Discussion of the Financial Accounting Standards Board's guidance providing relief in determining other-than-temporary impairment has overlooked an enormous benefit: the restoration of management flexibility for the available for sale portfolio.
For depreciated debt securities, "available for sale" once again truly means what it says.
Prior to 2004, accounting guidance generally required recognition in earnings of other-than-temporary impairments only for losses related to credit risk. Investment securities temporarily impaired for reasons such as interest rate or liquidity risk could be freely sold from the available for sale portfolio.
After the adoption of Emerging Issues Task Force Issue No. 03-1, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" (March 2004), an investor had to attest to its intent and ability to hold an impaired security to a reasonably forecasted recovery of its depreciation to avoid an other-than-temporary impairment. Moreover, selling impaired securities before the recovery of their depreciation could call into question the investor's intent to hold other depreciated securities, thereby "tainting" them as other-than-temporary impairments.
In effect, EITF 03-1 created an additional classification for securities under FAS 115: "held to forecasted recovery," an accounting twilight zone somewhere between "held to maturity" and "available for sale." Within this twilight zone, depreciated securities were no longer truly available for sale, with crippling results for managing investment securities to enhance earnings and minimize risk.
Under the impairment guidance for debt securities the FASB adopted in early April, FASB Staff Position No. 115-2 and 124-2, the new standard for triggering an other-than-temporary impairment is an intent to sell a depreciated security or the need to sell it, arising from factors such as "cash or working capital requirements or contractual or regulatory obligations."
This new standard returns impairment guidance very close to where it was before 2004. As a result, managers should be able to sell a depreciated debt security that is available for sale without fear of being second-guessed or having other depreciated debt securities tainted as being other-than-temporarily impaired, so long as the managers are not acting pursuant to a prior decision or foreseeable compulsion to sell.
The stealth benefit of the new impairment guidance has been overlooked for three reasons. First, banks and other financial institutions lacked the time to adopt it early. They are beginning to look closely at the new guidance this quarter, when it will become effective.
Second, the focus so far has been on understanding the mechanics of the new guidance, particularly in mitigating the earnings and capital impacts of other-than-temporary impairments, rather than exploring its implications for investment management.
Third, in today's dysfunctional markets, bids for many securities are so unacceptably low that portfolio managers would not sell them even with the accounting flexibility to do so.
However, as market conditions improve and financial institutions better understand the new guidance, its restoration of flexibility to the management of investment portfolios could prove to be its most important benefit.