1. Questions we should be able to answer 1) What is a Derivative Financial Instrument? 2) What is FAS 157? 3) What are arguments For and Against Fair Value accounting – also called Mark to Market Accounting 4) What was the conclusion of the 2008 SEC study of failed financial institutions?

2. History of Fair Value Accounting 1920 – 1940Fair value accounting was commonly used. Many companies routinely recorded unrealized gains in income resulting from appreciated values of land, buildings, equipment, and intangible assets. 1940-1975SEC required a more conservative approach to recording operational assets – the historical cost approach. 1975 FASB issued SFAS #12 which required all marketable equity securities to be recorded at the lower-of-cost-or-fair-value.

3. History of Fair Value Accounting 1980’sThe Savings and Loan crisis of the 1980s required that regulatory agencies take a new look at the accounting for financial instruments. 1990FASB issued SFAS #107 requiring complete disclosures about the fair value of marketable securities. 1994FASB issued SFAS #115 requiring companies to classify their marketable securities as either Trading, Available for Sale (AFS), or Held to Maturity (HTM).

4. History of Fair Value Accounting 1997FASB issued SFAS #130 establishing guidelines for Other Comprehensive Income to improve transparency on the financial statements. 1998FASB issued SFAS #133 requires all derivatives to be reported at fair value on the balance sheet (with minor exceptions). Derivatives – Financial instruments where the values of such instruments are derived from the values of other assets [the underlying assets]. Equity Derivatives ex. – Options or Futures; Debt Derivatives ex. – CDOs or CDSs. 2008 FASB issued SFAS #157 defines fair value and establishes a framework for finding the fair value of marketable securities classifying each between Level 1, Level 2, and Level 3 asset groups.

5. FAS 157 definition of Fair Value “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.”

6. SFAS #157 (2008) Fair Value Hierarchy Level 1Quoted market prices in active markets for identical assets or liabilities. [ex., stock and bonds traded directly in market] Level 2Observable inputs such as prices for similar assets or liabilities in active or inactive markets or inputs derived from observable related market data. [ex., options or futures] Level 3Unobservable inputs that reflect the entity’s own assumptions about the market and using the best information available under the circumstances. [ex., privately held corporate stock]

7. Arguments For Suspension of SFAS #157 or Mark to Market Accounting on Securities Critics of Mark to Market Accounting say the following: Fair Value accounting [using valuation guidelines as outlined in SFAS #157] for investment securities in an illiquid market causes misleading reporting and unnecessarily accelerates further write-downs and financial instability. Mark-to-market accounting, has significantly contributed to the financial crisis or, at least, exacerbated its severity Marking asset values to market becomes a problem when those assets are not easily measured in an illiquid market. “How can you mark to market something when there's no longer any market?" Steve Forbes

8. Arguments Against Suspension of SFAS #157 or Mark to Market Accounting on Securities Supporters of Mark to Market Accounting say the following: Fair value accounting enhances the transparency of financial information provided to the public. Suspension of fair value or market to market accounting would weaken investor confidence and result in further instability in the markets. Suspending fair value accounting would be akin to “shooting the messenger” and would only hide the true condition of a financial institution – hiding insolvency. Allowing Mark to Market accounting during a bubble period accelerates and exacerbates the inevitable crisis and requires that assets be marked down accordingly when the crisis eventually unfolds. The accounting policy cannot serve as a tool for income manipulation during prosperous periods and then be set aside as ineffective or too dangerous during economic downturns.

9. SEC Report Summary Mark to Market Accounting October 2008

10. Objectives of the SEC Study Include To determine the impact of Fair Value Accounting on Bank Failures in 2008 To determine whether or not there should be a suspension of Fair Value reporting for marketable securities during the current economic crisis.

11. The SEC study looked at the following sample group: Banks27 Insurance12 Broker Dealers 5 Gov’t Sponsored Enterprises 3 Credit Institutions 3

15. How Do Banks Earn Capital? Assets Lend $100,000 Earn 8% Liabilities Borrow $100,000 Pay 6% =+ Owner’s Equity Capital Increased by 2% Net Earnings When the Real Estate market bubble bursts and home values start falling, millions of homeowners face the decision of whether to continue making payments on a mortgage that exceeds the value of their home or turn in the keys. As more homeowner’s default on their mortgages, banks must recognize credit losses and a reduction in Equity or Capital balances. They become increasingly over-leveraged or unable to pay the mounting debt as it comes due.

16. Capital Ratio Common indicator of the viability of a bank Equity [CS + PIC + TS + RE] Risk Weighted Assets Adjusted Equity [excluding Accumulated Other Comprehensive Income] should be at least 10% or more of Risk Weighted Assets.

22. Conclusions “Fair Value accounting was not a primary underlying cause of the 2008 bank failures studied. For most of the failed banks studied, fair value accounting was applied in limited circumstances, and fair value losses recognized did not have a significant impact on the bank’s capital.”

23. Conclusions “While most of the failed banks studied did not recognize significant fair value losses, each appears to have experienced default rates on actual loans held that significantly exceeded default rates experienced at non-failed banks of similar size.”

24. SEC Recommendations Existing fair value and market to market requirements should not be suspended. Abruptly removing fair value accounting for securities would erode investor confidence in financial statements Fair value accounting does not appear to be the cause of bank and other financial institution failures. SFAS #157 should be improved, but not suspended

25. Questions we should be able to answer 1) What is a Derivative Financial Instrument? 2) What is FAS 157? 3) What are arguments For and Against Fair Value accounting – also called Mark to Market Accounting 4) What was the conclusion of the 2008 SEC study of failed financial institutions?

26. Update through April 2009 (Wikipedia) FASB issued the official update to FAS 157 that eases the mark to market rules when the market is unsteady or inactive. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. It was anticipated that these changes would significantly boost banks’ statements of earnings and allow them to defer reporting losses. Opponents argue that the implications for investors are that the valuation of assets underlying such securities will be increasingly difficult to analyze, not less so.