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Mike Boswell
TriPoint Capital Advisors, LLC

More or Less: Some Assets Will Get More Than One Price

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By: Chris Kentouris | September 20, 2009

An asset-backed security is trading at a price of $100. Suddenly, the market freezes and only a handful of transactions take place. The last one is for $20.

One fund manager prices the security at $20 and yet another one using projected future cash flows and taking into account the somewhat illiquid market picks $60 as the correct price. Each fund manager discloses the price of the asset on a financial report.

Sounds fair enough. But the Financial Accounting Standards Board, the standards setter for the U.S. accounting industry, is now proposing that firms disclose not only how they came up with their valuations for such a hard-to-price asset, but a range of fair values they could have also created. The range would be based on using different reasonable sets of assumptions to come up with significantly different prices.

The possible requirement is now out for public comment until October 12. It would become effective for reporting periods after Dec. 15, 2009.  "A number of constituents have recommended that the board improve disclosures about fair-value measurements," said Robert Herz, the FASB's chairman announcing the issuance of what it calls an "exposure draft" issued on August 28." The board believes that increased transparency resulting from the proposed disclosures would benefit financial statement users," said Herz about the draft for "improving disclosures about fair value measurements."

Middle- and back-office executives who will have to comply with the FASB's proposal, known as a "sensitivity analysis," don't think its all that fair. Providing more information on the proprietary methodologies and inputs used to value hard-to-price, or so-called Level 3 assets, could spell lots of administrative headaches. There is no mention of hefty additional costs in making multiple assessments of prices.

"The new rules proposed in the exposure draft raise the question of how much additional work will be required to provide a new sensitivity disclosure," says David Larsen, managing director at Duff & Phelps, a New York financial advisory firm. "Would the (price of) $20 need to be disclosed or would another pricing model using other reasonably possible inputs be required," he asks.

Interpreting the requirement won't be easy, agrees Nicholas Tsafos, a partner in the New York accounting firm of Eisner LLP. "A valuation expert might think that a ten percent different in valuation should be disclosed while a regulator might think it should be one percent. Taking two different approaches could get valuations which differ by as much as 20 or 30 percent," he says.

The FASB's proposal would most directly affect the Level 3 securities, where values are based on "unobservable inputs" or a company's "own assumptions." Level 3 securities represent one of three types of pricing methodologies, the FASB established in 2006 to comply with its interpretation of fair-value accounting.

The values of Level 1 assets are based on real prices, such as those of stocks traded on an exchange. Level 2 assets will be priced based on prices of similar assets. Because they are only traded in secondary markets--and are sometimes even illiquid--the fair value of Level 3 assets can only reflect a company's own ideas about the assumptions which market participants would use in their valuations of the asset or liability.  There are currently some disclosure requirements. Firms are only required to categorize securities in one of the three pricing buckets and reveal general valuation methodologies for each of the buckets. They must also price the total assets in each category at the beginning and the end of the reporting period.

Firms which invest in some types of asset-backed and mortgage-backed securities, distressed debt instruments and bespoke over-the-counter derivatives which typically fall in the Level 3 category will likely be the most affected by the FASB's sensitivity proposal. A study late last year by the Securities and Exchange Commission showed that 9 percent of financial instruments subject to fair value were classified as Level 3, compared to 76 percent for Level 1.

To comply with the FASB's new potential requirement, firms may need to hire outside valuation firms to help make judgments, according to Rick Martin, head of technical accounting for Pluris Valuation Advisors. Pluris, a New York-based valuation services firm specializing in asset and mortgage-backed securities, has received "numerous calls" from large and small banks about its services since the FASB's proposal was released.  Firms might also need for fork over more fees to their auditors. "We will have to do more work in ascertaining whether the multiple methodologies used to price the asset are reasonable," says Chris Mears, managing principal with Rothstein Kass, a Roseland, N.J.-based auditing firm specializing in hedge funds.

The bottom line, according to one worried New York hedge fund manager who contacted Securities Industry News: the costs of preparing financial statements could easily double depending on the investment strategy and the number of hard-to-price assets. It could come to anywhere from $200,000 to more than $1million, he said.

For a large broker-dealer or bank or even a hedge fund of $5 billion in assets, that might not be financially burdensome. But for start-ups or even fledgling hedge funds, the price-tag could be cost-prohibitive.

Firms which already rely on valuation companies to provide a range of values for each Level 3 asset, must also now ask for more details on the methodologies, models and inputs used to calculate the fair value of each asset separately.

"Companies will need to understand not only the methodologies and inputs used by their valuation firm, but how different techniques and inputs might affect values," says Martin. "That information is typically only given when there is a dispute between the price calculated by the valuation firm, the client or its auditor."

One hedge fund operations executive who spoke with Securities Industry News on condition of anonymity, recalled the instance of such a large discrepancy of the value of his firm's investment in several hundred acres of land it received as a creditor in a bankruptcy filing.

"We calculated the value of our investment based on our estimate of the value of each of the buildings and took into account the potential cash flows from revenue generating facilities such as the power plant," said the hedge fund executive who is responsible for his firm's valuations. "The third party valuation firm we hired did not include the revenue generating facilities. Instead, they came up with a potential depreciation of the value of the trees on the acreage. The auditing firm, in turn, didn't take either approach, instead looking mainly at the potential that homeowners might sell out due to concerns over air and water pollution levels."

Depending on the inputs used the difference in valuations came to $100 million. For a property valued at between $400 million and $500 million that could be considered sizeable enough to be disclosed. "That would mean we would have to go into a lengthy discussion of each of the valuations and methodologies," said the operations executive. "I can only wonder how many pages that would take and who would be brave enough to read through the entire document."

Keeping track of all the extra information will require more data storage capacity as well as computing power which might require the purchase of specialized valuation software. "For each calculation of the fair value of a Level 3 asset there may be two additional estimates required using reasonably possible alternatives to come up with an understanding of significant differences," says Larsen.

The FASB's recent proposal on Level 3 securities is one of three additions to the FAS rule 157 requirements but the one requiring the most work. The other proposal would require reporting entities to report significant transfers of assets and liabilities into and out of Level 1 and Level 2 and the reasons for the transfers. Yet another proposal would require companies to report information about purchases, sales, issuance and settlements of Level 3 assets separately on a gross basis than as one net number.

The FASB's clarification of the methodologies used to define fair-value accounting have come under substantial criticism. The American Bankers Association, the influential Washington, D.C. lobbying group, has blamed fair-value accounting for worsening the financial crisis. Merrill Lynch, Bank of America and Citigroup have been firms required to take writedowns.

Valuation experts, however counter, that fair value accounting is misunderstood. They say that as spreads widened for distressed mortgage instruments and other assets, many firms used the last price at which a security traded as the fair value, even if only a handful of transactions had been done.

In a statement issued with the SEC on Sept. 30, 2008, the FASB clarified just how firms should use its fair value methodologies. The FASB said that transactions in illiquid markets should be included in calculating the fair value of an asset but not automatically listed as the fair value. The FASB assured firms that they should continue to look for observable prices in determining the value of assets and liabilities in such markets.

On Oct 10, the FASB issued a staff position which included an example of how a collateralized debt obligation--an asset backed security with payments derived from a portfolio of underlying fixed-income assets--should be valued. According to the guidance, firms should look at older quoted prices for the same or similar CDOs, in addition to current prices; interest rate levels and other movements in relevant indexes; indicative broker quotes or prices from independent service providers; data on the performance of underlying assets; analyst and rating agency reports; and other observable inputs.

1, 2, 3: What's an Asset Worth?

These are some Financial Accounting Standards Board requirements for how firms must disclose the ways they value assets.

CURRENT

1 - Categorize assets into either one of three types:
a. Level 1: Markets determine pricing.
b. Level 2: "Observable inputs" determine pricing
c. Level 3: "Unobservable inputs" determine pricing
2 - Value securities in each level at the beginning and end of every reporting period
3 - Describe the method of valuing each level of assets
4 - For Level 3 securities, include information about purchases, sales, issuances, and settlements on either a gross or net basis

PROPOSED

1 - Provide a range of prices for the Level 3 asset, using different methods of valuation
2 - Reveal "significant" transfers of securities in and out of Level 1 and Level 2 categories.
3 - Provide the reasons for the transfers at the beginning and end of a reporting period.
4 - For Level 3 securities, include information about purchases, sales, issuance and settlements on a gross basis only