Loan Commitments: Issues Related to Pricing, Trading, and	 
Accounting (14-FEB-05, GAO-05-131).				 
                                                                 
Federal banking regulators reported that commercial banks held	 
about $1.6 trillion in syndicated loans in 2003. Loan		 
commitments--a promise to make a set amount of credit available  
in the future--represented $1 trillion (about 64 percent) of	 
these loans. Issues have been raised whether commercial banks	 
systematically underprice loan commitments and whether generally 
accepted accounting principles provide meaningful disclosure of  
the economics of these commitments. This report discusses (1)	 
differences between the pricing of loan commitments and loans,	 
and assesses data that are available about the trading of loan	 
commitments; (2) the extent to which credit default swaps are	 
used to reduce the credit risk from loan commitments, and what	 
credit default swap prices indicate about the prices of loan	 
commitments; and (3) differences between commercial and 	 
investment banks' accounting treatment of loan commitments, and  
the strengths and weaknesses of fair value accounting.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-131 					        
    ACCNO:   A17596						        
  TITLE:     Loan Commitments: Issues Related to Pricing, Trading, and
Accounting							 
     DATE:   02/14/2005 
  SUBJECT:   Accounting standards				 
	     Bank loans 					 
	     Banking regulation 				 
	     Comparative analysis				 
	     Data collection					 
	     Fair market value					 
	     Financial management				 
	     Prices and pricing 				 
	     Risk management					 
	     Loan commitments					 
	     Shared National Credit Program			 

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GAO-05-131

                 United States Government Accountability Office

                         GAO Report to Agency Officials

February 2005

LOAN COMMITMENTS

               Issues Related to Pricing, Trading, and Accounting

                                       a

GAO-05-131

[IMG]

February 2005

LOAN COMMITMENTS

Issues Related to Pricing, Trading, and Accounting

  What GAO Found

Loan commitments and loans have different characteristics, making it
difficult to directly compare the prices of these instruments. First, a
loan commitment gives a company the option to borrow a certain amount in
the future, while a loan actually provides funds to the borrower. Second,
lenders typically charge fees for making credit contingently available
through a loan commitment but charge interest on a loan. Third, loan
commitments are typically unsecured-that is, borrowers do not have to
pledge collateral-while loans are typically secured. Most of those we
interviewed told us that loan commitments are rarely traded in the
secondary market because selling them could jeopardize relationships with
borrowers and because institutional investors were reluctant to purchase
them. Some investment bankers expressed concerns that loan commitments
were systematically underpriced, but the available information did not
support such assertions.

Commercial bankers told us that they used credit default swaps-contracts
that can transfer the credit risk of a loan or loan commitment to another
party-to reduce credit risk on small amounts of their loan commitment
portfolios. Some investment bankers contended that credit default swaps
and loan commitments were similar instruments and that credit default swap
prices could provide information about the appropriateness of prices for
loan commitments. We found that it was not possible to use credit default
swap prices to determine the appropriateness of prices for loan
commitments. Specifically, they differed in triggering events, payment
schedule, trading, and financial covenants.

Under current accounting standards, designed to reflect their respective
business models, commercial and investment banks account for loan
commitments differently, causing a temporary difference in the recognition
of fee income. Further, revenue from fee income appeared to be relatively
small compared with revenue from other bank activity and the difference
would be resolved by the end of the commitment period. As a result, we did
not find any evidence that following a different accounting model offered
the commercial banks a consistent competitive advantage over investment
banks. Further, commercial and investment banks have similar fair value
financial statement disclosure requirements and, as a result, provide
similar information about the fair value of their financial instruments.
It appears that the economic substance of loan commitments is recognized
in the financial statements and related footnotes in a clear, measurable,
and evident fashion under both the historic cost and fair value approach.
While some have indicated that fair value accounting might disclose more
relevant information than the historical cost model, all the conceptual
and implementation issues have not been resolved. Until these issues are
resolved, commercial and investment banks will continue to follow
different accounting models for loan commitments.

United States Government Accountability Office

Contents

  Letter

Background
Results in Brief
Differences in Purpose, Price Structure, and Collateral

Requirements Make Direct Comparisons between Prices of Loan Commitments
and Loans Difficult

Loan Commitments Are Rarely Traded, and Available Data from Secondary
Market Does Not Support Claims of Systematic Underpricing

Although Commercial Banks Use Credit Default Swaps to Reduce the Credit
Risk of Their Loan Commitment and Loan Portfolios, Prices of These
Instruments Cannot Be Compared Directly

Commercial and Investment Banks Follow Different Accounting Models, but
There Is No Evidence That Either Model Provides a Consistent Competitive
Advantage

Fair Value AccountingMay Have Certain Advantages, but Significant

Implementation Issues Must Still Be Resolved Conclusions Agency Comments

                                                                       1 3 10

13

17

19

23

28 32 33

Appendixes

Appendix I: Objectives, Scope, and Methodology 35

Appendix II:	Differences in Accounting between Commercial and Investment
Banks for Loan Commitments 37

Appendix III:	GAO Contacts and Staff Acknowledgments 47 GAO Contacts 47
Acknowledgments 47

Tables Table 1:

Table 2:

Table 3:

Table 4:

Table 5: Table 6:

Average Fees for Investment-Grade and Leveraged Loan
Commitments, 1999-2003 15
Average Annual Charge Over Benchmark Rate for
Investment-Grade and Leveraged Loans 16
Average Fees for Investment-Grade Loan Commitments-
364-day facilities and Revolvers 1 year or More 16
Characteristics of Credit Default Swaps and Loan
Commitments 22
Accounting Differences for a Loan Commitment 43
Accounting Differences for a Loan Sale 46

Contents

Figures Figure 1: Figure 2:   Syndicated Loans, 1990-2003 Example of     4 
                                Hypothetical $350 Million Syndicated Loan  
                                       Package to ABC Corporation           6 
                     Figure 3:  Level of Funding for Investment-Grade and  
                                                Leveraged                  
                                       Loans and Commitments, 2003          7 
                     Figure 4:    Commercial and Investment Bank Use of    
                                             Credit Default                
                                                  Swap                      8 
                                   U.S. Secondary Loan Market Volume,      18 
                     Figure 5:                  1991-2003                  

Abbreviations

AICPA American Institute of Certified Public Accountants
FASB Financial Accounting Standards Board
FDIC Federal Deposit Insurance Corporation
ISDA International Swaps and Derivatives Association
LIBOR London Inter Bank Offered Rate
OCC Office of the Comptroller of the Currency
SEC Securities and Exchange Commission
S&P Standard and Poor's
SFAS Statement of Financial Accounting Standards
SNC Shared National Credit

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
separately.

A

United States Government Accountability Office Washington, D.C. 20548

February 14, 2005

The Honorable Alan Greenspan
Chairman
Board of Governors of the Federal Reserve

The Honorable Donald E. Powell
Chairman
Federal Deposit Insurance Corporation

The Honorable Julie L. Williams
Acting Comptroller of the Currency

The Honorable William H. Donaldson
Chairman
Securities and Exchange Commission

In 2003, federal bank regulators reported that commercial banks held about
$1.6 trillion in syndicated loans-those provided to corporate borrowers by
a group of lenders rather than a single lender.1 These loans are an
important
source of credit for large and mid-sized corporations in the United
States.
Syndicated loans include both loan commitments (a promise to make a set
amount of credit available in the future under certain terms and
conditions)
and funded loans. For 2003, loan commitments represented $1 trillion
(about 64 percent) of the syndicated loans reported by federal banking
regulators.

Issues have been raised about whether commercial banks systematically
underprice loan commitments and whether generally accepted accounting
principles facilitate the meaningful disclosure of the economic
implications
of these commitments. In our October 2003 report on bank tying, we
reported that based on our review of specific transactions, information
about underpricing was ambiguous and subject to different

1Syndicated loan amounts as reported by the Shared National Credit
Program. The Board of Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, and the Office of the Comptroller of the
Currency established the Shared National Credit Program in 1977, and in
2001 the Office of Thrift Supervision became an assisting agency. The
annual program, which seeks to provide an efficient and consistent review
and classification of large syndicated loans, generally covers loans or
loan commitments of at least $20 million that are shared by three or more
commercial banks.

interpretations.2 In addition, we reported that commercial and investment
banks adhere to different accounting rules, causing a temporary difference
in the recognition of the service fees from loan commitments. We further
reported that the volatility of the fair value of loan commitments was
more transparent on investment banks' financial statements. However, we
did not find any evidence that the accounting rules offered commercial
banks a consistent competitive advantage over the investment banks.
Further, we found that the revenue from loan commitments was relatively
small compared with revenue from other bank operations and the difference
in service fee recognition was temporary. Because of the significant
amount of outstanding loan commitments and concerns about the accounting
treatment for such commitments, we conducted a more in-depth review of the
prices of and accounting for loan commitments.

We discuss the following in this report: (1) the differences between the
price of loan commitments and loans; (2) data that are publicly available
about the trading of loan commitments; (3) the extent to which credit
default swaps are used to reduce the risks associated with loan
commitments, the similarities and differences between credit default swaps
and loan commitments, and what, if anything, the prices of credit default
swaps indicate about the prices of loan commitments;3 (4) the differences
between a commercial and investment bank's accounting for loan commitments
and whether there is evidence that these differences in accounting
treatment provide either type of bank with a consistent competitive
advantage; and (5) the strengths and weaknesses of fair value accounting
and the projects that the Financial Accounting Standards Board (FASB),
which sets the private sector accounting and reporting standards, has
underway that may change the way commercial and investment banks account
for loan commitments.

2GAO, Bank Tying: Additional Steps Needed to Ensure Effective Enforcement
of Tying Prohibitions, GAO-04-3 (Washington, D.C.: Oct. 10, 2003).

3Credit default swaps are financial contracts that allow the transfer of
credit risk from one market participant to another, potentially
facilitating greater efficiency in the pricing and distribution of credit
risk among financial market participants.

During our review, we obtained the perspectives of officials from six
large commercial banks that arranged about 67 percent of total U.S.
syndicated loan volume in 2003.4 To obtain the views of other loan market
participants, we also met with officials from two large investment banks
that are active in the syndicated loan market. To determine the
differences between the price of loan commitments and loans, we analyzed
data compiled by a loan pricing data firm, and we interviewed commercial
and investment bankers, federal bank regulators, and officials from credit
rating agencies. To determine what data were publicly available about the
trading of loan commitments, we reviewed secondary loan market trading
data compiled by a loan pricing data firm and other financial literature
related to secondary loan market trading. To determine the extent to which
credit default swaps were used to reduce the risk exposure of loan
commitments, the similarities and differences between credit default swaps
and loan commitments, and what, if anything, the prices of credit default
swaps indicate about the prices of loan commitments, we reviewed data on
credit default swaps compiled by federal banking regulators and a global
derivatives trade association, and we interviewed commercial and
investment bankers, officials from a loan market data collection firm, and
other industry observers. To determine whether the differences between a
commercial and investment bank's accounting for loan commitments provide
either firm with a consistent competitive advantage, the strengths and
weaknesses of fair value accounting, and the projects that FASB has
underway that might change the way commercial and investment banks account
for loan commitments, we reviewed our previous comparative analysis of
applicable accounting standards and updated our understanding through
interviews with officials from FASB as well as reviewing a recently issued
accounting exposure draft. We assessed all data for reliability and found
them to be sufficiently reliable for the purposes of our reporting
objectives.

Background	Since the mid-1990s, large and mid-sized U.S. corporations have
increasingly used syndicated loans as a source of credit. Federal banking
regulators collect data on large loan commitments and loans shared by
three or more commercial banks as part of the Shared National Credit

4Based on Loan Pricing Corporation 2003 U.S. Syndicated Loan League Table.

(SNC) Program.5 SNC program data show that outstanding loan commitments
held by commercial banks increased from $448 billion in 1990 to more than
$1 trillion in 2003 (see fig. 1).

Figure 1: Syndicated Loans, 1990-2003

Dollars in billions

2,500

2,000

1,500

1,000

500

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Total syndicated loans

Loan commitments

Source: Shared National Credit Program.

Most loan commitments and loans to large and mid-sized corporations are
made as part of a syndicated loan package. A syndicated loan can include
several components, including a revolving credit line, a 364-day back-up
facility, and a term loan. A revolving credit line or revolver-the
equivalent of a corporate credit card-allows borrowers to draw down,
repay, and reborrow specified amounts on demand. A 364-day facility is a
specific type of revolving credit line that has a maturity of less than 1
year and is commonly used as a backup line by corporations that issue
commercial

5The SNC Program covers any loan or loan commitment of at least $20
million that is shared by three or more supervised institutions.

paper.6 A term loan is a loan that borrowers repay in a scheduled series
of repayments or a lump-sum payment at maturity.

Syndicated loans are arranged by a commercial or investment bank, which is
referred to as the "lead bank." Large commercial and investment banks
compete to lead syndications and offer a potential borrower a syndicated
loan package that specifies various fees for loan commitments and terms
for loans. For large syndicated loans, there may be one or more lead
banks. The lead bank finds potential lenders and arranges the terms of the
loan on behalf of the lending group, which can include commercial or
investment banks and institutional investors, such as mutual and hedge
funds and insurance companies. However, each participating lender has a
separate credit agreement with the borrower for the lender's portion of
the syndicated loan. In 2003, 3 large commercial banks arranged 59 percent
of U.S. syndicated loans, and 10 large commercial banks arranged 84
percent of syndicated loans.7

Borrowers pay members of the lending group various fees associated with
syndicated loans. For example, borrowers pay the lead bank(s) fees to
arrange and administer the syndication. They also pay an up-front fee to
all participants in the syndicate upon the closing of a loan. Other fees
that borrowers pay the lenders include:

o 	a commitment fee, which is paid to lenders on undrawn amounts under a
revolving credit or a term loan prior to usage;

o 	a facility fee, which is paid against the entire amount of a revolving
credit regardless of usage and is often charged instead of a commitment
fee; and

o 	a usage fee, which is paid when the utilization of a revolving credit
falls below a certain minimum.

Borrowers also make interest and principal payments to the lenders for
amounts that are drawn under loan commitments and loans. Figure 2
illustrates an example of a hypothetical syndicated loan package.

6Commercial paper is an unsecured obligation issued by a corporation or
bank to finance its short-term credit needs, such as accounts receivable
and inventory. Companies that are able to issue commercial paper are those
with high credit ratings.

7Based on Loan Pricing Corporation 2003 U.S. Syndicated Loan League Table.

 Figure 2: Example of Hypothetical $350 Million Syndicated Loan Package to ABC
                                  Corporation

                   Loan fees; principal and interest payments

Commercial bank B

Investment bank C

Investment bank D

Corporation

Loan package:

o  $100 million revolving credit line

o  $250 million term loan

                    Sources: GAO and Art Explosion (images).

The U.S. syndicated loan market can be divided into two segments,
investment grade and leveraged. The investment-grade segment is confined
to the most creditworthy borrowers.8 In 2003, most syndicated loans to
investment-grade borrowers were loan commitments that generally remained
unfunded (see fig. 3). The leveraged segment is composed mainly of lesser
quality borrowers, defined either by their credit rating or the higher
interest rate charged on their loans. Figure 3 also shows that syndicated
loans to leveraged borrowers were almost exclusively funded loans or
partially or fully funded loan commitments.

8Standard and Poor's (S&P), FitchRatings, and Moody's are credit rating
firms that rate companies according to their creditworthiness. For S&P and
FitchRatings, ratings range from AAA (prime, maximum safety) to D
(default), with ratings above BB+ considered investment grade. For
Moody's, the corresponding ratings range from Aaa to C, with ratings above
Ba1 considered investment grade.

Figure 3: Level of Funding for Investment-Grade and Leveraged Loans and
Commitments, 2003

Investment grade loans (dollars in billions)

Leveraged loans (dollars in billions)

Other $19.5

                                       1%

                                   Other $3.3

Funded loans

                                      24.2

Partially or fully funded loan commitmentsGenerally unfunded loan
commitments

                                     165.9

                                  166.0 486.4

Funded loans

                          Total: $530.1 Total: $335.2

             Source: GAO analysis of Loan Pricing Corporation data.

Note: Other includes standby letters of credit, synthetic leases, and
other leases.

After a syndicated loan is closed and allocated among participating
lenders, these lenders can adjust their loan portfolios by trading these
instruments in the secondary loan market. This trading generally occurs
through dealer desks established by large commercial and investment banks.
Commercial banks and other financial institutions have increasingly used
the secondary market to trade loans. In 2003, the volume of secondary loan
market trading totaled $144.57 billion.9

Loan commitments and loans expose lenders to credit risk-the possibility
of loss due to a borrower's default or inability to meet contractual
payment terms. Commercial and investment banks can use credit default
swaps- essentially insurance against borrower default or other credit
event-to

9Loan Pricing Corporation.

transfer to another party (the guarantor) the credit risk from a loan
commitment or loan, without actually selling the asset. When a commercial
or investment bank purchases a credit default swap, they agree to make
periodic payments to a guarantor who is contractually obligated to pay the
bank in the event of a specified credit event, such as loan repayment
delinquency, default, or credit-rating downgrade (see fig. 4). According
to the International Swaps and Derivatives Association (ISDA), global
credit default swap contract amounts totaled $3.78 trillion in December
2003.10 However, only a small portion of this amount was used for reducing
the credit risk associated with loan commitments.

Figure 4: Commercial and Investment Bank Use of Credit Default Swap

Source: GAO.

Under current accounting standards, designed to reflect their respective
business models, commercial and investment banks account for loan
commitments differently. Commercial banks use a mixed attribute model to
account for their various products and services. As a result, some
financial assets and liabilities, including loan commitments, are measured
at the historical transaction price (cost), some at the lower of cost or
market value, and some at fair value. The historic transaction price
(cost) of a loan commitment is the value of the loan commitment service
fees at the time a firm extends the commitment. In contrast, investment
banks generally follow a fair value accounting model in which they report

10The $3.78 trillion of credit default swap contracts reported by ISDA
represents the notional principal-the amount that is used to calculate
payments in a swaps transaction rather than the actual value of the swaps
transaction. A credit default swap is the most commonly used type of
credit derivative, an arrangement that allows one party-the protection
buyer-to transfer credit risk to one or more parties-the protection
sellers. Other credit derivatives include total return swaps and
credit-linked notes.

inventory, which may include loans or loan commitments, at fair value. The
fair value of a loan commitment is the price at which it can be exchanged
between willing, knowledgeable parties without any compulsion such as a
forced liquidation or distress sale. Changes in the fair value of an
investment banks inventory are included in earnings in the periods in
which the changes occur. FASB has established these different accounting
models because investment and commercial banks have different business
models. For example, commercial banking activities have traditionally
included accepting deposits, originating loans, and holding loans. These
banks generally have the intent and ability to hold the vast majority of
their loan commitments and loan portfolios until maturity and usually have
a relatively small amount of loans held for sale. Investment bank
activities have traditionally included buying, holding as inventory, and
selling various financial instruments.11 Investment banks generally do not
hold loan commitments and loans until maturity.

The objective of a fair value measurement is to estimate an exchange price
for an asset or liability in the absence of actual transactions. The
estimate is based on a hypothetical transaction between willing parties
presumed to be market place participants representing unrelated buyers and
sellers that have a common level of understanding about factors relevant
to the asset or liability that are willing and able to participate in the
same market that the asset would be traded in. Because fair value presumes
the absence of compulsion or duress, prices derived from a forced
liquidation or distress sale would not be used as the basis for the
estimate. Fair value estimates use various market inputs. In an active
market, quoted prices represent actual transactions that are readily and
regularly available to provide pricing information on an ongoing basis. In
determining whether a market is active, the emphasis is on the level of
activity for a particular asset or liability. Inputs may be also used from
other less active markets. Examples of market inputs that may be
considered in a fair value measurement include, but are not limited to,
quoted prices that are adjusted as appropriate, interest rates, default
rates, prepayments, and liquidity.

11FASB has defined a financial instrument as cash, evidence of an
ownership interest in an entity, or a contract that both imposes on one
entity a contractual obligation to (1) deliver cash or another financial
instrument to a second entity or (2) exchange other financial instruments
on potentially unfavorable terms with the second entity and conveys to
that second entity a contractual right to (1) receive cash or another
financial instrument from the first entity or (2) exchange other financial
instruments on potentially favorable terms with the first entity.

We conducted our work in Charlotte, N.C.; New York City, N.Y.; Norwalk,
Conn.; San Francisco, Calif.; and Washington, D.C., between November 2003
and October 2004, in accordance with generally accepted government
auditing standards. (See app. I for more details on our objectives, scope,
and methodology.)

Results in Brief	In response to claims by some investment bankers that
loan commitments were systematically underpriced, many commercial bankers,
officials at rating agencies, and industry experts told us that price
comparisons between loan commitments and loans are difficult because of
fundamental differences in the purpose and structure of these financial
instruments. For example, with a loan commitment, a company buys an option
to borrow a certain amount in the future (under certain terms and
conditions), with a loan, the company agrees to pay interest (as well as
fees) in return for the funds a bank disburses. In addition, lenders
typically charge fees for making credit available on a contingent basis
under a loan commitment and an interest rate for loans, including the
amounts drawn under a loan commitment. Commercial bankers said that they
consider several factors when establishing the price of loan commitments
and loans, including existing business relationships with the borrower,
the borrower's creditworthiness, the price of the borrower's existing
debt, the price of loans to similar borrowers, and financial models.

Officials at commercial banks, rating agencies, FASB, and loan pricing
data firms told us that loan commitments were rarely traded in the
secondary market. According to commercial bankers, trading was limited
because banks make these commitments as part of their business
relationship with borrowers and selling these loans could jeopardize these
relationships. Officials at rating agencies told us that the trading in
loan commitments was limited because institutional investors-significant
participants in the secondary market-were reluctant to purchase
instruments that might require funding in the future. Because loan
commitments are rarely traded, secondary loan market trading data-which
show that overall secondary loan market trading has increased-reflect
trading activity predominately for loans. No comprehensive data are
publicly available about the actual prices for either loans or loan
commitments traded in the secondary market. Some investment bankers
contended that certain loan commitments were underpriced, as evidenced by
the sale of these commitments below face value shortly after origination.
On the other hand, commercial bankers, credit rating agency officials, and
other loan market participants told us that the secondary market for loan
commitments was

illiquid and that commitments could sell at a discount when large amounts
were brought to the market as a result of this illiquidity. Investment
bankers acknowledged that loan commitments that sold at a discount in
initial trading had current trading levels closer to face value. This
increase in market value would have significantly reduced any initial loss
to the investment banks and may indicate that the initial decline in value
was in response to other market factors. The limited evidence from
secondary trading of loan commitments cannot substantiate claims that loan
commitments are underpriced.

We also did not find any comprehensive data to show the extent to which
credit default swaps-essentially insurance against borrower default-are
used to reduce the credit risk associated with loan commitments and loans.
Further, officials from all six commercial banks we visited said that they
used credit default swaps to reduce the credit risk only on small amounts
of their loan and loan commitment portfolios. Officials at two investment
banks we visited said that credit default swaps and loan commitments were
similar enough such that inferences about the appropriateness of the price
of loan commitments could be drawn from the prices of credit default
swaps. However, we analyzed the characteristics of each instrument and
found that it was not possible to use credit default swap prices to
determine whether loan commitments were underpriced because of substantial
differences between the two instruments.

Under current accounting standards, designed to reflect their respective
business models, commercial and investment banks account for loan
commitments differently. If commercial banks do not expect borrowers to
exercise loan commitments, these banks generally recognize the revenue
from these commitments in equal amounts over the life of the contract, or
if the commitment is exercised, they recognize revenue over the life of
the loan. Investment banks recognize changes in the fair value of loan
commitments in income during the period when the changes occur. As a
result, the potential volatility of these fair value changes is reflected
more transparently in an investment bank's financial statements than in a
commercial bank's financial statements. We also found that following
different accounting rules may cause temporary differences in recognizing
the fees from loan commitments. Further, we found that the revenue from
loan commitments was relatively small compared with revenue from other
bank operations. We did not find any evidence that the differences in
accounting treatment offered commercial banks with a consistent
competitive advantage over investment banks. Further, both commercial
banks and investment banks have similar fair value footnote disclosure

requirements and generally provide similar information on their footnotes
about the fair value of various financial instruments, including loan
commitments. It appears that the economic substance of loan commitments is
recognized in the financial statements and related footnotes in a clear,
measurable, and evident fashion under both historic cost and fair value
basis. We found that the banks included in the scope of this review used
different methods to estimate the fair value of financial instruments and
that the level of detail in their financial statement disclosures varied.
However, all the financial statement disclosures we reviewed appeared to
be in accordance with current accounting guidance, and we did not identify
any objections to the disclosures by the banks' independent auditors.

While current accounting standards do not require fair value accounting
for all financial instruments, a FASB staff member published an article
indicating that fair value accounting may provide more relevant
information about financial assets and liabilities, such as loan
commitments, than information based on historical cost. This article
stated that the mixed-attribute model cannot cope with today's complex
financial instruments and risk management strategies and it is time for a
better accounting model. However, FASB staff indicated that not all the
conceptual and implementation issues related to fair value accounting have
been resolved. For example, fair value accounting may focus too much on
current market values that may not be relevant to a bank that has the
intent and ability to hold the financial instrument until maturity.
Further, in the absence of an active secondary market for loan
commitments, estimating the fair value would be difficult, imprecise, and
could be subject to manipulation. While FASB currently has projects
underway to improve its fair value accounting guidance, overall progress
in implementing fair value for all financial instruments has been limited,
in part, by this controversy, the complex nature of developing detailed
implementation guidance, and the limited secondary market for various
types of financial instruments such as loan commitments. As a result,
commercial banks and investment banks continue to follow different
accounting models for similar financial instruments such as loan
commitments.

We provided copies of this report to FDIC, OCC, and the Board of Governors
of the Federal Reserve System. They provided technical comments, which we
incorporated into the report as necessary.

Differences in Purpose, Price Structure, and Collateral Requirements Make
Direct Comparisons between Prices of Loan Commitments and Loans Difficult

Although some investment bankers have contended that commercial banks
systematically underprice loan commitments, commercial bankers and other
industry observers told us that the different characteristics of loan
commitments and loans-purpose, collateral requirements, and price
structure-limited direct price comparisons. For example, a loan commitment
gives a company the option to borrow in the future under certain terms and
conditions, while a loan provides borrowers with actual funds. In
addition, lenders typically charge fees for making credit available under
a loan commitment and an interest rate for loans (including loans drawn
under prior loan commitments). Commercial bankers said that they consider
several factors when establishing the price of loan commitments and loans,
including the profitability of the existing business relationship with the
borrower, the maturity of the loan or loan commitment, the
creditworthiness of the borrower, the price of loans to similar borrowers,
the price of existing borrower debt, and financial models.

Loan Commitments and Loans Differ in Purpose, Price Structure, and
Collateral Requirements

While both loan commitments and loans offer firms access to credit, these
instruments serve different purposes. Investment-grade loan commitments
are frequently used as backup lines of credit for borrowers that issue
commercial paper. Commercial bankers and rating agencies told us that
these lines are not expected to be drawn unless a firm loses access to the
commercial paper market. Because-as we have indicated earlier-access to
the commercial paper market is limited to companies with high credit
ratings, loss of access to this market does not, by itself, mean that a
firm that draws its loan commitment is in danger of defaulting. In most
cases where investment-grade borrowers drew upon their loan commitments,
they repaid the amount borrowed in full or otherwise performed in
accordance with the repayment terms for the amount borrowed. In contrast
to investment-grade borrowers, leveraged borrowers are expected to
partially or fully draw down on their loan commitments. Funded loans are
predominately used by leveraged borrowers that do not have access to lower
cost credit in the commercial paper market. Loan commitments and loans
also have different price structures, with lenders typically charging one
or more fees for making credit available under a loan commitment and an
interest rate on funded loans expressed as a spread or markup over a

benchmark rate.12 Loan commitments and loans also differ in security. Loan
commitments to investment-grade borrowers are typically unsecured-no
collateral is pledged-and have few restrictive financial covenants, while
leveraged loans are typically secured and have more covenants.13 While a
loan commitment gives a firm an option to borrow funds under prespecified
terms, a loan actually provides these funds to the firm. These differences
between the purpose of loan commitments and loans, together with
differences in their price structure and collateral requirements, make it
difficult to compare the price of loan commitments with loans.

Commercial Banks Consider Several Factors to Price Loan Commitments and
Loans

Commercial bankers said that they considered several factors in
establishing the price of loan commitments and loans. For investmentgrade
borrowers, the profitability of the banking relationship a bank has with
the borrower was one factor. Commercial banks establish relationships with
corporate customers and evaluate the overall profitability of these
relationships in terms of the various products and services customers use
and the prospects for additional business in the future. Commercial
bankers said that the extent and profitability of the existing business
they had with an investment-grade borrower would affect the decision to
participate in a syndicated loan and the price they would set if they were
syndicating the loan. As we previously reported, commercial bankers also
told us that they considered the need to set a price that provided an
attractive return to other investors in the syndication. For leveraged
loans, industry experts told us that pricing depended on the riskiness of
the transaction, but one commercial banker told us that customer
relationships also played a role.

Creditworthiness-a measure of a borrower's ability to meet debt
obligations-was another factor considered in establishing the price of
loan commitments and loans. As table 1 shows, the average fees for
investment-grade loan commitments were lower than for leveraged loan
commitments between 1999 and 2003, which demonstrates that lenders charge
higher fees for leveraged or more risky loan commitments. In addition, the
lower average fees for investment-grade loan commitments

12Lenders often use the London Inter Bank Offered Rate or LIBOR as the
benchmark or reference rate on loans. LIBOR is the base interest rate paid
on deposits between banks in the Eurodollar market.

13Financial covenants are provisions that prohibit a borrower from taking
actions that might impair the value of the lender's ability to collect the
loan.

might reflect the fact that lenders generally do not anticipate having to
provide the funds they have committed. Table 1 also shows that the average
fees for investment-grade loan commitments increased around 16 percent
between 1999 and 2003, while the average fees for leveraged loan
commitments decreased around 2 percent during the same time period.

Table 1: Average Fees for Investment-Grade and Leveraged Loan Commitments,
1999-2003

                             (Fees in basis points)

                     Year       Investment-Grade                    Leveraged 
                     1999                          12.2                  49.2 
                     2000                          11.8                  49.6 
                     2001                          11.3                  46.5 
                     2002                          12.8                  48.0 
                     2003                          14.2                  48.0 

Source: Loan Pricing Corporation.

Note: The fee measures the amount the borrower pays for each dollar
available under a commitment and adds the commitment and annual fees.

Table 2 shows the average annual charge over benchmark rate for
investment-grade and leveraged loans between 1999 and 2003. Lenders also
charge higher average annual charges over the benchmark rate for leveraged
loans than for investment-grade loans, which reflects the greater risk of
loss for leveraged loans. Between 1999 and 2003, the average annual charge
over benchmark rate increased about 39 percent for investmentgrade loans
and around 13 percent for leveraged loans. However, in neither case could
we determine whether the increase reflected overall higher charges for all
loans or represented an increase in the proportion of riskier loans.

Table 2: Average Annual Charge Over Benchmark Rate for Investment-Grade
and Leveraged Loans

                           (Charges in basis points)

                     Year       Investment-Grade                    Leveraged 
                     1999                          52.2                 285.9 
                     2000                          51.6                 294.3 
                     2001                          52.4                 300.1 
                     2002                          61.7                 315.7 
                     2003                          72.8                 322.0 

Source: Loan Pricing Corporation.

Note: The annual charge over benchmark rate adds the commitment and/or
facility fee plus the interest premium.

Commercial bankers also told us that they considered the maturity of a
loan commitment or loan in establishing the price of these instruments. As
table 3 shows, the average fees for investment-grade loan commitments with
maturities of 1 year or more were higher than for 364-day facilities, a
reflection that the longer the maturity the greater the risk the loan will
be drawn.

Table 3: Average Fees for Investment-Grade Loan Commitments-364-day
facilities and Revolvers 1 year or More

                             (Fees in basis points)

                      Year               364 day               1 year or more 
                      1999                   9.7                         15.6 
                      2000                  10.0                         14.1 
                      2001                   9.8                         13.8 
                      2002                  10.7                         16.0 
                      2003                  11.0                         18.4 

Source: Loan Pricing Corporation.

Note: The fee measures the amount the borrower pays for each dollar
available under a commitment and adds the commitment and annual fees.

Commercial bankers also said that they took into account the recent prices
of syndicated loans to borrowers with similar credit ratings, and the
price of a corporation's bonds and other debt instruments. However, most
commercial bankers we met with reported that they did not consider the

price of credit default swaps when determining the price of loan
commitments. Further, commercial bankers told us that they used financial
models to predict whether the price of a loan commitment or loan would
meet their minimum profitability target. These models predict how a
particular loan commitment will impact the risk and return of the
institution's overall portfolio.

During our review, some investment bankers asserted that investmentgrade
loan commitments were not profitable on a stand-alone basis. Commercial
bankers agreed that the price of these commitments was not very profitable
on a stand-alone basis and that they generally look to the entire
relationship with the customer to meet their profitability hurdles.
Commercial bankers added that competition from other loan market
participants constrained the prices they could charge, since
investmentgrade borrowers generally had syndication offers from more than
one lender. When determining the price of investment-grade loans, some
commercial bankers noted that competition limited their ability to raise
fees and they described themselves as price "takers" rather than price
"setters." Further, federal banking regulators told us that loan
commitments are not legally required to be profitable on a stand-alone
basis.14

Loan Commitments Are Rarely Traded, and Available Data from Secondary
Market Does Not Support Claims of Systematic Underpricing

We were told that loan commitments rarely trade in the secondary market,
primarily for two reasons. First, commercial banks did not want to
jeopardize their relationship with borrowers that might object to such a
sale, and second, institutional investors-such as the mutual and hedge
funds and insurance companies that are significant participants in the
secondary market-were reluctant to buy instruments that might require
funding in the future. Because loan commitments are rarely traded, the
available data, which showed increases in secondary trading, were mostly
for funded loans. Moreover, we found no comprehensive publicly available
data about the actual prices of loans (or loan commitments) traded in the
secondary market. For example, a loan pricing data firm compiles and makes
some data publicly available about the volume of secondary loan market
trading based on information solicited from key market participants.

14Although there is no federal law that prohibits a bank from making an
unprofitable loan commitment, a federal banking regulator might consider
it an unsafe and unsound banking practice for a bank to engage in a
systematically and consistently unprofitable business line.

As figure 5 shows, from 1991 to 2003, overall secondary loan market
trading increased from about $8 billion to about $145 billion. Officials
from a loan market trade association said that institutional investors,
attracted by the higher returns provided by loans as compared to bond and
equity instruments, largely contributed to the growth in secondary loan
market trading. The officials added that the development of standardized
loan trade documentation and other market practices also facilitated the
growth in secondary loan market trading by improving market liquidity.

Figure 5: U.S. Secondary Loan Market Volume, 1991-2003 Dollars in billions

150

120

90

60

30

0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Source: Loan Pricing Corporation.

Loan market trade association officials also said that there were no
comprehensive data publicly available about the actual prices for loan
commitments or loans traded in the secondary market. Loans are privately
placed based upon negotiated terms. As such, institutions that buy or sell
these instruments are not required to report actual trade prices. For
certain loans, the trade association independently compiles and makes
publicly available data on dealer quotes. However, the officials noted
that the dealer quotes do not represent actual trade prices or offers to
trade; rather, they are estimates provided by bank loan traders. Because
loan commitments rarely trade, similar dealer quote data are not collected
for these instruments.

Some investment bankers contended that certain loan commitments were
underpriced at origination, as evidenced by the price of these commitments
in the secondary market. However, the available evidence we reviewed did
not support the investment bankers' contentions. In one case, officials
from one investment bank said that they participated in a revolving line
of credit where the initial trading levels in the secondary market were
between 89 and 92 cents on the dollar. They said that, in their opinion,
this immediate decline in value implied an initial loss to the
participants and was evidence that the credit had been underpriced at
origination. Commercial bankers, credit rating agency officials, and other
loan market participants told us that the secondary market for loan
commitments was illiquid, compared with that for other securities. As a
result of this illiquidity, officials from one commercial bank said that
investors are able to buy loan commitments at a discount when large
amounts of a syndicated loan are placed on the market. The officials added
that these investors are often able to sell smaller amounts of these
commitments at a later time for a higher price. Investment bank officials
acknowledged that the trading levels for the revolving line of credit,
which had sold for between 89 and 92 cents on the dollar, had risen to
between about 97 and 98 cents on the dollar in the secondary market.
Investment bankers provided information on 3 other cases where loan
commitments that sold at a discount in initial trading had current trading
levels of more than 99 cents on the dollar. This increase in market value
would have significantly reduced any initial loss to the investment banks
and may indicate that the initial decline in value was in response to
other market factors and the commitments were not necessarily underpriced.

Although Commercial Banks Use Credit Default Swaps to Reduce the Credit
Risk of Their Loan Commitment and Loan Portfolios, Prices of These
Instruments Cannot Be Compared Directly

While some commercial banks reported that they used credit default swaps
to reduce the credit risk on their loan and loan commitment portfolios,
only limited information was available on the extent of this practice.
Officials at two investment banks believed that credit default swaps and
loan commitments were similar instruments, but we found that credit
default swaps and loan commitments were substantially different.
Commercial bankers, loan market experts, officials from rating agencies,
and other industry observers also agreed that credit default swaps and
loan commitments were different financial instruments. Based on our
analysis of the characteristics of credit default swaps and loan
commitments, we found that it was not feasible to use credit default swap
prices to determine whether loan commitments were underpriced because of
the differences between the two instruments.

Comprehensive Data Are Not Available about the Use of Credit Default Swaps
to Reduce Credit Risk

As previously discussed, credit default swaps are essentially insurance
against borrower default, and commercial banks and other financial
institutions use these instruments to reduce or diversify credit risk
exposures. Commercial banks are required to report the total amount of
their credit default swap and other credit derivative contracts in
quarterly reports submitted to federal banking regulators, but banks do
not have to distinguish between amounts they hold to reduce credit risk
and amounts they hold for trading purposes. Officials from the six
commercial banks we visited said that they used credit derivatives to
reduce the risk on between 2 and 12 percent of their loan and loan
commitment portfolios and held most of these instruments for trading
purposes-primarily customer service transactions. A credit rating agency
report on credit default swaps reached a similar conclusion.15

Credit Default Swaps and Loan Commitments Are Different Financial
Instruments

Officials at two investment banks we visited said that credit default
swaps and loan commitments were similar financial instruments. For
example, officials at one investment bank said that credit default swaps
and loan commitments were similar financial instruments because those who
sold the protection offered by credit default swaps and those who made
loan commitments were exposed to similar risks of credit losses. They
added that a credit default swap and a loan commitment were both similar
to a put option. In a put option, the option purchaser has the right, but
not the obligation, to sell an asset to the put option seller at a
specified price on or before the option's exercise date, and the purchaser
pays a premium to the seller for the put option. The officials noted that
if a swap was triggered by a credit event, the beneficiary had the right
to payment of the swap's full value from the guarantor, who would then be
exposed to any losses associated with the credit event. These officials
asserted that the same risk existed in a loan commitment, because the
borrower has the right to draw the full amount of the commitment and would
not exercise this right unless its credit rating had deteriorated to near
default levels and it could not raise funds in the financial markets.

However, we found that credit default swaps and loan commitments were
substantially different. We analyzed the characteristics of each
instrument and sought the opinions of commercial bankers and other
industry

15"Demystifying Bank's Use of Credit Derivatives," Standard and Poor's,
December 8, 2003,

p. 2.

observers. As table 4 shows, credit default swaps and loan commitments
differed in terms of the trigger event, pricing, trading, and financial
covenants. For example, the trigger for a credit default swap is a clearly
defined indication of the borrower's credit impairment, which typically
includes bankruptcy, insolvency, and delinquency, or may even result from
a credit-rating downgrade. However, the trigger for a loan commitment does
not necessarily indicate credit impairment on the part of the borrower. A
loan commitment may serve as a backup for commercial paper, and the issuer
may have to use the line for reasons other than impaired credit.16 We also
found differences in the payment schedule of credit default swaps and loan
commitments. For credit default swaps, the beneficiary makes fixed
payments-either on a quarterly or annual basis- to the guarantor. For loan
commitments, the fees that lenders charge typically vary based on the
credit rating for investment grade borrowers and financial ratios for
leveraged borrowers. As previously discussed, officials from commercial
banks we visited reported holding most credit default swap contracts for
trading purposes, but these same officials also noted that loan
commitments were generally not traded. Finally, loan commitment contracts
typically include financial covenants, or a series of restrictions that
dictate, to varying degrees, how borrowers can operate and carry
themselves. These covenants are designed to protect lenders against the
borrower's potential future credit deterioration. Credit default swap
contracts do not contain such financial covenants. Commercial bankers,
loan market experts, officials from rating agencies, and other industry
observers also agreed that credit default swaps and loan commitments were
different financial instruments.

16In 1998, Russia's declaration of a debt moratorium and the near failure
of a large hedge fund created financial market turmoil; since this
severely disrupted corporations' issuance of bonds and commercial paper,
they drew on their loan commitments from banks.

     Table 4: Characteristics of Credit Default Swaps and Loan Commitments

Credit default swap Loan commitment

                Triggering     Credit impairment of the Does not necessarily  
                    events                              indicate              
              specified in         borrower-bankruptcy,  credit impairment of 
                  contract                                                the 
                               insolvency, delinquency,              borrower 
                           or a credit-rating downgrade 
                                                            Variable-based on 
          Payment schedule      Fixed-payments made per         credit rating 
                             quarter or on annual basis  for investment grade 
                                                                   borrowers, 
                                                        financial ratios for  
                                                        leveraged             
                                                                    borrowers 
                   Trading    Yes-most held for trading   No-loan commitments 
                                               purposes  generally not traded 
                 Financial                                                    
                 covenants                           No                   Yes

                                  Source: GAO.

Commercial and Investment Bankers Disagreed about the Relationship between
Credit Default Swap and Loan Commitment Prices

According to officials at the two investment banks we visited, credit
default swap and loan commitment prices were similar enough to allow for
meaningful price comparisons. However, as previously discussed, we found
that credit default swaps and loan commitments were substantially
different financial instruments. Commercial bankers and other loan market
participants also told us that prices of the two financial instruments
should not be directly compared without adjusting for differences between
the instruments. For example, officials at one commercial bank told us
that they first adjust for differences in financial covenant protection
and recovery rates before using credit default swap prices in estimating
the value of their total loan commitment portfolio. These officials also
told us that the directional movements in credit default swap prices had
informational value regarding the fair value of their loan commitment
portfolio-that is, as credit default swap prices increased, the fair value
of their loan commitments decreased. However, these officials cautioned
that the adjusted prices for credit default swaps were likely to be
different from the actual sales price of the portfolio if the instruments
were to be sold. Because of substantial differences between credit default
swaps and loan commitments, we found that it was not possible to use
credit default swap prices to determine whether loan commitments were
underpriced.

Commercial and Investment Banks Follow Different Accounting Models, but
There Is No Evidence That Either Model Provides a Consistent Competitive
Advantage

Under current accounting standards, designed to reflect their different
business models, commercial and investment banks account for loan
commitments differently. We found that following different accounting
standards caused temporary differences in recognizing the fees from loan
commitments. Further, we found that the revenue from loan commitments was
relatively small compared with revenue from other bank operations and
these differences would be resolved by the end of the commitment period.
We did not find any evidence that the differences in accounting treatment
offered the commercial banks with a consistent competitive advantage over
investment banks. Further, both commercial and investment banks have
similar fair value footnote disclosure requirements and generally provide
similar information in their footnotes about the fair value of various
financial instruments, including loan commitments. We found that the banks
included in the scope of this review used similar methods to estimate the
fair value of financial instruments and that the level of detail in their
financial statement disclosures varied. However, all the financial
statement disclosures we reviewed appeared to be in accordance with
current accounting guidance, and we did not identify any objections to the
disclosures by the banks' independent auditors.

Commercial and Investment Banks Follow Different Accounting Models but
Have Similar Disclosure Requirements

According to FASB, which sets the private sector accounting and reporting
standards, commercial and investment banks follow different accounting
standards for similar transactions involving loan commitments because of
the differences in their business models. As previously discussed, most
commercial banks use varying accounting models depending on the type of
activity being accounted for-known as a mixed attribute model. With this
model, some financial assets and liabilities are measured at historical
cost, some assets at the lower of cost or market value, and some at fair
value. In contrast, investment banks generally follow a fair value
accounting model in which they report changes in the fair value of
inventory, which may include loans or loan commitments, in income during
the periods in which the changes occur.

FASB officials told us that many believe it is appropriate for commercial
and investment banks to follow different accounting models because the
institutions have different business models. For example, commercial
banking activities have traditionally included accepting deposits,
originating loans, and holding loans. These banks generally have the
intent and ability to hold the vast majority of their loan commitments and
loan portfolios until maturity and usually hold a relatively small amount
of loans

for sale. Some commercial bankers told us that the mixed attribute model
more closely reflects the commercial bank's operations than the fair value
model. Investment bank activities have traditionally included buying,
holding as inventory, and selling various financial instruments. As we
previously reported in our October 2003 report on bank tying, investment
banks often do not hold loan commitments until maturity. Officials at the
two investment banks we spoke with stated that the fair value accounting
model more closely reflects their operations than other models and
asserted that this accounting model should be used by all banks.

When commercial banks make loan commitments, they must follow FASB's
Statement of Financial Accounting Standards (FAS) No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring
Loans and Initial Direct Costs of Leases, which directs them to book the
fees received for loan commitments as deferred revenue (see app. II). The
way this revenue is recognized depends upon the likelihood that the loan
commitment will be exercised. When this likelihood is remote, the bank
will recognize the revenue in equal portions over the loan commitment
period. However, if it is likely that the commitment will be exercised,
the bank will defer recognizing all the fee revenue for this commitment
until the loan is drawn. The fee revenue from the commitment is then
recognized over the life of the loan. If this loan commitment remains
unexercised, the income would be recognized in total when the commitment
period expired. Currently, commercial banks are not allowed to recognize
changes in the fair value of loan commitments in their earnings.

Investment banks are generally required to follow the American Institute
of Certified Public Accountants (AICPA) Audit and Accounting Guide,
Brokers and Dealers in Securities, which directs them to record the fair
value of loan commitments. When using the fair value model, investment
banks must recognize, in income, gains or losses resulting from changes in
the fair value of a financial instrument, such as a loan commitment,
during the period the change occurs.

Although commercial and investment banks follow different models to
account for loan commitments, both firms are subject to the same fair
value footnote disclosure requirements in which they report the fair value
of all loan commitments in their financial statement footnotes along with
the method used to determine fair value. As a result, financial analysts
and investors are presented with similar information about the commercial
and investment banks' loan commitments in the financial statement
footnotes. According to FAS 107: Disclosures about Fair Value of Financial

Instruments, in the absence of a quoted market price, firms may estimate
fair value based on, among other things, the value of (1) the quoted price
of a financial instrument with similar characteristics, (2) option or
matrix pricing models, or (3) the discounted value of future cash flows
expected to be received.

As we previously reported in our October 2003 report on bank tying,
Securities and Exchange Commission (SEC) officials and the banking
regulators told us the footnote disclosures included with financial
statements were an integral part of communicating risk. They considered
the statement of position and statement of operations alone to be
incomplete instruments through which to convey the risk of loan
commitments. They emphasized that to fully ascertain a firm's financial
standing, footnotes must be read along with the financial statements.

We found that the banks included in the scope of this review used similar
methods to estimate the fair value of financial instruments and the level
of detail in their financial statement disclosures varied. For example,
all of the commercial bank footnotes we reviewed stated that fair values
were based on quoted market prices, when available. If quoted market
prices were not available, the banks used other methods such as internally
developed models, or based their fair value estimates on the price of
similar financial instruments. Some bank footnotes acknowledged that the
fair values were significantly affected by assumptions used in developing
the estimate, such as the timing of future cash flows and the discount
rate, and further recognized that the estimated fair values would not
necessarily be realized in an immediate sale of the financial instrument.
For some of the commercial bank's footnotes that we reviewed, the fair
value of loan commitments was not explicitly stated, apparently because
these amounts may not have been material to the financial statements and
therefore did not warrant separate disclosure. Despite the differences in
the methods banks used to estimate the fair value of financial instruments
and the level of detail presented, all of the financial statement
disclosures appeared to be presented in accordance with current disclosure
guidance. We found no instances of independent auditors' taking exception
to these disclosures in the audit opinions.

As part of our review, we asked bank officials if, for various
decisionmaking purposes, they assigned different values to their loan
commitments than the values reported on the financial statements and
related fair value footnotes. Four of the commercial banks included in our
review and both investment banks included in our sample responded to our
request for

information and stated that they consistently used the same values for
internal decision-making purposes that they used in their financial
statements.

During our discussions of accounting disclosures, one investment bank
official we spoke with asserted that the most appropriate method of
determining the fair value of loan commitments and reporting these values
in the financial statement footnotes was to use the value of a related
credit default swap because this official viewed the two financial
instruments as similar. FASB staff told us that generally accepted
accounting principles do not prescribe a specific method to estimate the
fair value of financial instruments that could be universally adopted by
all banks. While the price of a credit default swap could be used under
current accounting guidance as the market price of similar traded
financial instruments with a similar credit rating, interest rate, and
maturity date, this was only one possible method. Some of the other
possible methods of estimating the fair value of a financial instrument
that does not regularly trade include option pricing models or estimates
based on the discounted value of future cash flows expected to be
received. Moreover, commercial bank officials and FASB staff told us that
a credit default swap did not exist for every borrower that had a loan
commitment. As previously discussed, the price of the credit default swap
would likely need to be adjusted to account for the various other
differences between it and a loan commitment. One commercial bank that we
spoke with used credit default swaps as a basis for estimating the fair
value of their loan commitments. However, officials at this bank stated
that they first adjusted the swap price for the various differences
between the two financial instruments, cautioned that the resulting
estimate was unlikely to represent the actual sales price of the loan
commitments, and primarily used the adjusted credit default swap price to
assess directional changes in the estimated fair value of their loan
commitment portfolio.

No Evidence That Accounting for Loan Commitments Gives Commercial Banks a
Consistent Competitive Advantage over Investment Banks

Because commercial and investment banks follow different accounting
models, they would likely report different values for a similar loan
commitment or a loan resulting from an exercised commitment, and recognize
different amounts of the related deferred revenue. Further, revenue from
fee income would be relatively small compared with revenue from other bank
activity. In addition, because investment banks use fair value accounting,
the volatility of the fair value of loan commitments would be reflected
more transparently in their financial statements than a commercial bank's
financial statements, because investment banks must recognize these
changes in income as they occur. In contrast, commercial

banks do not recognize changes in the fair value of the loan commitment,
its related deferred revenue, or the related loan if it were drawn.

The differences in accounting between commercial banks and investment
banks are temporary, and, as demonstrated by the examples in appendix II,
whether a commercial bank or an investment bank recognizes more fee
revenue first would depend on various market conditions including interest
rates and spreads. Similarly, any differences between the fair value of a
loan or loan commitment on an investment bank's books and the net book
value of a similar loan or loan commitment on a commercial bank's books
would be eliminated by the end of the loan term or commitment period.17
Moreover, based on our review of the banks' financial statements, we found
that the revenue commercial banks earn from loan commitments was
apparently relatively minor compared with other sources of revenue, since
it was not identified separately in the statement of income as source of
income.18 Thus, differences in the amount and timing of recognizing
service fee income would likely be relatively small. Further, as
previously discussed, both commercial and investment banks are required to
make similar footnote disclosures about the fair value of their financial
instruments. Because these differences are relatively small and temporary,
we found no evidence that following different accounting models provided
the commercial banks with a consistent competitive advantage over
investment banks.

In addition, certain similarities in investment and commercial banks'
accounting treatment of loan commitments help mitigate any advantage one
type of accounting may offer over the other. First, as previously
discussed, both commercial and investment banks are required to make
similar footnote disclosures about the fair value of their financial
instruments. Second, when similar loan commitments held by a commercial
bank and an investment bank are exercised and become loans,

17The net book value of a loan is generally its unpaid principal balance
less any allowance for credit losses.

18In determining what information to specifically identify in the
financial statements, auditors and those making accounting decisions often
try to determine whether an item is large enough for users of the
information to be influenced by it. If not, the information may be
included with other financial statement line items. None of the banks we
reviewed identified service fees from loan commitments as a separate line
item, indicating that the amounts were relatively small and that financial
statement users would not be mislead by omitting these data. Further, none
of the independent auditors take exception to this presentation.

both firms are subject to the same accounting standards if the loan is
held to maturity. In this situation, both commercial and investment banks
are required to establish an allowance for probable losses based on the
estimated degree of impairment of the loan commitment or historic
experience with similar borrowers.19

Fair Value Accounting May Have Certain Advantages, but Significant
Implementation Issues Must Still Be Resolved

While current accounting standards do not require fair value accounting
for all financial instruments, FASB has recognized that commercial and
investment banks engage in similar transactions and the board is concerned
about having different accounting for those similar transactions. As new
accounting guidance is issued, the board is considering eliminating the
different business models where appropriate and has indicated a desire to
require all entities to report all financial instruments at their current
fair value where the conceptual and practical issues related to fair value
measurement have been resolved. As we reported in our October 2003 report
on bank tying, FASB has stated that it is committed to work diligently
toward resolving, in a timely manner, the conceptual and practical issues
related to determining the fair values of financial instruments.

An FASB staff member wrote a paper that summarized the strengths and
weaknesses of fair value accounting.20 In that paper, the staff member
stated that fair value measurement for financial assets and liabilities,
such as loans and loan commitments, provide more relevant information than
the historical cost model. The author also wrote that the mixed-attribute
model cannot cope with today's complex financial instruments and risk
management strategies and it is time for a better accounting model. In

19According to FAS 114: Accounting by Creditors for Impairment of a Loan,
a loan is considered impaired when, based on current information and
events, it is probable that a creditor will be unable to collect all
amounts due according to the contractual terms of the loan agreement. To
comply with FAS 114, creditors must create a valuation allowance that
reduces the value of the loan with a corresponding charge to a bad-debt
expense. FAS 114 has a limited scope and applies only to loans that have
been identified for evaluation for collectibility. When a loan is not
impaired under FAS 114, creditors must follow FAS 5: Accounting for
Contingencies and establish an allowance for loss when it is probable that
a loss or an additional loss has been incurred and the amount of the loss
can be reasonably estimated.

20FASB Viewpoints Financial Assets and Liabilities-Fair Value or
Historical Cost? Diana Willis, August 18, 1998. The views in this paper
were those of the author and did not reflect official positions of the
FASB, which are determined only after extensive due process and
deliberation.

addition, the article stated that under the mixed-attribute model, few
financial liabilities, such as deposit accounts, are measured at fair
value, which can misrepresent the financial position of an entity that has
a significant amount of financial liabilities. The paper further stated
that changes in the economic environment during the past 20 years have
increased the volatility of prices such as interest rates and the
introduction of derivatives and other complex financial instruments have
made the issue of how to measure financial instruments critical. According
to the author, a market price of a financial instrument reflects the
market's assessment of the future cash flows that this instrument will
provide under current conditions and an assessment of the risk that the
amount or timing of these cash flows will differ from expectations. The
article also stated that investors and creditors are primarily interested
in assessing the amounts, timing, and uncertainty of future net cash
inflows to an entity and, according to FASB staff, it seems logical that
information based on the market's assessment, under current conditions,
would be more relevant to investors and creditors. Moreover, the FASB
staff paper noted that in today's highly fluid economic environment,
significant changes often occur in short periods of time. These changes
may influence management's decision to hold a particular financial
instrument to maturity or sell it and invest the proceeds elsewhere. The
FASB staff concluded that the effects of these decisions might be
important to investors' and creditors' evaluation of the entities'
performance.

Officials at both investment banks that we spoke with asserted that
accounting for loan commitments on a fair value basis was better than the
mixed-attribute model that commercial banks use. Officials at one of these
investment banks stated that the current accounting requirements created a
disincentive for commercial banks to disclose the risks associated with
loan commitments and their fair value. This investment bank official also
stated that fair value accounting forces business discipline and asserted
that commercial banks should not continue to reflect a loan commitment on
their financial statements at a value exceeding its current fair value.

According to the FASB staff paper, while most people agree that fair value
is the most relevant measure for assets and liabilities that are actively
traded, some believe applying this accounting model to all financial
instruments may focus too much on current market information that does not
necessarily reflect management's intentions. The author noted that
implementing fair value accounting that focuses on current market prices
for all financial instruments would reflect the effects of transactions
and events in which the entity did not directly participate. The author
further

stated that some have indicated that if management has the intent and
ability to hold a financial asset or liability until maturity, the current
market price is less relevant than if they were actively considering
selling the instrument. Further, the FASB staff paper points out that
opponents of the fair value model assert that the effects of management's
decisions to hold or sell a particular financial instrument should become
apparent over time as the entity reports earnings that are higher or lower
than the current market. Thus, the current mixed-attribute model seems to
provide information that may be important to investors and creditors
evaluation of the entities' performance.

The rating agency officials that we spoke with told us that they were
comfortable with both historical cost and fair value accounting and could
work equally well with either type of accounting information. These
officials told us that the information in the bank's financial statement
footnotes provided enough information to assess a bank's financial
performance over time. In our October 2003 report on bank tying, we
reported that a loan market expert told us that, although the discipline
of using market-based measures works well for some companies, fair value
accounting might not be the appropriate model for the entire wholesale
loan industry.

FASB staff that we spoke with acknowledged that progress in implementing
fair value accounting for all financial instruments has not been required
because all the implementation issues have not yet been resolved. In our
October 2003 report on bank tying, we reported that FASB staff told us
that, although measuring financial instruments at fair value has
conceptual advantages, FASB has not yet decided when, if ever, it will
require essentially all financial instruments held in inventory to be
reported at fair value. FASB staff stated that it was important to
carefully evaluate all aspects of fair value measurement to avoid
unintended consequences. For example, in the absence of observable market
data, such as the secondary market for loan commitments, an estimate of
fair value would require significant judgment and the result would be
imprecise. FASB staff stated that many constituents have expressed
concerns that estimating fair value without an active market is too
subjective and there is potential for management to manipulate the fair
value of these financial instruments because of the significant level of
discretion involved in choosing the assumptions that may be used to
estimate fair value. As a result, the amount of revenue or losses from
changes in the fair value that banks would report could be unreliable.

Another significant issue that has not been resolved is the elimination of
the banks' allowance for loan losses account. This allowance account is
essentially an estimate of the amount of probable loss in a bank's loan
portfolio. FASB staff told us that eliminating the allowance for loan
losses is currently a controversial issue among commercial banks and the
bank regulators who want to maintain the current accounting model. FASB
staff also told us that commercial banks have asserted that the mixed
attribute model more accurately reflects their operations than fair value
accounting. FASB staff told us that the bank regulators use the allowance
for loan losses as one of several factors that are considered in assessing
a bank's asset quality. As discussed previously, under fair value
accounting, all financial instruments would be carried at a market price
that reflects the market's assessment of the future cash flows this
instrument will provide under current conditions and an assessment of the
risk that the amount or timing of these cash flows will differ from
expectations. While market values for some portions of banks' loan
portfolios may be readily obtained, such as residential mortgages where
there is an active secondary market, other segments of some banks'
portfolios, including loans to small and medium--sized businesses, are
more unique and obtaining reliable fair values could be more problematic.
As previously discussed, fair value estimates of these loans would require
a significant amount of management judgment and the results would likely
be imprecise. Until these issues have been resolved and more comprehensive
guidance has been issued by FASB, the current mixed-attribute model will
likely continue to be used by some entities while others use fair value.

FASB Plans to Revise Fair Value Accounting Guidance

According to the FASB staff that we spoke with, the board is taking steps
to improve the accounting guidance for fair value measurements and, on
June 23, 2004, issued an exposure draft regarding fair value
measurements.21 Prior to issuing this exposure draft, FASB noted that
there was limited guidance for measuring assets and liabilities on a fair
value basis and this guidance was dispersed among several accounting
pronouncements. Differences in this guidance created inconsistencies, and
concerns were raised about the ability to reliably estimate fair value,
especially in the absence of quoted market prices.

21Financial Accounting Standards Board Exposure Draft Proposed Statement
of Financial Accounting Standards Fair Value Measurements (June 23, 2004).

This exposure draft includes guidance that investment banks would follow
to determine the fair value of loan commitments. Further, the exposure
draft provides guidance that both commercial and investment banks would
follow in determining the fair value of loan commitments and presenting
this information in their footnote disclosures including the extent of
fair value measurement, how fair value was determined, the amount of
unrealized gains/losses, and the extent of market inputs that were used.
In addition, the exposure draft provides examples of the financial
statement footnotes to encourage more consistency in presentation. The
exposure draft, among other things, also clarifies the definition of fair
value and provides guidance on the hierarchy of techniques that can be
used to determine fair value. FASB is currently re-deliberating the
exposure draft and considering comments received from constituents during
the comment period. According to FASB staff members, they expect to
release the final guidance during the first half of 2005.

FASB staff told us that they had other projects under way that could
affect how commercial and investment banks account for loan commitments
including revising revenue recognition guidelines and coordinating with
the International Accounting Standards Board in an attempt to eliminate
differences in accounting standards. In addition, FASB staff is also
looking at the relevance and reliability of some attributes used to
estimate fair value. The goal of this effort is to provide guidance for
determining at what point an estimate becomes too unreliable to be
reported in the financial statements.

Conclusions	Although some investment bankers have contended that
commercial banks systematically underprice loan commitments, the available
evidence did not support these contentions. Because of fundamental
differences in the purpose and structure of loan commitments and loans,
commercial bankers, officials at credit-rating agencies, and other
industry experts told us that price comparisons between these financial
instruments are difficult. In addition, the evidence we reviewed from the
secondary loan market did not indicate underpricing of loan commitments.
In cases we reviewed where loan commitments had traded at a discount in
initial trading, the same commitments had current trading levels closer to
face value, which may indicate that the commitments were not necessarily
underpriced. Further, because of the substantial differences between loan
commitments and credit default swaps, it was not possible to use credit
default swap prices to determine whether loan commitments were
underpriced.

Because commercial and investment banks currently follow different
accounting standards, designed to reflect their different business models,
there are differences in the financial statement presentation of some
similar transactions such as loan commitments. Unlike commercial banks,
investment banks recognize changes in the fair value of loan commitments
in income during the period when the changes occur. As a result, the
volatility of these fair value changes is reflected more transparently in
an investment bank's financial statements. We found that following
different accounting rules caused temporary differences in recognizing the
fees from loan commitments. We also found that revenue from loan
commitment fees appeared to be relatively small compared with revenue from
other bank activity. We did not find any evidence that the differences in
accounting treatment offered the commercial banks a consistent competitive
advantage over investment banks. It appears that the economic substance of
loan commitments is recognized in the financial statements and related
footnotes in a clear, measurable, and evident fashion under both the
historic cost and fair value accounting approach. Further, both commercial
and investment banks have similar fair value disclosure requirements and
generally provide similar information on their financial statements about
the fair value of various financial instruments, including loan
commitments. Although one FASB staff member indicated that fair value
accounting may offer advantages over the mixed-attribute model, in some
instances, such as providing more relevant information than the historical
cost model, significant implementation issues must be resolved before it
can be applied to all financial instruments. It is important for FASB to
continue working diligently toward resolving these issues to help ensure
that financial statement users are provided with the most relevant and
reliable financial information and to keep pace with today's financial
markets. Until these issues are resolved, commercial and investment banks
will continue to follow different accounting models for similar financial
instruments such as loan commitments.

Agency Comments	We requested comments on a draft of this report from FDIC,
Federal Reserve, OCC, and SEC. FDIC, Federal Reserve, OCC, and SEC staff
provided technical suggestions and corrections that we have incorporated
where appropriate.

We will provide copies of this report to the appropriate congressional
committees. In addition, the report will be available at no charge on the
GAO Web site at http://www.gao.gov.

If you or your staffs have any questions about this report, please contact
me at (202) 512-8678 or [email protected] or Daniel Blair, Assistant
Director at (202) 512-9401 or [email protected].

Richard Hillman, Director Financial Markets and Community Investment

Appendix I

                       Objectives, Scope, and Methodology

During our review, we sought the perspectives of commercial banks that
were significant participants in the syndicated loan market. Officials
from six large commercial banks agreed to meet with us as part our review.
In 2003, these banks arranged about 67 percent of total U.S. syndicated
loan volume.1 We also interviewed officials from two investment banks to
obtain the perspectives of other loan market participants.

To determine the differences between the price of loan commitments and
loans, we examined data on loan commitments and loans compiled by a loan
pricing data firm, analyzed the various characteristics of each
instrument, and reviewed other financial literature related to the
syndicated loan market. We also discussed the price of loan commitments
and loans with commercial banks, investment banks, federal bank
regulators, officials from credit rating agencies, officials from a loan
pricing data firm and loan market trade association, and other industry
observers.

To determine what data were publicly available about the trading of loan
commitments, we analyzed data on secondary loan market trading compiled by
a loan pricing data firm and reviewed other financial literature related
to secondary loan market trading. We also interviewed commercial bankers,
investment bankers, and officials from a loan pricing data firm and loan
market trade association to obtain their perspectives on secondary loan
market trading. In addition, we discussed the trading of loan commitments
with federal bank regulators, officials from credit rating agencies, and
other industry observers.

To determine the extent to which credit default swaps were used to reduce
the risk of loan commitments, the similarities and differences between
credit default swaps and loan commitments, and what, if anything, the
prices of credit default swaps indicate about the prices of loan
commitments, we analyzed data on credit default swaps compiled by federal
banking regulators and a global trade association for derivatives and
reviewed the financial statements of the 6 commercial banks for
information on credit default swap usage. We also interviewed commercial
bankers and investment bankers to obtain their perspective. In addition,
we discussed the use of credit default swaps by commercial banks with
federal bank regulators, officials from a global trade association for
derivatives, officials from credit rating agencies, officials from a loan
market data collection firm and trade association, and other industry
observers.

1Based on Loan Pricing Corporation 2003 U.S. Syndicated Loan League Table.

Appendix I
Objectives, Scope, and Methodology

To determine whether the differences between commercial and investment
bank's accounting for loan commitments provide either firm with a
consistent competitive advantage, we reviewed our previous comparative
analysis of applicable accounting standards. We also updated our
understanding of the accounting standards for loan commitments through
interviews with officials from the Financial Accounting Standards Board
(FASB). In addition, we obtained the perspectives of commercial bankers,
investment bankers, federal banking regulators, officials from credit
rating agencies, and other industry observers regarding the current
accounting standards for loan commitments.

To determine the strengths and weaknesses of fair value accounting, and
the projects that FASB has under way that might change the way commercial
and investment banks account for loan commitments, we reviewed a recently
issued accounting exposure draft and conducted interviews with officials
from FASB. We also discussed the merits of fair value accounting in
interviews with commercial bankers, investment bankers, federal banking
regulators, officials from credit rating agencies, officials from a loan
market data collection firm and trade association and other industry
observers.

We assessed all data for reliability and found them to be sufficiently
reliable for the purposes of our reporting objectives. We conducted our
work in Charlotte, N.C.; New York City, N.Y.; Norwalk, Conn.; San
Francisco, Calif.; and Washington, D.C., between November 2003 and October
2004, in accordance with generally accepted government auditing standards.

Appendix II

Differences in Accounting between Commercial and Investment Banks for Loan
Commitments

Because commercial and investment banks follow different accounting
models, there are differences in the financial statement presentation of
some similar transactions. This appendix summarizes the differences, under
generally accepted accounting principles in how commercial banks and
investment banks account for loan commitments-specifically commercial
paper back-up credit facilities-using hypothetical scenarios to illustrate
how these differences could affect the financial statements of a
commercial and investment bank.1 We use three hypothetical scenarios to
illustrate the accounting differences that would occur between the
commercial and investment banks for similar transactions if (1) a loan
commitment were made, (2) the loan commitment was exercised by the
borrower and the loan was actually made, and (3) the loan was subsequently
sold. This appendix does not assess the differences in accounting that
would occur between a commercial and investment bank if one entity decided
to hold a loan to maturity while the other had the loan held for sale
because these are not similar transactions.

The examples in this appendix demonstrate that, as of a given financial
statement reporting date, differences would likely exist between
commercial and investment banks in the reported value of a loan commitment
and a loan resulting from an exercised commitment, as well as the
recognition of the related deferred revenue. In addition, the volatility
of the fair value of loan commitments and the related loan, if the
commitment were exercised, would be reflected more transparently in an
investment bank's financial statements, because an investment bank must
recognize these changes in value in earnings as they occur in net income.2
In contrast, commercial banks are not allowed to recognize changes in the
fair value of the loan commitment, its related deferred revenue, or the
related loan (if drawn and held to maturity). The differences in
accounting between commercial banks and investment banks are temporary,
and, as the examples in the following sections show, whether a commercial
bank or an investment bank recognizes more fee revenue first would depend
on various market conditions including interest rates and spreads.
Similarly,

1Commercial paper is generally a short-term unsecured money market
obligation issued by prime rated commercial firms and financial companies.
A commercial paper back-up facility is generally a short-term bank line of
credit that serves as an alternate source of liquidity for an issuer of
commercial paper lasting less than 1 year.

2FASB has defined fair value in SFAS 107, Disclosures about Fair Value of
Financial Instruments, as the amount at which a financial instrument could
be exchanged in a current transaction between willing parties, other than
a forced liquidation sale.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

any differences between the fair value of a loan or loan commitment on an
investment bank's books and the net book value of a similar loan or loan
commitment on a commercial bank's books would be eliminated by the end of
the loan term or commitment period.3 Further, both commercial and
investment banks are required to make similar footnote disclosures about
the fair value of their financial instruments. Thus, neither accounting
model provides a clear and consistent advantage over the life of the loan
commitment or the loan if the commitment were exercised.

Background	Since 1973, the Financial Accounting Standards Board (FASB) has
been establishing private sector financial accounting and reporting
standards. In addition, the American Institute of Certified Public
Accountants (AICPA) Accounting Standards Executive Committee also provides
industryspecific authoritative guidance that is cleared with FASB prior to
publication. Where FASB guidance is nonexistent, as is currently the case
in fair-value accounting for loan commitments, firms are required to
follow AICPA guidance.

Most commercial banks generally follow a mixed-attribute accounting

model, where some financial assets and liabilities are measured at

historical cost, some at the lower of cost or market value, and some at
fair

value. In accounting for loan commitments, banks follow the guidance in

Statement of Financial Accounting Standards (SFAS) Number 91,

Accounting for Nonrefundable Fees and Costs Associated with

Originating or Acquiring Loans and Initial Direct Costs of Leases.4

Broker-dealer affiliates and investment banks whose primary business is to

act as a broker-dealer follow the AICPA's Audit and Accounting Guide,

Brokers and Dealers in Securities, where the inventory (that may include

loan commitments) are recorded at the current fair value and the change in

3The net book value of a loan is generally its unpaid principal balance
less any allowance for credit losses.

4SFAS 91applies to loan commitments held by lending institutions. If a
commercial bank held a loan commitment in a broker-dealer affiliate
registered with the Securities and Exchange Commission, the affiliate
would follow the AICPA guidance for broker-dealers.

Appendix II
Differences in Accounting between
Commercial and Investment Banks for Loan
Commitments

value from the prior period is recognized in net income.5 Further, FASB
currently has a project on revenue recognition that includes, among other
things, the accounting for loan commitment fees by investment banks and
others. The purpose of that project includes addressing the inconsistent
recognition of commitment fee income and may eliminate some of the
accounting differences that exist between commercial and investment banks
described in this appendix.

FASB has stated that it is committed to work diligently toward resolving,
in a timely manner, the conceptual and practical issues related to
determining the fair values of financial instruments and portfolios of
financial instruments. Further, FASB has stated that while measurement at
fair value has conceptual advantages, all implementation issues have not
yet been resolved, and the Board has not yet decided when, if ever, it
will be feasible to require essentially all financial instruments to be
reported at fair value in the basic financial statements. Although FASB
has not yet issued comprehensive guidance on fair-value accounting, recent
literature has stated that the fair-value accounting model provides more
relevant information about financial assets and liabilities and can keep
up with today's complex financial instruments better than the historical
cost accounting model. The effect of the fair-value accounting model is to
recognize in net income during the current accounting period amounts that,
under the historical cost model, would have been referred to as unrealized
gains or losses because the bank did not sell or otherwise dispose of the
financial instrument. Further, proponents of the fair-value accounting
model contend that unrealized gains and losses on financial instruments
are actually lost opportunities as of a specific date to realize a gain or
loss by selling or settling a financial instrument at a current price. On
the other hand, a disadvantage of fair value accounting exists when there
is not an active market for the financial instrument being valued. In

5For simplicity, in this appendix the term investment bank will be used to
mean an investment bank in which the broker-dealer comprises a majority of
the financial activity. In practice, investment banks do not often hold
loan commitments in their broker-dealer affiliates because of the high
capital requirements of broker-dealers; rather, the investment bank would
generally hold these financial instruments in a nonbroker-dealer
affiliate. However, according to AICPA staff, at the consolidated level,
the entity would retain the specialized accounting model used for the
broker-dealer subsidiary. The commercial bank would continue to use SFAS
91 to account for its loan commitments. A nonbroker-dealer that is a
subsidiary of a broker-dealer holding company (not a bank holding company)
may also follow the accounting used by its broker-dealer subsidiary, if
the broker-dealer comprises the majority of the financial activity of the
consolidated entity; that is, the fairvalue model would also be used for
the consolidated broker-dealer holding company financial statements.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

this case, the fair value is more subjective and is often determined
either by various modeling techniques, based on the discounted value of
expected future cash flows, or based on the value of credit derivatives.

Hypothetical Scenario for Unexercised Loan Commitments

Revenue Recognition for the Commercial Bank

On the first day of an accounting period, Commercial Bank A and Investment
Bank B each made a $100 million loan commitment to a highly rated company
to back up a commercial paper issuance. This loan commitment was
irrevocable and would expire at the end of three quarterly accounting
periods. Because the loan commitment was issued to a highly rated company,
both banks determined that the chance of the company drawing on the
facility was remote. Both banks received $10,000 in fees for these loan
commitments. Commercial Bank A followed the guidance in SFAS No. 91 and
recorded this transaction on a historical cost basis, while Investment
Bank B, subject to specialized accounting principles that require
fair-value accounting, reported changes in fair value included the effect
of these changes in earnings.

Upon receipt of the loan commitment fee, Commercial Bank A would record
the $10,000 as a liability, called deferred revenue, because the bank
would be obligated to perform services in the future in order to "earn"
this revenue. In practice, because of the relatively small or immaterial
amounts of deferred revenue compared with other liabilities on a bank's
statement of position (balance sheet), this amount would not be reported
separately and would likely be included in a line item called "other
liabilities."6 Commercial Bank A would follow the accounting requirements
of SFAS No. 91 and recognize the revenue as service fee income in equal
portions over the commitment period, regardless of market conditions-a
practice often referred to as revenue recognition on a straight-line
basis. Thus, at the end of the first accounting period, Commercial Bank A
would reduce the $10,000 deferred revenue on its statement of position
(balance sheet) by one-third or $3,333 and record the same amount of
service fee revenue on the statement of operations (income statement). The
same accounting would occur at the end of the second and third accounting
periods, so that an equal portion of service revenue would have been
recognized during each period that the bank was obligated to loan the
highly rated company

6The concept of materiality is discussed at length in FASB's Concept
Statement 2, Qualitative Characteristics of Accounting Information,
paragraphs 123 - 132.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

$100 million.7 Commercial Bank A would not report the value of the loan
commitment on its balance sheet. However, the bank would disclose in the
footnotes to its financial statements the fair value of this commercial
paper back-up facility as well as the method used to estimate the fair
value.8

Revenue Recognition for the Although AICPA's Audit and Accounting Guide,
Brokers and Dealers in

Investment Bank	Securities does not provide explicit guidance for how
Investment Bank B would account for this specific transaction, the guide
provides relevant guidance on accounting for loan commitments in general.
This guide states that Investment Bank B would account for inventory,
including financial instruments such as a commercial paper back-up
facility, at fair value and report changes in the fair value of the loan
commitment in earnings. When changes occurred in the fair value of the
loan commitment, Investment Bank B would need to recognize these
differences by adjusting the balance of the deferred revenue account to
equal the new fair value of the loan commitment. Generally, quoted market
prices of identical or similar instruments, if available, are the best
evidence of the fair value of financial instruments. If quoted market
prices are not available, as is often the case with loan commitments,
management's best estimate of fair value may be based on the quoted market
price of an instrument with similar characteristics or may be developed by
using certain valuation techniques such as estimated future cash flows
using a discount rate commensurate with the risk involved, option pricing
models, or matrix pricing models. A corresponding entry of identical value
would be made to revenue during the period in which the change in fair
value occurred. Once the commitment period ended, as described in the
previous paragraph, the deferred revenue account would be eliminated and
the entire balance recorded as income because the fair value of the
expired loan commitment is zero.

If market conditions changed shortly after Investment Bank B issued this
credit facility and its fair value declined by 20 percent to $8,000,
Investment Bank B would reduce the deferred revenue account on its
statement of position (balance sheet) to $8,000, the new fair value.
Investment Bank B

7If the likelihood of exercising this commitment had not been remote,
Commercial Bank A would have followed the requirements of SFAS 91, and not
amortized the deferred revenue until the commitment was exercised. Once
exercised, the bank would recognize the fee income over the life of the
loan. If the commitment remained unexercised, income would be recognized
upon expiration of the commitment.

8This is required by SFAS No. 107, Disclosures about Fair Value of
Financial Instruments.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

Differences in Revenue Recognition are Temporary

would recognize $2,000 of service fee income, the amount of the change in
value from the last reporting period, in its statement of operations
(income statement). Investment Bank B would also disclose in its footnotes
the fair value of this credit facility, as well as the method used to
estimate the fair value.

If during the second accounting period there was another change in market
conditions and the value of this credit facility declined another 5
percent to $7,500, Investment Bank B would decrease the balance in the
deferred revenue account to $7,500 and recognize $500 in service fee
revenue. Further, Investment Bank B would disclose in its footnotes the
fair value of this credit facility.

During the accounting period in which the commitment to lend $100 million
was due to expire, accounting period 3 in this example, the balance of the
deferred revenue account would be recognized because the commitment period
had expired and the fair value would be zero. Thus, $7,500 would be
recognized in revenue and the balance of deferred revenue account
eliminated. In this accounting period, there would be no disclosure about
the fair value of the credit facility.

Table 5 summarizes the amount of revenue Commercial Bank A and Investment
Bank B would recognize and the balance of the deferred revenue account for
each of the three accounting periods when there were changes in the value
of the loan commitments. Commercial Bank A would recognize more service
fee income in accounting periods 1 and 2 than Investment Bank B. However,
this situation would be reversed in period 3, when Investment Bank B would
recognize more revenue. Thus, differences in the value of the loan
commitment and the amount of revenue recognized would likely exist between
specific accounting periods, reflecting the volatility of the financial
markets more transparently in Investment B's financial statements. The
magnitude of the difference is determined by the market conditions at the
time and could be significant or minor. However, these differences would
be resolved by the end of the commitment period, when both entities would
have recognized the same amount of total revenue for the loan commitment.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

    Table 5: Accounting Differences for a Loan Commitment Commercial Bank A
                               Investment Bank B

Accounting period

                                               Service-fee revenue recognized

Balance of deferred revenue

                                               Service-fee revenue recognized

Balance of deferred revenue

            Initial recording                                     
                of the credit                                     
                     facility          $0   $10,000            $0     $10,000 
                            1    3,333       6,667       2,000          8,000 
                            2    3,333       3,334            500       7,500 
                            3    3,334              0    7,500    
               Total service-                                     
                  fee revenue                                     
                   recognized   $10,000                 $10,000   

                                  Source: GAO.

Hypothetical Scenario for Commercial Bank A and Investment Bank B issued
the same loan

Exercised Loan commitment described previously. However, at the end of the
second

Commitments	accounting period, the highly rated company exercised its
right to borrow the $100 million. The accounting treatment for this loan
would depend upon whether the banks intended to hold or sell the loan. In
practice, this loan could be either held or sold, and as a result, the
accounting for both is summarized in the following sections.

Loans Held to Maturity	At the time the loan was made, Commercial Bank A
would record the loan as an asset on its statement of position (balance
sheet) at its principal amount less the balance of the deferred revenue
account ($100 million $3,334). Investment Bank B would initially record
this loan at its historical cost basis, less the loan commitment's fair
value at the time the loan was drawn ($100 million -$7,500). Further,
based on an analysis by the banks' loan review teams, a determination of
"impairment" would be made. According to SFAS 114, Accounting by Creditors
for Impairment of a Loan, "a loan is impaired when, based on current
information and events, it is probable that a creditor will be unable to
collect all amounts due according to the contractual terms of the loan
agreement." If the loan were determined to be impaired, SFAS 114 states
that, the bank would measure the amount of impairment based on the present
value of expected future cash flows discounted at the loan's effective
interest rate, except that as a practical expedient, the amount of
impairment may be based on the loan's

Appendix II
Differences in Accounting between
Commercial and Investment Banks for Loan
Commitments

observable market price, or the fair value of the collateral if the loan
were collateral dependent.

SFAS 114 directs both banks to establish an allowance for losses when the
measure of the impaired loan is less than the recorded investment in the
loan (including accrued interest, net of deferred loan fees or costs and
unamortized premium or discount) by creating a valuation allowance that
reduces the recorded value of the loan with a corresponding charge to
baddebt expense. When there are significant changes in the amount or
timing of the expected future cash flows from this loan, the banks would
need to adjust, up or down, the loan loss allowance as appropriate so that
the net balance of the loan reflects management's best estimate of the
loan's cash flows. However, the net value of the loan cannot exceed the
recorded investment in the loan.

If the loan were not impaired under FAS 114, both banks would still record
an allowance for credit losses in accordance with FAS 5, Accounting for
Contingencies, when it was probable that a loss from impairment of the
loan had occurred and the amount of the loss was reasonably estimable.
Thus, both banks would establish an allowance for loss in line with
historical performance for borrowers of this type.9 Because the loan was
performing, both banks would receive identical monthly payments of
principal and interest. Generally, these cash receipts would be applied in
accordance with the loan terms and a portion would be recorded as interest
income, and the balance applied would reduce the banks' investment in the
loan. At the end of the loan term, the balance and the related allowance
for this loan would be eliminated.

SFAS 91 also directs both banks to recognize the remaining unamortized
commitment fee over the life of the loan as an adjustment to interest
income. Because the borrower's financial condition had deteriorated, both
banks would likely have charged a higher interest rate than the rate
stated in the loan commitment. As a result, at the time it became evident
that the loan was to be drawn, Investment Bank B would record a liability
on its balance sheet to recognize the difference between the actual
interest rate of the loan and the interest rate a loan to a borrower with
this level of risk

9FAS 5 states that receivables by their nature usually involve some degree
of uncertainty about their collectibility, in which case a loss
contingency exists. If a loss were not probable and estimable, both banks
would disclose in their financial statement footnotes the loss contingency
when there was at least a reasonable possibility that a loss or additional
loss might be incurred.

                                  Appendix II
                       Differences in Accounting between
                    Commercial and Investment Banks for Loan
                                  Commitments

would have been made at-in essence the fair value interest rate.
Investment Bank B would also amortize this liability over the life of the
loan as an adjustment to interest income.

Loans Made Available for Sale	If Commercial Bank A and Investment Bank B's
policies both permitted the firms to only hold loans to maturity when the
borrowers were highly rated, it is unlikely that the banks would keep the
loan in the previous scenario and would sell the loan in the hypothetical
scenario soon after it was made.10 The banks would follow different
guidance that would provide similar results. Commercial Bank A would
follow the guidance in the AICPA Statement of Position 01-6, Accounting by
Certain Entities (Including Entities With Trade Receivables) That Lend to
or Finance the Activities of Others that was issued in December 2001.
According to this guidance, once bank management decides to sell a loan
that had not been previously classified as held-for-sale, the loan's value
should be adjusted to the lower of historical cost or fair value and any
amount that historical cost exceeds fair value should be accounted for as
a valuation allowance. Further, any subsequent changes in the loan's fair
value that would be required to be adjusted through the valuation
allowance, such as a further decline in fair value, would be recognized in
income. However, if the fair value increased to the point where it exceed
the historical carrying value, this gain would not be recognized in income
unless the loan were sold. Investment Bank B would follow the guidance in
the AICPA's Audit and Accounting Guide, Brokers and Dealers in Securities,
as it did with loan commitments, and account for inventory at fair value
and report changes in the fair value of the loan in net income.

For example, if bank management decided to sell the loan soon after it was
drawn when some payments had been made to reduce the principal balance and
the net book value of this loan was $88,200,000 (unpaid principal balance
of $90,000,000 less the related allowance of $1,800,000) and the fair
value was 97 percent of the unpaid principal balance or $87,300,000, both
banks would recognize the decline in value of $900,000 in earnings. While
the loan remained available-for-sale, any changes in its fair value would
be recorded in income. For example, if the loan's fair value

10To keep this exception scenario example simple, it is also assumed that
there are not conditions that would constrain Commercial Bank A and
Investment Bank B from selling the loan, that both banks will not retain
any interest in the loans sold, and the loans are sold without recourse.

Appendix II
Differences in Accounting between
Commercial and Investment Banks for Loan
Commitments

declined further to $85,500,000, both banks would recognize the additional
decline in value of $1,800,000 in earnings.

Table 6 summarizes the accounting similarities between Commercial Bank A
and Investment Bank B for the loan sale. Although the two banks followed
different guidance, the effect of the loan sale is the same for both
banks.

                Table 6: Accounting Differences for a Loan Sale

                                                Commercial         Investment 
                            Transaction Bank A loss amount Bank B loss amount 
         Transfer the loan to the held-                    
                     for-sale portfolio         <$900,000>         <$900,000> 
                   Change in fair value       <$1,800,000>       <$1,800,000> 
                Total loss on loan sale       <$2,700,000>       <$2,700,000> 

Source: GAO.

Appendix III

                     GAO Contacts and Staff Acknowledgments

GAO Contacts	Richard Hillman (202) 512-8678 Daniel Blair (202) 512-9401

Acknowledgments	In addition to those individuals named above, Emily
Chalmers, Marshall Hamlett, Robert Pollard, and John Treanor made key
contributions to this report.

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