On Sept. 18, 2006, the Financial Accounting Standards Board issued its Statement of Financial Accounting Standards No. 157, Fair Value Measurements. More commonly known as FAS 157, the statement redefines fair value through a new measurement system that separates observable and unobservable inputs into three categories: Level 1, Level 2 and Level 3. Level 1 consists of assets with observable market prices that are easily quoted. The assets at Level 2 have quoted prices that are used as inputs to construct a price for a particular instrument. Level 3 is reserved for assets where direct market inputs are either unavailable or insufficient for pricing determination.
FAS 157 went into effect for financial statements issued for fiscal years beginning after Nov. 15, 2007 – admittedly, a curious time for the financial services industry.
‘It is a coincidence in the timing that it happened when it did,’ observes Jeffrey A. Miller, president of NewArc Investments Inc., Naperville, Ill., who adds the changing market is well-met by FAS 157's arrival. ‘In today's new market, underlying demands have changed. There is still a demand for securitization of debt, but it has to be cleaner, simpler and easier to understand. The major investment banks are already at work on products that meet that criteria.’
Miller points to FAS 157 as the tool to bury what he calls the ‘old market,’ an environment where ‘financial institutions saw opportunities to create products to satisfy investor appetites for higher yields. But as certain tranches of mortgage pools showed signs of failing, whole production was under scrutiny, and no one knew how to evaluate that.’
Miller adds FAS 157 will ensure today's market doesn't fall back into the bad habits that created the current environment. ‘FAS 157 has forced firms to be realistic about evaluating illiquid holdings, and that's a good thing,’ he says.
So what will FAS 157 mean for mortgage banking? Opinions across the industry are split.
According to Edward B. Kramer, the New York-based executive vice president of regulatory programs for Wolters Kluwer Financial Services, the level of concern should be relatively low.
‘It is less of a problem for the mortgage banks than for the investment banks,’ he says. ‘Most of the mortgage bankers have been working the secondary market and have gotten that stuff off their books.’
However, Kramer notes there is a potential trouble spot outside of origination. ‘If the banks are retaining servicing rights and maintain a servicing portfolio, they could have issues there if the loans they service get into trouble,’ he observes.
Although it has been more than a year in coming, the relative newness of FAS 157 is still raising questions. Tim Frommeyer, senior vice president and chief financial officer at Nationwide Financial Services in Columbus, Ohio, addressed these challenges during a speech at the recent Credit Suisse Group Insurance and Asset Management Conference.
‘On the asset side, there's a lot of paperwork going on, a lot of documentation that needs to be put together,’ says Frommeyer. ‘On some of the more exotic products, like collateralized debt obligations (CDOs), there's not a lot of consistency in how companies are thinking about it. So, we're spending a lot of time with the industry and talking to consultants and getting a perspective on how to value some of these liquid investments.’
Frommeyer notes confusion is also present in regard to liability. ‘Companies are all over the place, because as you look at the Level 3 inputs (the non-observable market inputs), there's a lot of dialogue in terms of how much risk margin needs to be in there,’ he says. ‘Do you put a risk margin in every assumption? And have it be so conservative that you end up with a liability value that's way too high? Or do you use best estimate assumptions, and then just put a risk margin on top?’
Michael Gasior, president of Middletown, Conn.-based AFS Seminars LLC, a provider of financial training to the institutional investor community, is concerned about FAS 157's effects on the mortgage-backed securities market.
‘All mortgage-backed securities are at least Level 2, and a lot are Level 3,’ he says. ‘At that point, they may be viewed as less desirable, and that could lead to a demand for more spread and yield, which could then lead to a greater impact on the homeowner and mortgage rates.’
Gasior questions whether the audit firms will have difficulty assessing the trustworthiness of the mortgage products using their existing models, given that recent market convulsions have shown pre-FAS 157 inputs to be untrustworthy.
In some sectors, FAS 157 may be arriving too late to help.
‘FAS 157 may give false hope to the international finance community that has lost billions of dollars on thinly-traded securities such as CDOs,’ says Dr. Anthony B. Sanders, professor of finance and real estate at Arizona State University in Tempe. ‘CDOs, like many illiquid securities, are Level 3, which means that prices are not observable. As such, there is little relief because of FAS 157 since it is the Level 3 securities that are causing the problems in the international financial arena.’