Sunday, January 3, 2010

Skin in the Game: Interview with Bob Herz of FASB

Original posted on the Institutional Risk Analyst:

Robert H. Herz was appointed chairman of the Financial Accounting Standards Board (FASB) in July 2002, and was reappointed to a second term in 2007. The FASB has been making significant changes to the way in which off-balance sheet (OBS) entities are accounted for by banks and other sponsors of these vehicles. The good news is that thanks to the FASB's changes to the accounting rules for OBS vehicles, transparency has been greatly increased. The bad news is that most of these OBS vehicles created by BAC, C, WFC and other zombie banks, as we noted above, are guaranteed by the taxpayer via the GSEs. We spoke to Bob last week.

The IRA: Bob, thank you for taking the time to speak with us. Happy New Year. We want to talk to you about the past year and also 2010. Off-balance sheet finance was a very big part of 2009 as you of course are aware with the approval of the FASB rule on these vehicles. And we have just seen the publication of the FDIC's proposal on rules for bank securitizations following our interview with Mike Krimminger from that agency ("Fixing Bank Securitization: Interview with Michael Krimminger', December 14, 2009" ). What did we accomplish over the past year and what lies ahead for FASB?

Herz: Happy New Year. At the end of 2008, we put in a lot of new disclosures regarding companies' involvements with securitizations and special purpose vehicles in order to bring more transparency and significantly more information about these activities and the relationship between off balance sheet entities and the sponsors. I think people also knew we were coming down the home stretch in changing the actual accounting rules that would require that a lot more of these activities be shown on balance sheet. We finalized the new standards (FAS 166 and FAS 167) in mid-2009 and they are effective in 2010. We believe that all this will provide investors with a much better understanding of the existing involvements that financial institutions have with securitized assets and special purpose entities, and that the institutions and the marketplace will now have a better idea going forward of the accounting ground rules are for such transactions.

The IRA: There still does not seem to be any true industry perspective, a conversation involving the Sell Side and Buy Side firms beyond the various paid organs and lobbyists, as to the future model for securitization. What role is FASB going to play in this next phase of the discussion, especially now that FDIC has challenged the industry and the other regulators by proposing a normative standard for securitizations? If we forget the accounting for a minute and simply talk about securitizations as legal vehicles, there has been a lot of discussion about sponsors having "skin in the game," but the reality is that sponsors have always had skin in the game via substitution of collateral and cash advances and other industry practices. Now FDIC is raising basic issues about retained interests and, in so doing, has directly challenged the banking industry with the prospect of regulation. How do we foster a wider public discussion about these financial relationships within the new disclosure framework that FASB has established?

Herz: I think there has been constructive discussion on these issues as Congress progresses in exploring notions such as "skin in the game" as you describe it, but at the same time that currently remains something of a moving target. Our view is that we have taken a good look at the accounting and disclosure issues and passed the new standards that require better accounting and much more disclosure and transparency. My hope is that the industry, the regulators of financial institutions, Congress and the markets will start to establish principles and guidelines for the securitization markets of the future. That combined with our new accounting and disclosures should provide a sound base for a more healthy and transparent securitization market. In that regard, I welcome the recent FDIC release dealing with the regulatory capital impacts of the new accounting standards.

The IRA: Agreed, the information ought to be there one way or another, but that had not been the case historically. But isn't this the age-old problem? You could look at securitization over the last decade and it would be reasonable to ask whether market participants and regulators did not know that there was a hideous problem with securitizations and disclosure. The Congress bears first responsibility for legislatively allowing the growth of retrograde market formulations such as OTC derivatives and private placements securitizations where there was no disclosure and today there is still little information available to the public.

Herz: Everything seems clearer in hindsight, but I believe that with the benefit of hindsight we can now see that the pre-existing accounting standards on securitizations and special purpose entities were stretched and abused to accommodate the exploding markets for increasingly complex securities backed by what we now know were poorly underwritten mortgages and loans. We are not an enforcement agency. I will leave it to others as to whether this stretching of the rules was intentional or due to the overall rose colored glass syndrome that pervaded the markets in the years 2004-2007.

The IRA: Let's ask a big picture question. Do you think that the volatility in the markets and the efforts by the financial industry and the FASB to capture and describe these swings in valuation are caused by the growth of public sector debt and the Fed's monetary emissions to accommodate it? For example, if you look at the banks that we follow, in the past three years we have seen a 10 point swing in the market value of core deposits. Three years ago, buyers of banks were paying 10 point premiums for deposits and booking the intangible as goodwill. Today deposits are trading at a discount with the FDIC paying buyers of banks to assume these liabilities. Now FASB is planning to value certain of the liabilities of financial institutions. How does mere accounting clarify the valuation issue for investors?

Herz: I think your question and comments about volatility in the banking sector touches on some of the arguments that Paul Volcker has made about limiting activities of banks. And perhaps the volatility in the value of core deposits that you note is partly a product of competition in the marketplace?

The IRA: There has clearly been a large swing in the perceived value of bank deposits, but our question is more basic. When you talk about banks, these are companies that are lucky to make 1% asset returns and until recently have not been high-beta components of the stock market, but today we see swings in asset values of banks that are more like technology companies. Can accounting really be useful when we are talking about companies with observed levels of equity volatility measured in the hundreds of percent? Banks today trade like the tech stocks of the last decade.

Herz: Well, you are talking about companies that were once viewed as annuities and are now traded like tech stocks. The real question from an accounting perspective is whether the swings in asset values and valuation of these companies even out over time. Some in the banking industry would like to portray this as a situation where the volatility will, over time, balance out. But that may be a dangerous way of looking at the issue. History has shown that during these swings in value some institutions go over the cliff.

The IRA: Yes. And keep in mind that we are not trying to make a point with respect to mark-to-market vs. historical cost accounting. Regardless of what rule you have in place, the volatility of banks and other financial firms over the past several years has created huge challenges for analysts. Would you agree?

Herz: Yes. That is a question of how much of a company's financial condition and performance is a function of its business model and how much is due to changing conditions in the markets. I would argue that there may be some cases where the swings in volatility will even out over time, and others where it will not. But at any point in time, it's very difficult to forecast the outcome.

The IRA: Precisely. To the point about valuation and issues such as goodwill, it is going to be very interesting to see how long some of the banks we follow are able to defer write-downs of goodwill and core deposit intangibles when the assets are now trading at a discount to par value.

Herz: And also deferred tax assets.

The IRA: To go back to securitization, how much has the FASB been involved with the FDIC in this rule regarding bank securitizations? Is it simply the case that FASB has put in place the rule or is there ongoing involvement?

Herz: We spend a lot of time in discussions with the financial regulators. Throughout the process when we developed the new accounting standards for securizations and special purpose vehicles, we spoke to the regulators frequently. During the development of the bank stress tests, for example, we were in frequent consultations with regulators to make sure that we were all on the same page as far as the impact of the rule changes.

The IRA: There is a lot of buzz in the financial community now about disclosure of past due assets and foreclosed assets. Some investors accuse the bank regulators of encouraging forbearance with respect to loan losses, but the Fed and other regulators deny any implicit policy to look the other way when it comes to losses.

Herz: Yes. We are very aware of the concerns and have a proposal out now on much more granular disclosure of loan portfolio data and much more detail about recognizing losses and reserving.

The IRA: One of the questions we asked Mike Krimminger from the FDIC is whether we can ever see the US market evolve to the point that we have federal definitions for events such as delinquency or default, this without doing violence to state law contracts.

Herz: I don't know. We are going to be looking at these issues.

The IRA: The Fed recently put out guidance regarding the loss recognition on non-performing assets, which some people in the market interpreted as encouraging forbearance. The Fed has made clear that is not the case, but the perception persists.

Herz: I seem to recall that the instructions for the bank call reports require disclosure for loans that are 90-days past due, even though there is no definition of non-performing assets. In fact, we are going to discuss these matters in January.

The IRA: That is why we asked about whether we can have a clear federal standard for some of these terms without taking away the business flexibility of the sponsors of securitizations. Is that fair? In our federalist system, defining a contract term is not an easy thing to do. But under the current system, the issuers invent their own terms, so disclosure has limited utility. Reminds us of the way BCCI kept their internal accounts in Urdu. Each issuer of a securitization gets to invent their own language for each deal. This is what we call "innovation" in the US. How do we solve this issue of uniform accounting definitions for key terms used in a securitization?

Herz: Well, I've heard some in the banking community assert that in bad times changing their definition on what they regard as "past due " or "non-performing " is justified because people pay slower. Our main points of focus in 2010 in this area will be on improving the disclosures relating to loan portfolios and on trying to develop a more forward looking approach to developing loan loss allowances.

The IRA: Besides working on securitization and new rules on loss recognition, what is the FASB going to do to address the growing criticism that you and your counterparts in Europe are loosening standards to help the banks muddle through the crisis without fully recognizing losses.

Herz: Well, we are working very closely with the International Accounting Standards Board ( IASB ) on a variety of issues. In fact we now meet full board to board at least monthly. One of the areas where we are working together is on the accounting for financial instruments. In that area the IASB has finalized aspects of a new standard and we are working towards the issuance of a more comprehensive proposal in the first quarter of 2010. At the urging of the European Commission and certain other parties in Europe, the IASB accelerated some of their work and issued a new standard in November 2009 that basically provides for trading assets and highly volatile assets to be marked-to-market through income, but loans and debt securities held for the longer term would be carried at amortized cost subject to impairment. The proposal that we are currently headed towards is similar in terms of mark-to-market for financial assets that are traded or volatile, but for loans and debt securities held for the longer term we would show cost, any reserves taken and an adjustment to get to fair value. And we are working together on the loan loss allowance issues.

The IRA: That would be useful. All of this information is shown in the call reports, but the issuer does not have to relate changes in reserves to specific exposures. So you would juxtapose the fair value of the asset with the changes to the loss reserve?

Herz: The changes in the reserve account through provisions would affect earnings as today. But any incremental amount to adjust to fair value, in addition to or below the amount in the credit reserves, would be reflected in what's called "other comprehensive income." Kind of like what we did with impairment guidance on debt securities we issued in the spring of 2009. And we are also thinking about a fair value adjustment to certain liabilities that fund financial financial assets carried at fair value.

The IRA: This brings us back to bank deposits. The current market for core deposits taken via assumption in an FDIC bank resolution is not par. There are not many voluntary comps out there in terms of bank M&A transactions, but the FDIC sales via the receivership function are a reflection of the market. FDIC exposes failing institutions to the entire industry and then to investors, so 98-96% of par is fair value. If we fair value everything on both side of the ledger, what happens to the longevity of intangible assets?

Herz: We have been looking at the issues associated with valuing bank deposits with valuation professionals and other people knowledgeable in this subject.

The IRA: We wrote about this issue a couple of years ago. None other than Rodgin Cohen from Sullivan & Cromwell was trying to sell the idea of using core deposit intangibles as bank capital. We were not buying it. This is one of the reasons why the Street moved so quickly from tangible common equity to tier one common as the capital benchmark in IR presentations. During the crisis a year ago, the Buy Side made TCE the de facto standard for bank capital, but by the time Q2 disclosure was out, tangible common had been substituted in most investor presentations. How you feel about counting goodwill attributable to core deposits as capital?

Herz: I doubt that the regulators would allow that in terms of regulatory capital. However, I do think that understanding the value of core deposits and changes in those values can be important in analyzing banks.

The IRA: You have to admire the creativity behind the proposal.

Herz: Speaking of creativity, as I noted earlier, we're working with the IASB,financial instititutions, regulators, investors and auditors at loan loss reserving to see whether it can be made more forward looking without just saying that anything goes.

The IRA: Forward is right. In the old days, 1-1.5% loan loss reserves to total loans was judged to be sufficient. Now we are looking at loss rates that suggest more like 3% is needed. Going back to the point about volatility, how does the volatility of loss rates factor into your deliberations? If banks now are barely staying ahead of charge-offs with new provisions, how do we even talk about pro-cyclically setting aside more reserves?

Herz: The idea is to see if we can put some real rigor around the process. We have right now what is called an "incurred loss " model where we basically wait until the losses become probable. We are going to look at whether there are ways to estimate losses over a longer time horizon using relevant data, history, etc.

The IRA: Well, the Street will fight you on that point. This is the reverse of the situation we had with the banks three and more years ago where they wanted to take more reserves but the SEC would not allow it. And visible default rates were zero, so there was little empirical support for higher loss reserves levels.

Herz: The regulators generally want more reserves and more capital, but I think many investors would be wary of reserving techniques that lacked rigor if that allowed for inappropriate earnings management.

The IRA: Well, that is the great metaphysical tension between investor relations and ultimate truth, at least as revealed by GAAP accounting.

Herz: That is exactly right. Understandably, companies try to advance their goals, worry about the impacts of accounting on their reported results and on compensation. Regulators focus on safety and soundness and policy makers on overall impacts on the economy. Our focus is providing investors and the capital markets with relevant and transparent information of the financial condition and performance of companies, which we believe is also vital to the overall health of the economy.

The IRA: It is about getting paid and also the natural political bias in favor or growth and creating short-term employment opportunities. We can already see members of Congress planning to revive Fannie and Freddie and make them bigger and better before the November 2010 election.

Herz: After the binge of recent years and the hangover effects of a severe economic downturn, I sincerely hope that such policies will not, so to speak, encourage people to start drinking irresponsibly again.

The IRA: So last point, what is the most important issue facing FASB in 2010?

Herz: Well, we have a number of major ongoing projects on areas such as revenue recognition, financial statement, insurance and lease accounting that are of high importance. But in terms of your audience, I would say that the area of geatest interest is our project on revamping the accounting for financial instruments. As I noted, that includes looking at the issues relating to the use of fair value vs. amortized cost, to loss reserves, and to reporting of interest margins. It also involves hedge accounting.

The IRA: Are we going to see any movement on a convergence between GAAP and the IASB standards?

Herz: We have been working closely with the IASB at converging our standards and have recently "redoubled" these efforts. But for us this is not just about convergence, but very importantly, it's also about improving the standards. In terms of whether, when and how the U.S. might move wholesale to international standards, that's a matter for the SEC. They issued a proposal on potential adoption of international accounting standards in the U.S., received comments and are now considering the next steps. In the meantime we continue with our convergence efforts.

The IRA: Given the priority attached to collecting tax revenue by the Obama Administration, one would think that the EU standard with only one set of books would be very attractive.

Herz: That is true, but investors have voiced understandable concerns that we could be importing other people's economic philosophies into US financial reporting and into our capital markets. Clearly that is not what we are about at the FASB. We are about making reported financial information more useful and transparent to investors and other consumers of that information.

The IRA: Well said. Thanks Bob.

No comments: