Sunday, June 28, 2009

FASB's Herz Speaks About Principles, Politics In Remarks At National Press Club

In a speech at the National Press Club on June 26, 2009, Financial Accounting Standards Board Chairman Robert Herz outlined 4 major principles that he believes should guide financial regulatory reform. He noted threats to those principles include 'politicization' of accounting by 'special interests;' however, he acknowledged, "we certainly welcome active dialogue with lawmakers," and noted, "our system works because people advocate their causes."

Noting he believes "significant reforms are needed," Herz said the primary objective of financial regulatory reform should be to build "building a solid and sustainable platform for sound and stable economic growth through properly functioning financial markets that maintain public confidence in our system and our way of life.” The principles on which such reform should be based, said Herz, include transparency, infrastructure, balance/fairness, and global context.

Following his prepared remarks, Herz responded to questions posed by National Press Club President Donna Leinwand, a reporter with USA Today, selected from questions posted online and by attendees at the program. We provide highlights below from Herz' prepared remarks and a few of the questions raised during the Q&A.

Transparency [includes discussion of politics, independence, and fair value (mark-to-market)]
Herz described transparency as a fundamental principle. "Relevant, trustworthy, and timely information is the oxygen of financial markets," said Herz. "Depriving markets of such information—or polluting the information—can have very adverse consequences."

He noted concern about political influences on accounting standard-setting, such as by "certain major companies—including ones that subsequently failed and had to be rescued by the government—and industry trade groups that have sought political intervention into accounting standard setting." He continued, "While that is their right, and while we certainly welcome active dialogue with lawmakers, politicization of accounting standard setting by special interests risks undermining public confidence in the integrity of financial reporting. "

During the Q&A that followed, National Press Club President Donna Leinwand asked Herz, "You didn't name names when you accused major companies and trade groups of politicizing accounting standards... In the interest of disclosure and transparency, please name names."

After a general response, (see below) Herz replied, "I'll give you one good example, a three-letter insurance company that begins with A and ends with G." He detailed that former AIG CEO Marty Sullivan visited Capitol Hill "trying to convince lawmakers there were no problems with the credit default swaps that they had entered into, that it was all this bogus fair value accounting. And, of course, we're now as taxpayers some $150 billion-plus into AIG. There were real problems there. And in fact, the accounting was really the first sign to alert people that there were problems there."

Notably, before Herz responded with specifics to this question, he responded generally, "Our system works because people advocate their causes. We have a very important public policy mission, and that's good reporting to investors in the capital markets. So I understand, I don't welcome it, but I understand that people will, in what they view to be their interest, will try to get the answer they want. And if they don't get the answer they want from us or from the SEC... they take their views off into Congress. And our role is to explain to Congress why we're doing things, what we're doing and why it makes sense."

As to industry groups, Herz said, "There are trade groups that represent financial institutions, a number of them that... have views that the accounting ought to be one way or the other, particularly in dislocated markets. That was part of the hearing in March, and again I'm not going to tell them to stop that."

However, he added, "[T]he risk is that the perception can be if too much of that goes on, that it does make people think that... the politics are to bend the accounting rules. And that is dangerous because, in fact, we kind of create the rule or bending the rule is not appropriate."

Separately, Leinwand asked Herz, "What is your reaction to the recent charges by ITAC [FASB's Investor Technical Advisory Committee] that FASB has lost its independence?" (See ITAC's June 15 letter to the Financial Accounting Foundation, parent of FASB, which noted concern about FASB being pressured in a Congressional hearing on mark-to-market accounting on March 12, after which FASB issued additional guidance on mark-to-market (fair value) accounting in early April.)

Herz replied, "I think we believe pretty strongly that we responded to genuine issues in the system in a very highly responsible manner." Significantly, he added, "I think that it's important to distinguish between a correlation of events and causation of those particular events." He proceeded to explain the extensive due process entered into by FASB in arriving at the fair value guidance issued in April.

Leinwand later asked: "How can assets be correctly marked to market if there is no market, no transactions, no fair market pricing, a situation of total market paralysis?"

Herz replied: "That is at the core of some of the more thorny issues that have arisen over the past year. There are transactions going on for most things; but, they may be very inactive and it's not clear always who the parties are and what their motivations are, and whether they're distressed sellers, and the like." He noted "The famous Statement 157, which by the way did not introduce fair value, did not increase the use of fair value - fair value's been around for time immemorial; and the idea of marking assets down when there's bad times has been around probably for centuries. But, the problems are that we've now got - what was unexpected - was that we had all these structured securities and complex derivatives and everything was fine until people started to understand what was backing them up; i.e., mortgages, other things related to the economy, to housing, and when that all became evident and the housing market turned, the music stopped. Much less volume, the process went way down. People were less willing sellers and the like. Now, that is what we call a level three valuation, just to get technical here. Meaning that there are not a lot of observable transactions happening. And our standard covers level three."

He summed up, "Level three traditionally was meant for, in some cases, very exotic derivatives, but more usually things that for which there are not liquid markets, like intangibles. And there are well-worn techniques for that, but the issue then has been kind of making those portable in a much broader scenario of trillions of dollars of securities that all of a sudden unexpectedly became illiquid."

Herz was also asked during the Q&A if he believed the Obama administration's proposals regarding accounting standards [contained in the U.S. Treasury Department's June 17 report, Financial Regulatory Reform, A New Foundation] represented a politicization of accounting. He replied, "I don't view those as politicization of accounting. There's some recommendations in there towards the tail end that were actually included in the recent G20 declaration," adding, "I think they're consistent with a lot of the things we're doing directionally."(See related question under Global Context, below.)

Additionally, Herz spoke of the need for "additional systemic actions by others ... to improve disclosures and transparency at other levels—particularly those relating to the complexities and risks inherent in financial products, and to the information systems around the markets for structured securities and derivatives," adding, "transparency to the American public around taxpayer funded investments and financial support of major U.S. companies is also essential."

Herz recommended strengthening the infrastructure, ranging from enhanced clearing platforms, to increased disclosure that would enable price discovery, to improved regulation, which he said currently suffers from ‘balkanization’ in the U.S. and globally. He also noted the need for more attention to risk management by all parties, including financial institutions and investors. Additionally, Herz noted securities and accounting standard setters have different objectives than banking regulators, adding that while “the goal should be to promote a close working bond… I would be supportive of a greater decoupling between the determination of bank regulatory capital and our standards.”

Herz cautioned about the ‘too big to fail’ principle and about ‘perverse incentives’ of executive compensation. “Don’t get me wrong,” said Herz, “I am not in favor of the government setting and enforcing specific pay levels or pay limits in the private sector. But the investing public needs to see that the private sector is effectively addressing this issue either through continued improvements in transparency and corporate governance around executive compensation or by other means.”

Global context
Herz observed, “This crisis has been global in scale and clearly demonstrated the many linkages between financial markets and economies around the world. It has also revealed the problems that can result from regulatory gaps and differences in regulation across international financial markets."

He spoke of the need for coordinated efforts, adding, "while the prospect of having a single global capital markets regulator or a single set of regulatory rules across the international capital markets is not, in my view, a realistic prospect in the foreseeable future, much can be achieved through continued focus by groups such as the G20, the International Organization of Securities Commissions, the Basel Committee and the Financial Stability Board to develop solutions to regulatory problems in global financial markets.”

Leinwand asked: "With the Obama Administration's recommendations that we move toward a global set of financial statements, when do you think full adoption of convergence will occur? Do you think the U.S. will follow the SEC's roadmap?"

In my view, Herz sidestepped the timing question somewhat, noting that as far as the prospects for U.S. adoption of the SEC's proposed 'IFRS Roadmap" - on which SEC received over 200 comments - is concerned, "The ball's really now in their [SEC's] court to decide what to do to go forward." However, any perceived sidestep (i.e. not committing to when full convergence may occur) may have been because the question from the press combined two separate issues from a technical standpoint, i.e. by combining the terms "full adoption" and "convergence' in the same sentence. If one reads "full adoption" as implying adoption of a separate set of standards - International Financial Reporting Standards (IFRS) as promulgated by the International Accounting Standards Board (IASB) - which is the subject of the SEC's IFRS Roadmap, that is, as Herz noted, up to the SEC. However, the question of 'convergence' is a subset of the considerations or 'milestones' in SEC's IFRS Roadmap, and "convergence" does not necessarily require 'adoption' of IFRS, but rather can be achieved by the FASB and IASB converging their two sets of standards to - as Herz characterized it - a "common set of high quality standards." (That choice of words in itself was very interesting as noted further below.)

Although not commiting to a specific date for full convergence, Herz said more generally, "What I can tell you is that we continue to work closely with the International accounting Standards Board, and with other international standard setters; I told you [earlier] about China, for example, to try to get to this goal of a common set of high quality standards that would support common reporting across the capital markets, so we're just going to pursue that, but the determination of timing and that and who could use IFRS or who couldn't, those kinds of things, that rests with the SEC."

[My two cents: In my view, references to the goal of convergence being a 'common set of standards' vs. a 'single set of have varied over time. While some may view the two terms as interchangable, I have noticed a movement from 'common set' to 'single set' in recent years; however, there may be a return to 'common set' in light of concerns voiced in some comment letters and news reports about the timetable proposed in the SEC's IFRS roadmap. Those referring to an ultimate 'single set' of standards generally note that given the widespread worldwide adoption of IFRS, as noted by FASB Chairman Herz in remarks at an FEI conference in September 2007, any such 'single set' of standards accepted globally would likely ultimately be an improved set of IFRS.]

What does the future hold?
Leinwand closed the program with the question: "Some saw the perils of credit default swaps and other exotic instruments before the financial collapse. What do you foresee as the next problem in your world?"

Herz responded, "I think the next issue that I see is dealing with loans and loss accounting. "That's going to be part of our financial instruments project. Right now, loans are accounted for on a cost basis and what's called an incurred loss model. And I think it's been kind of clear that that is - kind of the provisions these have lagged downward, a downward spiral. And I think trying to think about a better model there, and that might also have a byproduct, I think, of reinforcing sounder lending practices as well." He added, "I agree with other people who say we need to think about inflation, and inflation has some accounting consequences as well."

More details
We provide more details of Herz' remarks and the Q&A in this FEI Summary. You can also watch the NPC's archived video of Herz' remarks; we understand the video will be available on the NPC website for approximately one week.

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