[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




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            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:]
    
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