The children’s rhyme about ‘rain’ can now be applied to Other Than Temporary Impairment (OTTI). Under specific direction from Congress, FASB has modified both GAAP accounting’s approach to measuring fair value as well as OTTI. As always, the devil is in the details and these are still proposals, subject to finalization. But the trend is clear on two basic fronts:
1 – You can separate declines in value due to the credit of an issuer or bond from all other impacts. And, only write down through income the amount subject to credit specific to the issuer or bond.
2 – Fair value is not the last quoted price, if the market isn’t operating in a ‘usual and customary’ manner and there are not multiple bidders. In those situations, you’ve got a distressed value and you can use more analytic approaches to valuation.
If passed as is — and we would fully expect this – you can probably expect the following:
1 – Lots of bonds will be shown to have a drop in price due to reasons not having to do with the credit of the bond, but simply due to the overall market sell off. We suspected that many insurers and other financial institutions were facing rather large OTTI hits in Q1, as bonds would be trading below 80% of book for six months. This will NOT be the case now, and we should start seeing much healthier earnings coming from most financials.
2 – More securities will be moving to the analytic pricing method instead of the, now typically used, ‘last quoted price’ of similar securities. The result should be less mark to market problems, generally, on the portfolio — e.g. less unrealized losses and material improvements, in some cases, in GAAP equity.
Although the economy did not much change in one day, financial statements of financials did…and that should be reflected in bond and stock prices of many financial institutions, including insurers.
In summary, Congress threatened to ‘cloud up and rain all over’ FASB unless changes were made…and FASB decided to sing ‘rain, rain, go away’. Some may think this to be ‘all wet’, that changing accounting in this manner does not change economic fundamentals. How true, but in financial markets, many times appearances will overcome or mask reality.
However, just in case this does not mark a key point in the saga of the financial crisis, I will get my umbrella ready.