Building a System of "Sound Securitization"

BY ROBERT HERZ

Editor's note: Click here or see instructions below to share your thoughts on the new off balance sheet accounting rules

 

The problems and abuses associated with the use of “off balance sheet” vehicles to finance mortgages and a variety of other consumer and commercial debt emerged as one of many serious issues in the ongoing financial crisis. There are many who would point to the lack of transparency in this “shadow banking system” as a factor adding to the crisis of confidence in the banks and the financial markets.

 

In early 2008, the SEC and the President’s Working Group on Financial Markets asked FASB to act quickly to review and reform the rules governing the accounting for securitizations and special-purpose entities (SPEs). The goal was to improve the accounting and overall transparency by eliminating abuses, thereby creating a system of “sound securitization,” and also help restore confidence in the reporting of our financial institutions.

 

In FASB’s review of these matters, it was determined that many banks favored the use of special-purpose entities both to improve the appearance of financial statements, and also to minimize regulatory capital requirements.

 

The main objective of financial reporting is to provide relevant and complete information about an entity to investors and the capital markets, including information relating to risks. Off-balance-sheet treatment masked the underlying risks. Many items that were treated off balance sheet—including structured investment vehicles, many collateralized debt obligations and other structured financings—did not reflect the risks being assumed by sponsors and were fundamentally mispriced. And this mispricing contributed to the financial crisis.

 

New rules enacted by FASB in June of this year will require that securitizations undertaken by banks and other entities in which the sponsor of the deal retains significant risks of the asset pool must be reflected on the banks’ balance sheets.

 

It has been suggested by some that this is not the time to change the rules for off-balance-sheet accounting. Skeptics say it could further damage an already wounded securitization market at a time when banks are still reticent to lend and thereby stymie the fragile recovery of the credit markets and economy.

 

I submit that the greater risk is permitting the lack of transparency that pervaded prior practices. It is an axiom that people manage what they measure. The corollary to that axiom is that people often don’t manage what they don’t measure. The off-balance-sheet accounting treatment also contributed to lax underwriting standards for subprime mortgages and other loans.

 

FASB is certainly cognizant of concerns by policymakers regarding the health of the banking sector. It is entirely appropriate that banking regulators use all tools at their disposal to ensure that credit markets remain liquid in this country.

 

But the mandate of FASB is to develop accounting standards that facilitate sound and transparent reporting to investors and the capital markets. We believe this will also help foster a return to sound securitization practices.

 

Robert Herz (communications@fasb.org) is the FASB chairman.

 

 

JOIN THE DISCUSSION

Are the new off balance sheet rules, effective January 2010, needed? Is the timing right? Or could the change complicate the economic recovery by damaging bank balance sheets? Send us your thoughts. Selected submissions will be published. To be considered for publication, submissions should include your name, title, affiliation and contact information. 

 

How to Participate

 

E-mail: Submit your responses to the discussion questions above to joaed@aicpa.org. Include “Off Balance Sheet Accounting Rule Change” in the subject line.

 

Facebook: Respond to discussion questions on the JofA Facebook page.

 

Mail: Send your responses to:

Journal of Accountancy

Off Balance Sheet Accounting Rule Change

220 Leigh Farm Road

Durham, NC 27707

 

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