November 12, 2008
Securities Exchange Commission: File 4-573
Item 1. Thank you for the opportunity to respond to the debate on fair value accounting. The obvious answer is that fair value accounting per FASB Statement 157 and the similar standard IFRS 7 are the best standards that we have currently for financial reporting purposes. For the purposes of investors, they are superior to prior standards, such as lower of cost or market. As noted by several respondents, the change to "fair value accounting" seems to result in lending institutions displaying robust balance sheets during the upswings and deficient balance sheets during the downswings. This may lead to excessive lending during the upswings and inability to lend during the downswings, a phenomenon referred to as procyclicality. One question is, if these are better standards for financial reporting purposes, then what went wrong?
Let us look at the historical perspective. The accounting standards boards long ago set some standards for displaying assets and liabilities that were used for many years, with varying degrees of success but also with some failures. The bank regulators created rules based on the then existing accounting standards. A very few years ago, the accounting standards boards changed their accounting standards to "fair value," and the bank regulators kept the same regulatory rules that were based on the prior accounting standards. The result seems to be a mismatch of current accounting standards (FASB 157 and IFRS 7) to the existing regulatory rules, and this may contribute to the so-called credit crunch. The reaction of some governmental bodies (and banks) is to attempt to rescind (and blame) the accounting standards rather than adjusting the regulatory rules to new accounting standards of fair value.
One possible course of action is have a temporary suspension of fair value while setting a deadline of no more than one year for the regulatory bodies to create an adjusted set of regulatory rules that are based upon and complimentary to fair value accounting.
Note that if financial accounting standards were to become stagnant because of regulatory rules that are based upon them, then financial accounting standards will become less useful to investors and creditors, and the financial markets will fail because of the lack of transparency. Therefore, when there is a change in financial accounting standards, the financial accounting standards boards should notify the regulatory bodies that they should change their rules to complement and harmonize with the updated accounting standards. Moreover, the regulatory bodies should have been alert to this problem as well, and should become alert in the future.
Item 2. The above discussion is limited to fair value accounting and does not address impairment of the assets in the loan portfolios. I believe that the subprime loans are impaired because the houses never were never truly worth what was then paid (start of the pyramid scheme), that the subprime houses have deteriorated for lack of care, for being in now blighted neighborhoods, and the occupants often are gone and will not make any more payments, and so forth. These loans were upside down at inception, and have become more so with time. The notion that the banks will hold these loans to maturity and receivefull value is fantasy, at best. The subprime and Alt A loans should be written down to reflect the current values of the underlying houses. No other course of action is reasonable.
Item 3. Many people are making statements that the decline in housing prices is the cause of the credit crunch. On the contrary, the rapid increase in housing prices is one of the true causes of the current subprime lending credit crunch. The falling prices will eventually result in levels that working people can afford, and from the standpoint of society, this is truly good event. The falling prices are definitely a problem for the institutions that made foolishly made these inflated loans. The falling prices are a problem to this nation and the world because these loans were made on such a massive scale and leverage, that the financial structure collapsed when this housing pyramid scheme collapsed. Pyramid schemes are not new, and this current one is no different than the tulip bulb scheme that collapsed centuries ago.
The creation of 100% financing, ARMs, interest only and negative amortization loans resulted in people occupying houses who could not reasonably be expected to repay these loans. The riskiest persons received loans with artificially low payments for high priced housing. Clearly, initial interest rates and monthly payments for the riskiest buyers should be higher than for those people who have solid ability to pay and are less risky. Generally, the subprime and Alt A loans were upside down from the very moment that the documents were signed. One accounting solution to problem is that the banks should carry houses on their balance sheets until the owner has 20% equity in the house, applying the principle of economic substance over legal form. This accounting change would reflect the economic reality of the transactions.
Item 4. Excessive leverage is another cause of the collapse of the credit markets. As I understand it, the subprime loans were repackaged into CMOs. These CMOs were often already overleveraged because an excessive price was paid with 100% financing. Thus, many CMOs were upside down at the time of creation. Subsequently, some of the CMOs were again repackaged into CDOs, and sometimes with another layer of leverage added. An additional layer of leverage on top of something that is already upside down simply makes the pyramid higher, and the collapse will be more catastrophic when prices inevitably fall. Sometimes, the CDOs were once again repackaged into SIVs, and this was sometimes done with additional leverage (3rd layer of leverage). These actions increased the size of the pyramid again, and contributed to making the credit crunch even much more catastrophic. One solution to this is that financial accounting should require that the various layers of leverage be separately identified and disclosed on the face of the financial statements and related to the current value of the underlying houses so that overleveraging becomes fully disclosed. In addition, the footnotes should provide extensive additional information.
Item 5. Off-balance sheet financing was created by the legal forms of some of the SIVs. Nothing should ever be off-balance sheet. Off-balance sheet financing is the easy path to fraud. It is nothing new as we learned with Enron. Yet the accounting standards boards have allowed this to occur and so have the regulatory bodies. This solution is prohibiting all forms of off-balance sheet financing, off-income statement activity and off-cash flow statement movements of green cash.
1. Fair value accounting should be maintained and strengthened (not gutted) by the SEC.
2. The regulatory rules based on accounting should be updated every time that there is change in the underlying accounting standards.
3. Banks should carry houses on their balance sheets until the borrower has 20% equity in the house (all loans on a particular dwelling, including home equity loans, are to be included in the computations).
4. Leverage layers should be disclosed on the face of the balance sheet, and the footnotes should provide extensive additional information.
5. Off-financial statement balances, transactions and cash flows should not be allowed.
In addition, I note that considering only one aspect of accounting, in this case fair value, in isolation from regulatory rules and related accounting standards is not productive. The goal of the SEC should be to have a set of accounting standards and regulatory rules that function in harmony and lead to full disclosure of all necessary information needed by investors and creditors.
Daniel Webster once said, Falsehoods not only disagree with truths, but usually quarrel among themselves. The SECs job is to distinguish truths from the many falsehoods. The nation and the world expect no less than that. I hope that you are up to the political challenges that propagate and side with the many false assumptions and statements related to the credit crisis.
Robert L. Benson, Ph.D. CPA, CMA, CIA, CISA