Fair Value Accounting & Finance Discussion

Chapter 8Securitizations
Securitizations
• Accounting for securitizations
➢ According to the text, under SFAS No. 140 (2000),
three issues for users of financial reports
❖ Despite SFAS No. 140’s (2000) focus on control, it is not
clear that issuers are affected substantially by whether
surrender control over the underlying financial assets.
❖ Certain retained interests concentrate the risk of the
underlying financial assets.
❖ Some retained interests are sensitive or illiquid
instruments that require expertise and judgment to value.
Securitizations
• Motivations for and alternatives to securitizations
➢ According to the text:
❖ Issuers have various motivations for securitizations.
❖ Securitizations provide funds for future organizations of
financial assets.
❖ They allow issues to diversify their holdings of financial
assets and to transfer or transform the risk of those
assets in diverse ways.
❖ Loan sales and syndications are common alternatives to
securitizations.
❖ Loan syndications can be structured legally as
participations or assignments.
Securitizations
➢ Residential Mortgages
❖ Was the first and remains the most important
type or securitized financial asset.
❖ Residential mortgage securitizations are
sponsored.
❖ Ginnie Mae and other government-sponsored
enterprises are the sponsors of securitizations.
▪ Ginnie Mae sponsors but does not issue
securitizations of mortgages.
▪ Ginnie Mae provides timing insurance.
Securitizations
➢ Securitizations of other financial assets
❖ “Are important to a wide class of financial
institutions that securitize an increasingly wide
range of loans, securities, and lease
receivables.”
❖ Almost any type of financial asset can be
securitized.
➢ Asset-backed commercial paper
❖ “Asset-backed commercial paper (ABCP) is a
type of short-term financing (less than 270 days
in the United States) that is employed by both
financial institutions and nonfinancial firms.”
Securitizations
• Securitization structures
➢ Pass-through securitizations
❖ Simplest form of securitization
➢ Estimation of prepayment risk
➢ Tranched securitizations
❖ Yield distinct tranches of securities with different
prepayment, interest rate, credit, or other risk.
❖ Collateralized mortgage obligations (CMOs)
▪ Tranched securitizations for residential
mortgages
Securitizations
• SFAS No. 140
➢ “Defines transfers of financial assets as
conveyances of noncash financial assets by and to
someone other than the issuer of the assets.”
➢ These transfers include securitizations.
➢ Scope exclusions
❖ Transfers of some types of financial assets.
▪ “Specifically, transfers of financial assets associated
with pension and other postemployment benefit
plans, leveraged leases, and insurance contracts are
excluded.”
Securitizations
➢ Three concepts to determine if the transfer is a
sale or secured borrowing:
❖ Financial components concept
▪ Reflects the sequence of transactions
leading up to a given position.
❖ Control concept
▪ Reflects legal and effective notions.
❖ Fair value concept
▪ “Uses fair value in two ways in accounting
for transfers of financial assets for which the
transferor has surrendered control over the
assets as sales.”
Securitizations
➢ Disclosures
❖ Requires minimal disclosures for
securitizations.
❖ According to the text, the issuer must disclose
▪ A description of the economic characteristics of
securitizations, including the nature of each retained
interest.
▪ The policies used to account for and the methodology
and significant assumptions used to estimate the fair
values of each retained interest, or the reason why it
is not practicable to estimate their fair value.
▪ Sensitivity tests indicating the hypothetical change in
the fair value of each retained interest or two or more
unfavorable changes in each significant assumption
used to estimate its fair value.
Securitizations
➢ Disclosures
▪ The gain or loss on sale during a period.
▪ The various cash flows between the issuer and the
securitization SPEs during the period.
Securitizations
• Financial analysis issues
➢ The text states, three financial analysis issues
❖ Is sale accounting applied when the issuer still
bears most of the risks and rewards on the
financial assets?
❖ Are the amounts recorded for retained interests
and thus gains on sale appropriate?
❖ Are these gains persistent, or are they timed to
manage income?
Securitizations
• Servicing and prepayment-sensitive securities
➢ Servicing rights
❖ “Are recognized separately from the remainder
of the financial assets only when those rights
are retained in a securitization or other transfer
or are purchased in the open market.”
❖ Servicing rights are most often assets.
❖ Servicing liabilities occur when the cost of
servicing exceeds the fees.
College of Administration and Finance Sciences
Assignment (2)
Deadline: Sunday 03/06/2023 @ 23:59
Instructions – PLEASE READ THEM CAREFULLY
•
The Assignment must be submitted on Blackboard (WORD format only) via allocated folder.
•
Students are advised to make their work clear and well presented, marks may be reduced for
poor presentation. This includes filling your information on the cover page.
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Students must mention question number clearly in their answer.
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Late submission will NOT be accepted.
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Avoid plagiarism, copying from students or other resources without proper referencing will
result in ZERO marks. No exceptions.
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All answers must be typed using Times New Roman (size 12, double-spaced) font. No
pictures containing text will be accepted and will be considered plagiarism.
.
Assignment Question(s):
(Marks 15)
Q. 1) Fair Value Accounting is argued to be conceptually and practically preferable to
Amortized Cost Accounting for most financial instruments. But there are some
arguments that are against fair value accounting. Understanding these arguments are
important because they speak directly to the strength and weakness of fair value
accounting. You are required to discuss these arguments in detail.
(5 Marks)
College of Administration and Finance Sciences
(Week 9 ,Chapter 6 )
Q. 2) Mortgage banks are exposed to interest rate risk on their mortgage-related asset
through prepayment and discounting effects that are not entirely distinct. Discuss the
Prepayment and Discounting Effects of Mortgage Banks in detail.
(Marks 5)
(Week 9 ,Chapter7 )
Q.3) Accounting for Securitization under SFAS No. 140 (2000) is a limited attempt to
describe complex transactions that are structured to yield desired economic and
accounting outcomes. This accounting raises three issues for users of financial reports.
State these three issues.
(Marks 5)
(Week 10 ,Chapter 8 )
Chapter 6
Fair Value Accounting for Financial Instruments:
Concepts, Disclosures, and Investment Securities
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Fair value accounting for financial instruments
➢ Fair value
❖ SFAS No. 157 defines fair value as:
▪ “The price that would be received to sell an
asset or paid to transfer a liability in an
orderly transaction between marketplace
participants at the measurement date.”
▪ Fair value if defined this way is know as exit
value.
▪ Distinctive from the price that would be paid
to purchase an asset.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Fair value hierarchy
❖ “SFAS No. 157 contains a hierarchy of the types of inputs that
may be used to estimate fair value, giving higher priority to
observable inputs that use market data more fully.”
❖ These inputs include:
▪ Quoted prices
▪ Other observable market data
o Quoted prices for similar assets or liabilities in active
markets
o Interest rates, yield curves, volatilities, prepayment
speeds, loss severities, credit premia, and default rates
▪ Unobservable inputs
o Inputs derived from or corroborated by market data
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Full fair value accounting
❖ According to the text, full fair value accounting has
three specifics:
▪ On the balance sheet, economic gains and losses are
recognized through adjustments to the carrying values of
assets and liabilities each period.
▪ On the income statement, economic gains and losses are
recorded as they occur, not when they are realized.
▪ On the income statement, interest is recognized on a fair
value basis, as the weighted-average fair value of a
financial instrument during the period times the
corresponding weighted-average market interest rate.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Argument against fair value accounting for financial
instruments
❖ Fair value accounting yields unnecessary income
❖ Gains and losses are nonrecurring
❖ Financial instruments are involved in economic hedging
relationships
❖ Fair values are not reliably measurable for some financial
instruments
❖ Some financial instruments are coupled with customer
relationships or other nonfinancial items.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Disclosures of the fair value of financial instruments
➢ SFAS No. 107
❖ “Requires that firms disclose the fair value and the
carrying value of both on- and off-balance sheet
financial instruments.”
❖ Exceptions to disclosure requirements
▪ Mortgage-servicing rights
▪ Core deposit intangibles
▪ Leases
▪ Insurance contracts
▪ Investments
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ SFAS No. 157
❖ Disclosures which are useful:
▪ “Fair value measurements are the reporting
date and the level within the fair value hierarchy
where they all must be disclosed.”
▪ “Fair values are estimated using Level 3 inputs
on a recurring basis.”
▪ “When fair values are estimated using Level 3
inputs on a nonrecurring basis.”
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
➢ Adjusting financial statements to reflect the fair value
of financial instruments
❖ “Fair value is the preferred valuation basis for
financial instruments, it is generally useful to adjust
financial institutions’ reported financial statements
to reflect the fair value of their financial instruments
using SFAS No. 107 (1991) disclosures.”
▪ Balance sheet
▪ Income statement
▪ Adjusting Golden West’s financial statements
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Investment securities
➢ Restrictions on reclassifying securities and the
possibility of gains trading
❖ “SFAS No. 115 (1989)
▪ Allows firms to exercise discretion to obtain desired
accounting treatments, including gains trading.
▪ Allows securities to be transferred out the HTM portfolio.
▪ “Requires that transfers of securities among the three
types be recorded at fair value in some fashion.”
➢ Other-than-temporary impairment
❖ “SFAS No. 115 (1989)
▪ Requires that the firm determine whether the impairment
is “other than temporary”.
Fair Value Accounting for Financial
Instruments: Concepts, Disclosures,
and Investment Securities
• Investment securities
➢ Disclosures and the assessment of gains trading
❖ Gains trading takes place in two forms:
▪ “The firm holds a portfolio of securities that have
appreciated or depreciated since purchase, from which it
chooses to sell selected securities.”
▪ “The firm holds securities that appreciate or depreciate
during the year, but its realization of gains and losses
during the year is not representative of this appreciation
or depreciation.”
Chapter 7
Mortgage Banks
Mortgage Banks
• Mortgage banking industry, major players, and
activities
➢ Begin in the 1950s originating mortgages by
federal government agencies.
➢ Took off in 1970, when the Government National
Mortgage Association (Ginnie Mae) sponsored
securitization of government mortgages.
➢ “Ginne Mae currently sponsors securitization of
mortgages insured by these government agencies:
❖ Federal Housing Administration (FHA) within HUD
❖ Department of Veterans Affairs (VA)
❖ Rural Housing Service (RHS) within the Department of
Agriculture
❖ Office of Public and Indian Housing (PIH) within HUD”
Mortgage Banks
➢ Fannie Mae and Freddie Mac are federally
chartered government-sponsored enterprises
(GSE)
❖ Regulated under the Federal Housing
Enterprise Safety and Soundness Act of 1992
➢ “Mortgage servicing entails various activities, such
as
❖ Billing
❖ Collecting and processing payments
❖ Dealing with defaulted mortgages
❖ Providing customer services”
Mortgage Banks
• Financial statement structure
➢ Balance sheet
❖ According to the text, mortgage banks have
three assets
▪ Mortgages and MBS held for sale, which are
valued at the lower of cost or market, like
inventory
▪ Retained securities from securitizations
▪ Mortgage servicing rights (MSRs)
➢ Income statement
➢ Cash flow statement
Mortgage Banks
• Financial statement structure
➢ Income statement
❖ Main revenues are:
▪ Fees for mortgage origination and servicing
▪ Gains on the sale of mortgages
❖ Main revenue line items are highly and differentially
associated with fixed-rate mortgage commitment rates.
➢ Cash flow statement
❖ “Mortgage banks’ main adjustment to net income in the
operating section of the cash flow statement is usually
the change in mortgages and MBS held for sale, which
are treated like inventory with respect to cash flow
statement classification.”
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Interest rate and prepayment risks
❖ “Mortgage banks are exposed to interest rate
risk on their mortgage-related assets through
prepayment and discounting effects that are not
entirely distinct.”
❖ “Prepayment effect reflects the fact that most
residential mortgages give mortgages a call
option to prepay.”
❖ “Prime residential mortgages usually are
prepayable without penalty.”
Mortgage Banks
❖ Mortgage banks have three types of exposure
to interest rate and prepayment risks include:
▪ Have an inventory of unsold fixed-rate
mortgages and MBS.
▪ “Mortgage origination fees reflect a base
level that occurs due to people moving or
refinancing for non-interest-rate-motivated
reasons.”
▪ Hold MSRs and two types of retained
securities.
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Credit risk
❖ “Mortgage banks bear credit risk on their mortgages and
MBS held for sale, mortgage commitments, retained
interests from securitizations, including MSRs, and any
recourse obligations they assume.”
➢ Liquidity risk
❖ Cash flow-based business
❖ Funds must be available to lend
➢ Persistence and growth of fee income
❖ Sources of fee income are concentrated in distinct
economic conditions.
Mortgage Banks
• Main risk-return trade-offs and financial analysis
issues
➢ Cross-selling and diversification
❖ Banks attempt to cross-sell other products.
❖ “Cross-selling opportunities exist because obtaining or
refinancing a mortgage is a relatively infrequent but very
important decision for their customers.”
➢ Operating efficiency
❖ Banks have different cost structures depending on how
they originate or acquire mortgages.
❖ Banks may originate mortgages through retail branches
or the internet.
Mortgage Banks
• Accounting fees and costs
➢ Most important accounting issues affecting
mortgage banks are:
❖ Securitization
❖ MSRs
❖ Retained securities