Credit losses are bad debt created when a debtor fails to repay a loan. Noncredit losses are caused by other conditions, such as a dearth of liquidity, the uncertainty surrounding the government’s plans for toxic assets, or fluctuations in interest rates. When the subprime crisis caused mortgage-related securities to lose value, bankers were livid that current accounting rules forced them to take titanic write-downs for noncredit losses.
Some observers reckon that noncredit losses at banks and other financial institutions dwarf credit losses in today’s market. But so far, no one has offered a solid aggregate estimate of those totals, says David Larsen, managing director at Duff & Phelps. In fact, he contends that the aggregate noncredit losses that will be moved into the OCI when the rule is issued depends on each company’s fair-value estimate of noncredit losses. That valuation will be performed using FASB’s criteria for valuing assets in an inactive or distressed market, notes Larsen, which is laid out in FAS 157-e, a rule revision that also was discussed Thursday and is due out in final form next week.
“The bifurcation of the credit loss piece is a key component of the revised rule,” says Larsen, “but the part that often gets missed when pundits talk [about the rule] on TV is that the trigger that starts the whole [measurement and recording exercise] is the realization that a loan is not going to be repaid. The rule addresses an impaired security, you still have to identify the fair value of that security, and all of the losses are disclosed on the balance sheet.”
Both Hanson and Larsen break down the practical application of the rule in an oversimplified, but telling, example of how the banks likely will calculate losses. Start, they say, with a bank that holds a securitized pool of mortgage-backed assets originally valued at $100. After modeling the future cash flow of the pool, the bank determines it ultimately will collect only $95, making the credit loss $5.
However, because of the liquidity crisis and other economic factors, the market price of the pool is worth only $40 — a $60 loss in value. The difference between the two calculations ($60 minus $5) is the noncredit loss — which in this case is $55. That $55 remains on the balance sheet in the OCI as a nonrealized loss, and is never run through the income statement. Only the $5 loss hits earnings.
Further, the noncredit loss portion of any impaired financial asset that a company currently holds can now be rolled forward and moved into the OCI.
Hanson claims that smaller banks will have a problem applying the new rule. He explains that banks have been separating credit and noncredit losses using FAS 114 guidelines since 1994, but this is the first time companies will be applying the provisions “in a new context”; that is, using the FAS 114 criteria to separate the credit and noncredit losses generated by toxic financial assets.
“One of the most difficult things about the new rule is that it will be tough for all but the 10 largest banks to apply this provision,” says Hanson, whose firm counts community banks as its clients. Most banks have experience using FAS 114 to separate out credit and noncredit losses on an individual loan basis, but in the context of complex financial instruments, the bifurcation task become onerous, require “much more discipline,…and will take a lot more work to dissect.”