Fair Value Accounting

EEI: Fair Value Bootcamp : 

EEI: Fair Value Bootcamp Frank J. Beil, CPA University of Minnesota beilx002@umn.edu 6/16/2008 Fair Value Accounting 1

Introduction to SFAS 157: Agenda : 

Introduction to SFAS 157: Agenda Overview and Effective Date Scope Fair Value Hierarchy New Definition of Fair Value Valuation Techniques Disclosure Requirements Practice Considerations Transition 6/16/2008 Fair Value Accounting 2

The FASB Has Fair Value On Its Mind : 

The FASB Has Fair Value On Its Mind March 2006 Statement 155, Accounting for Certain Hybrid Financial Instruments Statement 156, Accounting for Servicing of Financial Assets Years beginning after September 15, 2006 September 2006 Statement 157, Fair Value Measurements Years beginning after November 15, 2007 One year deferral for non-financial assets and nonfinancial liabilities no subject to recurring measurements February 2007 Statement 159, The Fair Value Option for Financial Assets and Liabilities Years beginning after November 15, 2007 Historical cost Fair value Hybrid 6/16/2008 Fair Value Accounting 3

The FASB Has Fair Value On Its Mind : 

The FASB Has Fair Value On Its Mind Summer 2007– FASB has formed valuation resource group Other projects that potentially expand fair value Statement 141(R), Business Combinations, Years beginning after December 15, 2008. Issued 4th quarter 2007 Phase 2 of the fair value option Non-financial assets and liabilities: commodities, investment properties. Deliberations beginning in 3rd Quarter 2007. Convergence w/ IFRS Statement 157 Financial Instruments Historical cost Fair value Hybrid 6/16/2008 Fair Value Accounting 4

Key Takeaways : 

Key Takeaways All entities are impacted Complexities Many clarifications are necessary (Firm Q&As) Extensive disclosure requirements Statement 157 – Three level hierarchy disclosures Use of Specialists 6/16/2008 Fair Value Accounting 5

Overview : 

Overview Why is this statement necessary? Different definitions of fair value in different standards led to inconsistency and added to complexity in GAAP FASB seeking more transparency in financial statements regarding fair value measurements in GAAP Expands disclosures about the use of fair value to re-measure assets and liabilities Does not require any new fair value measurements, but provides guidance on how to measure fair value 6/16/2008 Fair Value Accounting 6

Effective Date : 

Effective Date Effective for fiscal years beginning after 11/15/07* Early application is encouraged as of the beginning of a fiscal year, provided the entity has not yet issued financial statements for an interim period in the fiscal year *FASB has delayed, until November 15, 2008, the implementation of FAS 157 measurements for nonfinancial assets and liabilities 6/16/2008 Fair Value Accounting 7

In Scope : 

In Scope Applies to fair value measurements within 60+ existing pronouncements, examples include:

Scoped Out : 

Scoped Out Does not apply to fair value measurements or similar measurements in transactions involving: Share-based payments, Vendor-specific objective evidence (e.g., software revenue recognition), or Inventory (accounted for in accordance with ARB 43) FAS 13: Accounting for Leases The Statement does not remove any practicability exceptions that currently exist in GAAP (e.g., Statement 107, Statement 143, FIN 45, and FIN 47) 6/16/2008 Fair Value Accounting 9

FSP FAS 157-a : 

FSP FAS 157-a Statement 157 does not apply under Statement 13 (Leasing) and its related interpretive accounting pronouncements that address leasing transactions 6/16/2008 Fair Value Accounting 10

FSP FAS 157-b : 

FSP FAS 157-b Defers the effective date of Statement 157 to nonfinancial assets and liabilities to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of the FSP Examples Nonfinancial assets and nonfinancial liabilities measured at fair value in a business combination, but not measuring at fair value in subsequent periods (nonrecurring measurements) 6/16/2008 Fair Value Accounting 11

FSP 157-b : 

FSP 157-b Reporting units measured at fair value for step one of the goodwill impairment test (Statement 142) Nonfinancial assets and liabilities measured at fair value in step two of the goodwill impairment test (Statement 142) Indefinite lived intangibles measured at fair value for impairment under Statement 142 Long lived asset groups measured at fair value for impairment under Statement 144 Asset retirement obligations under Statement 143 Liabilities for exit or disposal under Statement 146 6/16/2008 Fair Value Accounting 12

FSP FAS 157-c : 

FSP FAS 157-c Measuring Liabilities Under Statement 157 Changes to 157 A quoted price for the identical liability (unadjusted) in an active market—level 1 input—is the best evidence of fair value for that liability In the absence of a quoted price for the identical liability in an active market, the entity may measure the fair value of its liability at the amount that it would receive as proceeds if it were to issue that liability at the measurement date 6/16/2008 Fair Value Accounting 13

Framework of FAS 157 : 

Framework of FAS 157 6/16/2008 Fair Value Accounting 14

Framework : 

Framework STEP ONE: DETERMINE UNIT OF ACCOUNT The reporting entity must determine the unit of account (i.e., what is being measured). As further discussed in FAS 157, paragraph 6, the unit of account is determined based on other applicable generally accepted accounting principles. Therefore, for example, the unit of account for a derivative generally is the entire contract and the unit of account for the first step of a goodwill impairment analysis is the reporting unit. ” 6/16/2008 Fair Value Accounting 15

Framework : 

Framework STEP TWO: DETERMINE POTENTIAL MARKETS BASED ON THE HIGHEST AND BEST USE After determining the unit of account, the reporting entity must assess the highest and best use for the asset, based on the perspective of market participants. In accordance with FAS 157, paragraph 12, the fair value of an asset is based on the use of the asset by market participants that would maximize its value. The highest and best use for an asset must be determined based on the perspective of market participants, even if the reporting entity intends a different use. Liabilities are valued based on the transfer of the liability to a market participant on the measurement date. However, reporting entities must still consider potential markets for the transfer of the liability. 6/16/2008 Fair Value Accounting 16

Framework : 

Framework STEP THREE: DETERMINE MARKETS FOR BASIS OF VALUATION Once a reporting entity has considered potential markets, market participants, and the valuation premise, it must assess whether it has access to any potential markets. If access is available, a reporting entity must consider the following: Is there a principal market for the asset or liability? In accordance with FAS 157, paragraph 8, the principal market is 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.   The reporting entity cannot incorporate potentially more advantageous markets in its fair value measurements when it has a principal market. 6/16/2008 Fair Value Accounting 17

Framework : 

Framework STEP FOUR: APPLY THE APPROPRIATE VALUATION TECHNIQUE(S) The Standard outlines three potential valuation techniques: the market approach, the income approach and the cost approach. It requires that the reporting entity consider and apply each valuation technique that is appropriate in the circumstances and for which market participant pricing inputs can be obtained without undue cost and effort 6/16/2008 Fair Value Accounting 18

Framework : 

Framework STEP FIVE: DETERMINE FAIR VALUE The outcome of the market determination and the application of valuation technique(s) will be a fair value measurement. To the extent that the valuation was applied to an asset that was valued in-use, the total calculated value must be allocated to each unit of account in the asset grouping based on the specific facts and circumstances. Fair Value Accounting 19

Fair Value Hierarchy : 

Fair Value Hierarchy 6/16/2008 Fair Value Accounting 20

Fair Value Hierarchy : 

Fair Value Hierarchy Standard establishes a three-level hierarchy What is the purpose of the hierarchy? To prioritize the inputs to valuation techniques used to measure fair value into three broad levels To maximize the use of observable market data and minimize the use of unobservable inputs To establish classification of fair value measurements for disclosure purposes Hierarchy applies to inputs NOT techniques 6/16/2008 Fair Value Accounting 21

Observable vs. Unobservable Inputs : 

Observable vs. Unobservable Inputs Observable: Inputs that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the reporting entity Unobservable: Inputs that reflect the reporting the entity’s own assumptions about the assumption market participants would use in pricing the asset or liability developed based on the best information available in the circumstances 6/16/2008 Fair Value Accounting 22

Observable—Market Based : 

Observable—Market Based 6/16/2008 Fair Value Accounting 23

Fair Value Hierarchy – Level 1 : 

Fair Value Hierarchy – Level 1 Level 1 Inputs Quoted prices (unadjusted) for identical assets or liabilities in active markets that the reporting entity has the ability to access at the measurement date Active Market Transactions occur with sufficient frequency and volume to provide pricing information (i.e., NYSE) Active market, available, yet not readily accessible Large number of similar assets/liabilities Pricing services or individual broker/dealers May use alternative pricing method (i.e., matrix pricing), yet renders the fair value measurement Level 2 6/16/2008 Fair Value Accounting 24

Fair Value Hierarchy – Level 2 : 

Fair Value Hierarchy – Level 2 Observable (either directly or indirectly) market inputs other than quoted prices Quoted prices for similar assets or liabilities in active markets Quoted prices for identical or similar assets or liabilities in markets which are not active Market inputs other than quoted prices which are directly observable Market inputs that are not directly observable, but are derived from or corroborated by other observable market data 6/16/2008 Fair Value Accounting 25

Fair Value Hierarchy – Level 3 : 

Fair Value Hierarchy – Level 3 Level 3 Inputs Unobservable market inputs Example – Inputs derived through extrapolation or interpolation that are not able to be corroborated by observable market data Example – Entity specific data Level 3 to be used if observable market inputs are not available FVM objective remains the same  exit price from seller’s perspective 6/16/2008 Fair Value Accounting 26

Fair Value Hierarchy – Levels 1, 2, and 3 : 

Fair Value Hierarchy – Levels 1, 2, and 3 Multiple inputs? Overall classification is a two step process: Identify what level each input falls in Determine lowest level input(s) with a significant effect

New Definition of Fair Value : 

New Definition of Fair Value 6/16/2008 Fair Value Accounting 28

Which Price? : 

Which Price? 6/16/2008 Fair Value Accounting 29

New Definition of Fair Value : 

New Definition of Fair Value “Fair value is 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” Exit Price: Not necessarily the price paid for an asset (for example), which is an entry price Market Participants: Buyers and sellers that are independent, knowledgeable, able, and willing Skepticism of a risk averse buyer Even if market participants would use the asset differently than the owner’s intended use 6/16/2008 Fair Value Accounting 30

Principal (or Most Advantageous) Market : 

Principal (or Most Advantageous) Market What if there is more than one market for the asset or liability? Which price is fair value? Measurement assumes transaction occurs in the principal (or most advantageous) market: Look for a Principal market – i.e., market with most volume or level of activity If there is no principal market, look to the most advantageous market (i.e., highest price, considering transaction costs) Analysis from the perspective of the reporting entity 6/16/2008 Fair Value Accounting 31

Transaction Cost vs. Transportation Cost : 

Transaction Cost vs. Transportation Cost

Example – Principal Market and Transaction Costs : 

Example – Principal Market and Transaction Costs Company A holds XYZ stock, which trades on two exchanges (A can access both): New York and London, for example. Assume stock price and transaction costs at the measurement date (for the respective exchanges) are as follows: What is the fair value of Stock XYZ? $26, if New York is the principal market $25, if London is the principal market $25, if no principal market, since London’s price (net of transaction costs) is the most advantageous result

Market Identification : 

Market Identification 6/16/2008 Fair Value Accounting 34

Determining Markets : 

Determining Markets 6/16/2008 Fair Value Accounting 35

Unit of Account : 

Unit of Account Fair value measurement is based on a particular asset or liability, which might be a stand-alone item, or a group of assets and/or liabilities “Unit of account” determines what is being measured by reference to the level at which the asset or liability is aggregated (or disaggregated) for purposes of applying other accounting pronouncements [Paragraph 6] 6/16/2008 Fair Value Accounting 36

Assets (Highest and Best Use) : 

Determined based on the use of the asset by market participants (even if the entity’s intent is different). Assets (Highest and Best Use) Fair value assumes the highest and best use that is (as of the measurement date): Physically possible, Legally permissible, and Financially feasible Highest and best use can be either (whichever maximizes fair value): In-use in combination with other assets, or In-exchange as a standalone asset [Paragraphs A6-A12 provide examples] Defensive Value – Trademarks, IPR&D 6/16/2008 Fair Value Accounting 37

Unit of Account vs. Unit of Valuation : 

Unit of Account vs. Unit of Valuation Example: Derivatives Portfolio What is the proper “unit of valuation”? Are portfolio-level valuation adjustments (i.e., for credit or liquidity) appropriate? What is the “unit of account”? If units of valuation and account are different, what are the disclosure implications? 6/16/2008 Fair Value Accounting 38

Valuation Techniques : 

Valuation Techniques 6/16/2008 Fair Value Accounting 39

Valuation Techniques : 

Valuation Techniques Use technique(s) appropriate under the circumstances Market Approach – Look to market pricing for identical or comparable assets/liabilities Income Approach – Convert future cash flows into present value (e.g., using Black-Scholes option-pricing model) Cost Approach – Current replacement cost Apply technique(s) consistently A change in the valuation technique or its application may be accounted for as a change in accounting estimate (SFAS 154) if, for example: New markets develop New information becomes available Information previously used is no longer available, and/or Valuation techniques improve 6/16/2008 Fair Value Accounting 40

Other Measurement Guidance : 

Other Measurement Guidance Block Discounts: If there is a quoted price in an active market, then fair value = Price x Quantity. P x Q not required for quoted prices in markets that are not active. Fair Value at Inception: Transaction price is no longer presumptively fair value (nullification in part of EITF Issue 02-03). Fair Value of a Liability: Includes impact of the entity’s own credit. Restricted Assets: The fair value of the restricted asset should incorporate the effect of the restriction, if the restriction would pass to another market participant. Bid & Ask Prices: Use a price within the bid/ask spread that is most representative of fair value (consistently applied), but a mid-market pricing (or other pricing) convention may be used as a practical expedient. 6/16/2008 Fair Value Accounting 41

Disclosure Requirements : 

Disclosure Requirements 6/16/2008 Fair Value Accounting 42

New Disclosures : 

New Disclosures Designed to increase transparency regarding how fair value is determined Disclosures are driven by SFAS 157’s three-level hierarchy. The hierarchy is used to establish classification for disclosure purposes. Disclosures apply to recurring and non-recurring fair value measurements reflected in the financial statements in periods subsequent to initial recognition. 6/16/2008 Fair Value Accounting 43

Recurring vs. Non-Recurring : 

Recurring vs. Non-Recurring Recurring Examples Trading or available-for-sale securities Derivatives at fair value through earnings Servicing assets & liabilities at fair value through earnings Financial assets and liabilities for which the FVO has been elected Investments carried at fair value in accordance with the AICPA Audit & Accounting Guide, Investment Companies Pension assets (sponsor’s books) – annual only Non-recurring Examples Impairment of goodwill Impairment of long-lived assets held and used Long-lived assets held for sale accounted for at the lower of cost or fair value (less cost to sell) Impaired HTM securities Impaired equity method or cost investments (APB 18) Impairment of loans using the practical expedients in Statement 114. Mortgage loans held for sale accounted for at the lower of cost or fair value. 6/16/2008 Fair Value Accounting 44

Example Disclosure – Recurring Assets* : 

Example Disclosure – Recurring Assets* *A similar table should be presented for liabilities when applicable **Additional disclosures are required for recurring Level 3 measurements

Example Disclosure – Level 3 Recurring : 

Example Disclosure – Level 3 Recurring

Example Disclosure – Nonrecurring* : 

Example Disclosure – Nonrecurring* *A similar table for liabilities is required, if applicable. Entities should also describe the reason for the nonrecurring fair value measurement. **Describe the inputs and information used to develop the inputs for nonrecurring Level 3 based fair value measurements.

Qualitative Information : 

Qualitative Information For all recurring and non-recurring fair value measurements, in the period of adoption (annually thereafter), disclose: The valuation techniques used to measure fair value For example, whether the income, market, or cost approach was used Any changes to the valuation techniques Refer to Letter regarding MDA disclosure for Statement 157 6/16/2008 Fair Value Accounting 48

Practice Considerations : 

Practice Considerations 6/16/2008 Fair Value Accounting 49

Fair Value of Liabilities* : 

Fair Value of Liabilities* Fair value measurement of a liability should include the impact of the reporting entity’s own credit standing. Counterintuitive result: As an entity’s credit standing declines, the fair value of its liabilities decreases with a resulting gain in earnings (and vice-versa). Impact will differ depending on the terms of any credit enhancements (for example, cash collateral). *FSP FAS 157-c—amends FAS 157 as to measurement of liabilities 6/16/2008 Fair Value Accounting 50

Fair Value of Liabilities – Example (No Credit Enhancements) : 

Fair Value of Liabilities – Example (No Credit Enhancements) Company X Note Holders $95 million Fixed Rate Notes ($100 million par) Company X issues fixed rate debt with $100 million par value Debt has a B credit rating Debt is issued with a below market coupon (i.e. coupon consistent with A credit rating), resulting in a discount Cash proceeds equal $95 million, which is presumed to equal fair value at inception. No credit enhancements What happens to fair value if Company X’s credit rating is downgraded to C (no other factors change)? 6/16/2008 Fair Value Accounting 51

Fair Value of Liabilities – Example (No Credit Enhancements) : 

Fair Value of Liabilities – Example (No Credit Enhancements) Fair Value of Company X’s Debt1: B Credit Rating $95 million C Credit Rating $90 million Increased Earnings $5 million 1 Fair value measurements are assumed. Company X’s non-performance risk under the obligation increases. Hypothetical C-rated borrower would be indifferent between: Receiving $90 million to assume Company X’s debt, or Issuing new debt with same terms and receiving $90 million in proceeds

Fair Value of Liabilities – Example (Collateral) : 

Fair Value of Liabilities – Example (Collateral) Company X Note Holders $100 million Fixed Rate Notes ($100 million par) Assets (Collateral) Contractually Linked to Notes Company X issues fixed rate debt with $100 million par value Debt has a B credit rating Debt is issued with a below market coupon (i.e. coupon consistent with A credit rating) Company X grants note holders a security interest in designated machinery and equipment as collateral Cash proceeds equals $100 million What does $100 million represent? 6/16/2008 Fair Value Accounting 53

Fair Value of Liabilities – Example (Collateral) : 

Fair Value of Liabilities – Example (Collateral) Fair Value of Company X’s Debt1: B Credit Rating $95 million Impact of Collateral $5 million Fair Value $100 million 1 Fair value measurements are assumed. Hypothetical B-rated borrower would require $100 million in a transfer: $95 million – amount B-rated borrower could raise in a new debt offering with the same terms and no collateral. $5 million – amount B-rated borrower would be compensated to ensure notes have the same non-performance risk as prior to the transfer. What happens to fair value if Company X’s credit rating is downgraded to C (no other factors change)? 6/16/2008 Fair Value Accounting 54

Fair Value of Liabilities – Example (Collateral) : 

Fair Value of Liabilities – Example (Collateral) Fair Value of Company X’s Debt1: C Credit Rating $90 million Impact of Collateral $10 million Fair Value $100 million 1 Fair value measurements are assumed. Hypothetical C-rated borrower would require $100 million in a transfer: $90 million - amount C-rated borrower could raise in a new debt offering with the same terms and no collateral. $10 million – amount C-rated borrower would be compensated to ensure notes have the same non-performance risk as prior to the transfer. Lenders still consider the loan well secured. Further deterioration in credit rating could have different result.

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) Company X Note Holders $100 million Fixed Rate Notes ($100 million par) Guarantor Obligation to pay future P&I to note holders in the event of Company X default and collect from Company X, where possible $5 million Company X issues fixed rate debt with $100 million par value Debt has a B credit rating Debt is issued with a below market coupon (i.e. coupon consistent with A credit rating) Company X purchases a third-party guarantee on the notes for $5 million, upfront fee (and no future payment obligation to Company X). Cash proceeds equals $100 million What does $100 million represent? 6/16/2008 Fair Value Accounting 56

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) Proceeds from Company X’s Debt Issuance: Fair Value of Debt (B Credit Rating) $95 million Cost of Guarantee $ 5 million Cash $100 million What is fair value of the debt? 6/16/2008 Fair Value Accounting 57

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) VIEW A - $95 million, guarantee should not be considered in fair value measurement. 2 units of account: notes and guarantee. For example, 2 counterparties to note holders: Company X and Guarantor. Company X is obligated under the liability irrespective of whether there is a 3rd party guarantee: either to the note holders or to the 3rd party guarantor. Company X is acting as an agent on behalf of note holders. Company X has no future benefit/obligation associated with the guarantee and no guarantee asset/liability to recognize. Par. 15 is read from the perspective of the reporting entity (Company X) 6/16/2008 Fair Value Accounting 58

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) VIEW A - $95 million, guarantee should not be considered in fair value measurement. Journal Entries at Issuance ($ in millions): Dr. Cash 100 Cr. Debt 95 Cr. Payable to Guarantor 5 Dr. Payable to Guarantor 5 Cr. Cash 5 6/16/2008 Fair Value Accounting 59

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) VIEW B - $100 million, guarantee should be considered in fair value measurement. 1 unit of account: guarantee is an embedded right in the notes. Hypothetical B-rated borrower would require $100 million in a transfer: $95 million – amount B-rated borrower could raise in a new debt offering with the same terms and no guarantee. $5 million – price to acquire a new guarantee, which results in notes having same non-performance risk as prior to the transfer. Same treatment as other types of credit enhancements (e.g. collateral). 6/16/2008 Fair Value Accounting 60

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) VIEW B - $100 million, guarantee should be considered in fair value measurement. Journal Entries at Issuance ($ in millions): Dr. Cash 100 Cr. Debt 100 Dr. Guarantee Asset 5 Cr. Cash 5 6/16/2008 Fair Value Accounting 61

Fair Value of Liabilities – Example (Third-Party Guarantees) : 

Fair Value of Liabilities – Example (Third-Party Guarantees) VIEW C - $95 or $100 million. SFAS 157 guidance is not clear, so a policy election is acceptable. VIEW A, B OR C? STAY TUNED! 6/16/2008 Fair Value Accounting 62

Fair Value of Liabilities – Other Considerations : 

Fair Value of Liabilities – Other Considerations Some Valuation Factors Current levels of benchmark interest rates Current credit spreads: borrower and guarantor Fair value of collateral or current cost of guarantees Other terms (for example, put or call rights, restrictions, etc.) Other current, relevant market information (for example, regulatory considerations) Disclosure Requirements – 157, 159 and 107 6/16/2008 Fair Value Accounting 63

Applying Guidance : 

Applying Guidance 6/16/2008 Fair Value Accounting 64

Framework : 

Framework Determine unit of account The unit of account is the interest rate swap contract, in accordance with FAS 133. Evaluate valuation premise Company Z determines that the highest and best use of the interest rate swap is in-exchange. Based on its assessment, Company Z determines that market participants would not group the swap with other assets. Assess principal market Company Z determines that it does not have a principal market for the interest rate swap. Its interest rate hedging program has historically included the purchase of swaps, when needed for debt hedging programs, and settlement with the counterparty. It does not trade in swaps or otherwise hold them for speculative purposes. 6/16/2008 Fair Value Accounting 65

Framework : 

Framework Determine the most advantageous market Company Z is aware that there is a retail market and a wholesale market for the type of interest rate swap that it holds. It does not have access to the wholesale swap market. Company Z therefore determines that the retail market is the appropriate market assumption. Determine valuation technique Company Z considers the use of each of the valuation techniques as follows: Market approach – Accommodation quotes are obtained from 2 dealers in the retail swap market. The quotes each indicate a fair value of $9.8 million (liability). Income approach – Company Z performs a discounted cash flow analysis based on available forward yield curves for plain vanilla swaps of the same type. The analysis concludes that the fair value is $10 million (liability), which includes a discount for nonperformance risk based on Company Z’s credit characteristics. Cost approach – As the analysis relates to a financial asset, Company Z concludes that the cost approach is not applicable. 6/16/2008 Fair Value Accounting 66

Framework : 

Framework Determine fair value Due to the nature of the swap (i.e., plain vanilla terms for which there are similar swaps that price in active markets), Company Z determines that the market approach provides the best estimate of fair value. Accordingly, Company Z records the interest rate swap at a value of $9.8 million (liability). No allocation is needed as the unit of account and valuation premise are the same. Hedge considerations The impact on hedge accounting of applying the concepts of FAS 157 will depend on the method used for measuring hedge ineffectiveness: 6/16/2008 Fair Value Accounting 67

Framework : 

Framework If Company Z is using Method 1 (Change in Variable Cash flows Method) of Derivatives Implementation Group (DIG) Issue G7, Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied (DIG Issue G7), and the terms of the variable leg of the swap and the hedged item match (i.e., variable rate index, interest rate reset dates, no basis differences) credit risk will impact ineffectiveness only when default is probable.    If Company Z is using DIG Issue G7, Method 3 (Change in Fair Value Method), credit and nonperformance risk would be considered when determining the fair value of the swap in each period that ineffectiveness is measured. 6/16/2008 Fair Value Accounting 68

Updated Guidance on FAS 133 : 

Updated Guidance on FAS 133 Hedge considerations (continued) Company Z may be precluded from using the short-cut method provided by paragraph 68 of FAS 133. If the exit price of the interest rate swap at its inception is different from transaction price, causing the swap’s fair value to be other than zero, paragraph 68(b) would not be met and the short-cut method would be precluded. In July 2007, the FASB issued proposed DIG Issue E23, Issues Involving the Application of the Shortcut Method under Paragraph 68 (DIG Issue E23). Finalized in its current form, DIG Issue E23 amends paragraph 68 of FAS 133 to permit the use of the shortcut method, if the interest rate swap was entered into for a transaction price of zero and its fair value at inception is other than zero solely as a result of the existence of a bid-ask spread in the reporting entity’s principal or most advantageous market for the swap. 6/16/2008 Fair Value Accounting 69

Transition : 

Transition 6/16/2008 Fair Value Accounting 70

Transition : 

Transition Prospective with two exceptions: Block discounts and Issue 02-03 and Statement 155 hybrid instrument day-one gain and loss deferrals Both exceptions are cumulative effect adjustments to beginning retained earnings in year of initial application 6/16/2008 Fair Value Accounting 71

Transition : 

Transition Issue 02-03 and Statement 155 hybrid instrument day-one gain and loss deferrals: Requires a “single-step” transition approach Example Derivative liability at transition date with an EITF 02-03 adjustment and no consideration of the entity’s own credit risk Statement 157’s inception gain/loss guidance (paragraph 17) should be contemplated in arriving at 157 fair value at adoption.

Transition – 157 vs. 159 : 

Transition – 157 vs. 159 Example 1: Assume Entity A does not elect FVO for an existing hybrid with an embedded derivative. Question: What is the transition for the embedded carried at fair value? For example, if the embedded is in a liability position and the entity must incorporate the effect of its own credit. Answer: Prospective through earnings Example 2: Assume Entity A elects the FVO for the hybrid. Question: What is the transition for the embedded and host (i.e., the hybrid)? Same assumption with respect to credit. Answer: Apply 159 transition (cumulative effect). Cumulative effect is the difference between carrying value of the host and the embedded (i.e., the hybrid) at adoption (pre-157) and the 157 fair value of the hybrid at adoption. May apply to other situations (e.g., loans at lower of cost fair value) 6/16/2008 Fair Value Accounting 73

Review : 

Review Entry vs. exit price Entity Specific vs. marketplace participants Highest & Best Use Principal and Most Advantageous Markets Observable and Unobservable Inputs Priority of Inputs Valuation Techniques Disclosure Requirements 6/16/2008 Fair Value Accounting 74

Slide 75: 

6/16/2008 Fair Value Accounting 75 Examples of Non-Recurring Measurements Using the Fair Value Framework

Applying the Framework : 

Applying the Framework Acquisitions of Companies Goodwill Impairment Long-Lived Asset Impairment 6/16/2008 Fair Value Accounting 76

Acquisitions: Market Participants : 

Acquisitions: Market Participants Reporting entity need not identify specific market participants. Reporting entity should identify characteristics that distinguish market participants generally, considering factors specific to the asset or liability, the principal (or most advantageous) market for the asset or liability, and market participants with whom the reporting entity would generally transact in that market.” 6/16/2008 Fair Value Accounting 77

FASB Guidance on Participants : 

FASB Guidance on Participants Strategic buyers: Strategic buyers could include the acquirer’s peers or competitors, or an entity seeking to diversify its operations. Strategic buyers will have synergies specific to their existing operations, and may have the ability and willingness to transact for the same assets and liabilities that the acquirer just purchased. Financial buyers: Other buyers, including those that have no ownership interests in similar businesses or operations of the acquirer, may also be considered market participants in certain situations. These market participants, commonly referred to as financial buyers, may include individual investors, private equity and venture capital investors and financial institutional investors. 6/16/2008 Fair Value Accounting 78

Goodwill Impairment : 

Goodwill Impairment Goodwill Impairment In 2000, Company C acquired a publicly-traded company, Subsidiary A, for $900. At the time of the acquisition, Company C determined that $100 of the purchase price related to goodwill. Subsidiary A’s operations are complementary to Company C and Company C decided to continue to operate Subsidiary A as a separate company. Company C determines that Subsidiary A is a reporting unit. Subsidiary A is still a public registrant due to publicly traded debt. Demand for Subsidiary A’s services has declined over the period since acquisition and its debt, which is not guaranteed or enhanced by Company C, is trading at a substantial discount. The carrying value of the reporting unit at the time of the impairment test is $700. In performing its annual goodwill impairment test, Company C calculates the fair value of Subsidiary A as follows: 6/16/2008 Fair Value Accounting 79

Framework : 

Framework Determine unit of account In accordance with FAS 157, the unit of account is established by the guidance in FAS 142. In this case, Subsidiary A is a separate reporting unit which is the unit of account used for measurement under FAS 142. Evaluate valuation premise Company C considers whether the highest and best use of the assets of Subsidiary A will be in-use or in-exchange. In this case, Company C has no complementary assets that would provide additional value to a market participant. As such, Company C concludes that the valuation premise is in-use as a single reporting unit (as the underlying assets are being used in a group). Assess principal market Company C determines that there is no principal market for the sale of Subsidiary A as a unit. 6/16/2008 Fair Value Accounting 80

Framework : 

Framework Determine the most advantageous market Company C determines that there is no known or liquid market for Subsidiary A. Company C determines that it would most likely sell Subsidiary A to one of its competitors (market participants with interests similar to its own) or spin off Subsidiary A as a separate entity for sale to a financial buyer or through public markets. Company C will hypothecate market participant assumptions based on its expectations of the assumptions of these competitors and/or potential financial investors. 6/16/2008 Fair Value Accounting 81

Framework : 

Framework Determine valuation technique Market approach – Company C has market information available based on the significant discount on Subsidiary A’s outstanding debt. This information, combined with publicly available information about the recent sale of a similar company, allows Company C to develop an estimate of the market value of Subsidiary A. The analysis concludes that Subsidiary A has a fair value of $500 • Income approach – Company C performs a discounted cash flow analysis based on its expectations of potential net income from the subsidiary. Company C concludes that market participants would shut down certain locations and would scale back other operations. These assumptions are incorporated in the cash flow analysis along with other market participant assumptions. The analysis concludes that the fair value is 550.  Cost approach – As the analysis relates to an operating business, Company A concludes that the cost approach is not applicable. 6/16/2008 Fair Value Accounting 82

Framework : 

Framework Determine indicative value Company C determines that the income approach provides the best estimate of fair value. As the fair value of the reporting unit is less than its carrying value, Company C will complete step 2 of the goodwill impairment analysis to determine the amount of the goodwill impairment loss. 6/16/2008 Fair Value Accounting 83

Impairment of Long Lived Assets : 

Impairment of Long Lived Assets In 2002, Company A purchased equipment for use in its production process. The equipment was originally recorded as a fixed asset at the purchase price (entry price), which established the initial carrying value. The current carrying value of the equipment is $150. Recently, more efficient machines have been introduced to the marketplace and the price per unit of the products produced by the new machines declines significantly. Accordingly, Company A performs step 1 of the impairment analysis and determines that the carrying value of its equipment is not recoverable. 6/16/2008 Fair Value Accounting 84

Framework : 

Framework Determine unit of account The individual equipment has separate identifiable cash flows. As such, the separate piece of equipment is the unit of account under the guidance of FAS 144. Evaluate valuation premise Company A considers whether the highest and best use of the asset will be in-use or in-exchange. In this case, Company A has no complementary assets that would provide additional value to a market participant. As such, Company A concludes that the valuation premise is in-exchange. 6/16/2008 Fair Value Accounting 85

Framework : 

Framework Assess principal market Company A determines that it does not have a principal market for the sale of this equipment as it has not previously transacted in similar sales and does not expect to do so in the future. Determine the most advantageous market Company A determines that there are various potential wholesale markets for the sale of similar equipment; however, there are no markets for the sale of identical assets. As such, the Company determines that it would most likely sell the equipment to one of its competitors (market participants with interests similar to its own). Company A will hypothecate a market based on its expectations of the assumptions of these competitors. 6/16/2008 Fair Value Accounting 86

Framework : 

Framework Determine valuation technique Market approach – the equipment is old and has been superseded by more modern equipment. As a result, after reasonable efforts, the Company was not able to develop pricing inputs for a market approach. Income approach – Company A performs a discounted cash flow analysis based on its expectations of potential product sales over the next seven years. It assumes the equipment will be scrapped in 2015. Management concludes that a competitor would transfer the equipment to another location with a cheaper workforce. This assumption is incorporated in the cash flow analysis along with other market participant assumptions. The analysis concludes that the fair value is $80. Cost approach – Company A assesses the replacement cost of the equipment and determines that it will cost $120 to purchase a new machine. However, the newer equipment has additional capabilities not incorporated in the current equipment. 6/16/2008 Fair Value Accounting 87

Framework : 

Framework Determine fair value Because the replacement equipment incorporates certain upgrades and as there is no clear resale market, Company A determines that the income approach provides the best estimate of fair value. As a result, the equipment will be written down to a carrying value of $80. 6/16/2008 Fair Value Accounting 88

Introduction to SFAS 159 : 

Introduction to SFAS 159 Fair Value Option EEI Conference on Issues in Fair Valuation 6/16/2008 Fair Value Accounting 89

Slide 90: 

SFAS 159 The Fair Value Option for Financial Assets and Financial Liabilities Evolution Overview Scope Advantages Disclosures Implementation Issues 6/16/2008 Fair Value Accounting 90

Evolution of Fair Value : 

Evolution of Fair Value Fair Value SFAC 7 February 2000 SFAS 107 December 1991 Fair Value Option February 2007 SFAS 157 September 2006 SFAS 133 June 1998 SFAS 155 February 2006 SFAS 156 March 2006 SFAS 115 May 1993 SFAS 119 October 1994 SFAS 140 September 2000 SFAS 105 December 1990 SFAS 157 Fair Value Measurements Effective: Nov. 15, 2007 SFAS 159 Fair Value Option Effective: Nov. 15, 2007 6/16/2008 Fair Value Accounting 91

Overview : 

Overview 6/16/2008 Fair Value Accounting 92

Overview : 

Overview What is the Fair Value Option? Option to elect fair value measurement For certain financial assets and liabilities On an instrument-by-instrument basis With changes in fair value reflected in current earnings 6/16/2008 Fair Value Accounting 93

Overview : 

Overview What is the objective of the Fair Value Option? Expands the use of the fair value measurement attribute Improves financial reporting by reducing the need for certain types of hedge accounting Establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities Achieves greater convergence with international accounting and reporting standards 6/16/2008 Fair Value Accounting 94

Overview : 

Overview How does the FVO-election work? Election is to be made initially or when an event gives rise to a new basis of accounting. Election must be made and documented at time of initial recognition (or adoption of SFAS 159). Election is irrevocable. Election is applied only to an entire instrument and not only to specified risks, specific cash flows, or portions of an instrument. 6/16/2008 Fair Value Accounting 95

Overview : 

Overview What are the documentation requirements? SFAS 159 does not provide specific guidance on what information needs to be included in the documentation, other than: The decision to elect FVO must be documented at the date of initial election or adoption An entity may establish an automatic election policy for certain types of instruments Compliance is a matter of an entity’s internal controls 6/16/2008 Fair Value Accounting 96

Overview : 

Overview FVO may be elected on an instrument-by-instrument basis, except for: Multiple advances are made to the same borrower and the advances become part of a larger loan balance Investments that would otherwise be accounted for under the equity method Eligible insurance or reinsurance contracts Insurance contracts with integrated and nonintegrated contract features or coverages 6/16/2008 Fair Value Accounting 97

Overview : 

Overview When is SFAS 159 effective? Effective for fiscal years beginning after 11/15/07 Unless early adoption was elected If early adoption was elected the company also had to early-adopt the provisions of SFAS 157 Fair Value Measurements 6/16/2008 Fair Value Accounting 98

Scope : 

Scope 6/16/2008 Fair Value Accounting 99

Scope : 

Scope What instruments are in the scope of FVO? Whole loans Debt Equity method investments Firm commitments Warranty rights and obligations Insurance and reinsurance contracts Loan commitments not accounted for as derivatives under SFAS 133 6/16/2008 Fair Value Accounting 100

Scope : 

Scope What instruments are not in the scope of SFAS 159? An investment in a subsidiary that would otherwise be consolidated (including VIE’s) Demand deposit liabilities Convertible debt with beneficial conversion features Lease related assets and liabilities Employer obligations for pension, other post-retirement benefits, employee stock option and purchase plans and other deferred compensation arrangements Deferred tax assets 6/16/2008 Fair Value Accounting 101

Advantages : 

Advantages 6/16/2008 Fair Value Accounting 102

Advantages : 

Advantages What are some advantages of the Fair Value Option? Avoid operational difficulties associated with hedges of portfolios of mortgage loans held for sale Eliminate the need for FV hedge accounting for “overall changes in FV” strategies Simplify the accounting for firm commitments at fair value Reduce accounting differences for entities that currently apply FVO under IAS 39 and have US GAAP filing requirements Simplify accounting for certain loans that may be impaired 6/16/2008 Fair Value Accounting 103

Advantages : 

Advantages

Disclosures : 

Disclosures 6/16/2008 Fair Value Accounting 105

Disclosures : 

Disclosures Objective is to facilitate comparisons Between entities that choose different measurement attributes for similar assets and liabilities Between assets and liabilities in the financial statements of an entity that selects different measurement attributes for similar instruments. BUT judgment and optionality in applying the FVO might reduce that comparability 6/16/2008 Fair Value Accounting 106

Disclosures : 

Disclosures Disclosure is expected to Enable users of financial statements to understand management’s reasons for electing or partially electing FVO Enable users to understand how fair value changes affect earnings for a particular period Provide the same information about certain instruments if FVO had not been elected Enable users to understand the differences between fair values and contractual cash flows for certain instruments. 6/16/2008 Fair Value Accounting 107

Disclosures : 

Disclosures Separate presentation required of assets and liabilities measured at fair value and reported using another measurement attribute (carrying amount), either: In same line item with amount measured at fair value disclosed parenthetically In separate line items to display the fair value and the non-fair-value carrying amounts. 6/16/2008 Fair Value Accounting 108

Disclosures*** : 

Disclosures*** In the Statement of Financial Position: Management’s reasons for electing each item, or group of similar items If FVO is elected for only certain items within a group of eligible items, management’s reasons for only electing certain items of the population Information detailing the amounts impacted by election of FVO within statement line items Aggregated differences between FV and unpaid balances relating to loans, long-term receivables, and long-term debt for which FVO has been elected For loans held as assets, the aggregated FV and principal value of loans >90 days past due ***See par. 18 & 19 in SFAS 159 for a comprehensive listing of disclosure requirements 6/16/2008 Fair Value Accounting 109

Disclosures*** : 

Disclosures*** When an income statement is presented: Gains/losses attributable to changes in FV during the period of each line item & in which line such are reported Methodology of measurement for interest and dividends, and where such amounts are recorded Gains/losses, and method of determination, related to changes in credit risk of loans, receivables and other liabilities for which FVO has been elected Other Disclosures: Annually, methods and significant assumptions used to estimate FV of items selected for FVO ***See par. 18 & 19 in SFAS 159 for a comprehensive listing of disclosure requirements 6/16/2008 Fair Value Accounting 110

Implementation Issues : 

Implementation Issues 6/16/2008 Fair Value Accounting 111

Implementation Issues : 

Implementation Issues Recognition of Interest Income What portion is recognized as income versus attributed to changes in FV? Potential methods of income recognition: Method 1: Effective yield method Method 2: Coupon on yield, everything else under the trading line item in I/S Method 3: Entire amount under the trading line item in I/S 6/16/2008 Fair Value Accounting 112

Implementation Issues : 

Implementation Issues Adoption Strategy Sale/Extinguishment strategy upon adoption of SFAS 159 for impaired assets and/or debt with fair value below the carrying value Loss recognized as cumulative effect adjustment in Retained Earnings Strategy might increase earnings in future periods FVO will not be elected on an ongoing basis Does not meet the objectives of FVO 6/16/2008 Fair Value Accounting 113

Early Adopters and Hot Topics : 

Early Adopters and Hot Topics Evidence from What Companies Have Done EEI Conference on Issues in Fair Valuation 6/16/2008 Fair Value Accounting 114

Fair Value … AGAIN!?!? : 

Fair Value … AGAIN!?!? Four Statements issued since March 2006 Headlines Restatements Inspection Findings It’s on everyone’s mind. BE AWARE!!! 6/16/2008 Fair Value Accounting 115

SEC Focus : 

SEC Focus Over 50 SEC comment letters related to valuation Acquisition/Business Combinations Goodwill Intangible Assets Cheap Stock “Discuss all significant assumptions made and estimates used in determining the assigned values … ” “Please explain … the procedures and analysis followed … to assure that all intangible assets have been properly identified and valued.” “Provide … your assumptions … used in determining your estimate of fair value … ” “Discuss the assumptions and methodologies used in determining the fair value of … ” SEC 6/16/2008 Fair Value Accounting 116

Inspection Findings – Our Reaction : 

Inspection Findings – Our Reaction Is your practice to insert the IFV Specialist memo in the workpapers without additional testing? Need to document testing of: Underlying data Reasonableness of method (market, income, cost) and approach Qualifications and objectivity of client’s specialist Reasonableness of assumptions used (i.e., projected cash flows, discount rates, market comparable information) and other data provided to the specialist Internal controls over valuation Provisions of Statement 157 and testing of disclosures 6/16/2008 Fair Value Accounting 117

SFAS 157 PRACTICE CONSIDERATIONS : 

SFAS 157 PRACTICE CONSIDERATIONS 6/16/2008 Fair Value Accounting 118

Level 2 v. Level 3 : 

Level 2 v. Level 3 6/16/2008 Fair Value Accounting 119

Level 2 vs. Level 3 : 

Level 2 vs. Level 3 There are two steps to determining where within the classification hierarchy a particular fair value measurement falls in its entirety: STEP 1 - Determine where each of the inputs fall. STEP 2 - Determine the lowest level input(s) with a significant effect. “Assessing the significance of a particular input to the fair value measurement in its entirety requires judgment, considering factors specific to the asset or liability.” [Paragraph 22] 6/16/2008 Fair Value Accounting 120

Examples: Level 2 vs. Level 3 : 

Examples: Level 2 vs. Level 3 10-year European Commodity Option Valuation Technique (e.g., “Black 76”) LESS: Credit valuation adjustment (CVA) LESS: Other “risk” adjustments EQUALS: Statement 157 “Fair Value” Forward Volatilities Forward prices Strike price Risk Free Rate MODEL VALUE: Initial Model Value 6/16/2008 Fair Value Accounting 121

Examples: Level 2 vs. Level 3 Inputs : 

Examples: Level 2 vs. Level 3 Inputs 10-year European Commodity Option Input: Forward prices Level 3 Input Forward price curve used in the valuation model is not directly observable or correlated with observable market data for substantially the full term of the swap (e.g., 9 or 10 years). Level 2 Input Forward price curve used in the valuation model is directly observable for 9 of the 10 years AND any reasonable extrapolation of the price curve for year 10 would not be significant to the swap’s entire fair value. 6/16/2008 Fair Value Accounting 122

Examples: Level 2 vs. Level 3 Inputs : 

Examples: Level 2 vs. Level 3 Inputs 10-year European Commodity Option (Corroboration) Input: Forward Prices Level 3 Input Forward price curve used in the valuation model is not directly observable or correlated with observable market data for substantially the full term of the swap. Level 2 Input Forward price curve used in the valuation model is not directly observable for substantially the full term of the swap, but correlation is established between the underlying swap price and another commodity price whose forward pricing is directly observable for the 10 year term. 6/16/2008 Fair Value Accounting 123

Examples: Level 2 vs. Level 3 Inputs : 

Examples: Level 2 vs. Level 3 Inputs 10-year European Commodity Option Input: Volatilities Level 3 Historical volatilities - no observable option prices available. Level 2 Volatilities implied from observable European option prices for the 10-year term. 6/16/2008 Fair Value Accounting 124

Examples: Level 2 vs. Level 3 Measurement : 

Examples: Level 2 vs. Level 3 Measurement 10-year European Commodity Option Valuation Technique (e.g., “Black 76”) LESS: $7 CVA LESS: Other risk adjustments EQUALS: $ 100 Fair Value Forward Volatilities - $5 impact from “shock” Forward prices Strike price Risk Free Rate MODEL VALUE: Assume that the volatility and CVA are the only unobservable inputs (and that a change in volatility does not impact CVA) Also assume the entity’s policy to determine “significance” is to use a quantitative threshold of 10%, evaluated in conjunction with qualitative factors. What Level is the $100 option fair value? 6/16/2008 Fair Value Accounting 125

Examples: Level 2 vs. Level 3 Measurement : 

What level measurement in its entirety is the option? View A – Level 2 Each unobservable input has less than a 10% impact Calculation: Volatility $5/$100 = 5% Credit $7/$100 = 7% View B – Level 3 Combined impact of all unobservable inputs is greater than 10% of the fair value measurement (12%). Examples: Level 2 vs. Level 3 Measurement ANSWER: View B. Entities need to aggregate lowest level inputs. 6/16/2008 Fair Value Accounting 126

Level 2 vs. Level 3 – Other Challenges : 

Level 2 vs. Level 3 – Other Challenges What constitutes “market data”? What about net asset value (NAV) provided by hedge funds that are not traded? Are pricing service and broker quotes always considered Level 2? 6/16/2008 Fair Value Accounting 127

Other Disclosure Considerations : 

Other Disclosure Considerations 6/16/2008 Fair Value Accounting 128

Other disclosure considerations : 

Other disclosure considerations Lower of cost or fair value adjustments Downward & Upward: Include in table (non-recurring) Exception: Upward, but fair value is greater than original carrying value. Not a fair value measurement, so no disclosure required. Level 3 recurring roll-forward table: How is the unrealized gain or loss for assets and liabilities still held at period end determined? Assumption regarding timing of transfers in/out of level 3 Pension assets. Is the sponsor subject to Statement 157 disclosures? 6/16/2008 Fair Value Accounting 129

Inception Gains and Losses : 

Inception Gains and Losses 6/16/2008 Fair Value Accounting 130

Fair Value (initial recognition) : 

Fair Value (initial recognition) “Par” Credit Swap – No consideration exchanged DEALER CORPORATE CUSTOMER DAY 1 – Books swap at Zero (transaction price) DAY 1 – Books swap at $1 million (Model Value) 6/16/2008 Fair Value Accounting 131

Pre-157: Fair Value (initial recognition) : 

Pre-157: Fair Value (initial recognition) EITF 02-3 FASB staff's view - an entity should not recognize an unrealized gain or loss at inception of a derivative instrument unless the fair value of that instrument is obtained from a quoted market price in an active market, or is otherwise evidenced by comparison to other observable current market transactions, or based on a valuation technique incorporating observable market data. In other words, the transaction price represents the best information available with which to estimate fair value at the inception of the arrangement 6/16/2008 Fair Value Accounting 132

Post 157 - Fair Value (initial recognition) : 

Post 157 - Fair Value (initial recognition) Transaction price might not represent fair value (par. 17) Related parties Under duress Unit of account differences Different markets “[S]ome believe that it is open season on inception gains. I would caution those constituents that there continue to be many instances in which day one gains are not appropriate.” SEC Staff Speech (McGrath, Dec. 2006) Facts and circumstances Documentation of inception gain/loss analysis is important. Multiple elements Unstated rights and privileges Transaction costs 6/16/2008 Fair Value Accounting 133

Fair Value (initial recognition) : 

Fair Value (initial recognition) “Par” Credit Swap – No consideration exchanged DEALER CORPORATE CUSTOMER DAY 1 – Books swap at Zero (transaction price) DAY 1 – Books swap at $1 million (Model Value) Retail Market Dealer Market 6/16/2008 Fair Value Accounting 134

Fair Value (initial recognition) : 

Fair Value (initial recognition) “Par” Credit Swap – No consideration exchanged DEALER 1 DEALER 2 DAY 1 – Books swap at Zero (transaction price and model value) DAY 1 – Books swap at $1 million (Model Value). Must recalibrate model. Dealer Market Dealer Market 6/16/2008 Fair Value Accounting 135

Calibration : 

Calibration Example 7 , Footnote 18: “If the transaction price represents fair value at initial recognition and a pricing model will be used to measure fair value in subsequent periods, the model should be calibrated so that the model value at initial recognition equals the transaction price.” Specific facts and circumstances will drive the 157 calibration approach. Emphasis on documentation. 6/16/2008 Fair Value Accounting 136

Calibration – Example : 

Calibration – Example Energy Company Z enters into a 5 year forward to purchase electricity at point X (assume annual settlement). Transaction price is zero and represents fair value at inception (per par. 17 analysis). Z’s model value at inception is $3 million gain, which Z believes is due to unobservable inputs. Assume there is observable data for one year, but not for years 2-5. The table below reflect Z’s model value by period (in millions): Under 02-3 diversity in practice - two common approaches: Straight-line amortization of 02-3 deferral ($.75 million per year in years 1-4) Cliff approach. Deferred until substantially all the value is derived from observable inputs (e.g., deferral until year 4 when $3 million is recognized). 6/16/2008 Fair Value Accounting 137

Calibration – Possible 157 Approach : 

Calibration – Possible 157 Approach Z determines that it does not meet the criteria in paragraph 17 of Statement 157 and therefore must calibrate its model to the transaction price of zero. At inception, Z should calibrate to the transaction price by adjusting the unobservable inputs (e.g., the forward prices in years 2-5) such that the model value produces a value equal to the transaction price. 6/16/2008 Fair Value Accounting 138

Calibration – Possible 157 Approach : 

When should Z remove the calibration adjustments? Subsequently, Z should periodically re-evaluate the need for the calibration adjustment (i.e., the adjustment to the unobservable input(s) in this example) Calibration adjustments may no longer be necessary when the calibrated unobservable input becomes observable or is settled For example, if year 4 also becomes observable during year 2, Z would release the $.75 million calibration adjustment for year 4 during year 2. Recognize subsequent changes in fair value in the period that they occur, regardless of whether or not observable (no change from EITF 02-3) Calibration – Possible 157 Approach 6/16/2008 Fair Value Accounting 139

Calibration – Possible 157 Approach : 

Calibration – Possible 157 Approach Assume the front year of the forward price curve remains observable throughout the life of the contract. P&L (caused by release of adjustment) comparison of 157 approach to common EITF 02-3 approaches: 157 approach may have different results than 02-3 approaches, depending on specific facts and circumstances (e.g., options).

SFAS 159 PRACTICE CONSIDERATIONS : 

SFAS 159 PRACTICE CONSIDERATIONS 6/16/2008 Fair Value Accounting 141

Up-front Costs and Fees : 

Up-front Costs and Fees 6/16/2008 Fair Value Accounting 142

Up-front Costs and Fees—No Deferral : 

Up-front Costs and Fees—No Deferral On 1/1/08, Bank A commits to lend in 90 days $100,000 to Company Z for 10 years at a fixed rate of 10%, with annual P&I payments of $16,275 Bank A charges Company Z a commitment fee of $3,000 Bank A does not elect to fair value this loan commitment Bank A incurs $1,000 in loan origination costs Bank A has a policy of electing to fair value all originated loan assets 6/16/2008 Fair Value Accounting 143

Up-front Costs and Fees (cont.) : 

Up-front Costs and Fees (cont.) Historically, Bank A followed FAS 91. Under FAS 91, the commitment fee and the origination costs were deferred, and the net impact of the commitment fee and the origination costs ($2,000) were amortized as part of the effective yield on the loan over 10 years Under the fair value option, the commitment fee received would be recognized as income and the origination costs would be recognized in earnings and NOT deferred 6/16/2008 Fair Value Accounting 144

Up-front Costs and Fees (cont.) : 

Up-front Costs and Fees (cont.) Consequently, interest income could differ substantially from amounts previously recognized under FAS 91 Presumably would only reflect the impact of the stated rate in relation to the market rate at the date of origination (i.e., the present value of the future cash flows associated with principal and interest discounted at the prevailing market rate at the date of origination) Gross vs. Net I/S presentation of Upfront Costs and Fees – Consideration of EITF 99-19 FAS 159 does not provide guidance for recognizing and measuring interest income 6/16/2008 Fair Value Accounting 145

Interest Bearing Financial Instruments Accounted for at Fair Value : 

Interest Bearing Financial Instruments Accounted for at Fair Value 6/16/2008 Fair Value Accounting 146

Presentation Of Interest – Income Statement : 

Presentation Of Interest – Income Statement Statement 159 does not require an entity to separately present interest income or interest expense in the income statement Separate presentation of interest is a policy election Unless such separate presentation is an identified industry practice for example, Bank holding companies Brokers and dealers in securities Investment companies 6/16/2008 Fair Value Accounting 147

Interest Bearing Financial Instruments Accounted for at Fair Value : 

Interest Bearing Financial Instruments Accounted for at Fair Value Record difference as a premium/or discount Amortize/accrete difference Record within interest income/expense (if presented separately) Principal amount due at maturity (“Par”) If initial fair value for interest bearing financial instrument, accounted for at fair value = NOTE: Accounting guidance applies to “plain vanilla debt instruments” or hybrids where embedded is indexed to interest or issuer’s own credit 6/16/2008 Fair Value Accounting 148

Interest Bearing Financial Instruments Accounted for at Fair Value : 

Interest Bearing Financial Instruments Accounted for at Fair Value What about a difference between fair value and par at inception that is due to features embedded in the instrument that are indexed to other than interest rates or the issuer’s own credit? At inception, entities should exclude such features from the discount or premium to be accreted or amortized. 6/16/2008 Fair Value Accounting 149

Interest Bearing Financial Instruments Accounted for at Fair Value : 

Interest Bearing Financial Instruments Accounted for at Fair Value Company A issues Convertible Debt At inception of the FVO what is the premium/discount? Embedded conversion option is indexed to equity and therefore the option should be excluded from the discount or premium.

Statement 159 Adoption Strategies : 

Statement 159 Adoption Strategies 6/16/2008 Fair Value Accounting 151

Statement 159 Adoption Strategies : 

Statement 159 Adoption Strategies Is there a “Statement 159 Mulligan”? Potential Issues for Financial Assets Portfolio enhancement strategies Interrelationship of a Company’s Portfolio enhancement strategy the adoption of Statement 159, and the determination of conditions under which recording other than temporary impairment may be appropriate NOTE – Companies must continue to apply Statement 115, Accounting for Certain Investments in Debt and Equity Securities, to assess securities for other-than-temporary impairment until adoption of Statement 159 6/16/2008 Fair Value Accounting 152

Example – Disappearing Losses : 

Example – Disappearing Losses Step 1 – December 31, 2007 – Company A earmarks all underwater AFS securities, and Plans to elect the fair value option Step 2 – January 1, 2008 – Company A applies the fair value option and accounts for securities as trading Losses included in opening retained earnings (bypassing the income statement) No taint associated with transfer of trading upon adoption of Statement 159 6/16/2008 Fair Value Accounting 153

Example – Disappearing Losses : 

Example – Disappearing Losses Step 3 - January 30 – Sell securities at a loss March 1 – Buy back similar or identical securities Classify securities as AFS Unrealized losses - NEVER affect earnings Future P&L – enhanced by higher yields on same or similar securities 6/16/2008 Fair Value Accounting 154

SFAS 159 - Center for Audit Quality Letter : 

SFAS 159 - Center for Audit Quality Letter If an entity proposes to adopt the fair value option merely to achieve an accounting result that is contrary to the principles and objectives in FAS 159…, the auditor should reach a conclusion that the entity’s proposed accounting departs from generally accepted accounting principles. 6/16/2008 Fair Value Accounting 155

Statement 159 Adoption Strategies : 

Statement 159 Adoption Strategies Potential Issues for Financial Liabilities Callable Debt strategy Other-than-temporary Impairments Disclosure Considerations Statement 159 required disclosures Consider additional disclosures as necessary to provide sufficient transparency 6/16/2008 Fair Value Accounting 156

Issuer’s Credit in Liability Value : 

Issuer’s Credit in Liability Value 6/16/2008 Fair Value Accounting 157

Issuer’s Credit in Liability Value : 

Issuer’s Credit in Liability Value On 1/1/08, Company A issues $100 million of 3-year 6.41% fixed-rate notes and enters into an at the market receive-fixed/pay-LIBOR interest rate swap to manage the risk associated with the fixed rate debt Company A may choose to hedge, to apply FVO, or to do neither Assume: The fair value change of the interest rate swap is $(1,149,000) - an unrealized loss The fair value change of the fixed rate debt due to changes in LIBOR and changes in Company A’s creditworthiness is $1,500,000—a gain The portion of the fair value change in the debt attributable to Company A’s creditworthiness is $351,000 6/16/2008 Fair Value Accounting 158

Issuer’s Credit in Liability Value (cont.) : 

End of Year 1 – Income Statement Impact (000s) Issuer’s Credit in Liability Value (cont.) * Note that FAS 159 does not provide guidance on recognizing and measuring interest expense separate from other changes in fair value 6/16/2008 Fair Value Accounting 159

Issuer’s Credit in Liability Value (cont.) : 

Issuer’s Credit in Liability Value (cont.) End of Year 1 – Balance Sheet Impact (000s) 6/16/2008 Fair Value Accounting 160

Equity Method Investments : 

Equity Method Investments 6/16/2008 Fair Value Accounting 161

Equity Method Investments : 

Equity Method Investments FVO is instrument-by-instrument—EXCEPT equity method investments Must apply FVO to all eligible financial interests: If investor has equity and debt interests in investee, cannot elect solely for the equity investment Only apply FVO to eligible items: If investor has other, nonfinancial arrangements with investee—do NOT include in FVO 6/16/2008 Fair Value Accounting 162

Equity Method Investments (cont.) : 

Equity Method Investments (cont.) 6/16/2008 Fair Value Accounting 163

Equity Method Investments Example : 

Equity Method Investments Example C Company has two equity method investments: Investment A relates to C’s investment in the common stock of Corporation Z Investment B relates to C’s General Partnership (GP) and Limited Partnership (LP) interests in Partnership X C Company has contracted to provide general management services to both investees Company C has provided a guarantee to third party creditors of both investees 6/16/2008 Fair Value Accounting 164

Equity Method Investments Example (cont.) : 

Equity Method Investments Example (cont.) The terms of the management contracts with both Corporation Z and Partnership X are the same. Company C receives a fixed fee plus: Company C will receive 20 percent of all returns of Corporation Z that exceed the performance of the S&P 500 Company C will receive 20 percent of all returns of Partnership X that exceed the performance of the S&P 500 6/16/2008 Fair Value Accounting 165

Equity Method Investments Example (cont.) : 

Equity Method Investments Example (cont.) The only differences between the arrangements that Company C has with Corporation Z and Partnership X are: Company C’s management arrangement is separate from its common stock ownership in Corporation Z and Company C will receive its performance based fee in cash Company C’s management arrangement is inherent in its GP interest in Partnership X and Company C will receive its fee in the form of a partnership allocation 6/16/2008 Fair Value Accounting 166

Equity Method Investments Example (cont.) : 

Equity Method Investments Example (cont.) Fair value for C’s equity method investment in Corporation Z: Z’s common stock is a financial instrument Financial guarantee is a financial instrument Performance based management agreement does not meet the definition of a financial instrument (it is a service contract) Company C will include the fair value of its common stock interest and the financial guarantee 6/16/2008 Fair Value Accounting 167

Equity Method Investments Example (cont.) : 

Equity Method Investments Example (cont.) Fair value for C’s equity method investment in Partnership X: GP interest DOES NOT meet the definition of a financial asset—it is not eligible for FVO LP interest is eligible for FVO Fair value option would apply to LP interest and financial guarantee 6/16/2008 Fair Value Accounting 168

Equity Method Investments – SOP 07-1 : 

Equity Method Investments – SOP 07-1 SOP 07-1, “Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies“ Issued June 2007 Effective Date – fiscal years beginning on or after December 15, 2007 Introduces requirements in order to retain investment company accounting for a parent company in consolidation or by an equity method investor in an investment company. Potential unexpected transition issues and accounting results for entities planning to elect FVO for certain equity method investments under 159. Further discussions with Big 4 firms and regulators related to guidance around financial instruments with future-services Components – Stay Tuned! 6/16/2008 Fair Value Accounting 169

Fair Value Standards - Early Adopter Statistics - : 

Fair Value Standards - Early Adopter Statistics - 6/16/2008 Fair Value Accounting 170

SFAS 157 & 159: Early Adopters : 

SFAS 157 & 159: Early Adopters Early adoption was required within 120 days of the beginning of an entity’s fiscal year (i.e. April 30, 2007 for a calendar year entity) Certain early adopters only elected SFAS 157 and not 159

SFAS 157 & 159: Early Adopters (cont’d) : 

SFAS 157 & 159: Early Adopters (cont’d) Upon adoption of SFAS 159 for existing assets/ liabilities, the difference between carrying amounts and FV is included as a cumulative-effect adjustment to beginning retained earnings.

SFAS 157 & 159: Early Adopters : 

SFAS 157 & 159: Early Adopters

SFAS 157 & 159: Early Adopters (cont’d) : 

Amongst the early adopters*, on average, the distribution of Levels 1, 2 and 3 is shown to the right Ranges for Levels 1, 2 and 3 are shown as follows – Level 1: 15% to 36% Level 2: 56% to 76% Level 3: 8% to 9% Range of net gains and losses associated with Level 3 items by SFAS 159 early adopters $325 loss to $2.3 billion gain *Statistics obtained from 10-Q filings of four large investment banks (with 11/30 YE) that were the earliest adopters of SFAS 157. SFAS 157 & 159: Early Adopters (cont’d)

Fair Value Sample Disclosures - Early Adopter - : 

Fair Value Sample Disclosures - Early Adopter - 6/16/2008 Fair Value Accounting 175

Goldman Sachs – Q2 Disclosure : 

Goldman Sachs – Q2 Disclosure Adopted FAS 157 and 159 as of 12/1/2006 FAS 157 FV Measurements: Longs & shorts are marked to bid and ask price, respectively Transition adjustment to R/E of $51 million (net of tax) Does not take “block discount” for Level 1 instruments FAS 159 FV Option: Primary reasons for electing FVO are mitigation of volatility, simplification and cost-benefit consideration. Categories of assets/liabilities elected: Securities (previously accounted for as AFS) Investments that would otherwise have applied the equity method of accounting Unsecured short-term borrowings Secured financings (Resale/repurchase and Secured borrowed/loaned) Unsecured long-term borrowings 6/16/2008 Fair Value Accounting 176

Goldman Sachs – Q2 Disclosure (cont.) : 

Goldman Sachs – Q2 Disclosure (cont.) FV Hierarchy - Assets 6/16/2008 Fair Value Accounting 177

Goldman Sachs – Q2 Disclosure (cont.) : 

Goldman Sachs – Q2 Disclosure (cont.) FV Hierarchy - Liabilities 6/16/2008 Fair Value Accounting 178

Goldman Sachs – Q2 Disclosure (cont.) : 

Goldman Sachs – Q2 Disclosure (cont.) Level 3 Disclosures 6/16/2008 Fair Value Accounting 179

Goldman Sachs – Q2 Disclosure (cont.) : 

Goldman Sachs – Q2 Disclosure (cont.) FAS 155 & FAS 159 Disclosures 6/16/2008 Fair Value Accounting 180

Slide 181: 

Questions? 6/16/2008 Fair Value Accounting 181

Fair Value Modeling andModel Validation : 

Fair Value Modeling andModel Validation Tools and Techniques 6/16/2008 Fair Value Accounting 182

Agenda : 

Agenda Fair Value, the modeling perspective Model Validation Overview Round table Q&A 6/16/2008 Fair Value Accounting 183

Overview: Recent Fair Value Guidance : 

Overview: Recent Fair Value Guidance FAS 159 The Fair Value Option for Financial Assets and Financial Liabilities Allows entities to measure eligible financial instruments at fair value FAS 157 Fair Value Measurements Defines Fair Value and provides guidance on how to measure assets and liabilities at fair value FAS 155 Accounting for Certain Hybrid Financial Instruments Allows entities to measure certain structured notes at fair value 6/16/2008 Fair Value Accounting 184

Fair Value and Model Reliance : 

Fair Value and Model Reliance Fair Value Option Increases Model Reliance Many categories of Level 1 assets could be carried at fair value prior to FAS 159 Many categories of assets and liabilities affected by 159 are likely to fall into Levels 2 or 3 e.g. unquoted debt Generally instrument values in Levels 2 and 3 represent MODEL-BASED FAIR VALUES FAS 159 adoption will therefore result in increased model reliance A “Mark-to-Model” measurement standard When appropriate, subject to certain limitations 6/16/2008 Fair Value Accounting 185

Fair Value Model Implementation Steps : 

Fair Value Model Implementation Steps Fair Value methodology Design and approval Documentation Valuation technique a required disclosure item Valuation models and tools Development or acquisition Implementation Documentation Validation Valuation process Design and documentation of process and procedures Production of F/S values and required disclosure items Integration with overall Fair Value implementation project 6/16/2008 Fair Value Accounting 186

Fair Value Modeling: New Challenges : 

Fair Value Modeling: New Challenges Selected Modeling Issues Covered Today: Modeling Fair Value of Issued Debt Incorporating entity’s credit spreads in the valuation of bonds and notes issued by the entity Modeling Derivative Fair Values Adjusting for entity’s and counterparties’ creditworthiness Modeling netting and collateral Modeling Uncertainty Market uncertainty Input uncertainty Model uncertainty 6/16/2008 Fair Value Accounting 187

Modeling Fair Value of Issued Debt : 

Modeling Fair Value of Issued Debt Fair Value vs. Fair Value Hedge Accounting Dynamic (changing) credit spreads Legacy methods: static credit spread assumptions Inception valuation assumptions Legacy view: no inception P&L recognized on debt issuances Impact of entity’s credit on embedded derivative components Legacy approaches: practices varied on including entity’s credit spreads in the value of embedded derivative Impact of changes in entity’s credit on derivative not generally tracked 6/16/2008 Fair Value Accounting 188

Modeling Fair Value of Issued Debt : 

Modeling Fair Value of Issued Debt Incorporating entity’s credit spreads in the valuation of bonds and notes issued by the entity Specific issues related to floating and structured notes Construction of entity’s credit curves Credit enhancements P&L attribution and disclosure Changes in fair values due to “changes in instrument-specific credit risk” and how they were determined is a required disclosure under FAS 159 Economic hedging issues Hedging exposure to entity’s own credit spreads Economic hedge effectiveness issues 6/16/2008 Fair Value Accounting 189

Modeling Derivative Fair Values : 

Modeling Derivative Fair Values Modeling Derivative Fair Values Creditworthiness of both counterparties affects derivative fair values Application to current derivative values (“Current Exposure”) Future potential changes in derivative fair values may also result in credit risk (“Potential Exposure”) Since a derivative could be an asset in one period and a liability in another period, modeling the effect of credit risk may require consideration of the range of fair values the derivative could have across multiple future periods 6/16/2008 Fair Value Accounting 190

Derivative Counterparty Credit Risk : 

Derivative Counterparty Credit Risk Modeling and aggregating results across multiple potential outcomes results in net expected loss Illustration: a vanilla interest-rate swap

Effect of Entity’s Own Credit Risk : 

Effect of Entity’s Own Credit Risk Modeling and aggregating results across multiple potential outcomes results in net expected gain The other side of the coin: entity’s own credit

Netting and Collateral : 

Netting and Collateral Counterparty Netting Arrangements Netting arrangements impact credit exposures for portfolios of derivatives with the same counterparty Netting impacts both current and future exposures Collateral Arrangements Credit enhancements affect Fair Values Collateral arrangements may reduce, but generally do not eliminate the impact of credit spreads on derivative values One-way collateral arrangements (where one party may be required to post collateral but the other is not) may significantly increase impact of counterparty credit on values 6/16/2008 Fair Value Accounting 193

Modeling Uncertainty : 

Modeling Uncertainty Market Risk / Uncertainty Example: uncertainty about future level of an equity index in pricing an equity index option Generally captured through market-based valuation inputs (e.g., forward prices, volatilities) Model and Input Uncertainty “risk inherent in a particular valuation technique” “risk inherent in the inputs to the valuation technique” Adjustments required if other market participants would be expected to take these risks into account in pricing Relevant risks captured in Fair Value – EXIT PRICE notion “A measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.” The risk averse buyer 6/16/2008 Fair Value Accounting 194

Slide 195: 

Valuation Issues – Credit Markets Securities Derivatives & Synthetic Exposures Whole Loans Sub-prime mortgages Alt-A, near-prime, scratch & dent Other asset-backed loans MSRs Categories Products Valuation Risks Mortgage-backed securities (MBS) Asset-backed securities (ABS) Collateralized Debt Obligations (CDOs) Corporate Bonds (High Yield, HG) Asset-backed Commercial Paper (ABCP) IOs / POs MSRs Credit Default Swaps (CDS) CDS on ABS CDS on ABS / CDO Tranches Total Return Swaps (TRS) on ABS CDS and TRS on ABS Indices Rising defaults and severities Extended recovery times Credit and prepayment speeds Impact of liquidity / lack of market All of the above PLUS: Rating downgrades and biases Accelerated rating migration Correlation breakdown / diversification benefit erosion Subordination / OC depletion Market impact of bulk liquidations Impact of liquidity on pricing “Price-discovery risk” All of the above PLUS: Implied defaults / severities ABS index behavior Index basis (e.g., vintage years) Derivatives / Cash markets basis Funding spread movements 6/16/2008 Fair Value Accounting 195

Investors’ Typical Pitfalls – Credit Markets : 

Investors’ Typical Pitfalls – Credit Markets Drive-by Due Diligence—Ratings Assumed to Subsume All Risks Concentration Risk—Correlations and Impacts not Examined or Modeled Instrument Features and Characteristics not Modeled Risk Reporting not Rigorous, Thorough or Integrated … and the same may apply to others (“sell-side,” originators, etc.) left holding these assets in inventory Many of the “buy-side” investors may be facing these issues… 6/16/2008 Fair Value Accounting 196

Other Modeling Challenges : 

Other Modeling Challenges Many significant major modeling challenges not covered in the slides above Multiple other asset and liability classes subject to fair value measurement In general, models have to be developed, approved, maintained and validated for each instrument class under a formal model governance structure Definition under governance structure of significant changes versus insignificant, and associated levels of approval Due to increased model reliance, model validation is viewed as a key control for Fair Value modeling In the next session, we walk through typical steps in a model validation process 6/16/2008 Fair Value Accounting 197

Model Validation Components : 

Model Validation Components Theoretical Foundations Inputs and Assumptions Model Implementation & Calculations Model Outputs and Reports Model Control Environment 6/16/2008 Fair Value Accounting 198

Model Validation : 

Model Validation Theoretical Foundations Theoretical soundness Financial mathematics Leading practice compliance Examples: Simulation integrity tests Theoretical foundations assessment 6/16/2008 Fair Value Accounting 199

Model Validation : 

Model Validation Inputs and Assumptions Market inputs Estimated inputs Assumptions Examples: Yield curves, prices, implied volatility surfaces Historical volatilities and factor correlations Risk factor selections 6/16/2008 Fair Value Accounting 200

Model Validation : 

Model Validation Model Implementation & Calculations Independent revaluation of positions Independent recalculation of model outputs Reconciliation to client results Key model validation step Examples: Independent derivatives/securities valuation Recalculation of VaR, potential exposures Recalculation of Greeks and risk statistics 6/16/2008 Fair Value Accounting 201

Model Validation : 

Model Validation Model Outputs and Reports Assessment of model outputs Model results processing and aggregation Reporting and use of model outputs Examples: Risk/Capital reports for Firm-wide risk models Potential Exposures profiles and statistics 6/16/2008 Fair Value Accounting 202

Model Validation : 

Model Validation Model Control Environment Documentation Benchmarking and Validation Back-testing Model controls Examples: Model documentation Back-testing of risk models vs. actual P&L Master model inventory Periodic validation and benchmarking 6/16/2008 Fair Value Accounting 203

Model Validation : 

Model Validation Model review as a control process Who does model validation? Risk management group Internal model review groups Internal audit No central model validation function 6/16/2008 Fair Value Accounting 204

Model Validation : 

Model Validation Success Factors Subject matter expertise Detailed approach – high content Independent recalculation – “numbers” 6/16/2008 Fair Value Accounting 205

Model Validation Overview : 

Model Validation Overview Sample Model Validation Areas Valuation Models ALM Models Credit Risk Models VaR Models 6/16/2008 Fair Value Accounting 206

Areas of Model Use : 

Areas of Model Use Valuation or “Mark-to-Model” Curve Building Interest Rate Term Structure modeling Derivatives Valuation Prepayment functions CMO cash-flow modeling Asset/Liability Management Economic Value of Equity (EVE) Modeling Net Interest Income (NII) Simulations Liquidity Modeling Funding Sources Mix Hedging with derivatives Model Validation – Additional Considerations 6/16/2008 Fair Value Accounting 207

Areas of Model Use (Continued) : 

Areas of Model Use (Continued) Market Risk Measurement/ Capital Requirements VaR Limit setting Stress-testing Accounting FAS 91 Effective Yield FAS 133 Effectiveness Testing/Analysis FIN 46 Economic Variability modeling for consolidation FAS 155 Structured Debt valuation FAS 157 Fair Value modeling Credit Risk Measurement Pricing Credit Enhancement Allowance for Loan Losses Model Validation – Additional Considerations 6/16/2008 Fair Value Accounting 208

Appropriate model documentation : 

Appropriate model documentation Static documentation Summary memo Policies Procedures Model documentation Process narratives / control matrix Approval Dynamic documentation Results Back-testing Approval 6/16/2008 Fair Value Accounting 209

Stress-Testing : 

Stress-Testing Realistic scenarios Solicit many different viewpoints Apply consistently across portfolios Specific variables may differ 6/16/2008 Fair Value Accounting 210

Model controls : 

Model controls Cross-functional participation Training Ownership Results documentation Data quality testing Data reconciliation Change management Spreadsheets Management adjustments Independent reviews Back-testing Stress-testing Benchmarking Quarter-to-quarter changes Management approval Policies and procedures Model assumptions Business environment analysis 6/16/2008 Fair Value Accounting 211

Model Validation - Common issues : 

Model Validation - Common issues Documentation – Sparse to non-existent, not linked to current process/version. Inputs – External data not consistently applied, Internal data definitions not stable. Model theory – Dated vs. flawed Validation – No testing on independent sample Back-testing – not testing results once implemented Model Controls – Passwords, Business continuity, Quality control Outputs – Contextual framework 6/16/2008 Fair Value Accounting 212

Model Validation - Questions : 

Model Validation - Questions How often should I model be validated, if it validated once already? I ask this question, given the recent credit turmoil in most credit markets? What is VaR’s ability to predict large and unexpected market declines in the various markets (mortgage, energy, equity, currency etc.)? 6/16/2008 Fair Value Accounting 213

Model Validation - Questions : 

Model Validation - Questions What is the best approach to auditing a third party owned model that is used by the business (i.e. QRM, ADCO, etc)? Because of proprietary constraints, we are often only able to treat the model as a “Black Box.” What are the best testing strategies to execute to get comfort that the model is well controlled and delivering the desired results? 6/16/2008 Fair Value Accounting 214

Model Validation - Questions : 

Model Validation - Questions Not being a Quant or PhD in mathematics often limits an individual’s ability to “pull apart” model logic and assumption sets and truly validate the model being reviewed. What are simple yet effective tactics that one can use to gain comfort that there are adequate controls in place around models that the results of the models appear reasonable? 6/16/2008 Fair Value Accounting 215

Model Validation - Questions : 

Model Validation - Questions Through the VaR model validation process, if one were to find the VaR model is inadequate (i.e. fail the validation test), what is the industry best practice to improve the VaR model so that it can pass the VaR model validation? 6/16/2008 Fair Value Accounting 216

Slide 217: 

Questions? 6/16/2008 Fair Value Accounting 217

Controls & Governance & Technology : 

Controls & Governance & Technology - 218 -

Agenda : 

- 219 - Agenda Getting Started “Operationalizing” Fair Value Initial Steps Controls Definition and Objective Issues Approach to Analysis and Remediation Governance Definition and Documentation Considerations and Tools Leveraging Technology Effective Uses for 157 Financial and Investor Reporting 6/16/2008 Fair Value Accounting

Getting Started: “Operationalizing” Fair Value : 

- 220 - Getting Started: “Operationalizing” Fair Value Fair Value methodology Design and approval Documentation Valuation technique a required disclosure item Valuation models and tools Development or acquisition Implementation Documentation Validation Valuation process Design and documentation of process and procedures Production of F/S values and required disclosure items Integration with overall Fair Value implementation project 6/16/2008 Fair Value Accounting

Step 1: Define and Document Procedures : 

- 221 - Step 1: Define and Document Procedures Map Fair Value Rules to Existing Processes Categorize securities by Level 1, 2 or 3 Determine which valuation methods are currently followed and documented Market data, broker quotes, models Identify Gaps Observable inputs – define, capture and document Unobservable inputs – models should be described and periodically proven Access to historical data Footnotes Design and Document New Approach Re-design process and in some cases, functional structure Incorporate pricing committee meetings, documentation and communication Prepare written procedures that are both practical and comply with the rules 6/16/2008 Fair Value Accounting

Step 2: Determine Securities Types and FV Data Required : 

- 222 - Step 2: Determine Securities Types and FV Data Required Historical cost Amortized Cost Market Income Take an inventory of investment strategies and underlying securities Identify types of inputs needed Determine sources of data and method of extraction Ensure access, ability to prove and means historical capture, storage and retrieval Lower of Cost 6/16/2008 Fair Value Accounting

Extracting quality data from pricing feeds and underlying applications is essential to automating fair value calculations. : 

- 223 - Extracting quality data from pricing feeds and underlying applications is essential to automating fair value calculations. Greater Visibility Transaction transparency Internal audit trail for verification Easy access to all governance-related data Consistent Compliance Approach Consistent processes, policies and procedures Well defined governance processes and communication channels Automated processes, workflows and exception handling, where appropriate Improved Efficiencies Reduced overhead and administration costs Reduced redundant IT development Use of industry standards Key Characteristics Performance tracks with expectations Continuous planning provides stakeholders with the data needed to react to changes in the business environment Information is provided rapidly following period completion Near real-time information is available to investors Data provided represents the true picture of performance Few if any restatements occur Information is simplified and standardized to make it easily understood Management provides a line-of-sight view to business drivers Implications for Business Applications Step 3: Identify Data Sources for Market and Observable Inputs 6/16/2008 Fair Value Accounting

Step 4: Identify Data Sources for Unobservable Inputs : 

- 224 - Step 4: Identify Data Sources for Unobservable Inputs Model Outputs and Reports Assessment of model outputs Model results processing and aggregation Reporting and use of model outputs Examples: Fair values of financial instruments and related disclosures (e.g., FV impact of changes in credit risk) ALCO reports for ALM models Risk/Capital reports for firm-wide risk models Greek/Hedge statistics for valuation models 6/16/2008 Fair Value Accounting

Controls : 

- 225 - Controls

Controls: Definition and Objective : 

- 226 - Controls: Definition and Objective Check for quality, accuracy and consistency Process or activity performed correctly Data is accurate Judgment is sound Separation of duties Avoidance of collusion Effective use of subject matter expertise Documentation of activities performed Validation Sources of data Assumptions correctly applied Testing 6/16/2008 Fair Value Accounting

Levels 1 and Level 2: Managing the Data : 

- 227 - Levels 1 and Level 2: Managing the Data Market Data Feeds Map sources to securities types Ensure that prices are based on exchange based transactions Check for deviation with other market data providers Broker Quotes Source of broker quotes: a market maker? reliable source with track record? Methodology applied, e.g., throw out the high and the low Timing and frequency Other Factors Liquidity Leverage Blockage 6/16/2008 Fair Value Accounting

Level 3: Model Validation and Key Requirements : 

- 228 - Level 3: Model Validation and Key Requirements Key requirements Subject matter experience Detailed approach Independent recalculation 6/16/2008 Fair Value Accounting

Common Model Validation Issues : 

- 229 - Common Model Validation Issues Documentation – Sparse to non-existent, not linked to current process/version Inputs – External data not consistently applied, Internal data definitions not stable Model theory – Dated vs. flawed Validation – No independent recalculation Back-testing – not testing results once implemented Model Controls – Passwords, Business continuity, Quality control Outputs – Contextual framework 6/16/2008 Fair Value Accounting

Controls Assessment Approach : 

- 230 - Controls Assessment Approach The proposed approach will seek to: (1) understand the current operating environment; (2) gap the current environment against leading industry practices; and (3) develop a list of recommendations for management consideration. Define the current state functional model and validate functions within scope Document current state operational workflows across front, middle, and back-office functional areas Highlight control and supervisory points within the existing workflow Capture high-level “core processes” to include responsible group/staff, general process description, data inputs/outputs and technologies deployed Assess processes against leading operational, compliance, and control practices Identify and categorize gaps according to “People”, “Process”, “Technology”, “Supervision”, “Controls”, and “Organization” findings Develop recommendations for improvement and alignment with industry leading operational, compliance, and control practices Prioritize recommendations against implementation criteria. “Quick hit” recommendations are isolated Deliver assessment report and implementation roadmap. Phase I: Current State Project Approach 6/16/2008 Fair Value Accounting

Slide 231: 

- 231 - Income Distribution – Process Flow Analysis

Slide 232: 

- 232 - Income Distribution - Control Points Identification

Slide 233: 

- 233 - Income Distribution - Control Points Remediation

Governance : 

- 234 - Governance

Governance: Definition and Objective : 

- 235 - Governance: Definition and Objective How rules will be applied and enforced Identification of what they are Determination of how they should be implemented Execution and oversight Organizational Structure Roles and responsibilities of individuals and functions Enterprise wide programs Information Technology Hierarchy Permissions Passwords and Encryption 6/16/2008 Fair Value Accounting

In order to provide executive management with clear “line-of-sight” into operations, firms need to monitor several dimensions across the business : 

- 236 - In order to provide executive management with clear “line-of-sight” into operations, firms need to monitor several dimensions across the business Company Policies Closing Policies HR and Compensation New Business Approval Other Operating Policies Financial Planning Capital Planning Operating Planning Variance Analysis Exception Reporting Surveillance Anti-Money Laundering Insider Trading Broker Fraud IPO allocations Employee Compliance Employee Registration Outside Accounts/Activity Trading Clearance Continuing Education Independence Conflicts of Interest resolution Chinese Walls Communications Management IT Governance IT Controls Infrastructure Security Data Security Intrusion Detection Sarbanes Oxley and Financial Reporting Financial Certifications Compliance Certifications Records Retention Disclosure Integrity Data Collection Disclosure Checklists SRO filings Corporate Governance Dimensions Organizational and Programmatic Forces 6/16/2008 Fair Value Accounting

Service oriented governance architecture enables the sharing of oversight functions across business applications while isolating their internal complexity. : 

- 237 - Service oriented governance architecture enables the sharing of oversight functions across business applications while isolating their internal complexity. Governance Architecture Creates a standardized governance function across all business applications in the enterprise Centralizes compliance rules as well as the governance data, thereby eliminating redundancy across multiple applications Improves IQTM – management has access to more timely and accurate information Reduces integration costs – by focusing only on systems that require change Enables consolidation of information at an enterprise level through standardized data usage Facilitates reusability and sharing at a functional level to reduce total cost of ownership Benefits 6/16/2008 Fair Value Accounting

Firms are adopting a variety of approaches to establish a governance architecture based on the challenges of their current environment : 

- 238 - Firms are adopting a variety of approaches to establish a governance architecture based on the challenges of their current environment Governance Architecture Approaches 6/16/2008 Fair Value Accounting

Technology : 

- 239 - Technology

Technology: Effective Uses for 157 : 

- 240 - Technology: Effective Uses for 157 Data Warehouse Capture, storage and retrieval of source data Management of statements, assumptions and disclosures Point in time scenario analysis Embedded rules and assumptions Model Validation Inputs and outputs Accuracy of assumptions Verification of calculations Exception Identification Pricing variances Identification of missing data Thresholds such as credit or risk tolerance Testing Financial and Investor Reporting Avoidance of collusion Effective use of subject matter expertise Documentation of activities performed 6/16/2008 Fair Value Accounting

Institutional Managers’ Reporting Packages : 

- 241 - Institutional Managers’ Reporting Packages Performance Analysis Transactions Holdings Reconciliation Valuation Compliance Regulatory Security Master Performance Measurement Attribution Analysis Positions Transactions Asset Allocations Benchmark Comparison Tax Information E Performance Measurement Attribution Analysis Positions Transactions Asset Allocations Benchmark Comparison Tax information Performance Measurement Attribution Analysis Positions Transactions Asset Allocations Benchmark Comparison Tax information Performance Measurement Attribution Analysis Positions Transactions Asset Allocations Benchmark Comparison Tax information Reports Package - Summary B A D C Large institutional asset managers have not traditionally provided detailed valuation information despite a trend toward more frequent and detailed reporting

Investor Reporting – Some Software Vendors : 

- 242 - Investor Reporting – Some Software Vendors FundWorks Vermilion CorrectNet SS&C - Pages Located in UK Additional offices in India, South Africa & USA in 2007 Flexible architecture Web based reporting ASP offering Established product Located in UK Additional offices in Scotland & USA in 2007 Flexible architecture Web based reporting ASP offering in 2007 Relatively new product, looking for market share Located in US Six data centers in five countries Flexible architecture Web based reporting Managed services offering Established product Located in U Offices in Japan Singapore, UK Ireland and Netherlands Customizable architecture Web based reporting Client sites installations Mature product, well established in the market Many institutional managers rely on vendor packages to perform and distribute investor reporting…. Note: This is a representative (not comprehensive) list of investor reporting software packages

Investor Reporting – Some Outsourcing Providers : 

- 243 - Investor Reporting – Some Outsourcing Providers State Street State Street provides customized investment operations outsourcing services for institutional asset managers. State Street’s services encompass all asset management activities following trade execution through portfolio management and client reporting, and are easily integrated with the full spectrum of accounting, custody and fund administration services that State Street provides to sophisticated investors around the world BONY Bank of New York will provide services around all functions of asset management, regardless of type of business. BONY will also provide full reporting capabilities for client reporting Merrill Merrill maximizes the effectiveness and efficiency of our clients' strategic communications initiatives by providing integrated design, production and distribution services. Merrill produces, prints and distributes comprehensive services and compliance documents (pre- and post-sale) for the mutual fund, insurance, banking and brokerage services industries. Integrated order management, inventory monitoring and activity reporting solutions coupled with our pick-and-pack, kitting and shipping capabilities. DSTi Offers document management solutions that deliver dynamic true one to one communications between businesses and their customers in a targeted and personal way using advanced color print technology, digital content management and web based workflow solutions …while others use outsourcing providers Note: This is a representative (not comprehensive) list of outsourcing providers for investor reporting

Questions? : 

- 244 - Questions?

Securities Industry - Fair Value Implementation Issues : 

Securities Industry - Fair Value Implementation Issues EEI Conference on Issues in Fair Valuation 6/16/2008 245 Fair Value Accounting

Implementation Issues : 

Implementation Issues 6/16/2008 246 Fair Value Accounting

Issue 1: Blockage Factors : 

Issue 1: Blockage Factors SFAS 157 paragraphs 27 and C80 preclude the use of blockage factors if An entity holds a position in a single financial instrument and The instrument is traded in an active market eliminate the exception to P x Q for a financial instrument that trades in an active market, even if the market’s trading volume is not sufficient to absorb the quantity held without affecting the price Adjustment for a blockage factor is not prohibited if the instrument does not trade in an active market Refer to relevant industry audit and accounting guides for measuring fair value for level 2 and level 3 inputs For entities following the broker-dealer guide, block discounts may continue to be appropriate for level 2 and level 3 inputs 6/16/2008 247 Fair Value Accounting

Issue 1: Blockage Factors (cont’d) : 

Issue 1: Blockage Factors (cont’d) Example 1: Adjustment for Post-Closing Events (Paragraph 26) Closing price of an actively traded instrument does not represent fair value (due to post-closing events) Adjustment to closing price causes the instrument to be classified as Level 2 for disclosure purposes Example 2: Use of an Alternative Pricing Method (Paragraph 25) An alternative pricing method that does not exclusively rely on quoted pricing (such as Matrix Pricing) is used as a practical expedient to determine the fair value of an instrument Accordingly, the instrument is classified as Level 2 for disclosure purposes Even though the instrument is classified as Level 2 for disclosure purposes, the Entity is not permitted to apply a blockage factor 6/16/2008 248 Fair Value Accounting

Issue 2: Principal/Most Adv. Market : 

Issue 2: Principal/Most Adv. Market Approach to determine the principal or most advantageous market for a financial instrument: First consider whether the entity has a principal market for the asset or liability before looking at most advantageous. Often an entity's principal market will be its most advantageous market because most entities attempt to maximize profits and therefore will transact in the most advantageous market with the greatest volume or level of activity. 6/16/2008 249 Fair Value Accounting

Issue 3: Mid vs. Bid/Ask Pricing : 

Issue 3: Mid vs. Bid/Ask Pricing SFAS 157 para. 31: Inputs Based on Bid and Ask Prices Use price within the bid-ask spread that is most representative of fair value. As a practical expedient mid-market or other pricing conventions within the bid-ask spread might be used. Implementation Issue: Does SFAS 157 permit any point within the bid-ask spectrum as long as that point is applied consistently? Does bid/ask pricing eliminate the need to provide for liquidity adjustments at a macro level to move from mid to bid or ask – depending on a net long or short position? 6/16/2008 250 Fair Value Accounting

Issue 3: Mid vs. Bid/Ask Pricing (cont’d) : 

Issue 3: Mid vs. Bid/Ask Pricing (cont’d) Bid-Ask Pricing – Consistent Application Bid-Ask pricing method should be applied consistently Bid-Ask pricing method should not be changed unless a change in method results in a measurement that is equally or more representative of fair value Same bid-ask pricing convention should be used for similar assets and liabilities unless the entity can support the use of a different point with the bid-ask spread for a particular instrument. 6/16/2008 251 Fair Value Accounting

Issue 4: Vendor Pricing : 

Issue 4: Vendor Pricing Many Entities use vendors in their securities pricing process (e.g., S&P, Reuters, Bloomberg, etc.) Vendors are not market participants Usually collect data from dealers and other sources Use in-house valuation techniques to produce specific CUSIP level prices (direct quotes, matrix pricing, relative value calculations) Implementation Issue: Are vendor provided prices level 2 or level 3? Lack of transparency into pricing methodology Cover both liquid and illiquid bonds Varying degrees of quality depending on vendor 6/16/2008 252 Fair Value Accounting

Issue 5: Consideration of Non-Cash Collateral : 

Issue 5: Consideration of Non-Cash Collateral SFAS 157 paragraph 15 states that The fair value of a liability shall reflect the nonperformance risk relating to that liability The effect of changes in credit risk may depend on the terms of the credit enhancements related to the liability Implementation Issues: When determining the fair value of an instrument, should the fair value and changes in fair value of collateral be considered? Should fair value changes of off-balance sheet collateral be considered? 6/16/2008 253 Fair Value Accounting

Issue 5: Consider. of Non-Cash Collateral (cont’d) : 

Issue 5: Consider. of Non-Cash Collateral (cont’d) Collateral should be considered in determining the FV of a liability, if: There is no prohibition in the contract with regards to transferring the collateral AND A linkage exists between the collateral and the liability. Concern: If the non-cash collateral was off-balance sheet prior to the adoption of SFAS 157/159, the inclusion of collateral in the fair value measurement of a liability could potentially bring fair value changes of an off-balance sheet item into the P/L. 6/16/2008 254 Fair Value Accounting

Issue 6: Portfolio Adjustments : 

Issue 6: Portfolio Adjustments Implementation Issue: How should portfolio level adjustments (in this case – CVA) be allocated (and disclosed) within the various instruments in the portfolio in light of: Individual units classified in different hierarchy levels Presence of netting within the portfolio Interrelated units (e.g. an instrument is a collateral for another) SFAS 157 states that such adjustments have to be allocated to the individual unit of account, and bulking up such portfolio level adjustments and disclosing them separately is not permitted. 6/16/2008 255 Fair Value Accounting

Issue 8: Disclosure Requirements : 

Issue 8: Disclosure Requirements SFAS 157 paragraphs 32 to paragraph 35 * Fair Value Measurements at reporting date Segregated by level within the fair value hierarchy Reconciliation of beginning and ending balance for level 3 fair value measurements separately presenting Realized and unrealized gains/losses Purchases, sales, issuances and settlements Transfers in and out of level 3 Amount of gains/losses included in earnings resulting from unobservable inputs for instruments held at reporting date; description of where these gains/losses are reported on the income statement. Valuation techniques used and a discussion of changes in valuation techniques (for annual periods only). Different disclosure requirements for assets and liabilities measured at fair value on a nonrecurring basis. * This does not represent a listing of all disclosure requirements. Please refer to the original standard for a complete description of the disclosure requirements 6/16/2008 256 Fair Value Accounting

Issue 8: Disclosure Requirements : 

Issue 8: Disclosure Requirements Portfolio Level Adjustments SFAS 157 paragraph 32 does not permit The disclosure of elements of measurement of fair value for a particular unit of account in different hierarchy levels The disclosure of a portfolio of instruments in a single hierarchy level when the unit of account is the individual instrument (unless all the instruments in the portfolio are classified in the same hierarchy level after allocation of the portfolio level adjustment) Allocation of portfolio level adjustments can affect the level of fair value measurement for that asset/liability, if The allocated portfolio adjustment is a Level 3 input and Has a significant effect on the measurement 6/16/2008 257 Fair Value Accounting

Issue 8: Disclosure Requirements (cont’d) : 

Issue 8: Disclosure Requirements (cont’d) Portfolio Level Adjustments (cont’d) SFAS 157 does not prescribe an approach for allocating portfolio level adjustments to individual assets/liabilities. Entities should establish and consistently apply a reasonable methodology for allocating portfolio level adjustments Entities should consider disclosing their policy in the notes to the financial statements. Look to early-adopters for different approaches to meeting the disclosure requirements in SFAS 157 and SFAS 159 6/16/2008 258 Fair Value Accounting

Questions : 

Questions

Banking, Mortgage & FinanceCompanies : 

Banking, Mortgage & FinanceCompanies EEI Conference on Issues in Fair Valuation 6/16/2008 260 Fair Value Accounting

Agenda : 

Agenda SFAS 157: Issues Re: Mortgage Loans HFS Unit of Account Principal Market / Most Advantageous Market Securitization Pricing vs. Whole Loan Pricing Valuation of Mortgage Loans Valuation Methods and Techniques SFAS 159: Implementation Issues Interest Income 6/16/2008 261 Fair Value Accounting

SFAS 157 Issues Re: Mortgage Loans Held for Sale : 

SFAS 157 Issues Re: Mortgage Loans Held for Sale 6/16/2008 262 Fair Value Accounting

Mortgage Loans Held for Sale : 

Mortgage Loans Held for Sale Practice Issues Unit of account vs. unit of valuation? What is the principal or most advantageous market? What if the principal or most advantageous market changes?

Unit of Account v. Unit of Valuation : 

Unit of Account v. Unit of Valuation Portfolio Value Loan 1 Loan 2 Loan X Unit of Valuation Unit of Account 6/16/2008 264 Fair Value Accounting

Securitization Market : 

Securitization Market View 1 Use prices prevailing in the securitization market if this “market” represents the entity’s principal market 6/16/2008 265 Fair Value Accounting

Securitization Market : 

Securitization Market Mortgage Originator Subsidiary (Bankruptcy Remote) Loan Portfolio (True Sale) QSPE 6/16/2008 266 Fair Value Accounting

Securitization Market : 

Securitization Market Mortgage Originator Subsidiary (Bankruptcy Remote) Cash QSPE Tranche 1 Tranche 2 Tranche 3 Residual 6/16/2008 267 Fair Value Accounting

Securitization Market : 

Securitization Market Mortgage Originator Subsidiary (Bankruptcy Remote) Cash QSPE Tranche 1 Tranche 2 Tranche 3 Residual Better Execution? Tranching efficiencies Rating benefits Avoided costs Optimistic residual values 6/16/2008 268 Fair Value Accounting

Whole Loan Market : 

Whole Loan Market View 1 Use prices prevailing in the securitization market if this “market” represents the entity’s principal market. View 2 View 1 mixes apples and oranges. Use the whole loan price. Remember, the loans have to be transformed into securities. 6/16/2008 269 Fair Value Accounting

Whole Loan Market : 

Whole Loan Market View 1 Use prices prevailing in the securitization market if this “market” represents the entity’s principal market. View 2 View 1 mixes apples and oranges. Use the whole loan price. Remember, the loans have to be transformed into securities. The [fair value] measurement should consider attributes specific to the asset…for example, the condition and/or location…at the measurement date 6/16/2008 270 Fair Value Accounting

Whole Loan Market : 

Whole Loan Market Mortgage Originator Loan Portfolio (True Sale) Investor Cash 6/16/2008 271 Fair Value Accounting

Key Considerations : 

Key Considerations Both methods are supportable, but… …Entity must have access to securitization market to use these prices Even if principal market is securitization, may use whole loan as that is legal form of asset Securitization price considerations Transaction versus transformation costs Spot prices vs. forward prices “Justifying” gains What if a Principal Market doesn’t exist? 6/16/2008 272 Fair Value Accounting

Valuation of Mortgage Loans : 

Valuation of Mortgage Loans 6/16/2008 273 Fair Value Accounting

Valuation of Mortgage Loans : 

Valuation of Mortgage Loans Using MBS securitization price for a whole loan FV Assume: 6.30% Coupon, 30yr, Conforming Loan, 35bps G-Fee, 20bps servicing fee Loan would price between 5.5 and 6.0 MBS equivalent (6.30% - 0.55% is 5.75% equivalent coupon) Price = 99 + 100.9 / 2 (100-282 equals 100.9) MBS Equivalent Price is equal to 99.95. Must be “carry adjusted” from Jan settlement to current period end Excerpt from a dealer Quote sheet 6/16/2008 274 Fair Value Accounting

Valuation of Mortgage Loans (cont’d) : 

Valuation of Mortgage Loans (cont’d) Other alternatives: Could use a discounted cash flow analysis Forecast interest / principal over life of the loan Make assumptions for prepayment, default, severity Very difficult for a portfolio given diverse geographic and borrower characteristics Discount Risk Adverse Third Party For non-conforming loans, what could be the appropriate market? Alt-A and Subprime securitization markets (not as readily traded) Whole Loan bulk delivery markets? 6/16/2008 275 Fair Value Accounting

Valuation of Mortgage Loans (cont’d) : 

Valuation of Mortgage Loans (cont’d) If using securitization price, how would you determine the haircut to the securitization price since the securitization process is not complete? 6/16/2008 276 Fair Value Accounting

Key Considerations : 

Key Considerations Securitization price considerations Risk Adjustments Model Risk Risks associated with unobservable inputs Transaction versus transformation costs Legal Costs Underwriting Costs Rating Agency Fees Accounting Costs Residual Interests Concentration of Risk in Subordinate Bonds 6/16/2008 277 Fair Value Accounting

Valuation of Mortgage Loans (cont’d) : 

Valuation of Mortgage Loans (cont’d) Securitization Market less Transformation costs (View 1): reporting entities to look to the market into which they will deliver loans forward whole loan or security prices should be adjusted for transformation costs (i.e. costs directly related to transforming loans into security form which could include attorneys’, rating agencies’ and underwriting fees) because forward security or loan prices would reflect what would be received by the reporting entity, no further adjustment of the prices would be appropriate 6/16/2008 278 Fair Value Accounting

Valuation of Mortgage Loans (cont’d) : 

Valuation of Mortgage Loans (cont’d) Principal Market less Fair Value Adjustments (View 2): Similar to View 1 except: Adjustments of forward loan and securities prices should be made to get to an exit price for the loans at the measurement date. Forward prices should be adjusted for factors that a market participant would consider in valuing the loans at the measurement date, which could include carry value (i.e. the net interest income on the loans from funding/purchase of the loans through sale), risk premium,  the embedded servicing rights,  any interests to be retained (or liabilities to be assumed) upon the sale of the loans and any other factors as determined by the entity under the circumstances 6/16/2008 279 Fair Value Accounting

Valuation of Mortgage Loans (cont’d) : 

Valuation of Mortgage Loans (cont’d) Whole Loan Market (View 3): Proponents of this view believe that the valuation of loans HFS should follow a fair value hierarchy approach: First - rely on current quoted market prices for identical loans if available Second - rely on current quoted market prices for similar loans if available Third – use a valuation technique. Such a technique could rely on forward whole loan prices -- or if unavailable, forward security prices -- adjusted for factors that a market participant would consider in valuing the loan at the measurement date, which could include carry value, risk premium, the embedded servicing rights, interests to be retained (and liabilities to be assumed) upon the sale of the loans and any other factors as determined by the entity under the circumstances. A loan is a loan, and not a security argument in View 3 6/16/2008 280 Fair Value Accounting

SFAS 159: Implementation Issues : 

SFAS 159: Implementation Issues Interest Income Disclosures (under SFAS 159, para. 19): How much to recognize as income and what portion is attributed to changes in FV? 3 potential methods of income recognition: Method 1: Effective yield method Method 2: Coupon on yield, everything else under the trading line item in I/S Method 3: Entire amount under the trading line item in I/S 6/16/2008 281 Fair Value Accounting

Slide 282: 

Questions? 6/16/2008 282 Fair Value Accounting

Fair Value – Implementation Issues for the Insurance Industry : 

Fair Value – Implementation Issues for the Insurance Industry 6/16/2008 283 Fair Value Accounting

Agenda : 

284 Agenda Implementation Issues Issues for Insurance and other industries Insurance-specific topics Other Items 6/16/2008 Fair Value Accounting

How do insurers make money? : 

285 How do insurers make money? Primarily two sources: Underwriting gains Investment Income Underwriting gains (losses) determined by taking: premiums earned, less claims paid, less underwriting expenses Investment income driven by yield and “float” 6/16/2008 Fair Value Accounting

How do insurers make money? : 

286 How do insurers make money? Excerpt from 2005 letter to shareholders by Warren Buffett: “What counts here is the amount of “float” and its cost over time. ““Float” is money that doesn’t belong to us but that we temporarily hold. Most of our float arises because (1) premiums are paid upfront though the service we provide – insurance protection – is delivered over a period that usually covers a year and; (2) loss events that occur today do not always result in our immediately paying claims, because it sometimes takes many years for losses to be reported (asbestos losses would be an example), negotiated and settled. The $20 million of float that came with our 1967 entry into insurance has now increased – both by way of internal growth and acquisitions – to $49 billion.” “Float is wonderful – if it doesn’t come at a high price” 6/16/2008 Fair Value Accounting

Slide 287: 

287 How does fair value affect insurers? 6/16/2008 Fair Value Accounting

Fair value and insurance : 

288 Fair value and insurance Current use of fair value: Investments in securities Derivatives Business Combinations Financial statement disclosures about financial instruments Most of balance sheet not at fair value Liabilities, insurance reserves, and many investments (loans, alternative investments, etc.) 6/16/2008 Fair Value Accounting

Fair value and insurance : 

289 Fair value and insurance Potential application of FAS 159 fair value option: Investments in mortgage loans and corporate loans not carried at fair value Securities classified as Available for Sale Industry companies historically averse to classification as trading Certain insurance liabilities Insurance companies economically hedge variable annuities (GMIB, GMDB) that do not contain embedded derivatives and do not qualify for hedge accounting Note that contracts with a servicing component may not be eligible for fair value option 6/16/2008 Fair Value Accounting

Slide 290: 

290 General Implementation Issues 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

291 SFAS 157: Implementation Issues Bid/Mid/Ask Pricing No requirement to mark Long to bid and short to ask although common industry practice (also see IAS rule) Select a policy most representative of fair value and apply consistently Block Discounts Not permitted for Level 1 Not permitted for Level 1 priced using the practical expedient Permitted for Level 2 or 3 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

292 SFAS 157: Implementation Issues Consideration of Credit Enhancements (e.g. collateral) Should fair value changes of on and off-balance sheet collateral be considered? Adjust the valuation of assets and liabilities for collateral and other credit enhancements Market participant assumptions Credit adjustments for Liabilities at fair value Includes two-way credit adjustments for derivative contracts 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

293 SFAS 157: Implementation Issues “Day 1 Gains” EITF 02-3 precludes immediate recognition of inception gains/losses unless valuation is supported by observable market data Day 1 gains no longer prohibited under SFAS 157 (However, Day 1 gains cannot be purely “model driven”) Some see such a provision as a means for rampant abuse Statement requires additional disclosures for non-market based fair value measurements (including, unrealized impact on earnings) 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

294 SFAS 157: Implementation Issues Private Equity Investments Currently EITF 02-3 precludes immediate recognition of inception gains/losses unless valuation is supported by observable market data Day 1 gains no longer prohibited under SFAS 157 Blackstone Group IPO: Holds private equity investments – tough to value It may recognize P&L upfront on these investments (for management fees and eventual sale) – However FVO is not permitted for interests where future service is a component of FV Statement requires additional disclosures for non-market based fair value measurements (including, unrealized impact on earnings) 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

295 SFAS 157: Implementation Issues Many Entities use Vendors (e.g. S&P, FDI, Reuters, Bloomberg) in their securities pricing process Vendors are not market participants. Usually collect data from dealers & other sources Use in-house valuation techniques to produce specific CUSIP level prices (direct quotes, matrix pricing, relative value calculations) Are vendor provided prices level 1, level 2 or level 3? Lack of transparency into pricing methodology Cover both liquid and illiquid bonds Varying degrees of quality depending on vendor 6/16/2008 Fair Value Accounting

SFAS 157: Issues - Disclosures : 

296 SFAS 157: Issues - Disclosures Challenges Level 1 or 2 vs. elaborate level 3 disclosures Portfolio level adjustments Allocation of portfolio-level adjustments See Example 1 Calculation of unrealized gain/loss for derivative contract held at the reporting date See Example 2 6/16/2008 Fair Value Accounting

SFAS 157: Implementation Issues : 

297 SFAS 157: Implementation Issues Determining valuation method(s) Lack of reliable market prices Requirement to follow hierarchy Setting “market” assumptions Bridging gap between PV techniques and market prices (day one and ongoing) Treatment of gain/loss at issue and ongoing volatility Method for incorporating credit spread and risk margins Complexity of modeling Communicating results to management Incorporating adequate controls 6/16/2008 Fair Value Accounting

SFAS 159: Implementation Issues : 

298 SFAS 159: Implementation Issues Interest Income Disclosures (under SFAS 159, para. 19b) How much to recognize as income and what portion is attributed to changes in FV? 3 potential methods of income recognition: Method 1: Effective yield method Method 2: Coupon on yield, everything else under the trading line item in I/S Method 3: Entire amount under the trading line item in I/S 6/16/2008 Fair Value Accounting

SFAS 159: Implementation Issues (cont’d) : 

299 SFAS 159: Implementation Issues (cont’d) Portfolio Restructuring Strategies (Accounting Alert 07-05) Sale Strategy/Extinguishment upon adoption of SFAS 159 for Impaired assets and/or Debt with fair value below the carrying value Loss recognized as cumulative effect adjustment in R/E Strategy might increase earnings in future periods FVO will not be elected on an ongoing basis Does not meet the objectives of FVO Additional transparent disclosure considerations if accounting for a sale or extinguishment strategy is appropriate Disclosure Challenges Reasons for electing for some, but not all within a group of similar assets/liabilities 6/16/2008 Fair Value Accounting

Slide 300: 

300 Insurance-specific Implementation Issues 6/16/2008 Fair Value Accounting

Variable Annuities : 

301 Variable Annuities May contain structured riders that provide protection to the policyholder, such as GMWB, GMAB, etc. Current approach is to model embedded as a swap (or deferred premium option) Calculate fees necessary to result in zero fair value at inception How does FAS 157 change the approach? 6/16/2008 Fair Value Accounting

Variable Annuities : 

302 Variable Annuities Exit price adjustments Need to include credit adjustment Include as component to stochastic analysis or as after-the-fact adjustment if liability? Market participant adjustments Need to add risk margin What is the appropriate market to determine risk margin? Reinsurance does not result in full risk transfer Capital markets instruments do not relieve policyholder and insurance risks 6/16/2008 Fair Value Accounting

Slide 303: 

303 Variable Annuities – Fair Value Methods

Separate Accounts : 

304 Separate Accounts Industry practice is to include in FAS 107 disclosure Is it required? Many questions in applying FAS 157 What is the unit of account? Is there a requirement to “look-through” to the underlying assets? Are the separate account liabilities subject to fair value? 6/16/2008 Fair Value Accounting

Policy Loans and GIC’s : 

305 Policy Loans and GIC’s Policy loans related to investment contracts and GIC’s are required to be disclosed under FAS 107 Industry practice pre-FAS 157 is to assume carrying value equals fair value For fixed rate contracts, FAS 157 will generally preclude assumption of carrying value equals fair value How to incorporate risk margins? What rate to use for discounting? Impact of crediting interest? 6/16/2008 Fair Value Accounting

Potential SFAS 159 Applications for Insurance Co’s : 

306 Potential SFAS 159 Applications for Insurance Co’s GMDBs and GMIBs with economic hedges Improves matching of claims costs and hedge gains as compared to current accounting (SOP 03-1) Issue is fair value of future fees Contracts with loss recognition concerns If currently in LR, enables upside recognition If potential future LR, can take now through OCI Issue is disclosure of reason for applying 159 (cannot be to avoid current impairment) 6/16/2008 Fair Value Accounting

Potential SFAS 159 Applications for Insurance Co’s : 

307 Potential SFAS 159 Applications for Insurance Co’s Assets not carried at fair value Mortgage and other loans Hedge accounting can be difficult to achieve / maintain However, requirement to calculate exit price may be equally challenging Contracts not getting SA treatment under SOP 03-1 Liabilities equal fair value of assets If assets not trading, can apply FVO to get asset/liability match 6/16/2008 Fair Value Accounting

End : 

End Questions? Comments Concerns 6/16/2008 Fair Value Accounting 308