FASB’s Exposure Draft on Mark-to-Market Accounting

If there are any bankers out there who haven’t read through FASB’s exposure draft issued on May 26, 2010, I encourage you to do so. The document can be found on the FASB website at www.fasb.org. The draft is 218 pages long but is a very quick read when you sit and read and keep looking for something that makes sense. Eventually you finish the document and are still searching.

Why in the world would the FASB consider this proposal at this point in time is unimaginable. FDIC Chairman Bair has stated that this year will bring more closures than the 140 of 2009. Many, many more institutions are in a very weakened condition as evidenced by the continuing rise of troubled institutions which stands currently at 775.

Mark-to-mark accounting has a very long history and one that apparently many have forgotten. It existed during the Great Depression for the same apparent reasons for which the exposure draft has recently emerged which is to, in theory, provide investors with the most useful, transparent, and relevant information about an entity’s financial assets and liabilities.

Let’s review this concept from the historical perspective. The Great Depression was a worldwide economic downturn that hit the U.S. in 1929. It still is the longest and most severe depression experienced by the U.S. In 1933 Franklin Roosevelt became president and on March 3, 1933 declared a banking holiday while temporarily closing all U.S. banks. There were approximately 4,000 commercial bank failures and 1,700 failures of savings and loans that year. On June 16, 1933 he signed into law the Banking Act of 1933 which established the FDIC and raised the confidence of the U.S. public in the banking system. By 1936, FDR believed the worst was over but the country slipped into another recession that lasted from 1937 until 1938. Banks continued to fail. In 1937, 77 institutions failed and in 1938 another 74 failed. President Roosevelt determined that mark-to-market accounting was prolonging the depression and suspended the practice in 1938. The concept didn’t work back then. Do we really think it’s going to work now?

The proposal requires the presentation of both amortized cost and fair value on an entity’s balance sheet even for financial assets, such as loans, that the institution has every intention of holding to maturity. The proposal acknowledges that “traditional banking-type institutions that currently measure a large number of financial assets at amortized cost would be affected to a greater extent than brokers and dealers in securities and investment companies that currently measure most financial assets at fair value”.

Loans represent the most significant portion of a typical bank’s balance sheet. These loans are funded and payed off by amortizing payments or refinancing. The historical cost has served the banking industry very well. The premise of a bank having to constantly mark-to-market these assets would place a significant burden on the resources of community banks, most especially, while subjecting financial statements to constant change. The most significant issue to me seems to be the reliability of the data used in the fair value estimates. How does a banker in the Midwest value a loan made to the local general store or to a farmer?

Another major issue to consider is that bankers may back away from making longer term loans for fear of having writedowns even for loans that are paying as agreed. Former FDIC Chairman William Isaac is a very outspoken opponent of this draft and has said that “Hardest hit will be lending to small businesses. If loans have to be marked to market prices, banks will be forced to limit lending to very short-term loans to only the highest quality borrowers”. Mr. Isaac has also been fighting hard for systemic risk oversight on FASB as well as the SEC.

The basis for determining a credit impairment would completely change should this proposal be approved. Currently institutions wait until a loss is “probable” to recognize an impairment. If adopted, banks would have to assess the amount of “cashflows expected to be collected” compared to contractual amounts due and not wait until a credit loss is probable to recognize an impairment. This standard does not give the bank or the borrower an opportunity to work out of a situation that may prove to be short term. Payment history in this scenario is also irrelevant. “An entity shall not automatically conclude that a financial asset is not impaired because all of the contractual amounts due or all amounts originally expected to be collected have been received to date.”

The proposal is currently in a comment period with a deadline of September 30, 2010. All comments are public and are posted to their website. There are some comments already posted but not as many as I expected. Most commenters are vehemently opposed to this proposal. Some comments are general in nature and just present the writers exasperation over the draft. Although it can help to blow off steam sometimes I can’t see FASB giving much credence to these types of letters. Try to be specific in your knowledge of the subject and how this will affect your organization specifically. You can submit a comment by email to director@fasb.org, File Reference No. 1810-100.

The FASB will also host a live webcast on this proposal on June 30, 2010, from 2:00-3:00PM (EDT) during which the panelists will present an overview. You can register at the following link: https://event.on24.com/eventRegistration/EventLobbyServlet?target=registration.jsp&eventid=217085&sessionid=1&key=D099CC4CFDD333F0978A797582066D20&sourcepage=register

Lessons learned from this banking crisis

Atlanta Federal Reserve Bank President and CEO Dennis P. Lockhart gave a speech on June 4, 2010, to the Alabama Bankers Association titled “Thoughts on Community Banks in the Southeast”. Some of the comments and statistics apply specifically to banks in the Fed’s six-state region; however, in my opinion the lessons learned apply to banks nationwide and could also be reiterated by all the federal regulators as well. Mr. Lockhart discussed the following three basic points about banking and two about supervision and regulation:

1) “Concentrations are deadly” - the most fatal concentration for community banks have been in real estate, particularly residential construction and development loans. This is blatantly obvious in failed institutions, especially in the Southeast. An even cursory glance at a regulatory enforcement often reveals the “Reduce CRE Concentrations” provision front and center. Mr. Lockhart answers the questions of why did bankers and regulators allow a concentration to build in this area of lending? He replies that the answer he most often hears from bankers is “because it’s there and there are not a lot of lending opportunities”. He discusses the migration of corporate borrowers in need of a C&I loan to the securities markets. In addition, the competitive factors are a sad reality to the world of community banking where loan officers have become proficient at originating CRE loans and have not developed the skills and knowledge necessary to branch into other types of lending. Other loan products also have big players to contend with. In the consumer area, it is difficult if not impossible to match the interest rates and ease of loan processing as a credit union. Any consumer can qualify for an account at a credit union, even one just based on the zip code of your residence, and immediately be able to prequalify themselves for a loan. For home mortgages many consumers still consult a loan broker who will direct the loan to the funding source he or she thinks will approve the credit request and the one offering the largest spread to the broker. Some consumers also have previous experience with a national lender, such as Wells Fargo, and will go directly by phone for the loan request. For credit cards, consumers are savvy about interest rates and the best deals for rewards points. It doesn’t appear that any of these factors will be changing in the near future so what other type of loans can a community bank specialize in?

2) “Speed Kills” – trying to grow a bank too fast usually results in overwhelming an organization’s internal structure and a collapse of much needed controls. These are essential in many areas of the bank but most notably in the loan department, especially if the bank engages in construction lending. An interesting statistic was mentioned in this speech. Historical bank assets over a 30year period have grown in nominal terms, 6.7 percent a year, according to the FDIC. During the real estate boom of 2003-2006 banks grew on average by 10 percent.

One can easily find evidence supporting the two points noted above. For analysis of the post-mortem reasons for a bank failure you can access the FDIC’s Office of the Inspector General website which has numerous Material Loss Reviews posted. In May 2010 a report detailing the findings of the failure of United Security Bank in Sparta, Georgia was posted. Under the Audit Results section it states “United Security failed because of loan concentrations in CRE, particularly ADC, that were a result of the Board and management’s decision to expand its operations….The Board and management….pursued a growth strategy without establishing a sound internal control system to support this strategy.

3) “Hot money can burn you” - rapid growth can often cannot be funded by deposits from the local community. When this happens institutions begin relying on wholesale funding which is often the start of the troubles. Mr. Lockhart stated that “the farther away a bank gets from consumer deposits the greater chance it has to be blown away by changing market sentiment”. Very well said.

Lessons learned from this banking crisis - Continued

Now for some supervisory lessons

1)Denovo bank charters – too many bank charters have been issued since 2000. Some states, like Georgia, have also had more than their share of new charters. This situation leads banks to fiercely compete for customers by pricing loans and deposits without regard to the cost of the institution to run effectively and adequately provide an acceptable return on equity. Mr. Lockhart also mentions the preponderance of failed institutions that deviated from their approved business plan. He went on to state that “regulators need to be more realistic in our assessment of proposed business plans and less tolerant of deviations from those plans”.

An example of the danger this represents to a young institution is detailed in the Material Loss Review for Hillcrest Bank in Naples, Florida. The institution failed on October 23, 2009, and the review was issued in May 2010. The Audit Results state “Hillcrest failed because it implemented a lending strategy in its first year of operation that resulted in loan concentrations in CRE…..The bank’s lending strategy constituted a deviation from the bank’s original business plan, and this change was not submitted in advance to the FDIC or the OFR for approval.”

When this banking crisis concludes and investors and misplaced bank management look to open a new institution we can expect tighter restrictions on denovo’s. The FDIC already issued enhanced supervisory procedures for newly insured institutions in FIL-50-2009.

2)Forward-looking assessments – this is for me the most interesting take away from this speech. Mr. Lockhart stated that regulators need to “broaden supervision from point-in-time solvency and compliance evaluation to include a more strategic, forward-looking, anticipatory, and holistic evaluation of the bank’s operating mix” and that the Fed is already working on incorporating a “horizontal” approach. I think there are some forward-looking elements currently present in the examination process but the regulators could do a far better job in this area. Regulators have access to the best statistical information available in the marketplace as well as any tool needed to incorporate this information into a “realistic as possible” future scenario for an individual institution or even a group or segment of regional institutions. Stress testing as an exercise will undoubtedly play a key role in risk management practices going forward.