Investments in Securities: Fair Value Accounting

Introduction

At the end of 2022, the parent of Silicon Valley Bank (SVB) reported total equity of $16.3 billion. In a note to its financial statements, it disclosed that the $91.3 billion of bonds it classified as held to maturity, carried at amortized cost, had a fair value of only $76.2 billion. The $15.2 billion difference, an unrealized loss caused by rising interest rates, appeared nowhere in its balance sheet or its equity. On March 8, 2023, the bank announced that it had sold about $21 billion of its other securities, those classified as available for sale, at an after-tax loss of about $1.8 billion, and was seeking new capital. Depositors withdrew their money, and on March 10 regulators closed the bank, appointing the Federal Deposit Insurance Corporation as receiver.

The accounting did not cause SVB's failure; a mismatch between long-dated bonds and flighty deposits did. But the classification of its bonds decided which losses were visible, and where. For any company that holds securities, from a bank to a cash-rich technology group, the categories determine whether market movements reach earnings, equity through other comprehensive income, or only the notes.

Under Accounting Standards Codification (ASC) 320, every debt security, such as a Treasury bond, a corporate bond or a mortgage-backed security, is classified when it is acquired into one of three categories:

Held-to-maturity securities

Debt securities that a company has the positive intent and ability to hold until maturity, measured at amortized cost under ASC 320, net of an allowance for expected credit losses. Their fair value is disclosed in the notes, but changes in it are not recognized in earnings or equity unless the securities are sold or transferred.

The held-to-maturity label comes with a constraint. Selling or transferring such securities, except in narrow circumstances such as a significant deterioration in the issuer's credit, calls into question the company's intent for the rest of the portfolio, and can force all its held-to-maturity securities to be reclassified to available-for-sale, at fair value. That is why a bank with large unrealized losses in held-to-maturity securities cannot easily sell some of them to raise cash without bringing the rest of the losses onto its balance sheet.

The Fair Value Hierarchy

Fair values are disclosed by how they were measured, under ASC 820. Level 1 values come from quoted prices for identical assets in active markets, such as listed shares and Treasuries. Level 2 values use observable inputs, such as quotes for similar securities or market interest rates, and cover most corporate bonds and mortgage-backed securities. Level 3 values rely on unobservable inputs, such as a company's own models for illiquid or private securities, and carry the most judgment. A large or growing Level 3 balance deserves the closest reading, because its values depend on management's assumptions; how fair value fits alongside historical cost in the statements more generally is covered in historical cost vs fair value.

Equity securities follow simpler rules since Accounting Standards Update (ASU) 2016-01, now in ASC 321. Shares with a readily determinable fair value are carried at fair value, with all changes in net income; the available-for-sale category no longer exists for equities. Shares without one, typically stakes in private companies, may be carried under the measurement alternative, at cost adjusted for impairments and observable price changes. Larger stakes that give significant influence or control use the equity method or consolidation instead, as described in fair value, equity method or consolidation.

Fair value changes from interest rates and losses from credit are treated differently. Under the current expected credit loss (CECL) model in ASC 326, a held-to-maturity security carries an allowance for expected credit losses, charged to earnings, much like a loan or a receivable, as described in accounts receivable and credit losses. For an available-for-sale security, the part of a decline in fair value that reflects credit is recognized in earnings through an allowance, limited to the amount by which fair value is below amortized cost; the rest of the decline, due to rates or other factors, stays in other comprehensive income. If the holder intends to sell, or will more likely than not have to sell, before the value recovers, the whole loss goes to earnings.

SVB's securities were mostly agency mortgage-backed securities with little credit risk, so its allowance for credit losses on held-to-maturity securities was just $6 million. Its losses were almost entirely from interest rates, which the accounting for held-to-maturity securities does not recognize at all.

SVB's 2022 annual report shows how the two categories presented the same economic problem differently:

The available-for-sale losses had reduced equity, through accumulated other comprehensive income, which stood at minus $1.9 billion after tax. The held-to-maturity losses, six times larger and close to the bank's entire equity, had not. Selling the available-for-sale portfolio turned an unrealized loss already in equity into a realized loss in earnings; it did not change equity much, but it signaled to depositors that the bank needed cash and capital, and drew attention to the much larger loss sitting in the notes.

For a non-financial company, securities are usually part of its cash and investments, a non-operating asset added in the bridge from enterprise value to equity value at fair value, as described in non-operating assets and excess cash. Gains and losses on them, whether in net income or in other comprehensive income, are excluded from earnings before interest, taxes, depreciation and amortization (EBITDA) and from operating forecasts, and interest earned on them is investment income, not operating income.

For banks and insurers, securities are central to the business, and their classification affects capital and earnings directly. Analysts adjust book value and tangible book value for unrealized losses in held-to-maturity portfolios, watch the duration of securities against the stability of funding, and track how much of accumulated other comprehensive income is likely to reverse as bonds approach maturity. The broader structure of a bank's statements is covered in bank financial statements: a primer for bankers.

The categories are a set of choices about when market values reach the statements. Held-to-maturity accounting keeps them out of earnings and equity; available-for-sale accounting brings them into equity but not earnings; trading securities and most equity securities bring them into earnings at once. Reading a company's securities means putting all three back onto the same basis: fair value.