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