FIRMA National Conference New Orleans 2009

FAS 157

Michael DalyVP Risk Management and Quality ControlUnion Bank of California

What’s New?What’s New?

Introducing FAS 157Introducing FAS 157 The Financial Accounting Standards The Financial Accounting Standards

Board’s (FASB) Statement of Financial Board’s (FASB) Statement of Financial Accounting Standards No. 157 provides Accounting Standards No. 157 provides direction for financial statements prepared direction for financial statements prepared in accordance with General Accepted in accordance with General Accepted Accounting Principles (GAAP).Accounting Principles (GAAP).

The new Financial Accounting Standard is The new Financial Accounting Standard is mandatory for financial statements mandatory for financial statements prepared in accordance with GAAP prepared in accordance with GAAP Principles for fiscal years beginning after Principles for fiscal years beginning after November 15, 2007.November 15, 2007.

Introducing FAS 157Introducing FAS 157 A principles based standard that A principles based standard that

provides limited implementation provides limited implementation guidance.guidance.

Proper disclosure will enable financial Proper disclosure will enable financial statement users to assess the assumption statement users to assess the assumption used in asset valuation.used in asset valuation.

The ConceptsThe Concepts

The ConceptsThe Concepts

SimplifiedSimplified

The ConceptsThe ConceptsFair ValueFair Value

Observable InputsObservable Inputs

Unobservable InputsUnobservable Inputs

Pricing MethodologiesPricing Methodologies

Key ConceptsKey ConceptsExit PriceExit Price Market Based

Principal and Most Advantageous MarketsPrincipal and Most Advantageous Markets

Nonperformance RiskNonperformance Risk

Conceptual CulpritConceptual Culprit

LIQUIDITYLIQUIDITY

““LIQUIDITY IS AN LIQUIDITY IS AN ILLUSION.ILLUSION.

It is always there It is always there when you don’t when you don’t need it and rarely need it and rarely there when you there when you do.” do.” Michael Michael Milken Milken

Fair ValueFair ValueFair Value is the price that Fair Value is the price that

would be received would be received to sell an asset or paid to to sell an asset or paid to

transfer a liability in an transfer a liability in an orderly transaction orderly transaction between market between market participants at the participants at the measurement date.measurement date.

The InputsThe Inputs

OBSERVABLE OBSERVABLE INPUTS =INPUTS =

Inputs that reflect the Inputs that reflect the assumptions market assumptions market participants would participants would use in pricing the use in pricing the asset or liability asset or liability developed based on developed based on market data obtained market data obtained from sources from sources independent of the independent of the reporting entity.reporting entity.

The InputsThe Inputs

UNOBSERVABLE UNOBSERVABLE INPUTS =INPUTS =

Inputs that reflect the Inputs that reflect the reporting entities reporting entities own assumptions own assumptions about the market, about the market, that participants that participants would use in pricing would use in pricing the asset or liability the asset or liability based on the best based on the best information information available.available.

The Fair Value Input The Fair Value Input HierarchyHierarchy

LEVEL 1 – quoted LEVEL 1 – quoted prices (unadjusted) in prices (unadjusted) in active markets for active markets for identical assets.identical assets.

LEVEL 2 – observable LEVEL 2 – observable for the asset or for the asset or liability, either liability, either directly or indirectly.directly or indirectly.

LEVEL 3 – LEVEL 3 – unobservable and unobservable and contain assumptions.contain assumptions.

Pricing Methodologies Pricing Methodologies Close of MarketClose of Market Reference DataReference Data Evaluation (dealer Evaluation (dealer

quotes, bond market quotes, bond market activity, and other activity, and other relevant information)relevant information)

Bid, Mean and Ask Bid, Mean and Ask (generally a price (generally a price adjustment to a bid adjustment to a bid price based on maturity, price based on maturity, credit standing and credit standing and trade frequencies)trade frequencies)

Exit PriceExit PriceOr Or

Market ValueMarket Value - versus -- versus -

Market Entry Value Market Entry Value OrOr

““Hypothetical Transaction” Hypothetical Transaction” ValueValue

Market BasedMarket Based Market inputs for evaluation include:Market inputs for evaluation include:

- benchmark yields- benchmark yields- reported trades- reported trades- broker/dealer quotes- broker/dealer quotes- benchmark securities- benchmark securities- etc.- etc.

Market BasedMarket Based The standard is very subjective for non-The standard is very subjective for non-

traded financial assets and liabilities.traded financial assets and liabilities. In 2007, less than 1% of USD In 2007, less than 1% of USD

denominated debt trades on an average denominated debt trades on an average day – In 2008, as a result of the sub-day – In 2008, as a result of the sub-prime crisis even less.prime crisis even less.

FAS 157FAS 157 Prior to FAS 157, transaction price or Prior to FAS 157, transaction price or

entry price was assumed to represent entry price was assumed to represent fair value at initial recognition.fair value at initial recognition.

Today the exit price objective applies Today the exit price objective applies regardless of reporting entities intent regardless of reporting entities intent and/or ability to sell the asset or and/or ability to sell the asset or transfer the liability.transfer the liability.

FAS 157FAS 157 Disclosure of pricing sourcesDisclosure of pricing sources(often what lurks beneath the vendor (often what lurks beneath the vendor

feed?)feed?) Tier I – “quoted prices (unadjusted) in Tier I – “quoted prices (unadjusted) in

active markets for identical markets”active markets for identical markets” Tier II – “observable for the asset or Tier II – “observable for the asset or

liability, either directly or indirectly” liability, either directly or indirectly” [similar assets or markets][similar assets or markets]

Tier III – “unobservable”Tier III – “unobservable”

Principal and Most Principal and Most Advantageous MarketsAdvantageous Markets

PRINCIPAL MARKET = the market with PRINCIPAL MARKET = the market with the greatest volume and level of activitythe greatest volume and level of activity

MOST ADVANTAGEOUS MARKET MOST ADVANTAGEOUS MARKET = the market in which the = the market in which the entity would recognize the highest entity would recognize the highest value, after considering transaction value, after considering transaction costs.costs.

Non Performance RiskNon Performance Risk NONPERFORMANCE RISK = the NONPERFORMANCE RISK = the

risk that the obligation will not be risk that the obligation will not be fulfilledfulfilled

The Re-think of Long Held The Re-think of Long Held Valuation AssumptionsValuation Assumptions

What about Hedge Funds?What about Hedge Funds?

Generally calculated a “net Generally calculated a “net asset value”asset value”Like mutual fund – but:Like mutual fund – but:

•More complexity of More complexity of investmentsinvestments•More uncertainty in More uncertainty in pricing of investmentspricing of investments•Less reliability in Less reliability in valuation received.valuation received.•Less liquidLess liquid•…….and …. Unregulated..and …. Unregulated.

The Re-think of Long Held The Re-think of Long Held Valuation AssumptionsValuation Assumptions

What about Investment What about Investment Advisor Influence?Advisor Influence?

•Receiving prices directly Receiving prices directly from investment advisorsfrom investment advisors•Multiple investment Multiple investment advisors pricing the same advisors pricing the same asset at different pricesasset at different pricesClient disclosure of all Client disclosure of all price sources?price sources?

The Re-think of Long Held The Re-think of Long Held Valuation AssumptionsValuation Assumptions

What will be the effect on Forecasted earnings and communicating those results?

Will there be a reduction in the number of transactions in certain asset classes?

Communicating the Communicating the Components of Components of

Valuation and PerformanceValuation and Performance

The “Bucketing The “Bucketing Approach”Approach”

Consideration of Consideration of types or groups types or groups of securities to of securities to determine the determine the pricing pricing methodology, methodology, evaluated pricing evaluated pricing applications and applications and models, and other models, and other inputs that may inputs that may have been used have been used by pricing and by pricing and reference data reference data vendors.vendors.

Let’s Review Let’s Review

FAS 157FAS 157 Buyer Beware to Buyer AwareBuyer Beware to Buyer Aware DisclosureDisclosure FASB (Financial Accounting FASB (Financial Accounting

Standards Board)Standards Board) FAS 157 – new standard – new rulesFAS 157 – new standard – new rules Fair value retains “exchange price Fair value retains “exchange price

notion”notion” ““exit price” – “not the price paid to exit price” – “not the price paid to

acquire asset or liability”acquire asset or liability”

FAS 157FAS 157 Disclosure of pricing sourcesDisclosure of pricing sources(often what lurks beneath the vendor (often what lurks beneath the vendor

feed?)feed?) Tier I – “quoted prices (unadjusted) in Tier I – “quoted prices (unadjusted) in

active markets for identical markets”active markets for identical markets” Tier II – “observable for the asset or Tier II – “observable for the asset or

liability, either directly or indirectly” liability, either directly or indirectly” [similar assets or markets][similar assets or markets]

Tier III – “unobservable”Tier III – “unobservable”

A New Mantra A New Mantra

Communicate Valuation Methodologies

Understand the Concepts

Be Helpful and Accurate and Don’t Opine

When Unclear - Escalate

CYA