On Oct 10th, 2008, the FASB Staff issued clarifications (“FSP FAS 157-3”) on “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”.  Their purpose was to bring additional clarity to how fair market value (“FMV”) should be determined in illiquid markets*1 .  Clearly their primary audience is financial firms who are reporting the FMV of their Level 3 mortgage-backed or asset-backed securities, loans, or MSRs that are held in trading or available-for-sale accounting classifications and the readers of these financial statements.  What is clear is that FASB staff is expecting a considerable level of mortgage valuation analytics, expertise and judgment to be utilized in the production of fair market values and in both the preparation and interpretation of these financial statements.

In the FSP, the FASB staff addresses the following issues:

1. How the reporting entity’s own assumptions (that is, expected cash flows and appropriately risk-adjusted discount rates) should be considered when determining fair value when relevant observable inputs do not exist.
2. How available observable inputs in a market that is not active or distressed should be considered when measuring fair value.
3. How the use of market quotes (for example, broker quotes or pricing services for the same or similar financial assets) should be considered when assessing the relevance of observable and unobservable inputs available to measure fair value.

Expected Cash Flows and Discount Rates:
How should a reporting entity determine the “expected cash flows and appropriately risk-adjusted discount rates”?  The FASB staff indicates that the reporting entity may exercise their own judgment in how to model the expected cash flows and discount rates.

“In determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available.”

The FASB guidance sounds simple enough.  For most mortgage assets, a reporting firm needs to determine the vector of future voluntary and involuntary prepayments (defaults) for each collateral cohort.  Once established, the reporting firm then generates the asset’s projected cash flows and use an appropriately adjusted discount rate.  Done.

The guidance is unclear on whether these vectors of collateral behavior are a reporting firm’s own proprietary assumption on the expected future behavior or a consensus which market participants would agree is the current expectation for future collateral behavior.*2

The distinction between the use of proprietary assumptions versus market consensus assumptions is very significant not only in the determination of the asset's FMV, but also in the comfort level that interested parties, both internal and external to the reporting firm, will have in such FMV.

For example, if the reporting firm’s proprietary model predicts a modest level of future involuntary prepayments (foreclosures), then a much higher level of expected future collateral cash flows are generated as compared with an actively updated and calibrated vector consistent with market expectations of involuntary prepayments/defaults.  With a substantially higher collateral cash flow, the FMV will likely be overstated unless then offset by a discount rate that is higher than market participants would require. The use of a higher discount might give a false sense of comfort to users of such financial statements when in fact no such comfort should exist.

How do users of the financial statements put into the proper perspective the discount rates from various reporting institutions on even the same or similar mortgage assets if reporting institutions have significantly different collateral cash flow assumptions?

Unfortunately, the translation is neither direct nor transparent.

Can reporting firms really predict Mortgage Collateral Behavior?
The ability to accurately model collateral behavior is not an easy task and requires extensive mortgage modeling expertise, active assumption discovery procedures, and ultimately considerable judgment.  Only the largest banks, rating agencies, a much smaller universe of investment banks and a handful of independent mortgage valuation firms have the internal staff and expertise to devote to this complex and dynamic problem.  The problem is compounded because the current economic environment and housing market are so very different than prior markets and therefore the application of historical behavioral trends are questionable.

Dislocated Market – Judgment Call:
The FASB staff makes clear that the objective remains “the price that would be received by the holder of the financial asset in an orderly transaction.”   But it also makes clear that “it is also not appropriate to automatically conclude that any transaction price is determinative of fair value.”   Nevertheless, the standards and criteria to determine how to utilize transaction prices are left up to the reporting firm’s judgment.

“Determining fair value in a dislocated market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.”

If a reporting firm believes that a recent transaction price is a “distressed sale”, then they can ignore it.*3   The reporting firm needs to use its judgment on the motives and circumstances of sellers in recent transactions.   If the current market is so universally acknowledged as highly dislocated, is there any current seller who isn’t a highly motivated distressed seller?   Who would sell illiquid mortgage assets in this market unless they were forced too?  Can’t a reasonable party then assume that all market prices are therefore to be ignored?

Broker Quotes need Questioning:
Apparently FASB does seem to endorse the use of third-party valuation experts or broker quotes, but again only ii in the judgment of the reporting firm an active market does not exist for the financial asset.

“Broker (or pricing service) quotes may be appropriate input when measuring fair value, but they are not necessarily determinative if an active market does not exist for the financial asset.  … However, when markets are not active, brokers may rely more on models with inputs based on information available only to the broker.”

Do reporting firms really want to rely on brokers that don’t provide all their pricing assumptions, particularly the broker’s expectations for specific collateral behavior and the broker’s process for arriving at market discount rates?  One would think that the reporting firm would take significant comfort in getting the full disclosure of the broker’s collateral behavior*4 and pricing assumptions and how their arrived at each assets value.

MIAC runs a virtual auction on 400 mortgage cohorts, Generic Servicing Assets (“GSAs™”) to address the central issue of price and assumption discovery.

Per the FASB, “When an active market for a security does not exist, the use of management estimates that incorporate current market participants' expectations of future cash flows, and include appropriate risk premiums, is acceptable."

MIAC runs a virtual auction on these 400 GSAs with the 10 largest mortgage companies each month to “incorporate current market participants’ expectations of future cash flows and appropriate risk premiums.  Moreover, the MIAC models incorporate the same collateral behavior assumptions; in general, for mortgage servicing rights as are used for the FMV of whole loans and mortgage-backed securities with the same collateral.

This price and assumption discovery process enables MIAC to defend all its mortgage asset valuations and to be completely transparent about the underlying collateral behavior assumptions and current risk premiums.  For those familiar with the GSA product, they understand how this information is very helpful in defending a FMV of illiquid mortgage assets under FAS 157.

Conclusion
FSP FAS 157-3 asks reporting firms to make judgments about their current expectations for collateral behavior, appropriate discount rates, whether transactions prices are distressed, and how much credence to place in broker quotes.  If so much of the disclosures for FAS 157 rely on the judgment of the reporting firm, valuation experts can provide not only their estimate and judgment of the asset price, but also fully transparent collateral behavior and pricing assumptions.