If you hold available-for-sale investment securities – thefollowing update is for you. In March 2004, the Emerging IssuesTask Force (EITF) issued No. 03-1 entitled, “The Meaning ofOther-Than-Temporary-Impairment and Its Implications to CertainInvestments.” The EITF was formed in 1984 to assist the FinancialAccounting Standards Board (FASB) with improving financialreporting through timely identification, discussion and resolutionof accounting issues. The initial interpretations of how to applythe impairment provisions were very broad. In the strictestinterpretation of the rule, if a financial institution sold oneavailable-for-sale security (AFS) at a loss, the remaining AFSportfolio would need to be valued at the lower of cost or market.These market value losses would need to be recorded through theincome statement. In other words, a credit union that sold one AFSsecurity at a loss would not only record the realized loss relatedto that particular security, but would also be required to recordan impairment charge for any other AFS securities that were inunrealized loss positions. Until the release of EITF No. 03-01,unrealized losses on the AFS portfolio were recorded through thebalance sheet under equity, and did not affect the income statementunless a severe impairment condition existed (i.e., the creditunion had reason to believe that it would not receive all of itsprincipal back). Within EITF No. 03-1 all declines in market valuebelow amortized cost are considered “other than temporary” unlessthe investor has the intent and ability to hold the security “untila forecasted recovery of fair value up to (or beyond) the cost ofthe investment,” which in certain cases may mean maturity. TheIssue continues, “The investor should consider whether its cash orworking capital requirements and contractual or regulatoryobligations indicate that the investment may need to be sold beforethe forecasted recovery of fair value occurs.The investor shoulddevelop an evidence-based judgment about a forecasted recovery offair value.” There have been many comments to date on EITF No.03-1, from accounting firms, credit unions, banks, and brokerages.As a result, the EITF has delayed the effective date of certainsections of the standard that are most controversial. Financialinstitutions are hoping that the final version of the guidance willlimit the scope of impairment to only those instances in which asevere credit event has occurred. Sales for liquidity purposes orsales in which the loss is not significant (i.e., less than 5% ofthe book value) should not taint the remaining AFS portfolio. TheEITF continues to receive comments and has recently indicated anupdate will be released in early 2005. As I listen and read thediscussions on EITF 03-1, I can't help being reminded of anotheraccounting pronouncement issued about a decade ago. That familiarpronouncement FASB 115, introduced the concepts of“Held-to-Maturity” (HTM) and “Available-for-Sale” (AFS) asdesignations for investment security holdings. At the time, as agood investment manager and asset/liability practitioner, Icouldn't possibly see FASB 115 becoming a reality. How could theaccounting profession allow recognition of changes in the value ofassets (investment securities) without looking at the change invalue of the liability side of the balance sheet? In a fairly wellmatched credit union, unrealized gains or losses on investmentsecurities could be substantially offset by changes in the value ofliabilities. Much to my surprise, the day ended with FASB 115implemented and changes in value of AFS securities pushed throughequity and a relatively restrictive HTM requirement for maintaininginvestment securities on an amortized cost basis. EITF 03-1reflects similar logic, this time using impairment, a concept longused to deal with the collectibility of debts, being applied tomarket valuation of investment securities. If the market value ofthe investment decreases by more than 5% it might have to bewritten down reducing current earnings. If the security is notwritten down, it would be subject to substantial scrutiny if sold.How will this impact credit unions? EITF 03-1, in its current form,would apply to all investment securities held by credit unions. AllAgency issued Callables, Mortgage Backed Securities, and CMOs wouldbe subject to the tests in EITF 03-1. A typical 15 year MBS carriesa price sensitivity or duration of about 4-5%. Thus an interestrate increase of just over 1% would move this security intoimpaired status. Investment securities managers at largeorganizations are expected to react in a few different ways. First,some will move more securities into the “trading” accountdesignation under FASB 115. This requires constant recognition ofchanges in market value to the income statement, thus beating EITF03-1 to the punch. Investment managers may also look to reduce theprice sensitivity of their investment holdings to dilute the impactof EITF. Lower duration securities have less of a chance of beingcategorized as “impaired.” Sophisticated investment managers areexpected to use derivative instruments to hedge their EITF exposureby utilizing hedge accounting treatments. For securities heldon-balance sheet managers may look to sell and reposition as themarket value approaches the 95% threshold. Thirdly, many will lookto reduce investment securities holdings by holding loans directlyinstead of MBS. As mentioned above, we also expect investors tolook more closely at instruments not likely to be covered by FASB115 and EITF 03-1, such as corporate CU certificates and jumboinsured bank CDs. To find out more about EITF 03-1 and itspotential impact to your investment security holdings, I encourageyou to contact your public accounting firm.