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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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).
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Implementation Discussion Items

Investments

Loans receivable

Impaired Loans

Mortgage Servicing Rights – FAS156

Mortgage Lending Derivatives

Shares
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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.
Fair Value Measurements and Disclosures
Valuation Techniques

Market Approach – Quoted prices in active markets for identical or
comparable assets or liabilities


Income Approach – Techniques to convert future amounts to a single
present amount.


Can include matrix pricing
Can include present value, option-pricing, and multi-period excess
earnings
Cost – replacement cost – does not apply to financial assets and liabilities
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
FAS 157 Fair Value Hierarchy
Level 1 – Quoted prices in active markets for identical assets or
liabilities.

Most reliable measure and should be used whenever possible
Fair Value Measurements and Disclosures
FAS 157 Fair Value Hierarchy
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
Fair Value Measurements and Disclosures
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.
Fair Value Measurements and Disclosures
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.
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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)
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Summary of Credit Union Assets
Cash
AFS investments
Other investments
1st mortgages
Other real estate loans
New car loans
Used car loans
Other loans
Other assets
9%
8%
11%
22%
12%
11%
11%
11%
5%
100%
Fair Value Measurements and Disclosures
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”
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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)
Fair Value Measurements and Disclosures
Impaired Investment Securities
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
Fair Value Measurements and Disclosures
Impaired Investment Securities
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
Fair Value Measurements and Disclosures
Impaired Investment Securities
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
Fair Value Measurements and Disclosures
Loans Receivable

Real estate loans

Auto loans

Mortgage loans held for sale
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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.
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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:
5.
a.
Changes in valuation inputs or assumptions used in the model
b.
Other changes in fair value and a description of those changes
Other changes that impact the balance and a description of those changes
A description of the valuation techniques used to estimate the fair value
Fair Value Measurements and Disclosures
Mortgage Banking Commitments
Interest Rate Lock Commitments (IRLCs)
Forward Loan Sales Commitments
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
IRLCs Valuation Example
Loan amount
A
Rates up
Loan at
Inception
50 bp
$ 100,000
$ 100,000
Lock in interest rate
6.375%
Market interest rate
Rates dow n
Loan
Processing
100 bp
Approved
Close
$ 100,000
$ 100,000
$ 100,000
$ 100,000
6.375%
6.375%
6.375%
Loan at
6.375%
6.375%
6.375%
6.875%
6.875%
5.875%
5.875%
5.875%
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%
100.50%
100.50%
100.50%
100.50%
100.50%
100.50%
-0.25%
3.75%
Market value w ith servicing
B
Price to borrow er
D
Value as percent of loan (1)
E
Dollar value A * E
F
Pull through percentage
G
1.25%
$ 1,250.00
-0.75%
$
(750.00) $
30.00%
45.00%
Derivative Value F * G
$
375.00
$
(337.50) $
Amount recorded
$
375.00
$
(712.50) $
(250.00) $ 3,750.00
60.00%
60.00%
(150.00) $ 2,250.00
187.50
$ 2,400.00
4.25%
$ 4,250.00
4.25%
$ 4,250.00
80.00%
100.00%
$ 3,400.00
$ 4,250.00
$ 1,150.00
$
850.00
Fair Value Measurements and Disclosures
IRLC Journal Entries
Journal Entrie s
De s cription
IRLC
De bit
A
$
Cre dit
Incom e
State m e nt
375
Origination income
IRLC
$
$
375
$
500
$
3,875
$
500
IRLC
$
4,250
Cash
$ 100,500
$
(375)
$
500
Cas h
Ware hous e
375
Record initial value
Origination expense
B
$
500
Cash
$
(500)
$
(500)
Record origination costs
IRLC
C
$
3,875
Gain on IRLC
$
$
3,875
(3,875)
Record changes in value
Origination expense
D
$
500
Cash
$
500
Record origination costs
Warehouse loan
E
$ 104,750
$ 104,750
$
(4,250)
$ (100,500)
Record loan f unding
$ 110,000
$ 110,000
$
(3,250)
$
-
$ (101,500)
$ 104,750
Fair Value Measurements and Disclosures
IRLCs

Derivative asset and derivative liability


In general, cannot be offset for accounting purposes
Level 3 in hierarchy
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Forward Sales Commitments

Derivative asset and derivative liability


In general, cannot be offset for accounting purposes
Level 2 in hierarchy
Fair Value Measurements and Disclosures
Summary of Credit Union Liabilities and Equity
Interest payable
Share drafts
Regular shares
Money market shares
Share certificates
Other shares
Other liabilities
Equity
4%
9%
23%
14%
28%
10%
1%
11%
100%
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Share Certificates

Interest rate

Term

Early redemption

Discount rate
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Disclosures Example for Items Measured and Reported on a Recurring Basis
Total
Carrying
Amount in
Statement
of
Statement
Financial
107 Fair
Position at
Value
12/31/08
Estimate
Available for Sale Securities
Assets /
Liabilities
Measured
at Fair
Value at
12/31/08
Quoted
Prices in
Active
Markets
for
Identical
Assets
Level 1
Significant Significant
Other
Other UnObservable observable
Inputs Level
Inouts
2
Level 3
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
-
20
20
20
-
-
20
B/E Forward Sales Commitments (a)
(15)
(15)
(15)
-
(15)
-
Long Term Debt
(50)
(55)
(40)
-
(40)
-
IRLCs
(a) Elected to measure and report at fair value
Fair Value Measurements and Disclosures
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
Unrealized gains or losses for items still
outstanding at December 31, 2008
20
1
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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:



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:



Information to show how the line item relates to FAS 157 and 107 disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
Auditing Fair Value Hierarchy

Consider incentives to inappropriately classify – level 2
when it should be level 1 thereby allowing more
discretion or judgment
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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
Fair Value Measurements and Disclosures
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?
Fair Value Measurements and Disclosures
Questions?