Friday, July 25, 2008

Cox, Geithner Tell Congress...

Accounting issues were among topics addressed to and by SEC Chairman Christopher Cox and New York Fed President Timothy Geithner at the House Financial Services hearing yesterday (July 24) on Systemic Risk and the Financial Markets. Cox indicated ‘real-time’ guidance is coming on fair value accounting in inactive markets, and Geithner said he expects additional recommendations of a working group on over-the-counter (OTC) derivatives infrastructure soon. Congressman Paul Kanjorski noted he has requested that GAO conduct a study of Structured Finance Products.
On a broader level, Cox and Geithner discussed their views of the role the SEC and Fed should play, including the recent Memorandum of Understanding (MOU) on cooperation signed by the two agencies, and noted where they believed additional legislation was warranted, regarding oversight and regulation of commercial and investment banks. (Links to written testimony: Cox and Geithner) We focus today on the accounting issues discussed at the hearing, including interplay of accounting and capital requirements. For a general more general summary of the hearing, see “SEC’s Cox Says Investment Banks Play a Unique Role,” by AP’s Marcy Gordon, carried on

Guidance on Fair Value Coming
Congressman Barney Frank, chair of the House Financial Services committee, noted there can be a “conflict between actions that protect investors, and systemic stability,” adding, “there are times those two could pull in different directions.” He cited mark-to-market accounting as an example of this conflict.

[Note: for simplicity the terms mark-to-market (MTM) and fair value (FV) are often used interchangeably, although the FASB standard - FAS 157, Fair Value Measurement - includes other measures besides market value. However market value is the most prominent and considered the most relevant input (level 1 in the 3 level hierarchy) for determining fair value in the standard.]

“Clearly investors are entitled to know what is the real value they are buying into,” continued Frank. However, he noted, “It is also the case that … mark-to-market could have procyclical effects, “ adding, “our interest [in] informing investors on mark-to-market could have negative consequences.”

“No one is suggesting back off mark-to-market,” said Frank, but referring to Cox’ testimony, noted “[Chairman] Cox’ suggestion, how to combine investor protection... [with] some flexibility in consequences [as to] how much capital has to be raised,” (i.e., to meet bank regulatory requirements for capital) is an important consideration.

N.Y. Fed President Geithner responded, “I don’t know how we get a better balance between accounting regimes that now apply, particularly to institutions that exist at the core of the system,” and capital requirements. He continued, “What you want is a system where you have a level of cushion in terms of capital reserves, liquidity, … [so] when things change, those cushions are stabilizing rather than destabilizing. If the cushions are too thin you risk amplifying the crisis.”

“If you look at incentives we create through [the] capital and accounting regime,” said Geithner, “the basic issue of procyclicality [is] very complicated.” He added, “Very thoughtful people spend a lifetime advocating benefits of both those regimes, we live somewhere in the middle.”

SEC Chairman Cox noted the SEC hosted a roundtable on FV accounting on July 9, at which “we heard from a wide variety of participants… the general consensus was FV has been a help to investors in these difficult circumstances, they want more not less… it has not been the cause of volatility in the markets or other problems we’ve seen in the current market turmoil.” He added, “There are in Europe existential questions about [whether to use] FV or not,” but “I don’t think we’re having that debate in the U.S.”

“The real question is,” said Cox, “at the margin,” [i.e. in inactive markets], “[using a] model trying to generate price, [when you have an] asset throwing off cash.. do you have to value at zero?” Importantly, Cox noted, “We are hoping to provide answers in real time in the form of guidance.”

[Note: this sounds to me like the SEC may issue guidance sooner than later in the form of a staff questions & answers (Q&A) document or a staff accounting bulletin (SAB). Additionally, as previously reported, at the close of SEC’s July 9 FV roundtable, Cox said staff of the SEC, FASB and PCAOB would consider next steps in developing further guidance on FV.]

[In related news, although not mentioned at the hearing, the IASB’s Expert Advisory Panel on valuing instruments in inactive markets noted in a summary posted on July 24 that it plans to discuss a draft document on July 31 and post it for public comment thereafter. The draft document will contain (1) a summary of the issues encountered in the credit crisis; (2) IAS 39’s requirements re: those issues; and (3) a summary of how the panelists have dealt with the issues in practice, focusing on the processes and approaches used when measuring the fair value of financial instruments when there is no longer an active market. The IASB adds (hat tip to BNA’s Daily Report for Executives for flagging this point): “Due to the urgency of completing this work in a timely manner, we will ask interested parties to provide comments to us fairly quickly.”]

Changes to Securitization, Off-Balance Sheet Accounting Discussed With Bernanke, Cox Says
One Congressman asked if the SEC and Fed are “studying implications of FASB fast tracking elimination of Qualified Special Purpose Entities (QSPEs), which allow for securitization in the marketplace.”

“Are you studying effects of this rulemaking on the marketplace,” asked the Congressman, who added, “after all, in my opinion, the Federal Reserve, but more importantly Treasury … stepped in [to support] Fannie Mae and Freddie Mac because of a Lehman Brothers report that explained the risks going forward on [upcoming amendments to the] FASB rule, [in which Lehman Brothers noted the] possibility they may need to raise $75 billion in capital.”

Cox responded, “I think it’s wrong to say this is being fast tracked, the likely scenario [is, there will be] a period for public comment.”

Referring to the FASB, the Congressman replied, “They’ve said they want it done [by the] end of [the] year.”

Cox said, regarding the effective dates for the changes described by the Congressman (particularly FASB’s plan to eliminate QSPEs as a vehicle to obtain sale treatment or off-balance sheet treatment for securitizations of mortgage-backed and other securities), “we’re talking years into the future.” UPDATE: See our separate blog post today (July 25), “FASB To Reconsider Timing on Proposed Changes to Securitization Rules.”

“The answer to your question, is yes, we are not just studying it, we have discussed this extensively with FASB, the Federal Reserve Bank of New York, and just yesterday with [Fed] Chairman Bernanke,” said Cox. “We are very focused on this and understand precisely the environment we are operating in on this, [we] understand the importance of reforming accounting, something the President’s Working Group asked FASB to do.” On the other hand, continued Cox, they don’t want to create unnecessary [burdens/challenges] (Note: I didn’t hear the exact word Cox used after ‘unnecessary’ but it seemed like it would have been ‘burdens’ or ‘challenges’).

Geithner agreed, saying the full range of dynamics of the credit market crisis need to be thought through, including implications of changes in accounting rules on the capital regime. He added he “appreciates Chris [Cox’ efforts] to bring more broadly to [attention of] the Fed and others those implications.”

Kanjorski Asks GAO to Study Structured Finance Products; Bachus Asks About CDS
As noted above, Congressman Paul Kanjorski said in his opening statement that he has asked the U.S. Government Accountability Office (GAO) to conduct a study on structured financial products, including credit default swaps and collateralized debt obligations.

“This study will examine the nature of these instruments and the degree of transparency and market regulation surrounding them,” said Kanjorski. “From this study, we should obtain a clearer picture of how to improve regulation in this sector of our financial system.”

Congressman Spencer Bachus, Ranking Member on the House Financial Services Committee noted the total volume of one such instrument, Credit Default Swaps (CDS), is currently “roughly twice the size of the stock market.”
Bachus acknowledged the Fed has worked with market participants to centralize clearing, automate trading and settlement mechanisms for CDS, but asked (as detailed further in his opening statement), “how [did] we arriv[e] at a system in which the issuers of credit default swaps are allowed to provide guarantees that so far exceed their capital reserves that there is virtually no possibility they can pay in the event of defaults of the underlying obligations?” He asked about the role of the SEC in supervising investment banks, and added, “why [did] our regulators … allo[w] credit default swaps to remain essentially unregulated while they became intertwined in transactions throughout our economy?” leading to a situation in which “almost every primary dealer is considered ‘too big or interconnected to fail’.”
“If we accept this premise — that every primary dealer is “too big to fail”,” said Bachus, “then we also have to conclude that our financial markets are no longer capable of self regulation and that government must exercise greater control, both as a regulator and as a lender — if not a buyer — of last resort. As I indicated at our first hearing on this subject two weeks ago, that is a conclusion that I am not prepared to accept.” Bachus asked Geithner: “How can we contain the risk of default of CDS and still maintain use of CDS as a valuable risk management tool?”

Geithner responded that CDS “bring very important benefits we want to maintain, but [also present] challenges.” Two critical things, said Geithner, are that dealers need to carefully manage their exposures, and there needs to be a centralized trade processing infrastructure to support and automate what is currently a ‘bilateral’ or dealer-to-dealer market.

Referencing the OTC Derivatives Market Infrastructure convened by the Fed, Geithner said, “You will see in the public domain in the next couple weeks another set of [recommendations/objectives] from those dealers.”

Where will you be a year from now?

One Congressman asked Cox and Geithner, “Where are you guys going to be a year from now?”

Cox replied, “[That’s a] fascinating question.” He added, “I hope at least the market environment in which I am operating at that time will be a positive one and a strong one.”

Geithner, asked specifically by the Congressman “Will you be at the Fed,” responded, “Life is uncertain, but I certainly expect to be.”

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