively, “front-end” traditional scenario-based financial models for valuing
structured finance cash-flows with rating transition matrices. Then generate correlated
normal (or ‘Student-t’) random variables to produce a wide range of rating transitions in
the asset pool over time.
 Modelling the asset pool as individually identified mortgage-backed securities in
place of more aggregated representations. This allows better “granularity” and
improves simulation of default behaviour.
Date: 2 June 2010
Page 20 of 21
Comments on Exposure Draft ED/2009/12
Submitted by: Hugh J Osburn, FCMA, ASA, CFA
Financial Instruments: Amortised Cost and Impairment
 Note: instead of using “normal” random variables, consideration should be given to
the use of random variables sampled from other distributions with “fatter tails”, such
the Student-t distribution. Appropriate functions can be acquired from third party
suppliers, e.g. The Numerical Algorithms Group (NAG), for use with Excel.
Producing Probability Distribution Curves where it is
impracticable to adapt existing models
To provide credible and supportable risk profiles for holdings of financial instruments,
liaise with risk management teams to assess the probabilities of realising the scenarios
used in the Stress Testing regime laid down by the regulatory bodies (such as the FSA)
 Understand the risk management teams’ approach to assessing Value-at-Risk (VaR)
 Address any previously identified shortcomings such as failing to adequately reflect
the likelihood of extreme market conditions (often referred to as: “encountering the
fat tails of anticipated probability distribution curves)
Date: 2 June 2010
Page 21 of 21