Sensitivity Analysis- It Could Have Been Worse

Posted by Investment Management Group on Aug 31, 2011 11:44:46 PM

During the 2009 ICI Tax and Accounting Conference “Sensitivity Analysis” or “Stress Test” was all the buzz. At that time, there were a lot of unanswered questions, and everyone was dreading the future implementation. Then in 2010, we received a bit of good news. Implementation would be postponed until 2011/2012. Unfortunately 2011/2012 is here (effective for interim and annual periods beginning after December 15, 2011)- however there is some good news that has come out of ASU 2011-4 which modifies Topic 820.

Based on the new update the stress test has been dropped for a more manageable disclosure compare the old to the new below:

Old: “A sensitivity analysis or stress test showing the hypothetical effect on the fair value of those interests (including any servicing assets or servicing liabilities) of two or more unfavorable variations from the expected levels for each key assumption that is reported under (2) above independently from any change in another key assumption, and a description of the objectives, methodology, and limitations of the sensitivity analysis or stress test”

New:For recurring fair value measurements categorized within Level 3 of the fair value hierarchy, this Topic requires a reporting entity to provide a narrative description of the sensitivity of the fair value measurement to changes in significant unobservable inputs and a description of any interrelationships between those unobservable inputs. A reporting entity might disclose the following about its residential mortgage-backed securities to comply with paragraph 820-10-50-2(g).

The significant unobservable inputs used in the fair value measurement of the reporting entity’s residential mortgage-backed securities are prepayment rates, probability of default, and loss severity in the event of default. Significant increases (decreases) in any of those inputs in isolation would result in a significantly lower (higher) fair value measurement. Generally, a change in the assumption used for the probability of default is accompanied by a directionally similar change in the assumption used for the loss severity and a directionally opposite change in the assumption used for prepayment rates.”

You can see an example of the proposed sensitivity disclosure relating to the quantitative information described above at the following link below.

http://www.fasb.org/cs/ContentServer?site=FASB&c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176158542829

One thing to note is that you are not required to create quantitative information to comply with this disclosure requirement if you do not use quantitative unobservable inputs in your valuation (for example, when you use third party pricing information without adjustment). We think this presents an area for further consideration for those in the industry who use a third party pricing agent for securities listed as Level 2. Pricing agents are not inclined to give away the proverbial “ keys to the black box,” however we do believe the weighting of inputs needs to be fleshed more to ensure compliance. The pronouncement states However, when providing this disclosure, a reporting entity cannot ignore quantitative unobservable inputs that are significant to the fair value measurement and are reasonably available to the reporting entity.”

In conclusion:

  • Stress Tests are out
  • Narrative disclosures and a table with quantitative inputs (when applicable) are in for Recurring fair value measurements categorized within level 3
  • There are additional disclosure requirements noted in ASU 2011-4

The ICI has published their comment letter on the ASU regarding the modifications made by the FASB. If you are a member of the ICI you can find it at http://www.ici.org/policy/comments.

Please note there are additional disclosure requirements noted in ASU 2011-4 that have not been discussed above. For the complete update issued by the FASB, please go to the link below.

http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176156316498

Contact Us