I will have a lot to say about the FASB's recent publication of its proposed revisions to the accounting for loans over the next few months. In particular, I'm going to vivisect the horrendous "basis for conclusions" section of Proposed Accounting Standards Update 2012-260. To give you a preview of the issues I'll be covering, however, nothing in the proposed ASU's basis for conclusions even acknowledges that the FASB once considered measuring all loans and most other financial instruments at fair value.
At least it proves my point that "due process" at the FASB is a myth.
Bless the Journalists, for They Know Not (Enough) of Accounting
For now, though, I want to get something else off my chest. As I began to gather my sources, and even before I reviewed the proposed ASU itself, I read the article that reported its issuance in the New York Times.
Let's begin with the good part. The author of the article, respected long-time columnist Floyd Norris, wrote:
"The international regulators [IASB] privately argued [to the FASB] that the pricing of loans reflected the degree of loss expected, therefore there was no need for an initial write-down." [emphasis added]
Kudos to Mr. Norris for pointing out that the IASB was initially on the right track – until it got sidetracked. The FASB even concedes that point – albeit very briefly in the proposed ASU before a clumsy finesse around this economic reality in paragraph BC21. (More on that in a later post.) The IASB's view also corresponds to the reasoning that I set out in a post this past August – see the section "A Mistaken Rationale for the Expected Loss Model."
The bad part of the article is that, instead of just sticking to the facts, Mr. Norris somehow somehow has seen fit to bestow upon us his own two cents worth of accounting logic:
"As a practical matter, it seems likely that any bank making a loan would almost immediately have to write down the value of the loan, even though nothing indicated that particular loan was likely to go bad, simply because experience would indicate that some percentage of similar loans do wind up defaulting." [emphasis added]
I'm not a journalist, but it seems to me that if Mr. Norris felt that his reporting would not be complete without a justification for the proposed "expected loss" approach to measuring loan losses, he should have found an independent expert to do the deed. For surely he knows plenty of them. Or, he could have actually referred to language in the proposed ASU itself. (Did he read it?)
One would hope that any expert without a dog in the hunt would have reminded Mr. Norris that the FASB had decades before explicitly rejected the kind of rationalization that he has made (SFAS No. 5), when it was clearly more concerned with establishing accounting standards that were consistently based on sound principles.
As to any "practical matter," I would suggest that the most salient might be the Board bucking the wishes of the American Bankers Association. Indeed, there are many reasons to believe that auditing the expected loss approach will prove to be impractical, if not downright ineffectual.
The expected loss approach in whatever form it may take is purely a political gambit to give the appearance that accounting is reforming itself after the latest financial crisis, while continuing to avoid providing investors the information they deserve – marking loans to market (which the big banks do every day for their own internal purposes). For evidence of who is actually pulling the strings at the FASB, see the ABA's press release that came out almost simultaneously with the proposed ASU. They're like a parent to a child coming home with a 3.7 GPA: 'very good, but not yet good enough.'
"FASB's proposal is a move in the right direction for both bankers and investors as it seeks to simplify many areas of impairment accounting. However, we believe additional work is needed to ensure that the model better reflects how banks manage credit risk."
It's okay to set up a Day 1 allowance for loan losses, but it shouldn't be too much, and don't ever second-guess management's estimates!
I believe (based on reading his columns and reporting over the years) that Mr. Norris made a good faith effort to be "balanced." However, in doing so he made a grievous error that resulted in misleading his readers to believe that policy makers are undertaking a good faith effort to fix a weakness in accounting standards. The real story is that the deliberations of the FASB amount to little more than constructing lame excuses for avoiding marking loans to market at the behest of the ABA. The "expected loss" approach is a red herring; it's nothing more or less than a long-ago discredited relic of German accounting.
The Opinion of a Real Expert
Subtract the gratuitous sarcasm from the forgoing critique, and you will pretty much have the gist of an email that I wrote to Mr. Norris soon after publication of his report.
I also cc'd that email to a couple of true experts on loan accounting, to solicit their reactions to my concerns. The irony did not occur to me at the time, but one of them, Lynn Turner (former SEC Chief Accountant), has been quoted by Mr. Norris on numerous occasions. Anyway, this is what Lynn wrote (with minor redactions by me) in response:
Tom – I agree with you that fair valuing a loan is the best way to go. The FASB proposed this while Bob Herz was chair, but that notion was dropped after Bob was pushed out at the FASB.[*] …
I note with interest that Floyd discussed that the proposal would require a write down when the expected cash flows would no longer be equal to those required in the loan agreement. Quite frankly, that is very much like the current standard. And of course, during the S&L and banking crisis of the late '80's and early '90's, banks did not take their write downs. A GAO report at the time issued while Chuck Bowsher was the US Comptroller and head of the GAO did favor going to fair value for loans.
During the most recent financial crisis banks again did not take timely writedowns, despite the accounting standard requiring them to do so when the cash flows from the loan was no longer expected to be equal to the loan agreement. In addition, SAB 102 and substantially the same guidance from the Banking regulators did require writedowns when economic conditions changed, as they did in '06 and '07. Yet the banking regulators, well aware of the problems with the subprime portfolios, did not require writedowns.
I was doing work for OFHEO [Office of Federal Housing Enterprise Oversight – later subsumed into FHFA] at the time and it was clear the subprime loan markets had major problems, including with respect to portfolios at Citi, Freddie and Fannie, and yet the regulators sat on their thumbs and did nothing.
What the banking regulators want quite simply is "cookie jar reserves" that can be used and drawn down when times get bad. This is typically done in a bank by building up the cookie jar and setting aside a portion of earnings each period, for the rainy day to come in the future, as it always does. The problem with this approach is it still requires the banking regulator to step in a make sure enough is being set aside, and is solely based on a safety and soundness approach. Yet I cannot recall a single instance of bad economic times when the federal banking regulators have actually been tough enough with their exams, to make sure the banks were safe and sound, and their allowances for loan losses sufficient. "Safety and Soundness" is a dream – a figment of imaginations emulating from the swamp lands of Washington DC.
I began my career as a CPA in 1976 auditing banks. I have audited both big and small banks, including as an audit partner. Twice I have also dealt with banks and their regulators as a member of the SEC staff. I have also done projects for OFHEO, the FHLBB, and IMF. And two things have been constant throughout all the years. First, Banks hate transparency, hate to report anything other than "smoothed" earnings, which in turn helps them deal with capital requirements. And their banking regulators, including the banking examiners, are pretty much worthless when it comes to ensuring banks comply with basic sound banking business practices, compliance with laws, and the establishment of adequate internal controls. In fact, many a CEO I have dealt with viewed the bank's balance sheet as "his" money more than the money of depositors or stockholders.
As a result, I have little to no faith in financial statements issued by these institutions. … The proposal by the FASB, which is worse than the one proposed by the IASB, but both of which are pretty bad, only convinces me more that financial statements are slowly evolving into a mediocre medium of value. [emphasis added]
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As Mr. Norris's colleague, Paul Krugman, has pointed out on more than a few occasions, balanced reporting is appropriate only when the arguments on both sides of an issue are balanced:
"News reports portray the parties as equally intransigent; pundits fantasize about some kind of ‘centrist’ uprising as if the problem was too much partisanship on both sides. Some of us have long complained about the cult of ‘balance,’ the insistence on portraying both parties as equally wrong and equally at fault on any issue, never mind the facts. I joked long ago that if one party declared that the earth was flat, the headlines would read 'Views Differ on Shape of Planet.'
My point is that rather than trying to defend the indefensible "logic" underlying the "expected loss" approach to loan accounting, the article that I would hope to read would provide the following information:
- Just how politicized the issue of loan accounting has become;
- Why it has become so politicized;
- The enormous stakes involved for economic stability; and
- A fulsome explanation of the choices (Mr. Norris, following the cue of the FASB, didn't even mention the possibility of marking to market in his article).
As a model of this type of reporting, there is the recent and ongoing coverage that NYT has recently devoted to the problem of gun violence in the U.S. It shows why NYT is the greatest English-language newspaper in the world.
But, unlike gun violence, which frustrates everyone on every side of the issue, accounting that can lead to prudent bank regulation and investor protection is straightforward and eminently feasible. If there is a special role in a free society for 'traditional' media, it must be to recognize its responsibility to communicate such facts.
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Happy New Year. My father and his twin brother would have had their 95th birthdays on New Year's Day. Sometimes I think that this blogging obsession with which I am afflicted is my homage to them.
Like the biblical Jacob and Esau, they were as different as night and day. With no disrespect to my dear mother, and with tongue only slightly in cheek, I'm about 50% Dad, 30% Uncle Leo and 20% a reaction to being ridiculed by other children (whose names I have forgotten).
*Readers who have accused me of inferring without adequate evidence the actual (opposed to 'official') cause of Herz's departure from the FASB, kindly take note.