Mortgage-Backed Securities and Fair-Value Accounting

By Tim Krumwiede, Ryan M. Scadding, and Craig D. Stevens

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MAY 2008 - Many entities are in the process of implementing FASB’s recently issued guidance on fair value, SFAS 157, Fair Value Measurements, and SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115. Proper implementation can require CPAs to exercise professional judgment. This professional judgment is being put to the test in the measurement of fair value for mortgage-backed securities (MBS) because of significant declines in values and reduced levels of trades resulting from the recent credit market crises. This article illustrates the application of this professional judgment to MBSs as well as a discussion on other-than-temporary impairments of MBSs under SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. In addition to providing a primer on the accounting treatment of MBSs, the discussion of SFAS 157 and SFAS 159 is expanded to help CPAs apply these standards in other situations.

Mortgage-Backed Securities Primer

The Office of Federal Housing Enterprise Oversight (OFHEO), an independent entity within the U.S. Department of Housing and Urban Development, defines an MBS as “a security that represents an undivided interest in a group of mortgages.” (See “Portfolio Caps and Conforming Loan Limits,” Mortgage Market Note 07-1, OFHEO, September 6, 2007.) Investors in these securities have the right to receive future mortgage payments (interest and/or principal). Payments on some MBSs are guaranteed by one of three agencies: the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae is associated with the federal government and its guarantee is backed by the full faith and credit of the government. Thus, an MBS guaranteed by Ginnie Mae is considered a low credit risk. (Although Fannie Mae and Freddie Mac were established by the federal government, they are not government-funded.) MBSs backed by the guarantee of Fannie Mae and Freddie Mac are generally considered to be low risk.

Additional MBSs are issued by private entities and are not guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae. Accordingly, these MBSs generally carry a greater credit risk than an MBS that has an agency guarantee. In recent years, the issuance of non-agency MBSs grew rapidly. For example, OFHEO estimates indicate that non-agency MBSs issued comprised 19.7% of all MBSs issued in 2001 and 55.9% in 2006 (table 1 in the aforementioned article “Portfolio Caps and Conforming Loan Limits”). In 2007, the trend started to reverse; in the second quarter of 2007, non-agency MBSs issued were 47.2% of the total MBSs issued.

The most common type of MBS is a pass-through security in which mortgages with similar characteristics are pooled together and each investor receives a pro- rata share of principal and interest. Other variations of MBSs include a collateralized mortgage obligation (CMO), which is formed when payments from a pool of mortgages are divided into different bond classes known as tranches. The distinguishing feature between the tranches is that each one represents a different maturity. For example, if a security has four tranches, payments are made to the bond class (tranche) with the shortest maturity. Once the entire principal is paid on this tranche, payments are made to the bond class with the next shortest maturity. The process continues until all tranches are paid.

Stripped MBSs are a special variation of a CMO. With a strip, the claim to the future principal and interest payments are separated into two classes. Owners of the interest-only strip have claims to the interest from the mortgage payments. Owners of the principal-only strip have claims to the principal from the mortgage payments. Interest paid on the interest-only strip is based on outstanding principal. Accordingly, interest-only strips have a greater prepayment risk than do other MBSs.

Unlike other bonds, the price of an interest-only strip has a positive correlation to interest rates. As interest rates decrease, prepayments will increase, which in turn will reduce the interest payments and the value of an interest-only strip. An interest-only strip can act as a hedge against traditional bonds, whose prices are inversely related to interest rates.

Recent years have seen non-agency institutions offer an increasing number of MBSs that are collateralized by subprime mortgage loans. Subprime loans are loans issued to borrowers with various suboptimal credit-risk characteristics. Many of these loans were issued with a high loan-to-value ratio (i.e., greater than 90%), were poorly collateralized, or were issued with initial “teaser” interest rates that eventually adjust to higher interest rates. Interest-rate adjustments and other factors have resulted in delinquent mortgage payments and subsequent foreclosures on homes. Continued construction of new homes, foreclosed homes being placed on the market, and reduced housing demand have resulted in a larger-than-normal number of single-family homes for sale. In turn, property values in a number of markets have started to decline, and many believe values will continue to decline into the foreseeable future. All of these factors have contributed to a decline in the value of many MBSs.

As mortgage and housing problems have unfolded, so has the need to address various subjective accounting provisions. First, because of the dynamic credit-market environment, the illiquidity of many MBSs backed by subprime loans has created another element of fair value that needs consideration. Second, under the provisions of SFAS 115, it has become necessary to exercise judgment in determining if the decline in value of certain MBSs is other-than-temporary. Before addressing these two important issues, the authors will discuss SFAS 159 and its relationship to SFAS 115.

SFAS 159

Under SFAS 115, MBSs are classified into one of three categories: trading securities, held-to-maturity securities, or available-for-sale securities. Pursuant to paragraph 14 of SFAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, certain MBSs that are subject to substantial prepayment risk, such as interest-only strips, cannot be classified as held-to-maturity securities. Trading securities and available-for-sale securities are reported at fair value on the balance sheet. Held-to-maturity securities are reported at amortized cost. Unrealized holding gains or losses are reported in net income for trading securities. On the other hand, unrealized gains and losses on available-for-sale securities are not included in the determination of net income; instead, the gains or losses are recorded as a component of other comprehensive income. An important exception exists for available-for-sale and held-to-maturity securities that have experienced an other-than-temporary decline in value. The exception, discussed below, requires that the unrealized loss be reported in the determination of net income rather than as a component of other comprehensive income.

The fair-value option for financial assets provided for in SFAS 159 modifies the rules of SFAS 115. If the election is made for a security that would otherwise be classified under SFAS 115 as available-for-sale or held-to-maturity, the security will be reported at fair value, and unrealized gains and losses will be reported in net income. Therefore, determination as to whether a decline in value is other-than-temporary is not relevant where the SFAS 159 election is made.

The fair-value election of SFAS 159 can be made for all securities, for a group of identical securities, or on a security-by-security basis. The election is made on the election date and is irrevocable unless another election date occurs. Most important, an entity can make the election on the adoption of SFAS 159 for financial assets and liabilities owned or issued before that date (e.g., on January 1, 2008, for calendar year–end companies). Additionally, the election can be made on a security when the security is purchased. Paragraph 9 of SFAS 159 includes a complete list of triggers allowing for an election. Once SFAS 159 is effective for an entity, the effect of the first remeasurement to fair value will be reported as a cumulative-effect adjustment to the opening balance of retained earnings (para. 25).

SFAS 159 is a concepts-based standard and its application should be consistent with its underlying objective. Application of the standard to “dress up” financial statements or obtain a desired accounting result that is inconsistent with the standard’s intent could easily draw the attention of the SEC and other regulators. The objective of SFAS 159 (according to para. 1) is “to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.”

As noted by the AICPA’s Center for Audit Quality, auditors should exercise appropriate professional skepticism for entities that may attempt to apply the standard in a manner inconsistent with its objective (“SFAS 159 Early Adoption Date Approaching—Factors to Consider,” www.thecaq.org/newsroom/pdfs/CAQPressRelease_041807a.pdf, April 17, 2007). For example, assume an entity holds MBSs that are underwater and are classified as available-for-sale or held-to-maturity. In the period adopted, the entity elects the fair-value option for the MBSs, records the loss as a cumulative-effect adjustment to the beginning balance of retained earnings, and in a later period sells the MBSs. After the sale of the MBSs, the entity reinvests the proceeds in other investments but does not elect the fair-value option for these new investments. The totality of these transactions could be construed as an attempt to avoid loss recognition in the determination of net income and, accordingly, be inconsistent with the objective of SFAS 159.

Disclosure requirements may discourage entities from violating the intent of the fair-value election. An entity must disclose its reasons for electing the fair-value option. If a partial election is made, an entity must disclose the reasons for the partial election.

Other-Than-Temporary Impairment

For securities recorded as available-for-sale or held-to-maturity, where the fair-value option is not elected, the entity must perform an analysis at each reporting period to determine whether a decline in fair value below the amortized cost basis is other-than-temporary.

For MBSs that are not of high credit quality, the first step is to analyze the securities for impairment in accordance with EITF 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets.” That guidance provides that an other-than-temporary impairment should be considered to have occurred if the “present value of the original cash flows estimated at the initial transaction date (or the last date previously revised) is greater than the present value of the current estimated cash flows” (para. 12). If, as a result of this analysis, an other-than-temporary impairment has been determined to have occurred, then the security must be written down to fair value with the resulting loss reported in the determination of net income.

If an other-than-temporary impairment has not been indicated as a result of this analysis (i.e., EITF 99-20), the investor should still determine whether the investment is other-than-temporarily impaired under other relevant guidance (i.e., SFAS 115). This second step is more qualitative than the analysis under EITF 99-20 and may require significant management judgment. The impairment analysis described in SFAS 115 applies to all debt and equity securities that are within the scope of that guidance, even if highly rated. SFAS 115 does not provide a definition of “other-than-temporary” impairment, but explains that the cost basis of the individual security shall be written down to fair value when one has occurred. The one example provided in SFAS 115 (para. 16) states, “If it is probable that the investor will be unable to collect all amounts due according to the contractual terms of a debt security not impaired at acquisition, an other-than-temporary impairment shall be considered to have occurred.”

FASB Staff Position (FSP) 115-1/124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” provides further guidance in analyzing an investment for other-than-temporary impairment by breaking the analysis down into specific steps. Nevertheless, no bright-line tests are available to help determine whether an other-than-temporary impairment exists, and all available facts and circumstances should be considered. The most specific guidance comes from SEC Staff Accounting Bulletin (SAB) Topic 5.M, “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities.” That guidance provides a few examples of factors that indicate a decline is other-than-temporary:

a. The length of the time and the extent to which the market value has been less than cost;
b. The financial condition and near-term prospects of the issuer, including any specific events which may influence the operations of the issuer such as changes in technology that may impair the earnings potential of the investment or the discontinuance of a segment of the business that may affect the future earnings potential; or
c. The intent and ability of the holder to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.

AICPA Statement on Auditing Standards (SAS) 92 (AU section 332, para. 47) provides further guidance on factors to consider, including:

  • Fair value is significantly below cost and—
    • The decline is attributable to adverse conditions specifically related to the security or to specific conditions in an industry or in a geographic area;
    • The decline has existed for an extended period of time; and
    • Management does not possess both the intent and the ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value.
    • The security has been downgraded by a rating agency.
    • The financial condition of the issuer has deteriorated.
    • Dividends have been reduced or eliminated, or scheduled interest payments have not been made.
    • The entity recorded losses from the security subsequent to the end of the reporting period.

The majority of guidance is geared toward providing indicators as to when a write-down could be necessary. In contrast, SAB Topic 5.M, point (c), focuses on when a write-down may not be needed. An enterprise could claim that an investment is not other-than-temporarily impaired if it represents it has the intent and ability to retain the investment for a period of time sufficient for a recovery in market value. The current tumultuous economic environment has led many companies to use this justification as a way to avoid write-downs on some MBSs. Managements are generally expected to document this intention and their ability at the time the security is first determined to be impaired, and to update that documentation on each reporting date to ensure that their representations are still valid.

The current subprime crisis has resulted in the fair value of many securities declining below their amortized cost. In certain cases, this might be a result of temporary illiquidity in the markets rather than an indication of a permanent decline in fair value. An investor may have to analyze the severity and duration of these declines to determine whether an impairment is other-than-temporary. Additionally, other factors previously discussed, such as the intent and ability of the investor to hold the securities for an extended period of time in anticipation of a sufficient recovery in fair value, should be considered.

Fair-Value Measurement

A comprehensive understanding of the fair-value measurement and disclosure requirements will be necessary for most investments in MBSs. Investment companies measure fair value for all MBSs. Other companies measure and report the fair value of an MBS held as an investment unless the MBS is classified as held-to-maturity and the fair-value option of SFAS 159 is not elected. SFAS 157 provides guidance in measuring fair value and appropriate disclosures.

SFAS 157 is effective for fiscal years beginning after November 15, 2007, if not adopted early. Although FASB considered delaying the effective date of this standard, on November 14, 2007, it issued a news release rejecting any deferral of SFAS 157 for financial assets and liabilities, although under FSP 157-2 a one-year deferral would be provided for nonfinancial assets and liabilities as long as these assets and liabilities are not reported at fair value on a recurring basis.

The intent of SFAS 157 is to provide a consistent framework for fair-value measurement. Accordingly, the following discussion focuses on the provisions of SFAS 157. For MBSs, fair-value measurements under SFAS 157 will generally be similar to measurements of fair value prior to the issuance of SFAS 157. Expanded fair value disclosures are also required under SFAS 157. Entities that have not yet adopted SFAS 157 are technically exempt from these disclosure requirements until the standard is adopted and implemented. In its whitepaper providing additional guidance on fair-value measurement for MBSs and other assets, however, the CAQ suggests that entities using unobservable inputs may wish to consider using disclosures similar to those required in SFAS 157 [“Measurements of Fair Value in Illiquid (or Less Liquid) Markets,” www.aicpa.org
/caq/download/WP_Measurements_of_FV_in_Illiquid_Markets.pdf
, October 3, 2007].

Definition of Fair Value

SFAS 157 (para. 5) defines fair value as “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.” This definition assumes an orderly transaction between market participants. It further points out (para. 7) that “an orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date … it is not a forced transaction (for example, a forced liquidation or distressed sale).”

With the uncertainty and decline in value of MBSs collateralized with subprime mortgages, the question arises as to whether recent market prices (when available) represent a true fair value, or a distressed sale. For example, an investment company may be allowed to hold only those debt securities that have a minimum credit rating. Recently, the credit ratings for many MBSs have been downgraded and, as a result, some investment companies may have been forced to sell a security that was downgraded. If such a sale is made into a market without significant liquidity, will the transaction price represent fair value? Was the sale a distressed sale?

The CAQ whitepaper addresses potential distressed sales at several points. First, it is noted that a significant decrease in transaction volume is not necessarily indicative of distressed sales. If transactions are occurring, even at a reduced level, they are still market transactions and “persuasive evidence is required to establish that an observable transaction is a forced or distressed transaction” (page 4). Because fair value is determined on the measurement date, current market prices are the relevant prices even if volume is thinner than normal.

The definition of fair value assumes a transaction between market participants. According to SFAS 157 (para. 10), market participants should be independent of the reporting entity, knowledgeable, able to transact for the asset or liability, and willing to transact in that they are motivated but not forced to sell. Although the CAQ whitepaper provides information on market participants, it does not explicitly address how to distinguish between sellers who are forced to sell and sellers who are not forced to sell.

Another aspect of the fair-value definition is that an appropriate market must be identified. SFAS 157 (para. 8) states that “the measurement assumes that the transaction to sell the asset … occurs in the principal market for the asset … or, in the absence of a principal market, the most advantageous market.” Important to note is that the principal market is not necessarily the most advantageous market. Additionally, the principal market for one entity could be different from the principal market for another entity.

In “Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialists” (Staff Audit Practice Alert 2, December 10, 2007, www.pcaobus.org), which appears motivated by factors related to MBSs, the Public Company Accounting Oversight Board (PCAOB) emphasizes the importance of determining an entity’s principal market when pricing services are used for fair-value measurements The alert states that “a pricing service might provide an amount for which a large financial institution could sell the financial instrument. However, a company that owns that financial instrument might not be able to transact in the same market as a large financial institution. If the price available to a large financial institution would not be available to the company, then that price may not be an appropriate measure of fair value under SFAS 157.”

Valuation Techniques

SFAS 157 (para. 18) provides three valuation techniques: the market approach, the income approach, and the cost approach. One or more of these approaches can be used for a single asset. The market approach and the income approach are the most likely approaches to be used for MBSs. With the market approach, prices and information from market transactions for similar or identical assets are used (the use of matrix pricing is a market approach). The income approach uses present-value techniques to convert future amounts (cash flows or earnings) to a single present value.

If one valuation technique is better than another in estimating fair value, then that should be the technique of choice. Additionally, if inputs are more readily observed for one technique, then that should be the technique given priority. However, multiple valuation techniques can be combined to value an asset. Once a valuation technique is chosen, it should be applied on a consistent basis among similar assets and across reporting periods. If a change in technique or mix of techniques is warranted because it becomes apparent that a change will result in a better measure of fair value, then the change is allowable. For example, assume a certain type of MBS has typically been valued using a market approach, but the liquidity of the market has decreased. A change in the valuation technique may then be warranted. The change may simply be that a decreased emphasis is placed on the market approach and an increased emphasis is placed on the income approach. However, when observable market transactions are available, they should at least be considered in the valuation process. Whether the change is from one technique to another, or is a change in the weighting placed on a technique, the change should be accounted for as a change in accounting estimate under SFAS 154 (SFAS 157, para. 20).

Inputs into Fair-Value Measurements

SFAS 157 identifies the following hierarchy of inputs to be used in measuring fair value:

  • Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities. An active market for the asset or liability is a market in which transactions for the asset or liability occur with sufficient frequency and volume to provide pricing information on an ongoing basis (para. 24).
  • Level 2 are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly (para. 28).
  • Level 3 are unobservable inputs for the asset or liability. Unobservable inputs shall be used to measure fair value to the extent that observable inputs are not available, thereby allowing for situations in which there is little, if any, market activity for the asset or liability at the measurement date (para. 30).

Preference should be given to Level 1 inputs. If Level 1 inputs are not available, preference should be given to other observable inputs (Level 2) over unobservable inputs (Level 3). Even when market activity for an MBS is at a reduced volume, if price quotes and observable transactions by market participants are available for identical MBSs, then Level 1 inputs should be used. For some MBSs, however, quoted prices from an active market may not be available. In this case, Level 2 or Level 3 inputs may be necessary.

Level 2 inputs would include quoted prices for similar assets in active markets or quoted prices for identical or similar assets traded in markets that are not active. For example, the uncertainty surrounding default rates and real estate values may result in a situation where identical or similar MBS pricing information is not current or is highly volatile. In such a situation, observed prices could be Level 2 inputs or possibly Level 3 inputs. The CAQ whitepaper (page 5) provides another example of the use of an observable input suggesting that “the pricing indicated by the ABX credit derivative index for subprime mortgage bonds may be a Level 2 input when used as an input to the valuation of a security backed by subprime mortgage loans.”

The use of Level 3 inputs is necessary when observable inputs are not available. For MBSs, this could happen when very little or no market activity is observed for identical or similar assets at the measurement date. In using Level 3 inputs, SFAS 157 (para. 30) indicates that “the fair-value measurement objective remains the same, that is, an exit price from the perspective of a market participant that holds the asset.” Assumptions in a model used to measure fair value should take into account assumptions that market participants would make in pricing an asset if the information can be obtained without undue cost and effort.

The current environment of foreclosures, defaults, and uncertain real estate values suggests increased risk and uncertainty of future cash flows for investors holding MBSs. Accordingly, measuring risk for some MBSs may have become more difficult. FASB’s Concepts Statement 7 (para. 62) suggests that a fair-value measurement should include a risk premium if the risk adjustment is identifiable, measurable, and significant. However, SFAS 157 clarified that a risk premium should be incorporated into fair-value estimates if a market participant would include one, even if the measurement of risk is difficult. Accordingly, an appropriate risk premium should be incorporated into models used to measure the fair value of MBSs.

Inputs used in a model to measure the fair value of subprime-related MBSs could include estimated default rates, prepayment rates, and discount rates. The fair value of an MBS would be more accurate to the extent that some of these inputs can be observed in market transactions. The CAQ whitepaper (page 7) suggests that a model could be tested by applying it to similar securities for which pricing information is available. If the model reflects current assumptions of market participants, it should approximate the market price.

Disclosing Professional Judgment

As noted, fair-value measurements based on the use of unobservable inputs (Level 3) requires the exercise of significant professional judgment. Consistent with the subjectivity of these measurements, extensive disclosures are required by SFAS 157 (see paras. 32–35). Among other disclosures, entities must disclose the levels (1, 2, or 3) in which inputs to fair-value measurements fall. Because Level 3 inputs are the most subjective, the additional information disclosed about Level 3 inputs must enable the reader of the financial statements to assess how the inputs affect the fair-value measurement. The disclosures should provide users of financial statements with the ability to assess the reliability of fair-value measurements.


Tim Krumwiede, PhD, CPA, is an associate professor of accounting and Ryan M. Scadding is a graduate student, both at Bryant University, Smithfield, R.I.
Craig D. Stevens, CPA, is a senior manager in regulatory and capital markets consulting at Deloitte & Touche LLP.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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