Statement for the Record. On Behalf of the AMERICAN BANKERS ASSOCIATION. Before the

Transcription

1 Statement for the Record On Behalf of the AMERICAN BANKERS ASSOCIATION Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises Committee on Financial Services United States House of Representatives

2 Statement for the Record On Behalf of the American Bankers Association Before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises Committee on Financial Services United States House of Representatives March 12, 2009 Chairman Kanjorski, Ranking Member Garrett and members of the Subcommittee, the American Bankers Association (ABA) appreciates the opportunity to submit a statement on the issues surrounding mark to market accounting. ABA works to enhance the competitiveness of the nation's banking industry and strengthen America s economy and communities. Its members the majority of which are banks with less than $125 million in assets represent over 95 percent of the industry s $13.9 trillion in assets and employ over 2 million men and women. The problems that exist in today s financial markets can be traced to many different factors. One key factor that is recognized as having exacerbated these problems is fair value accounting, also known as mark to marketing accounting. Current accounting is resulting in financial statements for banks that are not transparent and are misleading to users of financial statements. ABA unequivocally supports transparency in financial reporting, both as preparers of financial statements and users of others financial statements. Therefore, we believe it is critical to make improvements to financial reporting in this case, improvements to fair value accounting. Recording credit losses is an important part of this process. However, current mark to market accounting requires that additional losses be reported. This AMERICAN BANKERS ASSOCIATION 2

3 accounting has a pro-cyclical impact on the securities involved, as market uncertainty increases with such accounting and the downward spiral of market values continues. Detailed descriptions of the problems and our recommended solutions are outlined below. Mark to market accounting is broken and is causing havoc in the markets. Accounting guidance provided to financial statement preparers and auditors regarding mark to market accounting have either been insufficient or nonexistent. Immediate changes are necessary and can be made to provide more accurate, reliable, and transparent information to users of financial statements. I. Mark to market accounting is broken and is causing havoc in the markets Mark to market accounting (MTM) has been extremely controversial for many years. Under MTM, certain assets and liabilities are recorded in financial statements at their market values. Therefore, when the market swings, so do financial statements often ignoring the underlying economics. The current market environment has demonstrated the pro-cyclicality and other flaws related to mark to market accounting. MTM is required in a number of areas for commercial banks. Investment securities use MTM, whether they are in trading portfolios or designated as available for sale (AFS). Derivatives used by banks and mortgage servicing rights also use MTM. Under a relatively new accounting standard, all assets and liabilities, whether they are financial assets and liabilities or not, are marked to market during a business acquisition. All securities classified as other than temporarily impaired (also known AMERICAN BANKERS ASSOCIATION 3

4 as OTTI) are marked to market, whether the security is available for sale or being held to maturity. There are many other areas in the accounting literature that require MTM, thus, a broad suspension of MTM is not what we believe is the appropriate solution. In some cases, MTM changes are recorded only in capital (such as AFS securities), and in other cases, the changes in market values are recorded in earnings and capital (such as trading portfolios, most derivatives, and OTTI). In any event, MTM accounting can be pervasive at a bank and it can have a significant impact on publicly reported capital. Current market conditions have brought to light two major areas in the MTM accounting literature that are broken and need to be repaired: (1) the definition of fair value, and (2) the definition of OTTI. The definition of fair value needs repair. In 2006, FASB issued Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS 157), changing the definition of fair value to require that exit price be used. The new guidance, however, does not provide an adequate framework for applying MTM when markets become illiquid. Typical sellers are not selling in these markets and typical buyers are not buying in meaningful volumes. Many holders of assets are, thus, restrained from selling, because they know the economic values of their assets are greater than the infrequent and/or distressed sale values they are seeing in the marketplace. Thus, there is no true fair value. The use of exit price in an illiquid market results in an unrealistic downward bias, which reduces transparency and can have serious public policy implications. AMERICAN BANKERS ASSOCIATION 4

5 The definition of Other Than Temporary Impairment needs repair. Recording OTTI that is based on credit impairment is non-controversial in the banking industry banking institutions fully understand and support the need to record such impairment. However, there is much controversy with recording losses that are based on the market s perception of value (MTM), which often results in recognizing losses that exceed credit losses or, even worse, recording losses for instruments that have experienced no credit problems and are fully performing in accordance with their terms. The erosion of earnings and capital due to a market s perception of losses or due to a lack of liquidity that drives values lower is misleading to investors and other users of financial statements. In today s illiquid market, the results of improper OTTI rules can be severe: capital is artificially eroded despite solid fundamental credit performance, and the lending capability of a bank is needlessly reduced. This amplifies the pro-cyclical nature of MTM reduced lending slows economic activity, which puts mortgage and other borrowers at risk, and puts further pressure on mortgage-backed and other asset-backed security prices. The cycle builds on itself. Therefore, misleading information is contributing to the uncertainty in the markets and further constriction of credit in investment markets. The resulting credit squeeze has an impact on individuals, their savings and investments, and their spending decisions. Even in good times, this pro-cyclical effect introduces significant volatility, and, therefore, uncertainty related to financial information. Recommendations by the Group of 30, Federal Reserve Chairman Ben Bernanke, and others call for a review of mark to market accounting in light of its inherent pro-cyclical structure. In some cases, MTM changes are recorded only in capital (such as AFS securities), and in other cases, the changes in market values are recorded in earnings and capital (such as trading portfolios, most derivatives, and OTTI). In any event, AMERICAN BANKERS ASSOCIATION 5

6 MTM accounting can be pervasive at a bank and it can have a significant impact on publicly reported capital. II. Accounting guidance provided to financial statement preparers and auditors regarding mark to market accounting has either been insufficient or non-existent. The Securities and Exchange Commission (SEC) and the FASB have issued various clarifications on fair value accounting to help companies assign value to illiquid assets. However, this guidance has been insufficient. For example, the guidance still does not address how to determine when markets are sufficiently distressed in order to use modeling for estimating fair values. There has also been no further attempt to improve the OTTI rules in this environment, even though on October 14, 2008, SEC wrote to the FASB requesting that a review of OTTI be done expeditiously. Moreover, even though many believe that auditors may be applying the accounting rules in a way that was never intended, there has been no guidance from the Public Company Accounting Oversight Board (PCAOB) provided to auditors to assist them in their audits. The adverse affect of MTM almost always results in OTTI for banks, which directly reduces earnings and capital. This lack of timely guidance, then, on MTM is frustrating for banks, especially as it relates to OTTI. In the U.S., OTTI is triggered based on market values. If any OTTI exists, the asset must be written down to market value through earnings. That is, if an asset s market value is below the value on the books, it should be evaluated to determine whether it has OTTI. If OTTI exists, then the asset must be written down to market value, and the loss is reported in both earnings and capital. AMERICAN BANKERS ASSOCIATION 6

7 As just noted, some areas of the current market are now so uncertain that the market bid offering prices are significantly lower than the expected cash flows to be received. An example of this follows. A bank holds a mortgage security in its held to maturity portfolio. Based on the credit profile of the mortgages in the security, the bank may expect to collect 90 percent of the cash flows, so the security may have an economic value of 90 cents on the dollar. However, the bid price is only 50 cents on the dollar. Under the current application of OTTI rules, even if the cash flows are performing at 90 cents on the dollar and the entity holding the security has both the intent and ability to hold the security until it matures, the entity must write down the security through earnings to 50 cents. This write-down is permanent, and there is no subsequent reversal of the loss, even if the asset recovers its market value. Going forward, since interest received is applied to the written down asset, the reported yield on this investment is disproportionately high. Users of the financial statements will be thoroughly confused about the true financial condition of the security, and may make decisions about other similar securities based on this bad information. By way of comparison, international accounting standards are very different from those in the U.S. OTTI for debt securities that are held to maturity (including mortgage securities) is based on credit impairment rather than market value. In our example above, the security would be marked down to 90 cents for international accounting purposes, rather than 50 cents. Additionally, for international purposes, if the impairment recovers, then the amount written down can be reversed through earnings. Therefore, the U.S. rules generally result in higher losses for banks than their international competitors and less transparency as to the economic condition of their securities portfolios. AMERICAN BANKERS ASSOCIATION 7

8 III. Immediate changes are necessary and can be made to provide more accurate, reliable, and transparent information to users of financial statements. The current illiquid market we are experiencing has brought to light two major areas in MTM that need to be repaired: (1) the definition of fair value, and (2) the definition of OTTI. Some have suggested that these repairs be made to regulatory capital rules; however, ABA believes that the first priority should be to ensure that the publicly reported information is improved as soon as possible. Even banks that are well capitalized after recording OTTI are concerned that merely reporting an unnecessary loss can undercut the confidence that depositors and others have in our institutions. With this in mind, ABA recommends the following 1 : 1. The definition of fair value should be improved to replace exit price with the price between a willing buyer and a willing seller in an arm s length transaction that is not a forced sale. This would give a more representative estimate of fair value. 2. The U.S. model for OTTI should be based on an improved version of the international standards. The trigger for OTTI should be credit impairment (probable economic loss), and the securities whether held to maturity or available for sale should be written down for economic loss rather than market loss. Additionally, if OTTI recovers, the write-downs previously taken through earnings should be reversed through earnings. This would provide a more accurate and transparent estimate of economic loss. 1 Attached is ABA s letter to SEC, dated November 13, 2008, which is in response to SEC s request for its Congressionally mandated study on MTM. The letter provides additional details about the history of the issue and the ABA s recommendations for solving the problems. AMERICAN BANKERS ASSOCIATION 8

9 3. MTM (fair value) should not be the model used to account for all financial instruments, and the current efforts already underway to do so should be abandoned. Further consideration of MTM should be made based on a review performed as per recommendations by the Group of 30, Chairman Bernanke, and others. Conclusion All bankers want and critically need financial information that fairly presents financial condition and is transparent. Credit losses must be recognized, and the reporting of losses must be credible. Unfortunately, current mark to market accounting rules, including those used in the application of recording other than temporary impairment, provide neither the most relevant nor the most reliable information to any users of bank financial statements. Our recommended changes will help improve financial reporting by providing users whether they are long term investors, depositors, or regulators with more reliable and transparent information. AMERICAN BANKERS ASSOCIATION 9