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FAIR VALUE APPLICATION CASE Background Information Catamount Finance Co. (CFC) is a commercial bank located in Vermont with a December 31 year-end....

how would you disclose the first security regarding fair value in file that is attached and why?

consider the following as part of your support:

• The company’s determination of whether the respective markets for the instruments were active or inactive.
• The valuation techniques (market approach, income approach or both) used by the company.
• The fair value hierarchy classification of each input to the fair value measurement and how that classification impacts the fair value hierarchy classification of the entire instrument.

FAIR VALUE APPLICATION CASE Background Information Catamount Finance Co. (CFC) is a commercial bank located in Vermont with a December 31 year-end. CFC has an investment portfolio that it manages in an effort to earn returns in excess of interest paid on bank deposits and other liabilities. CFC invests in a variety of securities to enhance returns. As of December 31, 2011, CFC’s investments primarily consist of: collateralized debt obligation securities equity securities of nonpublic companies mortgage backed securities auction rate securities CFC accounts for all of its securities at fair value with changes in fair value reflected either in earnings (for trading securities) or other comprehensive income (OCI) (for available-for-sale securities). Facts related to specific securities owned by CFC are described below. 1. Collateralized Debt Obligation (CDO) On June 1, 2011, CFC invested in an S&P AA-rated tranche of a CDO. The underlying collateral for the CDO is a pool of U.S. Treasury and corporate bonds. Before September 30, 2011, CFC was able to determine the fair value of the CDO using a market-based valuation technique relying on inputs such as quoted prices in active markets for similar CDO securities that required only insignificant adjustments for differences between the CDO security held by FFC and similar CDO securities. However, since September 30, the market for CDO securities has become increasingly inactive. The inactivity was evidenced by the following two factors: Significant widening of the bid-ask spreads in the brokered markets in which the CDO securities trade. The widening of the bid-ask spreads continued throughout Q4. Progressively significant decrease in the volume of trades relative to historical levels in Q4. No recent transactions have taken place. On the basis of the above factors, CFC determines that significant adjustments to observed market transactions of similar CDO securities are required to determine fair value as of the measurement date (December 31, 2011) given the lack of recent and relevant transactions. CFC determines that any adjustments made to the observed market transactions would be based on management’s assumptions regarding market values. In addition, CFC also determined that an income approach valuation technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be more representative of fair value than the market approach valuation
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technique used on prior measurement dates (June 30 and September 30, 2011). Specifically, CFC uses the below mentioned discount rate adjustment technique to determine fair value. CFC determines that the appropriate discount rate that should be used to discount the contractual cash flows of the CDO security is 24 percent after considering the following: The implied rate of return on September 30, 2011 (the last date on which CFC determined the market to be active for the CDO security), was 15 percent. Since September 30, CFC estimates that credit spreads have widened by approximately 200 basis points and liquidity risk premiums have increased during that period by approximately 500 basis points. 1 Other risks (e.g., interest rate risk) have not changed. CFC has estimated that an indication of an appropriate rate of return for the CDO security is 22 percent. In making that determination, CFC considered all available market information (e.g., quoted prices that are not current for same/similar CDO securities, analyst/rating agency reports, current level of interest rates, information on performance of underlying collateral) that could be obtained without undue cost and effort. Two nonbinding indicative quotes for the CDO security from brokers implied a rate of return of 25 percent and 29 percent. The indicative quotes are based on the brokers’ proprietary models using hypothetical assumptions instead of actual transactions. CFC concluded that 24 percent is the point within the range of relevant inputs that is most representative of fair value given that there were multiple indications of the appropriate rate of return that market participants would consider relevant in estimating fair value. Accordingly, CFC determines that the risk-adjusted discount rate appropriately reflects the entity’s estimate of the assumptions that market participants would use to estimate the selling price of the asset as of the measurement date. As a result of the above assumptions, the fair value of the investment at December 31, 2011 is estimated to be $25. 2. Mortgage-Backed Security (MBS) On September 1, 2011, CFC invested in an S&P AA-rated tranche of a privately issued pass- through MBS with a stated maturity of 30 years. The underlying collateral for the MBS is subprime mortgages on residential properties. On September 30, 2011, CFC determined the fair value of the MBS using a market approach valuation technique based on inputs that did not require a significant adjustment. These inputs included quoted prices in active markets for similar MBSs with insignificant adjustments for differences between the MBS held by FFC and similar securities. In Q4, the market for the MBS has become increasingly volatile with some periods of declining activity. The volatility was evidenced through fluctuating bid-ask spreads. However, FFC 1 One basis point is the equivalent of 1/100 of one percent. Thus, 100 basis points = .01
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