Exam Answers and Grade Distribution

Accounting for Financial Instuments

Summer 2014
Professor Stephen Ryan
Grade Distribution:
Mean 70.1
Min 37.7
25% 62
Median 70.4
75% 81.2
Max 90.5
I do not give letter grades on individual exams or other assignments. Your final
grade will be based on a weighted average of your exam grade and group project,
with quarter-grade bumps for students with the best class participation. If I had to
give a letter grade on this exam, it would be roughly: 80+ A (18 students); 70+ A(19 students); 60+ B+ (18 students); 50+ B (10 students); 40+ B- (3 students); 30+
C+ (1 student).
Brief Answers:
1)
a) i, ii, vi
b) iii
c) i, iv, v (as I forgot to say pick all that apply, I graded any one of these correct)
d) i
e) ii, iv
f) v
g) iii
h) ii
i) iv
j) iv
2)
a) 0, because gains and losses on trading securities are already recorded in income
b) 30=20-(10)
c) 15=25-10
d) 3=15-12
e) 20=-10-(30), note the sign change because deposits are a liability
3) See the attached spreadsheet for detailed calculations of accretion. Both the
year 1 and year 3 impairments are based on the FSP approach due to YYZs
intent and ability to hold the security to maturity.
a) HTM security (cost basis)
Cash

63.55
63.55

HTM security (cost basis)

Interest revenue
AOCI
Loss
HTM security (cost basis)
HTM security (valuation allowance)

7.63=63.55*.12
7.63
2.71
35.59
35.59
2.71

note: At end of year 1, HTM security cost basis is 35.59=63.55+7.6335.59=50/1.123 and fair value is 32.88=50/1.153 (2.71 less than the cost basis).
b) HTM security (cost basis)
Interest revenue

4.27=35.59*.12
4.27

HTM security (valuation allowance)

impairment)
AOCI

0.66 (accretion for year 1

0.66

notes: Accretion of the AOCI and valuation allowance is based on the expected
cost basis and fair value using information at the time of the impairment at the
end of year 1. Neither the cost basis nor the valuation allowance for the HTM
security are increased at the end of year 2 for the increase in the cash flow
expectation from 50 to 80 (quite a number of you did this). The interest rate is
increased at the end of the year to 41.67% (note there was a typo in the exam
indicating this rate was 41.61%...naturally, my error did not affect your grade);
the increased interest rate affects interest revenue in year 3, not year 2 (some of
you used ending interest rates to accrue interest rates during years). At end of
year 2, HTM security cost basis is 39.86=35.59+4.27=50/1.12 2 and fair value is
66.12=80/1.12.
c) HTM security (cost basis)
Interest revenue

16.61=39.86*.4167
16.61

HTM security (valuation allowance)

impairment)
AOCI
AOCI
Loss
HTM security (cost basis)
HTM security (valuation allowance)

0.89 (accretion for the year 1

0.89
1.19
38.60
38.60
1.19

note: At end of year 3, HTM security cost basis is 17.86=39.86+16.6138.60=20/1.12 and fair value is 16.67=20/1.2.
d) HTM security (cost basis)
Interest revenue
Cash
HTM security (cost basis)

2.14 =17.86*.12
2.14
50
20

Gain
HTM security (valuation allowance)
impairments)
AOCI

30
2.36 (accretion for both
2.36

note: At end of year 4, HTM security cost basis is 0=17.86+2.14-20 and fair value is
0. The HTM security valuation allowance and AOCI are also 0.
4) a) SASG, due to higher PD and LGD.
b) It depends on the beginning allowance for GWTF, reflecting the fact that
PLL=LCO+ALL. For SASG, ALL0 due to the use of PD and LGD estimated over
10 years. Hence, if the beginning ALL for GWTF is more than slightly less (greater)
than the ending ALL, due to conditions worsening (improving) from 2 years prior to
1 year prior, then the PLL will be higher (lower) for GWTF than for SASG.
c) GWTF, due to PD and LGD varying from year to year.
d) Almost certainly SASG, because its ALL0, implying that its PLLLCO and that
the correlation of the two variables is very close to 1. Many of you correctly argued
that GWTF very likely has a higher covariance (not correlation) of its PLL and LCO,
due to its PLL and LCO both reflecting current conditions; I awarded these answers 3
out of 5 points if they were stated clearly. These answers generally did not
evidence understanding of the difference between correlation and covariance, in
particular, that a higher covariance does not imply a higher correlation. To provide
a little interdisciplinary education, the correlation of two variables is the covariance
of the variables divided by the product of the standard deviations of the variables.
GWTF has considerably higher variance PLL than SASG, as discussed in part c
above, which reduces the correlation of its PLL with LCO.
e) Due to its use of 10 years rather than 1 year of data, SASG has somewhat greater
ability than GWTF to evaluate FAS 5s probable and can be reasonably estimated
conditions. While this point induced many of you to select SASG as the answer to
this question, the bigger issue is whether SASGs loss rates based on averages
across the business/real estate cycle are associated with currently incurred losses.
This depends on how you conceptualize incurred losses for the banks residential
mortgages, which are fairly long-lived loans, but somewhat shorter lived (taking into
account prepayment) than the 10-year business cycle. FAS 5 provides minimal
guidance on this issue, although bank regulatory guidance indicates that for nonclassified loans a bank should only accrue for the next years LCOs, which are likely
(but by no means certain) to be more associated with last years loss rate than the
average loss rate across the business cycle. Personally, I lean towards GWTF as the
better answer to this question, but I was looking primarily for coherent reasoning,
not for that particular answer.
5) a) iv. The transferor cannot repurchase specific assets and meet the effective
control condition. All of the other conditions do not prohibit sale accounting in all
logically possible circumstances. In practice, viii comes pretty close, however,

because securitization entities generally are deemed passive, whether or not they
actually are passive; for this reason, I did not either take off or give credit for viii.
b) i and vii; ii and vii; and v and vi. A 2-SPE structure (i.e., not vii) is necessary to
meet the isolation condition if the transferor retains any form of first-loss interest,
which a residual security (i) and recourse (ii) generally constitute. If the
securitization entity is not passive (vi), then it is deemed the transferee and so must
be able to pledge or exchange the assets (i.e., not v) to meet the pledge or
exchange condition.
c) sale:
cash
servicing rights
residual security
repurchase obligation
mortgages
gain on sale
secured borrowing:
cash
debt
pledged mortgages
mortgages

1005
10
40
20
1000
35
1005
1005
1000
1000