[Senate Hearing 110-1011]
[From the U.S. Government Publishing Office]
S. Hrg. 110-1011
TRANSPARENCY IN ACCOUNTING: PROPOSED CHANGES TO ACCOUNTING FOR OFF-
BALANCE-SHEET ENTITIES
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
OF THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
ON
HOW ASSETS HELD OFF OF THE BALANCE SHEET CONTRIBUTED TO THE
SECURITIZATION OF RISKY ASSETS, SPECIFIC CHANGES THAT HAVE BEEN
PROPOSED BY FASB TO CURB INAPPROPRIATE USES OF OFF-BALANCE SHEET
ENTITIES, IMPLICATIONS FOR INVESTORS AND THE INDUSTRY OF DEFERRING
THESE PROPOSED CHANGES, AND NECESSARY DISCLOSURES TO ENSURE THAT
INVESTORS HAVE SUFFICIENT TRANSPARENCY TO MAKE INFORMED INVESTMENT
DECISIONS
__________
THURSDAY, SEPTEMBER 18, 2008
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate /
senate05sh.html
U.S. GOVERNMENT PRINTING OFFICE
50-413 WASHINGTON : 2010
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho
SHERROD BROWN, Ohio ELIZABETH DOLE, North Carolina
ROBERT P. CASEY, Pennsylvania MEL MARTINEZ, Florida
JON TESTER, Montana BOB CORKER, Tennessee
Shawn Maher, Staff Director
William D. Duhnke, Republican Staff Director and Counsel
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
------
Subcommittee on Securities and Insurance and Investment
JACK REED, Rhode Island, Chairman
WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York CHUCK HAGEL, Nebraska
EVAN BAYH, Indiana JIM BUNNING, Kentucky
ROBERT P. CASEY, Pennsylvania MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
JON TESTER, Montana
Didem Nisanci, Staff Director
Tewana Wilkerson, Republican Staff Director
C O N T E N T S
----------
THURSDAY, SEPTEMBER 18, 2008
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Allard............................................... 3
WITNESSES
Lawrence Smith, Board Member, Financial Accounting Standards
Board (FASB)................................................... 5
Prepared statement........................................... 33
John W. White, Director, Division of Corporation Finance,
Securities and Exchange Commission, and James L. Kroeker,
Deputy Chief Accountant, Securities and Exchange Commission.... 7
Prepared statement........................................... 44
Joseph R. Mason, Hermann Moyse Jr./Louisiana Bankers Association
Professor of Finance, E.J. Ourso College of Business, Louisiana
State University............................................... 17
Prepared statement........................................... 53
Donald Young, Managing Director, Young and Company LLC, and
Former FASB Board Member....................................... 20
Prepared statement........................................... 70
Elizabeth F. Mooney, Analyst, Capital Strategy Research, The
Capital Group Companies........................................ 22
Prepared statement........................................... 203
George P. Miller, Executive Director, American Securitization
Forum.......................................................... 23
Prepared statement........................................... 213
TRANSPARENCY IN ACCOUNTING: PROPOSED CHANGES TO ACCOUNTING FOR OFF-
BALANCE-SHEET ENTITIES
----------
THURSDAY, SEPTEMBER 18, 2008
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 2:35 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed, (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. The Subcommittee will come to order. Senator
Allard will be joining us in a moment. He is just moments away.
I want to thank the witnesses, not only the first panel but
the second panel. In the interest of time, I will go ahead and
read my statement and then ask Senator Allard to make his
statement, introduce the panel and ask for your statements.
Thank you, gentlemen, for joining us today.
At the outset, I want to acknowledge the importance of
FASB's independence, and I appreciate their appearance before
our Committee to discuss the topic of off-balance-sheet
accounting. This hearing is an opportunity to discuss some of
the concerns with current standards and FASB's recent proposals
to address these problems.
During the last 2 weeks, we have witnessed the most
challenging financial crisis since the Great Depression. The
aftershocks from these events continue and will be felt for
many years. This prolonged crisis threatens not just individual
firms, but the entire global financial system. Moreover, the
impact will be felt by families, individuals, and businesses on
Main Street as well as Wall Street.
Given recent events, there is emerging consensus that
companies that have more accurately accounted for their balance
sheets remain viable, while those companies that were slower to
recognize losses are punished by the marketplace. This is a
clear signal for investors that there is a premium on improved
transparency. Today's topic is at the heart of transparency in
our markets: properly acknowledging and understanding assets
held off balance sheets.
Over the last year or so, we have seen revelations of a
significant build-up of off-balance-sheet exposures among some
of the largest financial institutions. These exposures not only
weaken these institutions but, indeed, place significant risks
on the entire financial system, contributing to the severity of
the current crisis.
This phenomenon of moving assets off the balance sheets is
eerily familiar. We recall back in the days of Enron that its
schemes to manufacture false profits included special purpose
entities that conducted transactions off-balance sheet. The
goal was to avoid financial reporting. While no one is
necessarily suggesting scandals of the Enron kind, we cannot
fail to admit the irony. We are dealing with a similar problem
yet again, only 6 years later.
Many experts, market participants, investors, and
regulators have been calling for a change in this area. Reports
and recommendations of the Financial Stability Forum, the
President's Working Group, and recently the private sector-led
Counterparty Risk Management Policy Group III all similarly
recommended a more rigorous accounting of off-balance-sheet
vehicles in order to provide a more accurate view of a
company's exposures.
The drivers of the subprime crisis were not only excess
liquidity, leverage, complex products, and distorted
incentives, but accounting rules that allowed mortgage-backed
securities be held off the balance sheet. The securities
packaged from these mortgages, many of them risky subprime
mortgages, remain far from the view of investors and less
closely reviewed by regulators. If we have learned anything
from this recent mortgage mess--and I hope that we have--it is
that we need more transparency in our markets, not less.
Holding large amounts of assets off-balance sheet is not more
transparency. If firms hold such risk, it should be disclosed
so that investors can decide whether they are comfortable with
such risk. Given the current state of the financial sector,
this is the time to shore up confidence in our financial
sector, not undermine.
FASB has wrestled with accounting for securitization for
over two decades. Most recently, FASB issued a rule in 2000 and
then additional guidance after the Enron disaster to address
accounting for securitizations and off-balance-sheet entities.
In April of this year, FASB voted to remove a designation known
as a ``qualified special purpose entity,'' or QSPE, which
allows firms to move their mortgage-backed securities off the
balance sheet. These changes were voted on in July and will now
be effective in 2010. On Monday, FASB issued exposure drafts
for review and comment.
Now is the time to initiate these changes and to ensure
that they provide thorough transparency so that risk may be
properly assessed. With today's hearing, we hope that we can,
first, begin to evaluate whether the proposed changes result in
sufficient transparency and bring appropriate market discipline
to the process; and, second, understand whether or not there is
sufficient enforcement of these rules to ensure they are
implemented as written.
Though the topic may be technical and complex, its
implications are known. There is a real impact on investors,
including many of us who hold pensions and other savings. It
matters to anyone with mutual fund investments who want to know
that their fund managers can review all possible information in
making investment decisions with their money. And there is a
real impact and consequence for financial regulators who ought
to be fully aware of the concentration of risk for the firms
and, indeed, the health of the entire financial system and the
economy.
The ghost of Enron should be laid to rest finally. So let's
learn from our mistakes and move forward for a stronger
financial sector and a stronger economy that investors at all
levels can have confidence in.
Now I would like to recognize the Ranking Member, my
colleague Senator Allard, for his statement.
OPENING STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you for convening
today's hearing. I would like to welcome our panelists as we
examine the updated FASB rules regarding accounting practices
and off-balance-sheet entity disclosure, and I look forward to
the opportunity to hear from our guests.
Off-balance-sheet finance is an accounting technique in
which a company's debt obligation does not appear on the
balance sheet as a liability. Keeping that off the balance
sheet allows a company to appear more creditworthy but can
misrepresent the firm's financial structure to creditors,
shareholders, and the public.
It is critical that accounting methods for financial
institutions yield an accurate and transparent representation.
In the past, companies such as Enron have diminished our
confidence in accounting methods by not being open and
forthright.
Other current economic concerns, including the mortgage
crises, have been blamed in part on opaque and obtuse
accounting methods. In light of today's markets, it is of the
utmost importance that accounting is regulated in a way that
bolsters confidence by being precise, comprehensive, and open.
Many people are asking how we reached this point. I think
one of the reasons is that we do not know the full extent of
risk institutions were involved in. Healthy risk can bring
positive benefits to a company. However, investors and
regulators must be given a full and total understanding of what
risk is being undertaken.
Accounting practices that do not accurately represent a
company's actual position are detrimental and have played a
substantial role in creating financial turmoil. FASB has
proposed changes to its accounting rules that could potentially
alter the way banks, financial institutions, and other
companies account for off-balance-sheet assets. I am interested
to see how these FASB regulations could change long-term
accounting practices. These new rules force companies to be
more careful, carefully consider which of their assets they
have effectively control over, and could have an impact on how
assets are accounted for. Bringing enhanced clarity to the
marketplace has the potential to shore up confidence and
promote stability.
On another note, this is most likely the last hearing for
the Securities Subcommittee, so I want to take a moment to
express my deep appreciation to Chairman Jack Reed. He has been
not only a colleague but also a friend to me during my time
here in the Senate. We served on a number of committees
together. I think this is our fourth or so that we have served
on together through our term. While some of the people here
today may not know it, I have been fortunate enough to share
leadership with him on four different Subcommittees:
Securities, Insurance, and Investment; and Housing and
Transportation on the Banking Committee; and Personnel and
Strategic Forces on Armed Services. I have consistently found
both him and his staff a pleasure to work with, no matter what
the issue, and he brings a thoughtful, insightful perspective.
In an increasingly partisan atmosphere, it has been
refreshing to find someone who is willing to put politics aside
and work together for productive, common-sense solutions to
some of the problems facing our country. His willingness to
work together has allowed us to make progress in important
areas, such as preventing and ending homelessness and improving
access to reverse mortgages for seniors. Whether in hearings or
work on legislation, Senator Reed is a true gentleman, and I
have always looked forward to the opportunity to work with him.
His commitment to public service is commendable, and I wish him
and his staff all the best.
Again, thank you to our witnesses for being here today, and
I look forward to your testimony.
Chairman Reed. Well, thank you, Senator Allard, not only
for your statement but for those very, very kind words. And I
must respond, it has similarly been a pleasure for me to work
with you. And we have, both on the Armed Services Committee and
the Banking Committee, seemed fated to be Chair, Ranking
Member, and then switch to be Ranking Member and Chair. And it
has been a pleasure, and your staff, as yourself, have been
extraordinarily kind to work with, and I appreciate it very
much. One might hope this is the last Subcommittee hearing of
this Congress. [Laughter.]
Chairman Reed. But if we meet again, it will still be a
pleasure, and I wish you the best as you embark on your
different endeavors. But thank you very much, Wayne.
Senator Allard. Thank you. I think we set an example
perhaps for how we can work together in a bipartisan way. So
thank you.
Chairman Reed. Thank you.
Now let me introduce our panel. First, Mr. Lawrence Smith
has served on the Board of the Financial Accounting Standards
Board, FASB, since 2007 and has led the efforts to address off-
balance-sheet accounting issues at FASB. Thank you very much,
Mr. Smith.
John White is the Director of the Division of Corporation
Finance at the Securities and Exchange Commission. Prior to his
work at the SEC, he was a partner in the law firm of Cravath,
Swaine & Moore. In his position there, among other
responsibilities, he advised companies on corporate governance
and public reporting responsibilities.
James Kroeker is the Deputy Chief Accountant at the SEC,
and prior to this position, he was at Deloitte as a partner in
the National Accounting Services Group, where he provided
consultation on accounting standards.
We will begin with Mr. Smith, and I assume Mr. White will
have a statement, and Mr. Kroeker will be available to respond
to questions as well.
Mr. Smith, please.
STATEMENT OF LAWRENCE SMITH, BOARD MEMBER, FINANCIAL ACCOUNTING
STANDARDS BOARD (FASB)
Mr. Smith. Chairman Reed and Ranking Member Allard, good
afternoon. I am Larry Smith, a member of the Financial
Accounting Standards Board. I am pleased to appear before you
today on behalf of the FASB, and I thank you for inviting me to
participate at this very important hearing.
The FASB is an independent private sector organization. Our
ability to conduct our work in a thorough and unbiased manner
is fundamental to achieving our mission, which is to establish
and improve general purpose standards of financial accounting
and reporting for both public and private enterprises.
As significant reporting issues arise, the Board endeavors
to understand those issues and to identify the reasons why they
arose. The events that have occurred recently in the credit
markets created such a review, and the Board accelerated its
work in several specific areas.
While we have been working on a number of different
projects to address the reporting issues we identified, it is
important to understand and acknowledge that good financial
reporting requires both sound standards as well as faithful
application of those standards.
For example, the two standards that are the focus of my
testimony--Statement 140, which address the sale of
receivables, as well as other financial instruments; and
Interpretation 46(R), which addresses the consolidation of
variable interest entities, which includes most securitization
vehicles--both include disclosure requirements regarding the
extent of involvement with an entity holding receivables.
Also, in 2005, the Board issued guidance in response to the
proliferation of loans with non-traditional characteristics to
reinforce the extensive accounting and disclosure requirements
that are applicable to such products. Yet users have noted that
such disclosures were often missing from financial statements.
The two fundamental issues identified as problematic in
Statement 140 and Interpretation 46(R) are the concepts of
QSPEs, which were meant to be pass-through entities that have
minimal decisionmaking authority and were, therefore, exempt
from consolidation, and reliance on a mathematical calculation
to assess whether a holder of an interest in an SPE should
consolidate that entity.
On Monday, the Board issued three interrelated exposure
drafts that address these issues. Specifically, the Board is
exposing for comment: one, that we eliminate the concept of the
QSPE from our literature such that all entities will be subject
to our consolidation principles; two, that we first require a
qualitative assessment of control be performed to determine
whether an interest holder should consolidate an entity in
which it holds an interest; and, three, improvements in
disclosures to better enable users to assess the extent to
which an entity is involved with another entity, the related
potential risks related to that involvement, the degree to
which consolidated assets are restricted, as well as the
judgments and assumptions made in determining whether an entity
should be consolidated.
You might ask, If we are eliminating QSPEs now, why did the
FASB create them in the first place? The Board at the time
created the concept to allow securitization transactions to be
reported as sales of receivables because the QSPE's activities
were supposed to be significantly limited and entirely
specified. In other words, they were supposed to be simple
pass-through entities. However, practices have evolved
significantly such that the qualifying criteria have been
stretched well beyond the original intent and requirements of
Statement 140. The Board no longer believes the concept of a
QSPE is workable since practice has shown that there are few
assets capable of being managed when the activities of the
manager of those assets are significantly limited and entirely
specified.
You might also ask, If the FASB believes that a
qualification assessment of control is better than the
mathematical calculation currently required, why didn't the
FASB require that in the first place?
When 46(R) was written the Board thought the mathematical
calculation of expected losses would be a good indicator of who
ultimately controls the entity. However, we have seen in
practice that people have engineered around the math to avoid
consolidation. Some people have also questioned whether some of
the probability assessments made in connection with estimating
expected losses truly reflected the risks of those interests.
Blind exuberance may have contributed to overlooking some of
the risks faced by those involved with these entities, such as
some risks like liquidity risk and reputation risk which were
virtually ignored. We believe it will be more difficult to
ignore these risks through a qualitative assessment.
The Board is proposing that both the elimination of QSPEs
from Statement 140 and the requirement to first use a
qualitative assessment of control under Interpretation 46(R) be
effective for fiscal years beginning after November 15, 2009.
The Board would have liked to have eliminated the QSPE concept
and required the qualitative assessment earlier. However,
discussions with banking regulators and preparers lead us to
conclude that the consequential consideration of regulatory
capital requirements and other changes are impossible to
address any earlier. However, we have not delayed the
improvements in financial statement disclosures. The exposure
draft proposes that these disclosure improvements be required
for financial periods ending after the guidance is finalized,
which we expect to be late this year. We believe that the
required financial statement disclosures will enable investors
to understand a transferor's continuing involvement in the
financial assets that have been transferred to an SPE, the
nature of any restrictions on those assets that continue to be
reported by an entity in its balance sheet, the judgments and
assumptions made by the enterprise in determining whether it
must consolidate the variable interest entity, the involvement
of an entity with a variable interest entity, and the nature of
and changes in the risks associated with an entity's
involvement with a VIE.
The FASB shares your Subcommittee's concerns about the role
off-balance-sheet entities have played in the current financial
crisis, and we are working hard to address the shortcomings in
financial reporting. We encourage all interested parties to
provide us comments on the three exposure drafts we issued
earlier this week.
In closing, I again want to emphasize that good financial
reporting requires both sound standards as well as faithful
application of those standards.
Thank you again, Mr. Chairman, Ranking Member Allard. I
very much appreciate your continuing interest in and support of
the mission and the activities of the FASB.
Chairman Reed. Thank you, Mr. Smith.
Mr. White.
STATEMENT OF JOHN W. WHITE, DIRECTOR, DIVISION OF CORPORATION
FINANCE, SECURITIES AND EXCHANGE COMMISSION, AND JAMES L.
KROEKER, DEPUTY CHIEF ACCOUNTANT, SECURITIES AND EXCHANGE
COMMISSION
Mr. White. Good afternoon. I would like to thank you,
Chairman Reed and Ranking Member Allard, for the opportunity to
testify today, along with Jim Kroeker, on behalf of the
Securities and Exchange Commission.
I am going to start off by discussing transparency and
disclosure of off-balance-sheet arrangements, and then I am
actually going to ask Jim to complete our opening remarks with
a discussion of our work with the FASB, if that would be OK.
Chairman Reed. Fine.
Mr. White. We also have submitted a written statement for
the record.
Starting with transparency, transparency is the bedrock of
good disclosure, and it allows investors to make informed
decisions. Clear and understandable information about a company
and the risk that it faces reduces uncertainty in the market.
And, of course, capital markets are constantly changing, and as
markets change, risks change; financial products change; and so
a company's disclosure needs to change as well.
In response to the Sarbanes-Oxley Act, the Commission in
2003 adopted a significant set of changes in the way that
companies disclose information about off-balance-sheet
arrangements. And as a result of those disclosure rules, today
financial institutions must disclose extensive information
about off-balance-sheet arrangements if--and I underline the
``if ''--the arrangements are reasonably likely to have a
current or future material effect on the company's financial
condition, revenues, expenses, or liquidity.
At the Commission, since the adoption of those requirements
in 2003, we have continued to focus on enhancing transparency,
and in recent months alone, we have taken a number of actions
aimed at improving the disclosure requirements that came out in
2003, including last December issuing a letter to the CFOs of
over 25 large financial institutions about making additional
off-balance-sheet disclosures; in January of this year issuing
a letter providing additional guidance on the application of
FAS 140; in March issuing another letter about additional fair
value disclosures; in July we had a roundtable on fair value;
in August we had a roundtable on market turmoil; and just this
week we issued another letter to over 25 financial institutions
covering additional transparent disclosure of fair value
calculations.
In addition to those activities, we continue to have our
regular ongoing work of reviewing the financial statements of
every public company, including all public financial
institutions, at least once every 3 years. So I think it is
fair to say that we have a fair amount of activity in this area
at the Commission, both at the Commission level and the staff
level.
So that is what is happening on the disclosure front. I am
going to turn it over to Jim to talk about what is happened in
our role with the FASB.
Mr. Kroeker. I would also like to thank you, Chairman Reed
and Ranking Member Allard, for the opportunity to testify
today.
The continued review of the effectiveness of existing
accounting standards for off-balance-sheet arrangements and the
recent capital market pressures have highlighted the need for
improvement in the existing accounting guidance for off-
balance-sheet arrangements.
As you are aware, the FASB issued FIN 46(R) to improve the
accounting for off-balance-sheet arrangements after the Enron
fallout. However, FIN 46(R) provided a scope exception for
certain passive trusts, such as those commonly used in bank
securitization transactions.
To address the current issues related to off-balance-sheet
accounting, in January 2008, the Commission staff asked the
FASB to consider the need for improvements to the accounting
guidance and the disclosures for such transactions, including
securitizations. Based on the potential far-reaching impact of
this accounting topic and the important due process procedures
required to evaluate and implement the potential changes, the
speed at which the FASB has moved this project forward is
commendable.
In November 2008, after a 60-day comment period, we expect
the FASB to host a public roundtable on their proposed
amendments. If the FASB adopts the proposed rule and the
changes described earlier by Larry, we expect that the SPE
sponsors of such off-balance-sheet arrangements would
consolidate some larger portion of existing off-balance-sheet
transactions, including some portion of existing QSPEs, SIVs,
and commercial paper conduits.
We believe that the proposed amendments hold promise in
enhancing the transparency around the financial reporting for
off-balance-sheet transactions, and we continue to monitor the
effectiveness of any changes and mandate further changes if
necessary.
As John mentioned earlier, the Division of Corporation
Finance reviews the financial statements of every public
company, including financial institutions, at least once every
3 years. This effort is aimed at enhancing disclosure and at
improving compliance with Federal securities laws.
In addition to this work, another important aspect of our
involvement in accounting standards is the rigorous enforcement
of Federal securities laws. The Commission regularly
investigates allegations of accounting irregularities and
reporting violations, including those related to off-balance-
sheet accounting. Just to highlight a recent example, the
Commission has brought action involving allegations of improper
accounting for mortgage securitizations by three NYSE-listed
Puerto Rican financial institutions. Additional examples of
enforcement in this area are included in our written testimony.
The Division of Enforcement will pursue allegations such as
these whenever warranted.
We look forward to evaluating the FASB's exposure draft and
the related comment letters that they received, and, again, I
want to thank you for holding this hearing, and we would be
happy to address any questions that you might have.
Chairman Reed. Well, thank you very much, gentlemen, for
your testimony.
Mr. Smith, you indicated in your testimony that there are
shortcomings with the current rule, and that has prompted the
reevaluation by FASB. Could you highlight in more detail some
of the shortcomings with the current rule that you are trying
to address with this new rulemaking?
Mr. Smith. Sure. First I will talk about 140. 140 has a
concept called ``qualified special purpose entities,'' QSPEs,
and basically, as the Board has discussed this over some time,
the Board believed that QSPEs should be brain-dead or pass-
through entities. So, effectively, the person that is servicing
the loans that are held by a QSPE should not have any
significant decisionmaking authority over them.
Over time, as things change, et cetera, more and more
different types of assets or different types of receivables
have been put into QSPEs, such that the application and
practice has been that QSPEs are holding probably, you know,
different types of assets than the Board originally envisioned.
We went back and tried to--when we were dealing with this
issue--and we have been dealing with this issue for a number of
years. We tried to figure out ways to put parameters around the
operations of the QSPE in terms of defining the types of assets
that could go in, the types of activities or decisions that can
be made. But, ultimately, after careful consideration of
existing structures, et cetera, we decided that that was
impossible and felt that because the QSPE is an exception to
current accounting rule, we should just eliminate that
conception and fall back on the principle regarding whether an
entity holding those receivables should be consolidated.
Now, in terms of the application of 46(R), which is the
other one that I mentioned, 46(R) was in direct response to
Enron, and the mathematical calculation that was put into place
to determine whether an entity should consolidate an entity was
based upon the expectation that the holder of an interest that
has the most expected losses, that would absorb the most
expected losses or reap the most benefits would be effectively
the entity that controlled that special purpose entity.
Well, as time has gone on, people have engineered around
that concept. There have been various mechanisms put in place.
Just one example is an expected loss tranche, which is a way of
getting a group of investors that hold a fairly minor position
in the special purpose entity to absorb those losses, yet they
have no other rights associated with it. If those expected
losses occurred, they would lose their investment period, and
that is all they could do. But yet, because of the application
of the math, they were deemed to be the primary beneficiary,
yet there were other people or holders of interests who had
much greater potential risks.
We also think that contributing to this was, you know, the
overly optimistic assessments of probabilities of expected
losses. So the Board decided that we should first consider some
qualitative aspects of control, you know, whether from a
practical standpoint the combination of different interests
effectively put another--a holder of those interests in control
rather than rely on the math, hoping, truly hoping that people
cannot structure around it the way they can the math.
So that is what we have done. You know, we have put it out
for comment, and we will see what people say.
Chairman Reed. I understand the proposal has as a default
position the quantitative measure, that if the qualitative
approach does not work, what is to prevent someone from doing
sort of a paper drill, you know, a qualitative analysis to
satisfy Mr. White and Mr. Kroeker and their colleagues and then
essentially just say, well, here is the number, and----
Mr. Smith. We will fall back on----
Chairman Reed [continuing]. We got this, this is under the
rule? We are right back where we started from?
Mr. Smith. I will comment on that in two respects. First of
all, we put the fallback position in the exposure draft and put
it out for exposure and people to comment on. Whether we
continue to rely on that fallback position remains to be seen.
A number of us were uncomfortable with just removing the math
to start out with.
We have also put in the standard--I think it is nine
different examples of fairly common structures that you will
see out there, and put at least our assessment of whether in
those situations someone should consolidate. So we have given
some illustrative guidance to people in terms of how to apply
this in the future, which we hope will overcome that.
The staff at the FASB does not think there will be any
situations where people fall back on the math.
Chairman Reed. I understand ISB does not use the
quantitative approach. They use the qualitative approach. Is
that accurate?
Mr. Smith. That is true. Currently, they have a standard
that requires a qualitative assessment. It is not the same as
ours, but it has similarities to ours. And at the same time,
they are also taking a more fundamental look at their
consolidation model in general, which, in fact, was the subject
of--at least a staff draft was the subject of a roundtable over
in London just 2 days ago.
Chairman Reed. What I think would make sense is let me
finish my questions of Mr. Smith and then ask Senator Allard
for questions, and then we will do a second round, and I will
have some questions for Mr. White and Mr. Kroeker.
The purpose of some of the expansion, or whatever the right
term is, the use of the rules or the misuse of the rules, to
avoid regulatory oversight, to not diminish capital on, you
know, the overall institution. What do you feel is driving the
creative use, if you will, in retrospect of these rules?
Mr. Smith. I think it is a combination of factors. I think
economic times informs people's behavior. I think the
complexity of securitization transactions are tremendous. It is
not--at least what I have been told, it is not unusual for a
particular securitization transaction to have a stack of legal
papers perhaps this high. So there might be, you know, some
overlooking of certain requirements that are embedded in some
of those legal documents.
I also believe that, you know, people looked at certain
aspects of what was permitted before and then evaluated
something fairly similar, but let's say just a little bit over
the line, and said, ``Well, that must be OK because it is only
a little bit over the line.'' And over time, these practices
just stretch.
A lot of people thought that securitization transactions
through QSPEs were permitted, and we had some guidance in terms
of how to apply that. And they looked to those and then made
their own interpretations themselves. But I think over time it
is just that, you know, things stretch. And that is what
happens when you have--when you basically have exceptions to
accounting principles. You know, we have been criticized for
being overly rules based in this country and that exceptions
have really effectively created a lot of those rules. And now
we are going back, and we are trying to eliminate them.
Chairman Reed. Thank you, Mr. Smith.
Senator Allard, and then we will do a second round.
Senator Allard. If we were to apply the more stringent and
different off-balance-sheet entity regulations and they were
active several years ago, would the mortgage crisis be worse
today, or better? Or where would we stand?
Mr. Smith. I do not know the answer to that question. I
mean, it would be conjecture on my part as to try to say what
would have happened in terms of the extent to which people, you
know, would have entered into these transactions had other
rules been in place. I really do not know the answer to that
question.
Senator Allard. So when we come to the case of securitized
mortgages, then you would not have an automatic pass-through
then. I would assume they are sort of considered special
purpose entities.
Mr. Smith. Right.
Senator Allard. And so then they would not be just a pass-
through group. They would have--well, you do not even have them
now. But you have some mechanism now where they would be
recalculated or reassessed as far as risk. Is that right?
Mr. Smith. Yes. If we remove the QSPE status, there will
still be a vehicle that hold these mortgages, and what will
happen is there will be an evaluation of the roles and
responsibilities of the different parties who hold interest in
these transactions to assess who ultimately controls the
entity. And it is usually a combination of the ability to
prescribe what types of assets go into the entity to begin
with, combined with the ability to service those assets, and
perhaps combine with some type of a liquidity guarantee or
credit guarantee or something like that.
Senator Allard. Now, just recently, Fannie Mae and Freddie
Mac have been basically taken over by the Government. Do these
accounting rules apply now to a Government agency in this
particular instance?
Mr. Smith. Well, if they continue to put out financial
statements in accordance with generally accepted accounting
principles in the U.S., yes, they will be subject----
Senator Allard. And they have done that in the past?
Mr. Smith. Have they?
Senator Allard. Done that in the past?
Mr. Smith. Yes.
Senator Allard. And so we would expect that they would
continue to do that, even though they are taken over by the
Government at this point in time.
Mr. Smith. I do not know specifically, but I believe--I
would not be surprised if they continued to do that.
Senator Allard. Now, as I understand it, Fannie Mae and
Freddie Mac, when they securitized their mortgages, they ended
up buying their own securitized mortgages off of the market.
How would these new accounting provisions treat something like
that?
Mr. Smith. Well, first you would evaluate the new
accounting rules pertaining to the vehicle that was set up to
hold the mortgages that they guarantee. You would then assess
whether Fannie or Freddie effectively control that entity. And
I will just give you my personal opinion. Not going through any
legal documents or what have you, but based upon my
understanding of the combination of risks, et cetera, it
appears that Fannie and Freddie would be the consolidator of
those entities, and then in terms of them buying their own
interest, effectively it is an intra-company transaction.
Senator Allard. And so go in as an added risk?
Mr. Smith. Well, no. It is just that it would be----they
would be dealing with themselves, if you will.
Senator Allard. And so what practical effect does that have
on their financial stability?
Mr. Smith. You know, the accounting for this really does
not, I do not think, enter into their financial or end
stability. It will change the way their financial statements
look dramatically.
Senator Allard. Well, then, let me put it this way: Will
their financial statements reflect that increased risk?
Mr. Smith. Yes. The assets and liabilities would be on
their books.
Senator Allard. I see. Okay. So then there would be more
transparency, for example, on Fannie Mae and Freddie Mac under
these new accounting provisions.
Mr. Smith. That would be my expectation.
Senator Allard. Okay. Now, you plan on putting these into
effect in the beginning of 2009. Is that correct?
Mr. Smith. No. Let me explain.
Senator Allard. Okay.
Mr. Smith. The changes regarding the elimination of QSPEs
and the change in how you would assess control under FIN 46(R)
would be applicable to 2010 calendar year companies.
Senator Allard. Starting on January 1.
Mr. Smith. Yes. The disclosures, the enhanced disclosures,
would be in effect for the reporting period ending after we
release them. So if we release the final disclosure standard
December 15th, they would be applicable to December 31st year-
end companies.
Senator Allard. Okay. And are we going to have adequate
time for comment between now and when we start requiring them
to do these evaluations?
Mr. Smith. We have put in a 30-day comment period for the
disclosures and a 60-day comment period for the 46(R) and 140.
We believe that that--we know that people are watching us. We
know that interested parties have been following our projects,
and we expect that they are geared up to respond to our
proposals.
Senator Allard. Is this the same time period that you have
allowed on previous proposals?
Mr. Smith. It varies from proposal to proposal.
Senator Allard. And so the time period you came up with
here, was that just some assumptions that you made? I mean, how
do you decide which ones you take a longer time period for
comment and which ones do you take a shorter time period for
comment? Because I suspect there will be a fair amount of
comment on this as it applies from consumer groups as well as
accountants and everybody else that has an interest in it,
companies probably themselves.
Mr. Smith. I expect you are right there. In terms of the
disclosures, we did consider the timing of the application, and
we are hoping to get these disclosures in place by the end of
the year. So, yes, the comment period is a function of when we
wanted these increased disclosures applied.
In terms of the time period for the other two, we felt that
this was adequate time for people to respond and for us to
release the final standard probably by the beginning of next
year, or some time in the first quarter.
Senator Allard. Now, is it your view that if we had applied
these principles that you have now before the mortgage-backed
securities had proliferated to the point they are now that we
would not be dealing with a mortgage crisis, at least to the
degree that we are now?
Mr. Smith. I really--again, I do not know the answer to
that question. You know, back in 2005, the Board became aware
of the significant proliferation of non-traditional loans, so
these are loans where there were no payments or, you know, no
significant payments required, you know, negatively amortizing
loans, et cetera, and the fact that you did not need any kind
of documentation to secure a loan or regarding either your
wanting to live--whether you were indicating you were going to
live in the house or what your income was. And as a result of
that, we put out a standard to try to convey to the world that
there are existing accounting requirements that call for
disclosures and how to account for these types of transactions
as well as the risks that are created by those types of
transactions. And we did not see any significant changes in the
disclosures as a result of that.
But I cannot really tell you how the market would have
reacted had we put these rules in place earlier.
Senator Allard. Yes. Well, Mr. Chairman, you said you have
more questions, so I will hold the rest of mine for the next
round. Thank you.
Chairman Reed. Thank you, Senator Allard.
Mr. White and Mr. Kroeker, I have communicated with the SEC
and FASB regarding these issues in letters, and you have
responded back. This goes to the issue of the overall
regulatory regime, which rules, principles, together with
interpretations--you indicated that several interpretations
have been given by SEC--and then enforcement.
In a letter that FASB sent back to me, they indicated that
they had knowledge of some entities that were not following the
accounting standards with respect to these off-balance-sheet
entities. Have you had a conscious, concerted effort to follow
up and to see that these rules were being adequately embraced
or applied?
Mr. White. The answer is yes.
Chairman Reed. And can you elaborate?
Mr. White. Much of our efforts have been devoted on the
disclosure side, and I think I described a fair amount of that
earlier. In addition looking at whether companies are
disclosing in accordance with our rules, we have also looked to
see whether companies are complying with the accounting rules
as they exist today. And I would say, by and large, we have
found that companies have been complying with the existing
accounting rules.
Chairman Reed. Will you be reviewing these rules that are
being proposed to ensure that they capture what should be
captured in terms of off-balance-sheet entities and that are
brought back on properly? Is that something you can positively
be engaged in?
Mr. White. Jim, maybe you should respond.
Mr. Kroeker. Absolutely. Part of our ongoing process and
our oversight of FASB and their role in the standard-setting
environment, we certainly will be following these rules. We
will be particularly interested in comments that they receive
from investors about the improved transparency that we believe
these rules have the promise to provide. So in addition
following and commenting directly with the FASB our thoughts on
the proposed enhancements, including issues that Larry
addressed in terms of the concept that you might have an entity
that is very limited in its power, yet somebody has got to be
there to service assets and liabilities, and, therefore, it
stretches what people think ought to exist in terms of the
notion of control, we will be looking right at that aspect in
this proposal.
Chairman Reed. In my discussions with Mr. Smith, he noted,
we both noted, that the international accounting rules have a
qualitative approach to this recognition, and that is the
approach, the direction that the new rules seem to go in.
Some commentators, I think Ms. Mooney in particular, have
indicated that under the IASB rules, there is a significant
amount of SIVs that could stay off the balance sheet. And this
becomes particularly critical as the Securities and Exchange
Commission is proposing that companies, big companies, are able
to elect one or the other.
First, this would seem to be the ideal opportunity to work
collaboratively together for one rule which both the
international standards and the FASB standards converged.
Second, would this allow an opportunity with the proposed
sort of choice of accounting regimes to essentially defeat what
FASB is trying to do by allowing a reporting company to use an
international standard and keep these entities off their
balance sheet?
Mr. White. Maybe I will start it and then switch it over to
Jim.
Chairman Reed. Sure.
Mr. White. The proposal with respect to IFRS that you are
referring to, if adopted--it is a proposal at this point--but,
if adopted, would allow a limited number of U.S. companies to
elect to use IFRS if IFRS was the predominant accounting system
used in their industry internationally. So at least those
companies would be able to choose, if you want to use that
word, between using IFRS and using U.S. GAAP.
But, Jim, maybe you want to describe the differences
between the two.
Mr. Kroeker. Yes. It relates to the idea and the
opportunity to use what we are seeing today to foster
convergence. I could not agree more. I think it is a wonderful
opportunity to move toward a higher quality standard for off-
balance-sheet accounting.
We are also, though, interested in ensuring that the FASB
moves quickly to improve off-balance-sheet accounting in the
U.S. And so to the extent that a convergence project would take
longer than simply addressing the more immediate issue of
application of accounting standards in the U.S., we have been
supportive of the FASB's project to move quickly on improving
off-balance-sheet accounting.
The IASB likewise has a project on their agenda to improve
off-balance-sheet accounting, and as Larry mentioned, the FASB
and the IASB are working very closely on that.
Chairman Reed. But it seems to me there still is at this
juncture the distinct possibility that there could be two
different rules about qualitative recognition, that a company
could, in terms of regulatory arbitrage, choose the one that
allows them to keep these entities off their balance sheets,
which would go against the very essence of this hearing,
getting most of these entities that should be recognized on the
balance sheets. And I think that adds a further complexity to
this notion of selecting either the international regime or the
FASB regime.
That is a comment, but if you would like to respond.
Mr. White. I might mention that at the roundtable we had
this summer that I referred to earlier, one company that was
there said that when they switched to IFRS, they actually
brought 200 of their subsidiaries on balance sheet in the
process of moving to IFRS. So I am not sure there is a
particular assumption about how consolidation would work.
Chairman Reed. I would presume--and this is a presumption--
that that issue of whether this effectuates the same thing that
FASB is trying to do, maybe not in exactly the same way is it
accomplished, would be at least a factor that you would try to
examine. Is that fair? Thanks.
We have talked about these, you know, special investment
vehicles, the QSPEs, but there is a whole other group of
entities out there--credit derivatives--that are in some cases
off the balance sheet, but we are seeing have a significant
impact on the operations of a company. One could speculate that
the reason that AIG is now a subsidiary of the Federal Reserve
is because their involvement in the credit derivatives market
is so significant. And yet do you think that was properly
reflected on their balance sheets, Mr. White?
Mr. White. I guess I would not think that we should be
discussing individual registrants that we review. That is not
our common practice. AIG is one of the companies----
Chairman Reed. Well, in general terms then, do you feel
that in addition to these vehicles that are created, there are
other classes of investment securities or financial
transactions that could have a material impact on the company,
but are not effectively disclosed under current rules?
Mr. White. I would not have thought that we thought there
were gaps in the disclosure requirements in our current rules.
Mr. Kroeker. As it relates to the accounting particularly
for highly complex things like credit default swaps, the FASB
put in place in the late 1990s, early 2000s, guidance on
accounting for derivative transactions, and many of those types
of instruments are, in fact, derivatives. And so in terms of
bringing them on balance sheet and reflecting the exposure,
that has happened, although the FASB recently issued--and Mr.
Smith might have some additional background on some enhanced
disclosures about credit default and structured, highly
structured insurance-type products.
Chairman Reed. Can you comment, Mr. Smith?
Mr. Smith. Yes. In September, this month, we issued a final
requirement to improve the disclosures surrounding credit
derivatives. What happened was we had a project to address the
accounting for financial guarantee industry, and in connection
with that, we proposed a number of disclosures surrounding the
risks that an entity takes on in issuing those guarantees--or
that guarantee insurance. And we noted very--some similarities
between those guarantees and the nature of credit derivatives.
So we basically embarked on another project to address the
disclosures and credit derivatives, which, as I just said, were
issued earlier this month.
Chairman Reed. Thank you. Senator Allard had to step out to
take a call, but that allows me, for the record, to ask Mr.
White and Mr. Kroeker a question that Senator Allard asked
about the timeliness of the rules, the ability to have the
comments, and the implementation. Do you think there is
adequate time for the comment period and also an adequate time
for reporting companies to adjust to the new rules?
Mr. White. The 60-day comment period is the comment period
that we normally use on our rulemaking at the SEC. So certainly
my experience over the last few years has been that 60 days
produces a flood of public comments and provides adequate time.
If I understand it, the disclosure rules where you are
thinking of 30 days, those are probably less complex and easier
to understand, and----
Mr. Smith. Yes.
Mr. White. Probably that is part of the reasons why you
went to 30 days. The rest is so you could get them into effect
earlier.
Mr. Smith. Correct.
Chairman Reed. Just a final question, and, again, Mr.
Smith, you might--I just want to make sure I understand. The
disclosure requirements would become effective very shortly
after the rules are finalized.
Mr. Smith. That is correct.
Chairman Reed. Which would require, I think, or which could
require immediate disclosure of significant off-balance-sheet
assets or liabilities, but they would not necessarily have to
be brought on to the balance sheet. Is that a fair way to----
Mr. Smith. That is correct.
Chairman Reed. I know that we are all arguing for
disclosure, but the disclosure itself would cause, I think,
evaluation or reevaluation of the reporting companies. That is
fair to say, correct?
Mr. Smith. Yes. The purpose of the disclosures is to
enhance the user's ability to assess the risk that a company
holds, regardless of whether those assets are presented on the
balance sheet or not.
Chairman Reed. Senator Allard has other questions, I am
sure. So do I. We will keep the record open for several days,
and if you would be prepared to respond in writing to our
written questions, I would appreciate it, and other members of
the panel. But thank you very much, gentlemen, for your
testimony, and I will call up the second panel.
Well, I want to welcome the second panel, and thank you all
for joining us today. Let me introduce the panel; then I will
ask you to make your statements and try to stay within the 5-
minute guidelines. Your statements will be made part of the
record automatically. And, indeed, if you want to comment about
what you have heard, that is also appropriate.
First we have Joseph Mason. Mr. Mason holds the Hermann
Moyse Jr. Endowed Chair of Banking at the E.J. Ourso College of
Business, Louisiana State University. He has written
extensively on the role of securitizations in the mortgage
problems the country currently faces. Earlier in his career, he
worked at the OCC and studied the role of securitizations in
banking. Thank you, Professor Mason.
Elizabeth Mooney is an analyst for the Capital Strategy
Research of the Capital Group covering global accounting
issues. She is a certified public accountant and a member of
the FASB Investor Task Force and Investors Technical Advisory
Committee and the International Accounting Standards Board, and
served a term on the FASB Advisory Council. Thank you.
George Miller is the Executive Director of the American
Securitization Forum, an association that represents various
participants in the securitization industry. Previously, Mr.
Miller was an attorney at Sidley Austin where he specialized in
structured financial transactions.
Donald Young recently completed a term as a Board member of
FASB. He is current the Managing Director of Young and Company
where he provides consulting and research services for
technology and private equity clients.
Thank you all very much for joining us. Professor Mason.
Turn on the microphone, please.
STATEMENT OF JOSEPH R. MASON, HERMANN MOYSE JR./LOUISIANA
BANKERS ASSOCIATION PROFESSOR OF FINANCE, E.J. OURSO COLLEGE OF
BUSINESS, LOUISIANA STATE UNIVERSITY
Mr. Mason. Thank you, Chairman Reed, Ranking Member Allard,
Members of the Committee, for the opportunity to testify today.
Chairman Reed, as you pointed out earlier, this week's
financial crisis was largely due to the lack of transparency
about investment exposures, which has been promulgated by
ineffective accounting rules and inefficient bond ratings.
Back in 1997, Moody's Investors Successful wrote, and I
quote, ``The simple act of securitizing assets can affect the
appearance of the income statement and balance sheet in a
profound manner without, in many cases, significantly altering
the underlying economics of the seller. With securitization,
reported earnings are overstated and reported balance sheet
leverage is understated while there may be little, if any, risk
transference.''
As early as 1987, Moody's pointed out that while, and I
quote, ``the practices developed by the accounting and
regulatory world . . . do not fully capture the true economic
risks of a securitized asset sale to the originator's credit
quality.'' So, long ago, market insiders fully realized that
standard accounting rules do not apply to securitizing firms.
But while the market is well aware of these problems, excess
returns in recent years led to regulatory and investor
complacency and the financial crisis we have with us today.
Recently, there have been suggestions that having sellers
retain some risk in their securitizations can align incentives
of sellers and investors as well as borrowers. The reality is
that they have always retained risk, and that retained risk is
precisely the problem. That retained risk is indelibly related
to the variable interest entity that was the foundation of the
proposed FASB revisions. Prior to financial engineering,
ownership--and, therefore, on-balance-sheet treatment--was
dictated by voting interest. If you owned more than 50 percent
of voting equity shares, then you owned the firm.
With financial engineering, as demonstrated by Enron, all
that changed. The first attempt to account for ownership in
financially engineered construct was attempted in FASB 140,
which stipulated that if somebody else did not own at least 3
percent of the funding liabilities and equity, you had to carry
it on your own books. Of course, Enron found this requirement
very easy to obviate by lending someone else money to buy the 3
percent and then selling the rest back by Enron guarantees,
thus retaining a substantial first-loss stake in the
arrangement.
Under FIN 46, created to revise the rules that were used to
create the failed Enron structures, the 3-percent rule became
the 10-percent rule. The entities used by Enron were labeled
``Variable Interest Entities,'' and others were labeled
``Qualified Special Purpose Entities,'' or QSPEs, which were
excluded from the 10-percent rule because they were thought to
be what FASB termed ``passive securitizations.''
The key problem with us today is that the purportedly
``passive'' credit card, mortgage, home equity, auto loan, and
other QSPEs are not really passive at all. Those passive
structures routinely manipulate pool value through servicing
and direct replacement of loans in the pools under
representations and warranties, just like Enron. When there are
no reserves behind the warranties, trouble is hidden until the
product breaks down. When loan performance sours beyond the
ability of the seller to support pool performance out of
regular operating earnings, the seller has to either increase
earnings or stem losses. Since the seller's earnings primarily
arise through making new loans to generate underwriting fees,
the seller, therefore, counterintuitively accelerates
underwriting in these circumstances. Since better-qualified
borrowers will most likely obtain cheaper loans from
financially sound lenders, the seller targets down-market
consumers--subprime borrowers--for the new business. Of course,
less creditworthy borrowers mean more losses. As the firm
enters a death spiral, it attempts to modify loans using
repayment and forbearance plans, while aggressively re-aging
loans and even committing fraud to classify as much of the
portfolio as possible as ``current.''
The loan servicing rights that allow such practices are
often the final asset remaining in the failing firm and the
substantial potential for servicer malfeasance as the seller/
servicer approaches bankruptcy can deteriorate their value
significantly. Since there is so little to recover from a
failed seller/servicer, the FDIC itself has maintained that it
may disallow ``true sale'' status if it desires and seize those
purportedly ``truly sold'' assets in a securitization to
recover deposit insurance outlays.
So this true sale that is the accounting foundation of
securitization itself does not make sense. The problem is a
tragic collision of economics, finance, and accounting.
Economic risk has been placed where it is difficult to value
financially and even the most complex accounting rules do not
apply.
Any discussion of necessary accounting reforms for
securitization would be incomplete without a section on gain-
on-sale accounting. In short, in gain-on-sale accounting, the
first estimates the value of the thing that they want to sell
with a financial model. Then they sell the thing and receive
some money and other items in the actual sale of that thing.
Then the firm gets to, last, record the difference between
their own valuation of the thing that they sold and the value
of the cash and other things that they received as cash
revenue. Of course, this is not cash. So what we have here is a
situation where many of the mortgage companies and similar
firms that have been associated with previous securitization
fiascos--and there have been many--have never been cash-flow
positive in their entire corporate lives. So we have a
financial world that is littered with hundreds of firms with
exceedingly high stock values that had never actually earned
positive cash profits in a manner typical of a classic bubble.
None of the problems I review here are new, unique, or
unknown, nor is their manifestation in today's credit crisis.
Rating agencies' characterizations of past crises eerily
presage the present crisis. In 2002, Moody's wrote, and I
quote, ``The seller's capital structure, its diversity of
funding sources, types of assets, and the business factors
motivating its securitizations are all important
considerations. The examples of deals gone `bad' over history
reveal that an overreliance on securitization as a funding
source is an important risk factor. The overuse of
securitization coupled with aggressive gain-on-sale accounting
was a particularly lethal combination. . . . New or unusual
asset classes pose particular risks as well.'' From 2002.
The current crisis, therefore, was merely wrapping all
these influences into one and applying them to nearly all
collateral types in the market.
In conclusion, while FASB continues to try to pigeonhole
securitization accounting into simple on- and off-balance-sheet
classifications, the issue is far more complicated due to other
legacy accounting treatments surrounding the entire
securitization process, as well as securitizations' unsettled
legal status. And I think you talked a little bit about this
with derivative product companies. We cannot expect any
resolution to on- and off-balance-sheet treatment by continuing
to implement the dichotomous approach used so far. Nor can we
expect securitization accounting to improve significantly
without removing other perverse incentives in gain-on-sale
accounting and true sale status.
So while all this does not augur for prohibiting
securitization in the long term, it does provide a rationale
for constraining financial product development in a manner
similar to that written into H.R. 6482 that was introduced in
July on bond rating reform so that new products do not grow
systemically large before finance and accounting can properly
characterize their risks and their returns.
So much work remains to be done to adequately characterize
securitizations in a credible and transparent manner.
Nonetheless, we have had several decades to get this work done
already. The problems of both bond ratings and FASB, therefore,
seem to be that a private organization is operating in the
public interest with no overt responsibility or constraints
imposed by the Government. Perhaps it is time to expect
something better.
Thank you.
Chairman Reed. Thank you, Professor Mason.
Mr. Young.
STATEMENT OF DONALD YOUNG, MANAGING DIRECTOR, YOUNG AND COMPANY
LLC, AND FORMER FASB BOARD MEMBER
Mr. Young. Chairman Reed and Ranking Member Allard, thank
you for your interest in improving financial reporting.
Accounting standards have been a major factor in reducing
transparency for investors and have directly contributed to the
current credit crisis. I do not believe the proposed FASB
solution will stop the ``cycle of crisis'' that we have now
repeated. And I believe it would be a mistake to focus on
expanded regulation alone.
A better solution is to provide transparency in the
reporting of securitizations and increase investor involvement
in financial reporting to end this cycle of crisis.
Now, under the proposed FASB solution, which was exposed on
Monday, the self-administered test for qualified special
purpose entities in Statement 140 will be replaced by another
self-administered test in FIN 46(R).
These custom designed entities that are the subject of the
self-administered test provide little transparency to
investors, and they are not subject to the forces of the
marketplace. They are custom designed. Their business purpose
is to get favorable accounting treatment.
The proposed rules will likely force consolidation of
special purpose entities designed in the past. But the more
important question is: Will future securitization structures
enable management to inappropriately de-recognize financial
assets and gains? Unfortunately, I believe the answer is yes.
Market transparency would be better served and the
accounting simplified if the FASB had pursued a model where an
originator continues to recognize financial assets and
liabilities while there is any continuing involvement. The
determination of whether a sale has occurred is shifted from
management and auditors to investors and markets.
In early 2005, when I joined the FASB, the Board was very
aware of the problems in accounting for securitizations. It was
the subject of a joint conference with the American Accounting
Association where research was presented that indicated
investors' near complete distrust of FAS 140 accounting.
Investors generally reversed the sale accounting propagated by
the standard.
By the way, I have submitted a copy of this research with
my written testimony.
The FAS Board was working on changes to Statement 140 which
were exposed for comment in 2005, but very little progress was
made in 2006 and 2007 when the subprime securitization was
rapidly expanding. In fact, I think there were two or fewer
board meetings held over a 2-year period.
Now, for most of the period, there was an unending series
of issues related to 140-and Larry Smith talked about some of
those today--where we made little progress, and in my written
testimony, I have outlined three troublesome examples of that.
Now, there is no question that the FASB knew it had a
serious problem in the financial reporting of securitizations.
The question is: Why was it not addressed until after this
crisis was evident?
Now, when I asked the staff the reasons for the delay, I
was informed that there were concerns over the standard-setting
actions we were considering. The changes would more accurately
reflect the underlying economics, but this in turn would
undermine companies' ability to execute securitizations worth
many billions of dollars. In other words, it would be bad for
business to provide transparency to investors--at least that
could be said in the short term.
There was unending lobbying of the FASB not just by
preparers, which should be expected, who are in economic
conflict with investors, but also by their regulators--all
looking to preserve sale accounting for activities that clearly
indicate that there was no sale.
The SEC, for example, was actively involved in expanding
the originator's ability as a servicer to renegotiate loans yet
still keep sale accounting and potentially harming investors in
the securitization. I have also documented that in my written
testimony in an SEC Office of the Chief Accountant letter from
January of 2008.
Another factor noted by the FASB staff was resistance from
Federal Reserve regulators.
Now, my purpose is not to argue that company managements
need to be protected from harming themselves--because in the
end that is what happened--nor is it to criticize regulators
but, rather, to recognize the limitation of regulation.
The essential problem is that the FASB is not capable of
providing financial reporting transparency until a crisis
provides the political cover to overcome lobbying efforts that
are in conflict with serving investors and providing
transparency to the markets.
Because managements and regulators control the financial
reporting process, we will continue to be in the cycle of
crisis where we are unable to address financial reporting
problems until a major crisis unfolds. Enron all over again.
Now, you can end the cycle of crisis only by engaging the
markets and investors in the financial reporting process, which
requires a fundamental change in the composition of standard
setters and their trustees. Instead of token investor
representation or, in the case of the FASB today, no investor
representation, we need investors to be equally represented,
both on the Board and in the trustees. Then we would have a
chance of stopping the cycle of crisis.
Thank you again, Mr. Chairman, for inviting me to testify
at this hearing. I look forward to responding to your
questions.
Chairman Reed. Thank you very much, Mr. Young.
Ms. Mooney.
STATEMENT OF ELIZABETH F. MOONEY, ANALYST, CAPITAL STRATEGY
RESEARCH, THE CAPITAL GROUP COMPANIES
Ms. Mooney. Thank you, Chairman Reed and Ranking member
Allard, for the opportunity to be here to testify on a very
important issue to investors.
I am an analyst with the Capital Group Companies and
together with our affiliates we manage the American Funds
mutual fund family and public and institutional retirement
plans as well as private client accounts. We are long-term
investors in equities and fixed-income securities globally, and
we are one of the largest active institutional money managers.
We manage accounts, over 55 million accounts, primarily for
individuals and institutions and employ over 9,000 people
globally around the world. And we conduct extensive,
fundamental research on companies and rely heavily on financial
statements prepared by public companies.
At the Capital Companies, we feel that it is critical that
the views of investors are considered in establishing
accounting standards. So thank you again for the opportunity to
be here today.
There are six points I wish to emphasize today.
No. 1, that the current rules are inadequate and allow
institutions to have too much, far too much involvement and
risk exposures with entities off the balance sheet.
No. 2, while the FASB rule proposals have just come out and
I have not fully studied them, my preliminary view is that
together they represent a good response and a significant
improvement over what we have today. Reforms in this area need
to be adopted on a timely basis.
No. 3, the SEC should enforce the rules as enacted and not
weaken them or permit management or auditors to weaken them
through interpretation, as they did with the current rules. The
inadequate accounting as well as the weak enforcement of the
current rules equally contributed to the well-documented
transparency problems.
No. 4, the Congress should be supportive of FASB's efforts
and not undermine them. In the oversight capacity with respect
to the SEC, Congress should monitor and encourage enforcement
of the new rules. Congress does not need to legislate in this
area.
No. 5, the FASB rule proposals are better than the current
international standards, and we are waiting to see improvements
to IASB's draft proposal. The U.S. should not adopt the
International Financial Reporting Standards if they are not
substantially equivalent to the FASB's rules. We must be sure
this fix is not undone if IFRS rules are adopted in the U.S.
U.S. and International standard setters should converge to the
highest-quality accounting and disclosure requirements.
No. 6, investors are an important constituent without a
sufficient voice at the table in accounting standard setting,
as Mr. Young alluded to. The FASB and IASB should expand
investor representation on their boards.
So it is important that the accounting gets fixed, that
financings get reflected on the balance sheets on a timely
basis.
Thank you. That concludes my remarks, and I would be happy
to answer any questions.
Chairman Reed. Thank you very much.
Mr. Miller.
STATEMENT OF GEORGE P. MILLER, EXECUTIVE DIRECTOR, AMERICAN
SECURITIZATION FORUM
Mr. Miller. Thank you and good afternoon, Chairman Reed,
Ranking Member Allard, and Members of the Subcommittee. I very
much appreciate the opportunity to testify on behalf of the
American Securitization Forum and the securities industry and
Financial Markets Association. Our members include issuers,
investors, financial intermediaries, and other professional
organizations who are involved in the securitization and
broader financial markets.
Quality accounting standards are critically important to
the accuracy, relevance, and utility of financial reporting for
securitization transactions and to the efficient functioning of
the financial markets generally. We, therefore, strongly
support the need for high-quality accounting standards
governing the removal of assets from a transferor's balance
sheet and, similarly, robust consolidation, financial
reporting, and disclosure standards relating to off-balance-
sheet entities.
Briefly, ``securitization'' is a term that includes a wide
range of capital markets transactions that provide funding and
liquidity for an equally wide range of consumer and business
credit needs. These include securitizations of residential and
commercial mortgages, automobile loans, student loans, credit
card receivables, equipment loans and leases, trade
receivables, asset-backed commercial paper, and other financial
assets. Collectively, securitization represents by far the
largest segment of the U.S. debt capital markets, with over $10
trillion of mortgage- and asset-backed securities currently
outstanding.
Many, but not all, securitizations qualify for off-balance-
sheet accounting treatment under current accounting guidance.
By and large, these transaction structures are long established
and are accompanied by extensive risk and accounting
disclosures. We agree that a comprehensive review of de-
recognition and consolidation of accounting standards is in
order. However, we are very concerned that FASB's current
proposals to amend FAS 140 and FIN 46(R) in the near term
without sufficient consideration of other and possibly superior
accounting frameworks may have serious and unintended
consequences. Especially in light of the challenges facing our
financial markets, we believe that a more thorough and
deliberative process in developing these changes is essential
and will produce better accounting policy, financial market and
economic outcomes in both the short and long term.
In particular, to the extent that FASB's current proposals
may result in widespread consolidation of existing and future
securitization special purpose entities, the balance sheets of
affected entities would swell, impairing financial ratios and
disrupting financial covenant performance and regulatory
capital tests. Importantly, these results would be produced not
by any change in the economics of securitization transactions,
but solely by a change in accounting standards.
Although we cannot presently estimate which or how many
securitization transactions would be affected by the proposed
changes, consolidation of even a significant fraction of the
multi-trillion-dollar securitization market would represent a
momentous shift. The consequence of this change could be a
material reduction in the availability and increase in the cost
of consumer and business credit, precisely at a time when the
availability of capital, credit, and liquidity are severely
constrained throughout the financial markets.
We encourage FASB and the policymaking community to work
together with the industry to develop a coherent, consistent,
and operational securitization accounting framework that better
reflects the economics of securitization transactions. We
believe that a binary, ``all-or-nothing'' approach to
consolidation--where an entity consolidates either all or none
of the assets and liabilities that reside in a securitization
special purpose entity--often does not reflect the underlying
economics of those transactions. Overconsolidation of SPEs can
be just as misleading to users of financial statements as
underconsolidation. For these reasons, we believe that a
different and more nuanced approach should be considered.
For several years, therefore, we have advocated linked
presentation as a concept that has great potential to resolve
many of the issues and ambiguities that surround securitization
accounting. Under a linked presentation approach, the non-
recourse liabilities that are issued in a securitization
transaction would be shown directly on the balance sheet as a
deduction from securitized assets. We strongly advocate that
FASB engage in a full exploration of linked presentation, among
other possible alternatives, as part of the current round of
accounting revisions.
Finally, we believe that proceeding with significant
accounting changes in the United States without meaningful
convergence of international accounting standards in this area
risks prolonged drain on the time and resources of FASB and
industry participants alike. We believe that FASB should
coordinate now with the IASB to develop and issue converged
standards rather than proceeding with a separate initiative.
Thank you once again for the opportunity to present these
views, and I look forward to answering any questions that
Members of the Subcommittee may have. Thank you.
Chairman Reed. Thank you. Thank you very much, ladies and
gentlemen.
Let me just start with Mr. Miller. What further studies
might be done to estimate the impact--your testimony suggests
that there will be an impact; I think we all recognize that.
But what studies should be done, or is it possible to quantify
that impact?
Mr. Miller. Well, I think that is underway right now. I
think the most important predicate to being able to do that is
the issuance of guidance and to be able to evaluate that and
develop a clear understanding of how FASB's proposals would
apply in practice to existing and future securitizations. So
that is underway.
Chairman Reed. As I understand from Mr. Smith, the first
significant implication of the changes would be disclosing
these off-balance-sheet engagements, but not necessarily
bringing them back onto the balance sheet. That sounds a little
bit like the linked presentation you talked about. Is that sort
of a fair or rough analogy?
Mr. Miller. Well, the linked presentation, as we have
proposed it, actually would be an alternative accounting
framework. The disclosures that other witnesses today have
spoken about, I think it is important to recognize there are
already disclosures in place relative to off-balance-sheet
entities. FASB has proposed enhancements to those disclosures,
and we certainly support enhanced disclosures as a step to aid
and increase overall transparency regarding relationships with
off-balance-sheet entities. Beyond that, what linked
presentation would be is to serve as a potential alternative to
the accounting framework that FASB is proposing.
Chairman Reed. Professor Mason and Mr. Young, your comments
on sort of a linked presentation as an alternative to what FASB
is proposing now or what you would think would be appropriate.
Mr. Mason. I think a concept similar to a linked
presentation makes sense for at least part of a new accounting
paradigm in this area, particularly because there was
discussion earlier today about financial models reporting
things like mean loss estimate. And, of course, the first thing
you learn in statistics is you do not just rely upon the mean
but you examine the median, the mode, then you learn about
standard deviation.
So the linked presentation gives an idea of really how bad
things can get, and if the bottom really fell out of the world,
here is your total off-balance-sheet exposure that could be, as
we have seen in recent cases, forced to be bought back through
legal threats or other means. But this is your total exposure,
a worst-case scenario, and leave it to the investor to
participate in the process of valuation by deciding what is the
probability of that worst-case scenario.
Chairman Reed. Mr. Young, do you have any comments about
that approach?
Mr. Young. I actually strongly support it. I think that, in
conjunction with the no continuing involvement, displays the
information on the statement. You can use linked presentation
as a de-recognition model. You can use it as a consolidation
model. You can use it as a note structure. But I think as a
basic way of implementing any continuing involvement in
securitization, it is the most rational way that I have seen so
far.
Chairman Reed. Let me ask a question which will reveal, I
think, my lack of accounting training. The disclosure is
important to investors, but when you bring these assets on the
balance sheet, it has a significant impact particularly for
regulated financial institutions, the capital ratios that they
must maintain. Is it possible that the disclosure, good
disclosure would not be adequate because it would not be able
to force the entity to raise sufficient capital? Is that a
concern?
Mr. Young. Well, I think what we found, what I found is the
compliance with disclosure is far below the compliance with
statements, particularly to go after, Chairman Reed, what you
said about capital requirements. One of the nice things about
linked presentation is that you show sort of a net exposure
which does not offset your--it does not make your total assets
look large. It nets it down for the beneficial interest or
other liabilities that stand against that asset. So, in a way,
one of the attractions to linked presentation, at least in the
preliminary work I saw in the FASB Board, was it would not
screw up the capital markets.
Now, I did not talk about measurement might be different
and other things might be different, but the basic netting
approach would preserve, I think, some of the regulatory
capital issues.
Chairman Reed. Ms. Mooney, do you have a comment? I want to
make sure that you have an opportunity on this issue.
Ms. Mooney. Well, I think the information on the balance
sheet, it is about conveying information about judgments that
are made by management and agreed to by auditors conveying that
to investors; what happens with regulatory capital is between
the banks and the regulators. But we are talking right now
about reporting the information to investors, and we read a lot
into the decisions about whether an asset or liability goes on
the balance sheet or off the balance sheet. And we start with
that when we are doing our financial analysis, we start with
the balance sheet. So it is really critical to get that right
and that financings are reflected on the balance sheet.
Chairman Reed. Professor Mason, do you have a quick
comment?
Mr. Mason. Yes, I just wanted to weigh in on this. My own
research published in academic journals has shown that heavy
securitizers have, at least in the past, typically held a
little bit of extra capital on-balance sheet against the market
risk that is out there, typically about 2 percent as compared
to an 8-percent bank capital ratio.
Furthermore, the bank regulators under Basel II are
beginning to deal with some of these problems. The Basel II
rules for credit card securitization, in fact, require a bank
to start holding capital against their credit card
securitizations as the performance of the loans in those pools
begins to sour, recognizing that in kind of an end game, the
bank will probably need some capital here to back some of that
off-balance-sheet risk.
Chairman Reed. Thank you.
Both Mr. Young and Ms. Mooney indicated that part of the
problem was not the rule, it was the enforcement interpretation
suggesting that the SEC, in your case I think it gave
permission to begin renegotiating contracts. Can you comment
about what specifically happened with respect to the SEC
interaction with the FASB rules?
Mr. Young. Well, I think it can change based on who is
serving in those positions.
Chairman Reed. Right.
Mr. Young. I can only comment on the time I was on the FASB
where I think a number of efforts--and I tried to document them
in my written testimony. Part of the activity of what is
allowed in this passive QSP entity that we have been talking
about was put forward by the Office of the Chief Accountant.
And I also include in my submitted written testimony some
research done by the Federal Reserve of New York which talked
about the steep economic conflict between the servicer, which
was getting the ability to do more activities than 140 would
normally allow and the investor, what conflict they were. And
it was, Chairman Reed, a little crazy that here we are
empowering the preparer or the servicer to take advantage of
the investor. It is supposed to go the other way at the SEC.
Chairman Reed. Ms. Mooney, do you have a comment?
Ms. Mooney. No.
Chairman Reed. Because I think you made another comment
with respect to SEC involvement. OK. Thank you.
I will recognize my colleague, the Ranking Member, for his
questions.
Senator Allard. Thank you, Mr. Chairman.
I inquired somewhat about the timeline in implementing
these rules and regulations, and I think it was your letter,
Mr. Miller, that maybe prompted that in that you suggested that
for a longer timeline and give the public an opportunity to
speak. Do you have a timeline in mind that would be adequate
from your point of view?
Mr. Miller. Well, to clarify, we see the fundamental issue
as being providing enough time to consider a range of potential
alternatives to what has been proposed, including linked
presentation. Perhaps there are other alternatives. We are not
taking issue necessarily with the length of the comment period.
I think 60 days is probably sufficient to comment on the rules
as proposed, although I would note the effective comment period
is 45 days because FASB has scheduled a public roundtable
meeting earlier than the close of the comment process and would
require anyone like ourselves who would wish to participate to
have our comment letter in early.
But leaving that aside, I think our fundamental concern is
that there be enough time provided to consider other frameworks
and have a thorough deliberation of them before making
decisions about changes to accounting standards, and for that
reason, we think the time should be taken between now--and we
would agree with a 2010 implementation date as long as there is
sufficient time allowed to thoroughly consider other potential
alternatives.
Senator Allard. So you do not think that all of the
alternatives have been checked out thoroughly enough? Do I
understand that right?
Mr. Miller. That is correct, and in particular relative to
linked presentation, I believe FASB had indicated that they
simply did not feel that they had enough time to give that
thorough or serious consideration, and we strongly believe that
they should, again, among other potential alternatives.
Senator Allard. I see. This question here is for all of the
witnesses, and I hope I am not duplicating any questions that
the Chairman may have asked while I was not here. I apologize
for my absence.
I like the idea of transparency, and I support it. I think
it is key, if we want markets to work, to have informed
consumers, and then they can make decisions themselves, not get
too heavy on the regulatory side.
These proposals could result in very significant changes to
companies' balance sheets in a relatively short period of time.
Do you think that these sudden changes could in some way thwart
the goal of transparency? Anybody want to comment on that?
Ms. Mooney. Having the transparency should help stabilize
the situation. Providing investors with transparency should
improve liquidity and help stabilize the market.
Senator Allard. OK. So you do not think it any way or
another we have kind of forced this to come about so quickly
that transparency in some way would be maybe limited more than
we would expect it to?
Ms. Mooney. Investors can use it and move on. Once they
know what the facts are, they can digest it and move on.
Senator Allard. OK. Mr. Miller?
Mr. Miller. Yes, I think our concern in that respect, as I
indicated in my oral statement, would be that to the degree
that adoption of these rules results in overconsolidation of
special purpose entities, we do not see that as being
particularly helpful. And I would just also comment I think it
is important to have sound accounting rules and principles.
There are many other steps that the industry can and should
undertake to promote broader and better transparency about risk
exposures in these vehicles, whether they are on or off balance
sheet.
Senator Allard. I see where you are concerned, not so much
the time to implement it, but this consolidation. OK.
In making the switch to accommodate these new off-balance-
sheet entities rules issued by the Financial Accounting
Standards Board, many financial institutions would have to
raise additional capital and significantly adjust their
accounting practices. What will be the full practical impact of
these changes in today's world and the stress that everything
is going through right now? And, in particular, how will these
significant changes affect an already fragile and volatile
market situation? Anybody want to comment on that?
Mr. Mason. I want to say in reply to this and your previous
question, I think rapid implementation of good accounting rules
is not only desirable right now, but crucial right now. I think
a rapid implementation of bad rules can indeed be tremendously
disruptive. But, in fact, implementing a rule right now that
would require the entire recognition of a securitized
arrangement on-balance sheet enforce full capital raising
against that, I think you are right, is tremendously disruptive
right now, and it is not necessarily a good rule.
While there is not complete risk transfer in today's
securitization arrangements, there is some, as evidenced by the
study I did that showed that certainly banks do hold some
capital against their securitizations, even though they are not
required to by regulators or under accounting rules. But,
clearly, the market believes that there is a worthwhile goal of
holding some capital.
So I think if we are looking for a kind of recognition
paradigm, an accounting paradigm, it is important, as Mr.
Miller noted, to look outside the box a bit to get away from
this on- or off-balance-sheet paradigm and see where the
reality really is. If investors are asking banks to hold not 8-
percent but 2-percent capital, why shouldn't a bank regulator
require that 2-percent capital holding, which, in fact, the
bank probably already has if it is a well-managed bank. So that
well-managed banks are not disrupted by the transition, and, of
course, ill-managed banks are. But then, again, they should be,
to help them recognize their true financial situation, help
investors see the situation, invest in the good banks, avoid
the bad banks, and get over the crisis.
Senator Allard. Yes?
Mr. Young. I guess, Senator Allard, I would look at that
question a little bit differently in light of recent events. We
just had an investment bank go bankrupt with a fair-value
balance sheet that showed it had plenty of assets and
liabilities. And it almost seems like financial reporting is
out of control and not trusted and not believed in. And I think
what we do here has got to establish transparency.
If the transparency is such that we are going to bring out
some bad news that was not there before, that is a risk. But I
think the benefit of reestablishing confidence in the markets
will overwhelm that. And I think, you know, for us to say let's
go slow or not proceed when we have lost all confidence in
financial reporting in some cases now I think is a very
difficult tradeoff to make. I would think we would be--we do
not have a whole lot to lose right given the low level of
confidence.
Senator Allard. Any other comment on that question? Yes?
Ms. Mooney. I would just say that, you know, working on
this issue has been in the works for research and study by
standard setters for decades. So it is about time that we get
it right, we get financings on the balance sheet, transparent
reported, so we can get trust and confidence back in the
markets. And we should be able to do this on a timely basis
after all the work that has been put in.
Senator Allard. Yes, Mr. Miller?
Mr. Miller. I would agree that it is very important to move
forward quickly to develop and implementation sound accounting
principles here. I believe there are great risks to the
financial markets and to the economy of moving forward quickly
with bad rules and specifically especially given capital
liquidity credit constraints that are now being faced. It is
not clear that there is sufficient capacity if many assets are
moved back on-balance sheet for financial institutions to be
able to provide funding for the business and credit--consumer
and business credit needs that exist. So I think those risks
are very serious.
Senator Allard. Ms. Mooney?
Ms. Mooney. As I mentioned earlier, in terms of capital,
which you alluded to, regulatory capital decisions, if the Fed
would feel it prudent to--for prudential regulations to
exercise some forbearance on the capital and require more or
less capital to be raised despite the accounting, it should be
done.
Senator Allard. Mr. Chairman, I have one more questions.
Can I ask it?
Chairman Reed. Please.
Senator Allard. In your testimony--and this is to you, Ms.
Mooney--you testified that--or at least in your written
testimony, you raised concerns about the possibility of IFRS
standards being weaker than U.S. standards. How do you see
these issues resolved in the context of convergence?
Ms. Mooney. I do not think we should be adopting IFRS if it
is not substantially equivalent to what the U.S. FASB comes up
with as a fix. Right now the international standard has as a
lighter qualitative test that even with reputation risk that
could lead to, you know, obligations to absorb losses that
could potentially be significant, to not have to consolidate
that, and also have significant voting rights to appoint
directors. It would not be appropriate to go backwards and
adopt that. So we should not unless we----
Senator Allard. So you would be opposed to the IFRS
standards being applied at all?
Ms. Mooney. In this area, absolutely. If we fix it--if we
fix it in the U.S. and come up with a higher-quality standard,
convergence should not only occur unless we have the highest-
quality accounting and disclosure adopted in the U.S.
Senator Allard. OK. Thank you.
Thank you, Mr. Chairman.
Chairman Reed. Well, thank you, Senator Allard. In fact,
you asked precisely one of the questions I was going to ask to
Ms. Mooney about this convergence issue of international
standards and our FASB standards.
The topic that I want to raise--and this is the end of the
hearing, so it might require educating me, which would take
years. So it is perfectly OK to say, you know, we will send you
a note or something.
It seems at the heart of this, Professor Mason and Mr.
Young, you know, stepping away from specific items of
disclosure or bringing back on the balance sheet, is this
notion of whether it is a sale or financing. Does that have to
be reconciled, or are we sort of suboptimizing by saying, well,
we got into the sale box years ago, and now we just have to
sort of do what we can to get as much information on the
balance sheet, in some cases bring the entity back on the
balance sheet? But if you can just briefly comment, Professor
Mason and Mr. Young, and if Ms. Mooney or Mr. Miller want to
also, on this whole issue of the sale versus financing.
Mr. Mason. Well, you are right, that is a big issue in the
accounting world. I have a working paper right now that looks
at investor reactions to securitization and suggests that they
react to a securitization as if it is a financing not a sale.
But in a way the distinction is artificial. Perhaps
securitization is something different. It is something in
between. And, in fact, we should offer firms an array of
different arrangements, perhaps spanning the middle ground
between financings and sales. And as long as we properly
account for the risk transfer, I think that we have made the
system more efficient.
Now, the rub there is that accounting deals with accounting
for returns. There is no accounting system for risk. And in
this world where we have financial engineers shifting risk and
moving risk and slicing and dicing risk, it becomes critical to
at least attempt to track the risk, allocate it correctly,
follow what the engineers are doing, and build smart accounting
rules that can at least get close. And the problem is right now
we are nowhere near close, and that is evidenced by the cliff
risk that we see in the market today. We see firms that we
thought there was no problem with suddenly fail. So, clearly,
the accounting has missed something, and that is what we need
to fix.
Chairman Reed. Mr. Young, your comments?
Mr. Young. Chairman Reed, I think that is a pivotal issue.
The determination of the sale has become too complex for
accounting. And when you look at the way securitizations can be
structured, how you can slice and dice them and spread the
risk, it is hard for FASB to come up with a way to do that. And
that is why the statement prior to 140 has had problems, why
140 had a problem, why we had two exposure drafts that went
nowhere in 2003 and 2005. And I just think it is time to step
back and say let's not make a judgment on whether they are sale
or not by the accountants and the management. Let's put that
information in the financial statements in a way that is not
detrimental to understanding and transparency, and let the
investor and the market decide. That is really the gist of the
question.
I think, you know, to FASB's credit, in some ways they did
that in the disclosure requirements. In fact, if you are a
sponsor, under FIN 46(R) that they are proposing, you have to
disclose any exposure to a VIE where you are the sponsor,
regardless of how significant it is. I am just saying, instead
of it being on the disclosure, we ought to think more about
putting that on the financial statements.
Chairman Reed. Ms. Mooney.
Ms. Mooney. I think the qualitative test is principles
based, and as you alluded to earlier, that it would be
unfortunate if companies defaulted to what we have today, which
is broken, and I would hope that that would be seriously
revisited if that is the behavioral fact pattern that results.
But I do think, based on the examples provided and the
implementation guidance in the proposal, that it would be a
good step forward, especially and only if management, auditors,
and regulators complied with and enforced the rules.
Chairman Reed. Mr. Miller, any comments?
Mr. Miller. No.
Chairman Reed. Thank you very much. Thank you very much for
your testimony, and my colleagues might have their own
statements, which will be made part of the record if they are
submitted no later than September 25th. We might have
additional questions for the record which we would get to you
and ask you to respond within 2 weeks in writing back to us.
Thank you very much for your very helpful testimony, and
the hearing is adjourned.
[Whereupon, at 4:20 p.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]