Board to Ban Accounting Practice That Helped Lending Proliferate
Monday, May 18, 2009
The end is nearing for an accounting trick destined to be remembered as a hallmark of the housing boom, because it allowed financial firms to conceal a vast expansion in their lending from regulators and investors.
Under this strategy, firms placed trillions of dollars in loans in the financial equivalent of self-storage facilities. They were not required to disclose the contents or maintain capital buffers against potential losses. By allowing firms to expand lending without increasing capital, the practice increased profits. But it left firms ill-prepared to absorb losses as defaults rose.
Now, as regulators move to prevent another financial crisis, the trick has become an early target. The Financial Accounting Standards Board, the nonprofit organization that sets bookkeeping rules for U.S. companies, is scheduled to vote this morning to prohibit the practice as of the beginning of next year.
"It was intended as a convenience, but it got stretched," said Marc A. Siegel, one of FASB's five members. "It got stretched to the point that we want to eliminate that loophole."
The creation of new storage facilities already has dwindled, but a rule change also would force companies to report the contents of existing facilities and to increase their capital reserves accordingly. Regulators calculated as part of recent stress tests that the new rule is likely to force the 19 largest U.S. banks to acknowledge about $900 billion in loans and other assets.
The change also eliminates a basic part of the securitization process by which loans were bundled and sold to investors. The recovery of that market is viewed as critical to a full-fledged lending revival, because investors in recent years provided the bulk of funding for new loans. It is increasingly clear that the system will have to be redesigned rather than simply restarted.
The history of the storage facilities -- known on Wall Street as qualified special purpose entities, or simply Q's -- embodies many of the key features of the financial crisis.
The tool became popular with the rise of securitization in the mid-1990s.
In a typical arrangement, a bank would place a large number of mortgage loans in a storage facility. Investors would pay into the facility for the right to collect future payments from borrowers, and the bank would collect the money.
Because regulators require banks to keep capital reserves in proportion to their outstanding loans and other commitments, every $100 in loans shipped off to the storage facility saved the bank $6 in capital.
Citigroup reported that its Q's held more than $800 billion as of June.
Many financial experts say this ability to obscure the details of these loans probably encouraged banks to take larger risks. Comptroller of the Currency John C. Dugan has said that banks applied less rigorous underwriting standards on loans sold to investors compared with the loans retained by the banks.
Outrage among investors reached a boiling point last year as banks announced billions of dollars of losses on holdings they had concealed from shareholders through use of these tools.
Siegel said the new attitude guiding this rule is to ensure that investors are not surprised by the details of banks' balance sheets.
"If it's going to cause a liability to the corporation, that should be reflected," he said.