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Tuesday, November 25, 2014

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SRC Insights: Fourth Quarter 2008

Monitoring Other-Than-Temporary Impairment Charges in a Challenging Environment

One of the effects of the current turmoil in the financial markets and housing industry has been the marked rise in other-than-temporary impairment (OTTI) charges taken by institutions, as the fair values of many investment securities have fallen drastically below their cost basis. Most notably, Fannie Mae and Freddie Mac preferred and common stock lost almost all of their value after the government takeover of these agencies. This article will provide a refresher on the evaluation, accounting, and reporting related to the other-than-temporary impairment of certain assets.

Overview

The increasing severity and duration of unrealized losses on investment securities brought about by the changes in the economic environment have, in turn, led to heightened OTTI analyses by banks and external auditors, as well as increased scrutiny by examiners. Regulatory capital ratios at a number of institutions have fallen below the well-capitalized threshold under the Prompt Corrective Action statute as a result of these impairment charges, requiring several capital-raising activities.

Guidance on other-than-temporary impairment is provided in FAS 115, Accounting for Certain Investments and Debt Securities; FASB Staff Position (FSP) No. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments; SEC Staff Accounting Bulletin (SAB) No. 59, which has been codified as SAB Topic 5M, Other-Than-Temporary Impairment of Certain Investments in Debt and Equity Securities; and Emerging Issues Task Force (EITF) Issue No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets.1

The accounting standards require institutions to determine whether impairment is temporary or other-than-temporary. It should be noted that other-than-temporary is not intended to mean permanent. If an OTTI exists, the security should be written down to fair value, the unrealized loss reported in earnings for the reporting period, and the fair value then becomes the new cost basis. Subsequent recoveries in fair value should not be recognized in earnings until the security is sold.

When Is an Investment Impaired?

An investment is considered impaired if its fair value is less than its cost basis (including adjustments for accretion, amortization, previous OTTIs, and hedging). Impairment is assessed at the individual security level at the date of the financial statements. In most cases, the assessment must be done in each reporting period (annual and interim periods). As presented in the guidance, indicators of possible impairment include, but are not limited to, the following:

  • A significant deterioration in the earnings performance, credit rating, asset quality, or business prospects of the issuer
  • A significant adverse change in the regulatory, economic, or technological environment of the issuer
  • A significant adverse change in the general market condition of either the geographic area or the industry in which the issuer operates
  • A bona fide offer to purchase, an offer by the issuer to sell, or a completed auction process for the same or similar security for an amount less than the cost of the investment
  • Factors that raise significant concerns about the issuer's ability to continue as an ongoing concern, such as negative cash flows from operations, working capital deficiencies, or noncompliance with statutory capital requirements or debt covenants

When Is an Impairment Other-Than-Temporary?

It is difficult to determine that an OTTI exists, and it requires reasonable judgment by the institution's management based on the facts and circumstances associated with the institution and the individual securities. There are no bright-line or rule-of-thumb tests for determining OTTI. The following are indicators to consider when evaluating whether an impairment is other-than-temporary and that a write-down to fair value is required:

  • The length of time and the extent to which the fair value has been less than cost
  • The financial condition and near-term prospects of the issuer, including any specific events that may influence the operations of the issuer
  • The intent and ability of the institution to retain its investment for a period of time sufficient to allow for any anticipated recovery in fair value.

Management's impairment evaluation process and OTTI determination should be reviewed by the institution's external auditor.

Disclosure Requirements

OTTI guidance requires extensive tabular, quantitative, and narrative disclosures for investments having an unrealized loss position for which OTTI impairments have not been recognized. Examples of expected disclosures are: fair value of investments with unrealized losses, amount of unrealized losses, nature of the investment, cause(s) of the impairment, number of investments that are in an unrealized loss position, severity and duration of the impairment, and other evidence that the investment is not other-than-temporarily impaired.

Implications on Regulatory Capital

The proper classification of an investment as a debt or equity security has important regulatory capital implications. An institution's accurate reporting of its investments as equity or debt securities determines the regulatory capital treatment of unrealized gains and losses on investment securities, as well as the calculation of risk-weighted factors for these investment securities.

Common and preferred stock should be reported as equity, excluding preferred stock that must be redeemed by the issuer or is redeemable at the option of the investor, which are reported as debt securities. Tier 1 capital will be reduced by unrealized losses on available-for-sale (AFS) equity securities, while the recognition of an OTTI would adversely affect earnings. Unrealized gains on AFS equity securities, however, are not included in tier 1 capital, but can be included in tier 2 capital with some limitations.2

Unrealized gains and losses on AFS and HTM debt securities, meanwhile, are excluded from the calculation of tier 1 capital. However, when unrealized gains and losses on debt securities become realized, either when a security is sold at a profit or loss or when an OTTI charge is taken, such amounts are reflected in retained earnings and, thus, in regulatory capital.

The proper classification of an investment as equity or debt securities also affects its corresponding risk-weight category and the calculation of risk-weighted assets used to determine the institution's risk-based capital ratios. For instance, equity securities for government-sponsored entities (GSEs) should generally be risk-weighted at 100 percent, while GSE debt securities are generally risk-weighted at 20 percent.

Risk Management

Institutions should have sound risk management processes for identifying, measuring, and managing OTTI risk exposure, and senior management and the board of directors should exercise appropriate oversight of the OTTI function. The table below outlines suggestions for these processes.

Risk Management Processes for OTTI Risk Exposure
Include policies and procedures regarding OTTI assessments, determinations, and documentation appropriate to the size of the institution and the nature, scope, and risks of its investment activities.
Establish internal risk guidelines or thresholds that would trigger an impairment review, such as risk limits on the severity and duration of an unrealized loss.
Clearly define criteria, events, and conditions that lead to OTTI of value.
Ensure that processes are in place for evaluating whether management has the intent and ability to hold an investment until recovery in fair value.
Specify the fair valuation process and the measurement frequency.
Ensure that policies and procedures describe a systematic and objective methodology for performing impairment analysis of all relevant factors.
Consider all available and verifiable information to evaluate the investment's realizable value and whether the decline in value is temporary or other-than-temporary.
Fully document impairment evaluations, including ability and intent to hold an investment, to show how management supports its determinations and complies with the guidance.
Perform more robust, extensive, and frequent impairment analysis as unrealized losses increase in severity and duration over time.
Stress testing is another sound risk management practice, particularly during times of deteriorating economic and market conditions. Management should consider likely adverse trends and scenarios on an investment security's fair value and determine the potential impact to both earnings and capital of a temporary impairment or an OTTI, to allow for appropriate capital planning. Institutions that have high concentrations of impaired investments relative to regulatory capital should hold additional capital commensurate with OTTI risk exposure.

Final Thoughts

Establishing a policy and related risk management procedures is the first step to managing OTTI risk. It is very important that senior management and the board of directors review and re-approve the OTTI policies and procedures at least annually, and management information systems should appropriately monitor and report OTTI exposure. In addition, internal audit should periodically audit and test the adequacy of internal controls surrounding the OTTI risk management process. Implementing effective management of OTTI risk is an important element to ensuring an institution's safety in a difficult financial environment.

  • 1   Guidance to external auditors is provided in the AICPA's Statement on Auditing Standards No. 92. The glossary entries (under Securities Activities) of the Call Report and the FR Y-9C summarize the related accounting requirements for determining whether impairment on an available-for-sale (AFS) or held-to-maturity (HTM) investment security is other than temporary.
  • 2   The amount that can be included in tier 2 capital cannot exceed 45 percent of the institution's pretax net unrealized holding gains on AFS equity securities.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.