In the spring of 2007, I wrote a piece for MIAC Perspectives entitled, “SFAS 157: A Walk Down Implementation Lane”.   In the article, I drew a road map on how owners of illiquid mortgage assets, particularly MSRs, could adequately address some of the most challenging issues in implementing FAS 157.  None of us had any idea at the time that interpreting FAS 157 for illiquid mortgage assets would be the daily topic of financial news broadcasters and writers for the next 12 months. The confusion and misunderstanding of how FAS 157 should be implemented and what a Level 3 fair market value means has apparently only grown exponentially.  I would like to continue the discussion on implementing FAS 157 for mortgage assets with difficult price discovery.  In particular, I would like to discuss the PCAOB December 2007 Practice Alert and the SEC March letters sent to 30 CFOs clarifying FAS 157 disclosure. 

      In December 2007, the Public Company Accounting Oversight Board (“PCAOB”) issued a staff audit practice alert entitled, Matters Related to Auditing Fair Value Measurements of Financial Instruments and the Use of Specialist.  The PCAOB audits the largest public accounting firms (more than 100 public company clients) annually and the remaining public accounting firms every three years.  These public accounting firms have been the leading watchdogs of the actual implementations of FAS 157 Fair Value for the largest balance sheets in the financial community.  The ongoing public debate in the financial news swirls around the methods and validity of the Fair Value disclosures of structured subprime bonds and other illiquid mortgage assets in their very thinly traded markets.   Are the firms writing down the assets too much so that they have a cushion to draw future fair value gains from?   Are the firms writing down the assets insufficiently to minimize their current losses and postpone their misery?  What if the most recent similar trade was clearly a “fire sale” disposition?  Is the fire sale price a valid reference instrument price?  Who can be an honest broker of what represents FAS 157’s Exit Price in an orderly market at the measurement date when these markets are so thinly traded? 

Let’s first look at how the PCAOB clarifies on the role of third-party valuation specialists.  The PCAOB identifies three roles for a third-party valuation specialist.

• The Role of the Valuation Specialist for the Disclosing Firm
• In lieu of the client’s valuation
• In support of the client’s valuation
• The Role of the Valuation Specialist for the Auditing Firm
• In support of the accounting firm’s compliance function

      “In lieu” of a client’s valuation is clearly the less preferred role because as one would expect, the PCAOB would surely want the owner of the assets to have their own procedures for valuing and measuring the price and risk of their assets.  Given the significance of the Level 3 Fair Value disclosures and the high level of scrutiny of these valuations, the PCOAB properly “encourages’ the public accounting firms to ask their audit clients to make sure that the disclosing clients fully understand, acknowledge and challenge their “In support” third-party’s assumption discovery procedures.
Clearly an independent third-party valuation firm can offer an opinion that can give additional transparency and some additional clarity to otherwise murky valuations.  Are the third-party valuation specialists the sole arbitrators of the truth?  No, but they can broaden the perspective of asset owners by giving clarity as to how a valuation would have been derived, what reasonable assumptions would have been utilized, and importantly what are the sensitivities of the Level 3 fair value disclosures to the pertinent input assumptions, particularly the collateral behavior assumptions.  Clearly “inputs {that] are unobservable inputs” are subjective inputs and in order for a company to justify and defend their “unobservable inputs”, they might elect to utilize a third-party valuation specialist in support of their own valuations.

The SEC offers some clarity on FAS 157 when the market isn’t orderly

http://www.sec.gov/divisions/corpfin/guidance/fairvalueltr0308.htm

      The SEC sent the above letter to 30 CFOs of the largest holders of asset-backed securities.  It appears that the intent of the letter is to address the question:
If the most recent similar trade was clearly a “fire sale” disposition does FAS 157 require a mark-to-“distressed” market or mark-to-model? 
The letter addresses this in this way:

      The SEC is essentially saying that in many of today’s asset-backed markets, the transactions are a result of forced liquidations or distressed sale.  As a result, the SEC is clarifying that a mark-to-model is most appropriate.

            For holders of these assets, the mark-to-model should be broken down into its component parts: market consensus collateral behavior assumptions (See Robert Lee’s Pricing, it’s all about the Market Consensus Prepays, in MIAC’s September 2007 Quarterly Perspective: http://www.miacanalytics.com/FS/AboutMIAC/PR/MiacPerspectivesSummer2007/SubPrimeMSR.html) that drive the assets anticipated cash flows and the valuing or discounting of the asset’s cash flows.   If a mortgage-backed or asset-backed collateral behavior is broken into anticipated voluntary prepayments and involuntary prepayments, the transparency of the “unobservable inputs” can be compartmentalized and quantified.

            In addition to the mark-to-model clarification, the SEC letter highlights other important disclosures that should be addressed in the MD&A (Management Discussion and Analysis).  One of the most important disclosures is to require the firms to measure the sensitivity of the mark-to-model to specific changes in the underlying “unobservable inputs” to quantify the significance of each pricing input. 

MIAC’s Variable Assumption Set Tool (VAST) is designed to addressed this particular issue and has been configured at some of the largest mortgage companies for this purpose.