FAS 115-2 is here

FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (“FSP 115-2”), must be adopted now, in the second quarter. 115-2 introduces new guidance on measuring other-than-temporary impairment (“OTTI”) of debt securities classified as held-to-maturity or available-for-sale. This includes all auction rate securities (“ARS”) that are classified as such. 115-2 also requires a transition adjustment, so its application is required at both April 1, 2009, and June 30, 2009. Further, the results of applying 115-2 at 4/1 will have a roll forward impact on 6/30, so sequence is critical. IMPACT: BIFURCATION FSP 115-2 requires companies to separate the credit and non-credit components of OTTI. For previously recognized OTTI, the credit component will be recognized in earnings, while the non-credit component will be recognized in OCI. New OTTI recognized in the second quarter will also need tobe split between credit and non-credit. In performing this bifurcation, companies are required to consider their best estimate of the present value of cash flows expected to be collected from the debt security. However, 115-2 does not specify an approach to use when determining present value. The FSP refers to paragraphs 12-16 of FAS 114, Accounting By Creditors for Impairment of a Loan, which measures impairment on the basis of the present value of expected future cash flows. Unfortunately, this methodology cannot be readily applied to debt securities without further modification. It also relies on a subjective projection of future cash flows, for which there is no observable data, rather than relying on empirical market data. As with all debt valuations, an analysis limited to projecting future cash flows is deficient and would be unacceptable in most circumstances. The discount rate is a critical component of the valuation. Depending on the nature and type of the auction rate security, there can be wide fluctuations between how much OTTI relates to credit and how much relates to non-credit. One of the most vexing parts of the fair value analysis is determining the most appropriate discount rates to apply to ARS. METHODOLOGY We believe that separating the credit and non-credit portions of OTTI for auction rate securities requires in-depth analysis of discount rates and that this analysis should be based on empirical market data. Therefore, we have developed a methodology that not only incorporates considerations of the guidance provided in FAS 114 , but also empirical market-data. Our methodology consists of two approaches, described below. In the first approach, we back out the impact of non-credit risk from the yield spread by evaluating, side-by-side, highly liquid non-ARS debt securities that have similar characteristics as ARS, as well as other ARS from the same issuers with characteristics similar to the non-ARS securities. In our second approach, we rely on academic research on liquidity spreads to determine the non-credit spreads (yielding credit spreads alone as the balance). For both approaches, we rely on transaction data reflected in our LiquiStat™ database or arm’s-length transactions in ARS, along with public data on similar, freely-tradable securities, in order to develop yield spreads. Calculating the net present value of future cash flows with a yield spread that removes all non-credit issues from the calculation yields the credit-loss-adjusted fair value of the ARS (CLAFV). The difference between the carrying book value of a particular security and its credit-loss-adjusted fair value would be equal to the portion of OTTI that should be recorded in earnings, whereas the non-credit portion would be recognized in other comprehensive income on the balance sheet. This applies to previously existing OTTI as well as new OTTI in the second quarter. SUMMARY The separation of credit and non-credit within OTTI for auction rate securities is more complicated and labor intensive than subjectively estimating the collectability of future cash flows. Companies need a robust analysis to support the bifurcation, particularly with respect to the discount rate. Now is the time to begin the analysis, as this must be performed for 4/1 and 6/30, and the former date will impact the latter date. Pluris has developed a method for separating credit from other losses that is derived from empirical data on discount rates for illiquid securities. We believe such market data is crucial for ensuring consistency and comparability of reported valuations. ¹ The FAS 114 methodology, which is intended for certain loans (and which scopes out debt securities, such as ARS), relies on an estimate of expected future cash flows and assumes that the discount rate equals the interest rate for the loan. The methodology favored by bond market participants is to set expected cash flows equal to contractual cash flows and to then estimate higher or lower fair values based on changes in the yield.