There You Go Again
By Gordon Yale, CPA
In a January 11 column, Floyd Norris, the venerable New York Times business columnist, reported that the Mortgage Bankers Association, supported by five of the nation’s largest lending institutions, asked the Financial Accounting Standards Board (“FASB”) to relax certain accounting rules concerning how restructured—that is failed—residential loans are written down. The purpose of the request, according to the Mortgage Bankers Association, was to relieve banks from the administrative burden of complying with the accounting rules, but the effect will be to materially limit the onerous loan losses lenders will absorb as more residential loans default and if home prices continue to decline.
This request for relief stacks one unfortunate irony upon another. Supported by Citigroup, JP Morgan Chase, and its potential acquisition, Washington Mutual, Bank of America and its new acquisition, the apparently failing Countrywide Financial, the rationale for relaxing the accounting rules was that compliance with existing standards “would be extremely time-consuminig and would likely involve additional staff dedicated to this purpose.” In fact, the motives appear strictly financial and the underlying hope is to buy time. Sound familiar?
It should because accounting for restructured or impaired loans has been a matter of some controversy for more than 30 years. The FASB, the primary source of accounting standards in the United States, first grappled with the issue in 1976, on the heals of the sharp recession, when it issued an exposure draft of FASB Statement No. 15. That standard initially provided that when lenders granted creditors concessions on troubled loans, a loss should be recognized if the present value of future payments was less than the carrying amount of the loan. The proposed accounting made both economic and financial sense. If, for example, a lender attempted to sell a troubled loan, the market purchaser would value the loan on its future cash flows discounted for a fair rate of return. And that rate of return—the discount rate—would be based upon the risk that the cash flows would be realized as anticipated.
Economic and financial sense, however, don’t always make political sense. Citibank and Chase Manhatten (Citigroup and JP Morgan Chase’s predecessors) were among a record 850 responsdents to the exposure draft, most of whom were critical of the FASB’s proposed accounting standard. Using a present value calculation, the bankers argued then, would compel write downs that would prevent banks from paying dividends, from making long-term, fixed rate loans or from reporting results of operations with any consistency. In other words, the accounting rules would exacerbate losses. Further, others argued banks would no longer be able to make loans to disadvantaged borrowers, municipalities,emerging companies, or less developed countries as if these endeavors were charitable. Finally, the bankers argued, the FASB, through the imposition of
FASB Statement No. 15, was attempting to impose fair value accounting and in its stead, what the bankers proposed was that restructured loans should only be written down to the future value of anticipated payments, a method with no economic basis whatsoever.
Faced with the criticism of Chase’s David Rockefeller, Citibank’s Walter Wriston, Federal Reserve Chairman Arthur F. Burns and a hostile banking industry buffeted by a recent recession and portfolios stocked with bad loans to emerging nations, the FASB capitulated and the final rules adopted the future value methodology. The surrender, however, was not without consequence, but it would be years before the full effects were realized.
By the early 1980’s, many U.S. financial institutions were again in servere financial distress, particularly banks that lent to oil-related businesses or newly deregulated thrift institutions that had made long-term, fixed rate loans that had been financed with short-term, high-yield deposits in a period of rising interest rates. By mid-decade, when both the commercial and residential real estate markets began to decline in many areas of the country, if not simply fall off the ledge, real estate loan restructurings were as common pastry in a French bakery.
But because these and other permissive accounting rules, deliberate redefinitions of regulatory capital that magically created equity where none previously existed, corrupt appraisals, and auditors too pliant to recognize the valuations for what they were and too often compliant in management financial reporting frauds, there were hundreds of zombie savings and loan institutions that were, in reality, operating as the living dead by failed managements who continued to take their inflated salaries and unearned bonuses and subjected their institutions to even greater risks simply because they knew there was nothing left for their already insolvent institutions to lose.
As a result, scandals that could have been discovered in the early stages festered and losses that may have been staunched at far smaller levels multipled into a national financial catastrophe. These were the prices of artificial accounting, a head-in-the-sand regulatory environment and the management objective of simply buying more time.
In the aftermath of the the S & L debacle, one of the primary changes made by the FASB was to scrap future value methodology and revert to the present value of anticipated payments that had been initially proposed in the exposure draft of FASB Statement No. 15 some 16 years before. With the promulgation of FASB Statement No. 114 in 1993, good sense, it seemed, finally prevailed over bad politics at least with respect to restructured or impaired loans. Enron was still to come, however.
FASB Statement No. 114 provides something closer to a fair value approach to impaired loan accounting. The standard further provides that if it is probable that contractual payments will not be made, then the loan should be valued on the the present value of future payments utilizing the effective interest rate inherent in the initial loan contract. The standard also permits, as a practical expedient, the loan to be valued at a market value if a market for the loan exists or at the fair value of the underlying collateral if the loan is collateral dependent or foreclosure is probable.
To vitiate FASB Statement No. 114, as the Mortgage Bankers ask, would also call into question the newly promulgated FASB Statement No. 157 on Fair Value Measurements that provides additional clarity and requires more disclosure on fair valuations in financial statements. FASB Statement No. 157 provides a reasonably detailed framework for the valuation of assets, including a market approach relying upon the exit or sale price in an orderly transaction. If no such market for the assets exists, fair value may be determined by an income approach utilizing present value techniques—that is, discounting future, anticipated cash flows. In short, the Mortgage Bankers proposed exception has no basis in current accounting literature and is antithetical to the direction of modern accounting.
In his column, Norris was openly skepical that the nation’s banks have substantial systems problems calculating the discounted present value of restructured residential mortgage loans. “No one anticipated a day when potentially hundreds of thousands of residential mortgage loans would be modified,” Norris quoted a spokesperson for the Mortgage Bankers Association. Still, Norris concluded: “Some may doubt that the issue really is a systems problem at the banks, given that the accounting the banks would prefer would allow them to report smaller losses as they restructure loans—and thus make their financial statements look better. If the reverse were true, the effort being put into changing the rule might instead be directed at finding ways to comply with it.”
Given that a number of major banks have been compelled to raise substantial additional capital to cover loan related losses—Citigroup alone accepted a $7.5 billion equity investment from Abu Dhabi in November and has reportedly raised an additional $12.5 billion from other foreign sources—there is clearly much at stake.
Despite these massive stakes and the bankers’ plaintive plea for relief, the FASB rejected the bankers’ request at their January 30 Board meeting.
Perhaps institutional memory of the accounting profession is improving.
Gordon Yale, a CPA, is a Denver-based forensic accountant and the principal of Yale & Company and the president of Yale Group, Inc., a boutique investment bank and member of FINRA.