Peeling away financial reporting issues one layer at a time

FCIC Gives Accounting Standards a Free Pass (Along with Practically Everybody Else)

Darn few, if anyone who wrote about the Financial Crisis Inquiry Commission's 600-page report has  anything good to say about it. Jonathan Weil at Bloomberg may have described its shortcomings as well as anyone, and he also provides a vivid example of how the commission took great care to avoid tread marks on the toes of the rich and powerful:

"To get to the heart of what went wrong with the report released yesterday by the Financial Crisis Inquiry Commission, check out its account on page 254 of how the largest investor in a cash fund managed by Bank of America suddenly pulled out $20 billion of its money in November 2007.

The withdrawal crippled the fund, which had $40 billion of assets at its peak, forcing Bank of America to step in and prop it up. The commission included a note about the episode in the back of its report.

'The identity of the investor has never been publicly disclosed,' it says. The note then referred readers to the source of the information: A couple of stories published in December 2007 by Bloomberg News and the New York Times.

And here I had thought the purpose of the commission's inquiry was to uncover new facts that the public didn't already know. Such as: The identity of the mystery investor that single- handedly kneecapped Bank of America's Columbia Strategic Cash Portfolio, once the largest cash fund of its kind in the U.S. The commission had subpoena power. It should have been able to get this information. It didn't, though." [emphasis supplied]

Thus, it should not have come as a surprise that the loan, derivative, repo and securitizations accounting standards so highly coveted by the members of the American Bankers Association – a lobbying group with political clout fast approaching the NRA's – weren't even discussed.

PwC Couldn't Get Out of the Way

I haven't read the report; and I won't, because I gotta make a living, OK? So I asked Lynn Turner, former SEC Chief Accountant, to confirm for me that the FCIC had indeed turned a blind eye on accounting standard setting. Lynn not only responded in the affirmative, he also excerpted for me a very interesting portion of the report dealing with the accounting by AIG for its now infamous "credit default swaps."

"AIG Financial Products did not have its own model or otherwise try to value the CDO portfolio that it guaranteed through credit default swaps, nor did it hedge its exposure. Gene Park explained that hedging was seen as unnecessary in part because of the mistaken belief that AIG would have to pay counterparties only if holders of the super-senior tranches incurred actual losses. He also said that purchasing a hedge from UBS, the Swiss bank, was considered, but … the head of credit trading … rejected the idea because it would cost more than the fees that the AIG Financial Products was receiving to write CDS protection.

Therefore, AIG Financial Products relied on an actuarial model that did not provide a tool for monitoring the CDOs' market value. The model was developed by [a finance professor who was close to AIG Financial Products' CEO]. The … model had determined with 99.85% confidence that the owners of the super-senior trances would never suffer real economic losses, even in an economy as troubled as the worst post-World War II recession. … [PwC], who were apparently also not aware of the collateral requirements, concluded that 'risk of default … has been effectively removed and … there are no substantive economic risks in the portfolio and as a result the fair value of the liability stream … could reasonably be considered to be zero." [pp. 266-267, emphasis supplied]

Here's some of my reactions:

  • These contracts are in a gray area between insurance and derivatives. I'm sure AIG subrogates much of its insurance exposure (i.e., buys reinsurance), so why didn't it even consider 'hedging' its CDS exposure? Surely, the inability to obtain a reasonable price from UBS to take on some of the risk must have been a hint to AIG and PwC that they could be heading for a big tumble.
  • How convenient it was to get a friend of the CEO finance professor to tell PwC what it most desperately wanted to hear. Basically, the finance professor was sent on a field trip to look for black swans. Since he didn't see any, he concluded with near 100% certainty that black swans did not exist. 
  • Neither AIG's top executives, nor its auditor's actually understood the terms of the contracts they were evaluating!

And Lynn's comments are even more trenchant:

"[T]he FCIC report highlights how AIG did not have any models that would allow it to value its positions in its CDO portfolio. This was a huge multibillion dollar portfolio. Given this, one has to ask how the heck the company could comply with GAAP let alone manage its business. Furthermore, it calls into serious question how PWC did the audit and gave a clean opinion on AIG's internal controls. In court documents it has come out that PWC told AIG in the summer of 2007, before it signed off on the 2nd quarter 10-Q, that the company needed to get better models. Yet there was no public disclosure at the time of a lack of internal controls or problems with the financial reporting.

Even more concerning, is the FCIC report gives no indication the commission questioned or challenged PwC on this."

 

All's Clear. Full Speed Ahead on the Race to the Bottom

So, it seems that except for PwC, the Accounting Establishment escaped scot-free. Yet, just from this one incident should have suggested that accounting and auditing had some underlying issues. We are left to conclude that either: (a) the commission couldn't bring itself to even ask the tough questions about financial reporting; or (b) it didn't know enough to ask the right questions; or (c) all of the above.

If the S&L debacles, and then the Enron-era debacles, and now the 'financial crisis', all in less than 20 years, are not enough to kick start a fundamental re-thinking of financial reporting, then what will it take? Here's just a few of the questions that the commission could have investigated:

  • Was S-0X 404 ineffective in preventing at least some part of the financial crisis? What is the evidence that reporting on internal controls over financial reporting is more than a go-through-the-motions boondoggle for auditors (and their bank clients) – unless and until an egregious accounting error has actually occurred and has actually been discovered?
  • Does the evidence suggest that auditors lack the training and competency to evaluate the "reasonableness" of management's assertions – especially when it comes to complex contracts that hope to evade accounting rules and auditors' scrutiny? Can we really expect auditors to discover and take into account all of the critical terms of these complex arrangements?
  • Do financial institutions, and preparers in general, have undue influence on accounting standards?

FASB Chair Leslie Seidman and accounting know-nothing Mary Schapiro (SEC chair) must be extremely relieved to have escaped the spotlight. Everybody knows that the accounting standards for loans, derivatives, repurchase agreements securitizations and even contingent liabilities all stink, and nothing more than band aids have been proposed thus far.

So, with the FCIC report behind her, and having "reversed course" set by her fired predecessor away from fair value measurement of loans, Seidman and the rest of the carefully selected shills on the FASB are free to focus on the priorities that will no doubt be her legacy: donning goggles and flippers with the EU to see who can take revenue recognition and leases the farthest toward the bottom on only one breath.

The Journal of Accountancy reported: "Seidman said FASB received 'overwhelming feedback' that preparers, auditors and others would prefer to have loans held for collection recorded on the balance sheet at amortized cost with a more robust impairment test." [emphasis supplied]

It seems that the new FASB chair can't even bring herself to utter the word "investors." Message to the FCIC: investigate that.

1 Comment

  1. Reply Independent Accountant February 1, 2011

    Tom:
    I won’t read the report either. I posted on PWC’s audit failure at AIG. It’s hopeless. Most big financial institutions are UNAUDITABLE. I am reading Taleb’s Black Swan. It’s magnificient.

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