FAS 157 Mark-to-Market Accounting


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  • FAS 157 Mark-to-Market Accounting

    1. 1. FAIR VALUE AND ITS IMPACTS ON WELLS FARGO BANK MGP270-Corporate Financial Reporting “ Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.” – Albert Einstein
    2. 2. AGENDA <ul><li>Introduction to FAS 156, 157 and 159 </li></ul><ul><li>Application in Mortgage-related Assets </li></ul><ul><li>Fair Value Implications and Impacts </li></ul><ul><li>How Wells Fargo can use FV to its benefit </li></ul><ul><li>Lessons Learned </li></ul>
    3. 3. FAS 156 (Servicing of Financial Assets) <ul><li>Separate recognition of servicing rights </li></ul><ul><li>Mortgage Servicing Rights (MSR) </li></ul><ul><li>Two ways to value MSRs </li></ul><ul><ul><li>Amortization </li></ul></ul><ul><ul><ul><li>Amortize over period of income </li></ul></ul></ul><ul><ul><ul><li>Valuation Allowance and Impairment </li></ul></ul></ul><ul><ul><li>Fair Value </li></ul></ul><ul><ul><ul><li>Measure at each report date </li></ul></ul></ul><ul><li>Effective Date – September 15, 2006 </li></ul>
    4. 4. FAS 157 (FAIR VALUE MEASUREMENT) <ul><li>FAS 157 in GAAP </li></ul><ul><ul><li>Defines fair value </li></ul></ul><ul><ul><li>Establishes a framework for measuring fair value </li></ul></ul><ul><ul><li>Expands disclosures about fair value measurements. </li></ul></ul><ul><li>Approved in September 2006 </li></ul><ul><li>Effective from November 15, 2007 </li></ul><ul><li>What is Fair Value? </li></ul><ul><ul><li>“ the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” </li></ul></ul>
    5. 5. FAS 157 ASSET CATEGORIZATION <ul><li>Level1 </li></ul><ul><ul><li>Assets that have observable/quoted prices for identical assets or liabilities </li></ul></ul><ul><ul><li>Mark to Market Valuation. </li></ul></ul><ul><ul><li>E.g., Stocks traded in NYSE </li></ul></ul><ul><li>Level 2 </li></ul><ul><ul><li>Assets have observable inputs such as recent transaction price for similar items. </li></ul></ul><ul><ul><li>Mark to Model Valuation </li></ul></ul><ul><ul><li>E.g., Interest-rate swap whose components are observable data points like the price of a 10-year T-Bond </li></ul></ul><ul><li>Level 3 </li></ul><ul><ul><li>Assets that has un-observable inputs used in fair value measurements. </li></ul></ul><ul><ul><li>There is no real market for these assets, valuation is subjective based on future assumptions of the firm. </li></ul></ul><ul><ul><li>Mark to Make Believe Valuation. </li></ul></ul><ul><ul><li>E.g. Private equity investments, MBS and CDOs </li></ul></ul>
    6. 6. FAS 157 VALUATION GUIDELINES <ul><li>Market Approach </li></ul><ul><ul><li>Comparable values in all markets </li></ul></ul><ul><li>Income Approach </li></ul><ul><ul><li>Discounted Cash Flows </li></ul></ul><ul><ul><li>Black-Scholes Option Pricing </li></ul></ul><ul><ul><li>Multi-period Excess Earnings </li></ul></ul><ul><li>Cost Approach </li></ul><ul><ul><li>Cost to acquire a substitute asset with the same utility </li></ul></ul><ul><li>Level 1 – Market </li></ul><ul><li>Level 2 – Market & Income </li></ul><ul><li>Level 3 – Income & Cost </li></ul>
    7. 7. FAS 156 and159 (FAIR VALUE OPTION) <ul><li>Companies can choose which financial instruments to be recorded at fair value </li></ul><ul><li>One-time election to use Fair Value </li></ul><ul><li>Applied to entire instrument </li></ul><ul><li>First time gains or losses to be recognized in OCI </li></ul><ul><li>Later on gains or losses goes into Income Statement </li></ul><ul><li>FAS 159 Approved in February 2007 </li></ul><ul><li>FAS 159 Effective from November 15, 2008 </li></ul>
    8. 8. JOURNAL ENTRIES (FAIR VALUED ASSETS) <ul><li>Fair Value Mortgage Assets </li></ul><ul><ul><li>Mortgage Backed Securities </li></ul></ul><ul><ul><li>Mortgage Servicing Rights </li></ul></ul><ul><li>Initial Classification </li></ul><ul><ul><li>Assume undervaluation before using FV </li></ul></ul><ul><ul><li>DR XYZ Asset </li></ul></ul><ul><ul><li>CR Other Comprehensive Income </li></ul></ul><ul><li>Subsequent Periods </li></ul><ul><ul><li>Assume FV increased in period </li></ul></ul><ul><ul><li>DR XYZ Asset </li></ul></ul><ul><ul><li>CR Non-Cash Income </li></ul></ul>
    9. 9. PROS AND CONS OF FV <ul><li>The Good </li></ul><ul><ul><li>Provides much needed Guidance for measuring fair value. </li></ul></ul><ul><ul><li>More Transparency and Disclosure for Level 3 assets </li></ul></ul><ul><ul><li>Consistent Valuation </li></ul></ul><ul><ul><li>Level Playing Field </li></ul></ul><ul><ul><li>No need for complicated hedge accounting (FAS156) </li></ul></ul><ul><li>The Bad </li></ul><ul><ul><li>Reopens the door for potential accounting abuses. </li></ul></ul><ul><ul><li>Fair value accounting , poses significant challenge for auditors to evaluate companies approach for coming up with the numbers </li></ul></ul><ul><ul><li>Exit Value vs. Economic Value </li></ul></ul><ul><ul><li>No specific execution guidance </li></ul></ul>
    10. 10. EARNINGS MANAGEMENT 101 <ul><li>Fair value gives an easy way to dump your losing asset, how: </li></ul><ul><ul><li>Identify losing assets </li></ul></ul><ul><ul><li>Apply FAS 156/159 and elect Fair Value option </li></ul></ul><ul><ul><li>Take a one-time loss in OCI without affecting Income Statement </li></ul></ul><ul><ul><li>Sell or refinance the asset </li></ul></ul><ul><ul><li>Choose not to use Fair Value option for the new replacement asset </li></ul></ul><ul><li>Can everyone do this? </li></ul><ul><ul><li>Qualitative/Governance </li></ul></ul><ul><ul><li>Adoption of FAS 157 </li></ul></ul><ul><ul><li>Previous assertions about intent to hold </li></ul></ul>
    11. 11. WELLS FARGO: FAIR VALUATION <ul><li>Wells Fargo chose Fair Value Option </li></ul><ul><li>Mortgage Servicing Rights </li></ul><ul><ul><li>Subjective Valuation Models </li></ul></ul><ul><ul><li>Book income into earnings statement </li></ul></ul><ul><li>Why? </li></ul><ul><ul><li>Residential real estate boom </li></ul></ul><ul><ul><li>Wiggle room for valuation of assets </li></ul></ul><ul><ul><li>Easier hedge accounting </li></ul></ul><ul><li>If Fair Value Option was not chosen </li></ul><ul><ul><li>Income would have been lower </li></ul></ul><ul><ul><li>Assets allocated to Valuation Allowance </li></ul></ul>
    12. 12. FAIR VALUATION LEVELS <ul><li>Securities Held for Sale </li></ul><ul><ul><li>Mortgage backed Securities - $60 billion </li></ul></ul><ul><li>Mortgage Servicing Rights </li></ul><ul><ul><li>Residential Only </li></ul></ul>
    13. 13. VALUATION GAINS AND NET INCOME Trading Assets Securities Available for Sale Mortgages held for Sale Mortgage Servicing Rights Derivative Assets and Liabilities Other Liabilities Net Income 2008 Q1 (40) (4) (5) (1794) (27) (66) 1999 2007 Q4 (86) (31) 1 (594) 6 (98) 1361 2007 Q3 (37) - (1) (603) (17) (20) 2283 2007 Q2 76 - - 1810 (76) (28) 2279 2007 Q1 (25) - - (10) (43) (6) 2244
    15. 15. VALUING WELLS FARGO’S MSRS <ul><li>Option 1 – Amortization (Per FAS 156) </li></ul><ul><ul><li>Commercial MSRs ($1.8b) </li></ul></ul><ul><li>Option 2 – Fair Value (FV) </li></ul><ul><ul><li>Estimates of Prepayment Speeds </li></ul></ul><ul><ul><li>Discount Rate </li></ul></ul><ul><ul><li>Default Rate </li></ul></ul><ul><ul><li>Cost to Service (including Delinquency and Foreclosure) </li></ul></ul><ul><ul><li>Escrow Account Earnings </li></ul></ul><ul><ul><li>Contractual Servicing Fee Income </li></ul></ul><ul><ul><li>Ancillary Income </li></ul></ul><ul><ul><li>Late Fees </li></ul></ul><ul><ul><li>Residential MSRs ($15b) </li></ul></ul>
    16. 16. THE EFFECT OF VALUATION MODEL Change in Valuation Model & Assumptions Change due Collection/Realization in Cash Flows 2008 Q1 ($1798) ($766) 2007 Q4 ($1935) ($711) 2007 Q3 ($638) ($719) 2007 Q2 $2013 ($808) 2007 Q1 ($11) ($788) 2006 Q4 $36 ($783) 2006 Q3 ($1147) ($663) 2006 Q2 $550 ($521) 2006 Q2 $552 ($477)
    17. 17. IS OTHER COMPREHENSIVE INCOME ALSO A WRITEDOWN? Total Available for Sale Mortgage Backed Securities Unrealized Gains Unrealized Losses Realized Gains Realized Losses 2008 Q1 79,126 60,848 1,630 (2,228) 378 (88) 2007 Q4 72,271 54,118 - (129) 472 (127) 2007 Q3 56,859 41,533 857 (276) 211 (23) 2007 Q2 60,857 72,179 568 (477) 21 (47) Actual OCI Citigroup 40.9 2 Merrill 31.7 5.3 HSBC 18.3 1.3 Actual OCI WAMU 8.3 0.8 ING 0.4 5.6
    18. 18. LEVEL 3 ASSETS TO EQUITY Level 3 Equity Ratio Morgan Stanley $88b $25b 2.51 Goldman Sachs $72b $39b 1.85 Lehman Brothers $35b $22b 1.59 Bear Sterns $20b $13b 1.54 Citigroup $135b $128b 1.05 Wells Fargo $23b $48b 0.47 Merrill Lynch $16b $42b 0.38
    20. 20. OTHER ASSETS THAT CAN BE LEVEL 3 <ul><li>Most Mortgage-Backed Securities </li></ul><ul><li>Securitized Credit Card Obligations </li></ul><ul><ul><li>$915b outstanding </li></ul></ul><ul><li>Leveraged Buy-Out Bridge Loans </li></ul><ul><ul><li>$250b on balance sheets </li></ul></ul><ul><ul><li>Susceptible to decline in underlying value, cash flows lower than debt repayment, loss of credit ratings </li></ul></ul><ul><li>Asset-Backed Commercial Paper </li></ul><ul><ul><li>Dropped to $900b </li></ul></ul><ul><li>Complex Derivative Contracts </li></ul><ul><li>Credit Default Swaps </li></ul><ul><ul><li>$2.4 trillion outstanding </li></ul></ul>
    21. 21. SUMMARY <ul><li>Fair Valuation is an option, not a necessity </li></ul><ul><ul><li>Direct impact on OCI, Net Income </li></ul></ul><ul><ul><li>More guidance is needed from FASB on valuation models </li></ul></ul><ul><li>What investors should look for </li></ul><ul><ul><li>Gains/Losses due to changes in valuation model </li></ul></ul><ul><ul><li>Unrealized Gains/Losses in OCI </li></ul></ul><ul><ul><li>Transfers to Level 3 </li></ul></ul><ul><li>An important ratio – Level 3 Assets to Equity </li></ul>
    22. 22. Questions ?