OTTI

OMG, have you heard about OTTI? It’s not on this list of IM abbreviations so we’ll try to explain. OTTI, or Other Than Temporary Impairment, is a term found in FASB and SEC literature to denote when a loss in market value of an investment in debt or equity securities must be written off. Key considerations include current market conditions as well as conditions of the issuer of the security, and the intent and ability of the investor to hold the securities until recovery. Existing guidance (written before the credit crisis) includes:

• SEC staff speech by Ashley Carpenter, PAF, Dec. 2007 AICPA National Conf. on Current SEC and PCAOB Developments – see section on Other Than Temporary Impairment of Securities, which references SEC SAB Topic 5-M, Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities,
• SEC Corp Fin Current Accounting and Disclosure Issues (last updated Nov. 2006), Section H: Investments, covers (1) Other Than Temporary Investments, (2) Government Sponsored Enterprises, and (3) Auction Rate Securities. References parallel FASB guidance set forth in FAS 115, Accounting for Certain Investments in Debt and Equity Securities, EITF No. 03-01, Other-Than-Temporary Impairments, FSP Nos. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments, which amends certain portions of EITF 03-01.
  

More recently, questions have been raised over the application of OTTI guidance in light of recent events:

• “Regulators and Bankers at Odds Over GSE Seizure,” By Rob Blackwell and Emily Flitter, Sept. 11, on FinancialPlanning.com, originally published in American Banker.
• “Top Accounting Firms Crack Whip,” by Chelsea Emery, in Reuters, Aug. 28. This article cites comments of various analysts, with one saying: "There has been a large degree of variability …as is often related to the approach of the auditors. In many cases, certain auditors, such as KPMG, have been more aggressive at requiring banks to take OTTI marks on such securities," and another analyst saying: “Fitch believes weak guidance on OTTI recognition by accounting standards has resulted in significant inconsistencies among companies on what is/is not written down in their financial statements.”

As has been widely reported, representatives of the American Bankers Association (ABA) met with SEC staff on Sept. 25 to discuss fair value (mark to market) issues generally, including OTTI. Last week, we provided links to ABA’s letter to the SEC, as well as letters from the Financial Services Roundtable (FSR) and CFA Institute.

We asked Donna Fisher, ABA’s Senior Vice President for Tax and Accounting, if she could share any insights following her meeting with the SEC. According to Fisher, attendees included SEC, FASB, and PCAOB staff, the chief accountants from the four federal banking agencies, and representatives of the eight largest accounting firms.

“Our goal was not to suspend fair value,” said Fisher, “rather, it was to identify the problems with the complex issues in the existing accounting standards.” She continued, “Specifically, we focused on determining fair value in the current economic environment for the purpose of estimating ‘other than temporary impairment’ [OTTI]. We had a frank discussion of the issues and believe that the SEC understands the need for guidance as soon as possible.”

Fisher told us she is not certain what form any potential guidance may take as a result of the meeting. However, she shared with us the topics which ABA posed for discussion:

• What is an “inactive market”, what represents an “orderly transaction,” and how should they be considered in determining fair value? [NOTE: According to the Summary of Discussions to Date as of July 1, 2008 of the FASB Valuation Resource Group (VRG), Issue 2007-4: “The VRG agreed that any definition of active market must be principles-based and that it would be difficult to develop any additional principles-based guidance that does not include bright-line rules. Accordingly, the staff does not believe that any Board action or further action from the staff is warranted at this time. The staff will continue to monitor this issue.”
• How do you define a “market participant” in a dysfunctional market?
• How should cash flow projections and illiquidity premiums be considered in determining fair value and impairments?
• What are the appropriate recovery periods to be utilized for under water securities?

According to Fisher, ABA provided the SEC staff with their views on possible answers to these questions. She added, “We reiterated the importance of providing timely guidance as quarter-end approaches.”

I’d like to close with a cite to an article in the current issue of The New Republic: “Bailing Upward - Why Congress needs to suck it up and act--and then go even further,” by Larry Grafstein and Jim Millstein, who write: “[T]he Treasury bailout, however necessary, should merely be a prelude to systemic reform. Consider the three very fragile links in a chain of risk that many observers recognized years ago: high financial leverage; accounting-rule arbitrage, inducing the purchase of credit insurance; and a reliance on a relatively narrow array of counterparties to underwrite those credit guarantees... TARP [Treasury’s proposed Asset Relief Program] addresses none of these issues.”

“There is no question that one immediate factor exacerbating the solvency crisis for banks has been the application of fair value or "mark-to-market" accounting rules to the balance sheets of the troubled institutions,” continue Grafstein and Millstein. “These rules, put into effect over the past 15 years by the Financial Accounting Standards Board and the SEC, have pegged the valuing of assets to wild (often panicked) fluctuations in the market, rather than at a value justified by the assets' fundamentals. Heavy markdowns coupled with extreme leverage have proved a lethal combination, making it difficult to survive the possibly temporary impairment of asset values in the absence of further accounting flexibility. At the same time, the fair value rules themselves would not have sparked anywhere near the financial damage were the relevant institutions not so heavily indebted.”

As I’ve written before (reminding readers the views in this blog are my own, not those of my employer, its officers, members or other staff), I concur with President Bush’s and Treasury Secretary Paulson’s assessment that “extraordinary times call for extraordinary measures.” @TEOTD, will it remain BAU for FV and OTTI? IANAL, so DYOR, and T+. GTG, TTFN. Sign up here if you'd like to be on our email list.

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