SHARING THE VISION™ Fair Value Under SFAS 157 Presented by: Daniel Chavez, CPA Audit Manager

SHARING THE VISION™ Objectives 1.Understanding the logic and basics of SFAS 157 Background Concepts Disclosure requirements 2. Examples of application Financial institutions Financial statements 3. Regulatory requirements Call report

SHARING THE VISION™ Reasons for Changes in the Focus of Accounting Standards to Fair Value It’s a new world! Economic and regulatory environments have changed Convergence! FASB and IASB Projects The FASB’s Conceptual Framework Project

SHARING THE VISION™ The Changing Economic Environment The Information Revolution –Escalation and availability of information –Impact on decision-making process Global competition Wall Street Demands –More transparency in reporting (a timely telling of the how and the why) Increasing Complexity of financial transactions

SHARING THE VISION™ The FASB and IASB Convergence Project “One single set of high quality, understandable and enforceable global accounting standards The Norwalk Agreement in 2002 –Best efforts to make existing financial reporting standards fully compatible Projects: –Identification of individual differences between IFRS and US GAAP Conceptual framework project to serve as a foundation –Fair value is on the agenda

SHARING THE VISION™ Recent Standards Require Fair Value Measurements SFAS No. 159 The Fair Value Option SFAS No. 158 Employer Accounting for Defined Benefit Plans SFAS No. 157 Fair Value Measurements SFAS No. 156 Accounting for Servicing of Financial Assets SFAS No. 153 Exchanges in Nonmonetary Assets SFAS No. 150 Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Debt SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activities SFAS No. 144 Accounting for Impairment of Long-Lived Assets SFAS No. 143 Accounting for Asset Retirement Obligations SFAS No. 142 Goodwill and Other Intangible Assets SFAS No. 141 Business Combinations SFAS No. 133 Accounting for Derivative Instruments and Hedging Activities SFAS No. 123 Share-Based Payments

SHARING THE VISION™ SFAS No. 157 Fair Value Measurements What does it do? Defines fair value for financial reporting purposes singular definition Establishes a framework/approach for measuring fair value Expands disclosures about the use of fair value – to allow users to assess the relative reliability of FV measurements and the impact on earnings of Level 3 measurements Effective for financial statements issued for fiscal year beginning after November 15, 2007, with early adoption encouraged.

SHARING THE VISION™ SFAS No. 157 Fair Value Measurements What doesn’t it do? Require additional fair value measurements under GAAP Provide detailed “how to” guidance with respect to valuation Eliminate the practicability exceptions to fair value measurements that exist in other accounting pronouncements

SHARING THE VISION™ SFAS No. 157 Fair Value Measurements Understand the definition of Fair Value Understand the market participants concept Understand “highest and best use” Be able to distinguish between valuation premises –In use and exchange Be able to determine the Fair Value Hierarchy Understand the required disclosures under SFAS No. 157

SHARING THE VISION™ Old Definition of Fair Value from SFAS 141 and 142 “The amount at which an asset (or liability) could be bought (or incurred) or sold (or settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale.”

SHARING THE VISION™ Revised Definition of Fair Value from SFAS No. 157 “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the market in which the reporting entity transacts.”

SHARING THE VISION™ Elements of the Definition of Fair Value Price Principal Market Market Participants

SHARING THE VISION™ The Price The objective of the fair value measurement is to determine the price that would be received to sell the asset (or paid to transfer the liability) at the measurement date Price in a hypothetical transaction to sell an asset or transfer a liability (exit price) Not the price in actual transaction to acquire an asset or assume a liability (an entry price)

SHARING THE VISION™ Define the Principal Market The Principal Market – 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. If no principal market exists, then choose –The most advantageous market is the market in which the price obtained maximizes the amount received (not the price).

SHARING THE VISION™ Observation: If a principal market exists, fair value is the price in that market, even if the price in a different market is potentially more advantageous.

SHARING THE VISION™ Multiple Markets for the same asset? Which is principal? An entity-specific determination (entity specific volume)? – the market where the entity has sold with the greatest frequency and volume, or A market-based determination? – the available market with the greatest frequency and volume

SHARING THE VISION™ Why not use the Most Advantageous Market all the time? The higher level of transactions in the principal market provides more reliable pricing (relevance and reliability) Focus on the principal market avoids a required continual assessment of process across all possible markets to find the highest Generally, principal and most advantageous markets

SHARING THE VISION™ Who Are the Market Participants? Market Participants are the buyers and sellers in the principal market that are: –Independent of the reporting entity –Knowledgeable of the asset or liability and the transaction (including the results of usual diligence) –Able to transact for the asset or liability (qualified) –Willing and motivated to transact for the asset or liability (but not forced or otherwise compelled

SHARING THE VISION™ Who Are the Market Participants? May be other entities in the same industry and may not Example: –A manufacturing company holds land whose highest and best use is for residential development. A residential real estate developer may be a market participant. Specific individual market participants do not have to be identified.

SHARING THE VISION™ Who Are the Market Participants? Reporting entity need not identify specific market participants; instead, indentify characteristics that distinguish market participants generally, considering factors specific to: –The asset or liability –The principal or most advantageous market –Market participants with whom the reporting entity would transact in that market Fair Value is determined based on the assumptions that market participants would use in pricing an asset or liability

SHARING THE VISION™ Definition – Highest and Best Use Definition – The use of an asset by market participants that would maximize the value of the asset (or the group of assets within which the specific asset would be used).

SHARING THE VISION™ Highest and Best Use Criteria The use must be: –Physically possible –Legally permissible –Financially feasible Highest and best use is that of the market participants, even if that use differs from that of the Company

SHARING THE VISION™ Valuation Premise Used Highest and best use establishes the valuation premise for the asset In-use – the asset would provide maximum value to the market participants principally through its use in combination with other assets as a group In-Exchange – the asset would provide maximum value to the market participants principally on a stand alone basis (example: a financial asset) Fair value measurements consider the assumptions that the market participants would use in pricing the asset, whether using an in-use or an in-exchange premise of value

SHARING THE VISION™ Three Approaches to Measuring Fair Value Market Approach Income Approach Cost Approach

SHARING THE VISION™ Valuation Principles Economic PrincipleValuation Approach Principle of substitutionA. Market Approach B. Asset-based (cost) approach Principle of future benefitsC. Income approach

SHARING THE VISION™ Economic Principles Principle of Substitution – One would not pay more for a particular asset than the cost to construct or purchase one with equivalent economic utility. Principle of Future Benefits – The value of an asset is the present value of the stream of future benefits available to the owner.

SHARING THE VISION™ Income Approach Converts expected (predicted) future amounts to a current price Examples include: –Option-pricing models (Black-Scholes; Merton formula) –Binomial model (Lattice models) –Discounted future cash flows

SHARING THE VISION™ Cost Approach The cost approach determines the amount that currently would be required to replace the service capacity of an asset. The price that would be received for the asset is determined based on the cost to a market participant (the buyer) to acquire or construct a substitute asset of comparable utility, as adjusted for obsolescence.

SHARING THE VISION™ And the Answer IS?? IT DEPENDS!!! In some cases, the fair value result will be from one of the three approaches (only one will be appropriate). –Example: Unadjusted quoted price from an active market can be used. (Quantitative conclusion) In other cases, multiple valuation approaches may be selected with the final conclusion being a point within the range that is most representative of fair value in the circumstances (Qualitative conclusion)

SHARING THE VISION™ Which of the Three Approaches to Choose? The availability of inputs relevant to the asset or liability being measured at fair value and the reliability of those inputs will affect the selection of the appropriate valuation techniques –Availability –Relevancy –Reliability

SHARING THE VISION™ Valuation Inputs Inputs = Assumptions the market participants would use in pricing the asset or liability They consist of: –Observable inputs (market data obtained from sources independent of the reporting entity – e.g. closing prices on NYSE) –Unobservable inputs (inputs reflecting the reporting entity’s own assumptions about the assumptions used by market participants – e.g. growth rates, rates of return) Valuation techniques used to measure fair value should maximize the use of observable inputs and minimize the use of unobservable inputs)

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 1 – Quoted prices in active markets for identical assets or liabilities Level 2 – Inputs other than the quoted prices that are observable, either directly or indirectly. Level 3 – Utilizes unobservable inputs based on the best information available in the circumstances

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 1examples: –Financial Assets Available for sale securities – publicly traded securities (stocks and bonds) Principal market –Exchange market –Dealer market (OTC) –Brokered market –Principal to principal market –Level 1 is best way to go when the data is available.

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 2 – Inputs other than the quoted prices that are observable, either directly or indirectly. –Quoted prices for similar assets or liabilities –Quoted prices for identical or similar assets or liabilities in markets that are not active –Observable inputs other than quoted prices (interest rates, yield curves, credit risks, default rates) Level 2 is the second best way to go (when data is available)

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 2 examples: –Interest rate swaps Receive-fixed, pay-variable interest rate swap on the LIBOR swap rate –Licensing arrangement Royalty rates at inception –Finished goods at a retail outlet Price to customers in a retail market (adjusted downward) Wholesale price to retailers in a wholesale market (adjusted upward) –Building held and used Price per square foot from comps –Reporting unit Earnings or revenue multiples from comparable businesses

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 2 more examples: –Restricted stock (using quoted price from active market) –Corporate and municipal bonds that trade infrequently (using quoted prices for identical or similar assets or liabilities in non-active markets) –Certain residential and commercial mortgage related assets (using pricing models whose inputs are derived principally from or corroborated by market data)

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 3 – Utilizes unobservable inputs based on the best information available in the circumstances –Example: A financial forecast (cash flow or earnings) developed using the company’s own data, if no information shows market participants would make different assumptions. Level 3 is the third best way to go (when nothing else will work)

SHARING THE VISION™ Fair Value Hierarchy for Inputs Level 3 examples: –Financial forecast (cash flow of earnings) developed using the company’s own data, if no information shows market participants would make different assumptions –Venture capital investments

SHARING THE VISION™ Level Three Observations A Level 3 fair value measurement can include inputs that are observable (Level 1 and Level 2) and unobservable (Level 3) The level within which the fair value measurement falls for financial reporting purposes is the LOWEST level input that is significant to the fair value measurement in its entirety Assets can move between categories

SHARING THE VISION™ Example OTC Option (long-dated) inputs on a traded equity security (using Black-Scholes) –Risk free rate of interest (level 2) –Dividend yield (Level 2) –Volatility (Level 3) Because the volatility is a significant input, the entire measurement might fall within Level 3 for disclosure purposes

SHARING THE VISION™ Level Three Observations – 10Q Third Quarter 2007 – Merrill Lynch “During the third quarter of 2007, a significant amount of assets and liabilities was reclassified from Level 2 to Level 3. This reclassification primarily relates to U.S. sub- prime residential mortgage related assets and liabilities, including ABS CDOs, due to a significant decrease in the observability of market pricing for these assets and liabilities in the third quarter.”

SHARING THE VISION™ Use of Third-Party Pricing Service Not necessarily Level 1 just because a price is obtained from such a service –Management will need to understand the sources of information and inputs used in the price quotes –Management is responsible for the fair value measurements and required disclosures

SHARING THE VISION™ Disclosures – Assets and Liabilities Measured on a Recurring Basis FMV at reporting date Level used within the FV hierarchy (segregated by Level 1, 2, and 3) If Level 3 (unobservable) inputs were used, a reconciliation is required between beginning and ending balances. –Amount of total gains and losses –Purchases, sales, issuances and settlements –Transfer in and out of Level 3 (transfers due to changes in the observability of significant inputs) The valuation technique(s) used and changes in such technique(s) qualitative discussion.

SHARING THE VISION™ SFAS157 – Recurring Basis Assets Measured at Fair Value on a Recurring Basis ($ in 000s) Fair Value Measurements at Reporting Date Using: Description12/31/XX Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Trading securities$115$105$10 Available-for-sale securities 75 Derivatives Venture capital investments 10 Total$260$205$25$30 (Note: For Liabilities, a similar table should be presented)

SHARING THE VISION™ Selected JP Morgan Disclosures Methodology Level 2 - Securities Purchases Under Resale Agreements Market inputs in discounted cash flow model Loans expected to be securitized: Level 2 – Commercial and residential mortgages Observable pricing of asset-based securities with similar collateral, adjusted for securitization uncertainties Level 3 – Subprime loansConsideration of liquidating proceeds and property repossession/liquidation information Other Loans: Level 3 – Purchased nonperforming loans No observable pricing so modeled factor analysis

SHARING THE VISION™ Selected JP Morgan Disclosures Methodology Securities: Level 1 – Highly Liquid government bondsQuoted prices Level 1 – Mortgage products for which there are quoted prices Quoted prices Level 2 – Collateralized Mortgage Obligations, High Yield debt securities Pricing models, quoted prices Level 3 – Collateralized Mortgage Obligations, High Yield debt securities Benchmarking, analyzing default and recovery rates Level 3 – Collateralized Debt ObligationsMarket standard models Level 3 – Asset backed securitiesExternal prices and assumptions

SHARING THE VISION™ Selected JP Morgan Disclosures Methodology Derivatives: Level 1 – Exchange traded derivativesQuoted prices Level 2 – Derivative contractsInternal models, Black Sholes Level 3 – Credit default swapsReferenced to mortgage-backed securities, benchmarked based on implied spreads relevant observable market indices Mortgage Service Rights: Level 3 – Mortgage Service RightsOption adjusted spread valuation model Retained Interests in Securitization: Level 3 – Interest only stripsDiscounted cash flows Private Equity investments: Level 2 – Publicly held obtained thru IPOQuoted price, less adjustments for sales restrictions Level 3 – Nonpublic private equity investmentsMarket comps, adjusted for company specific issues

SHARING THE VISION™ SFAS 157 Added Disclosures for Level 3 Reconciliation Assets Measured at Fair Value on a Recurring Basis ($ in 000s)Fair Value Measurements at Reporting Date Using Significant Unobservable Inputs (Level 3) DescriptionDerivatives Venture Capital InvestmentsTotal Beginning Balance$14$11$25 Total gains or losses (realized/unrealized) Included in earnings (or changes in net assets) 11 (3) 8 Included in other comprehensive income Purchases, issuances, and settlements (7) (2) (9) Transfers in and/or out of Level 3 (2) - Total $20$10$30 (Note: For Liabilities, a similar table should be presented)

SHARING THE VISION™ Disclosures – Assets and Liabilities Measured on a Nonrecurring Basis Example: Impaired Assets –FMV measurements recorded during the period and the reasons for the measurements –Level used within the FV hierarchy –If Level 3 inputs were used, a description of the inputs and the information used to develop the inputs. –For annual periods only, the valuation techniques used and changes in techniques from prior periods.

SHARING THE VISION™ SFAS 157 Assets Measured on a Nonrecurring Basis Assets Measured at Fair Value on a Nonrecurring Basis ($ in millions) Fair Value Measurements Using: Description12/31/XX Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Long lived assets held and used$75 Goodwill 30 Long lived assets held for sale 26 (Note: For Liabilities, a similar table should be presented)

SHARING THE VISION™ Regulatory Issues Call report –FFIEC 031 and 041 effective June 30, 2008, fair value amounts to be disclosed. –FFIEC 002 effective for September 30, –To be completed by banks that have adopted FAS 157 and have elected to account for financial instruments or servicing assets and liabilities at FV option or are required to complete Schedule RC-D – Trading Assets and Liabilities

SHARING THE VISION™ Questions