As we discussed earlier, FAS 167 would become a nightmare for asset managers. Instead of providing more transparency, the FAS167 reporting would actually end up with less.
E&Y: As written, Statement 167 may result in asset managers consolidating many hedge funds, private equity funds and other investment funds that they manage. Some financial statement preparers and users have indicated that consolidation of funds by asset managers will result in less meaningful financial statements
FASB recently decided to defer hitting asset managers with 167 until these consolidation issues are addressed.
E&Y: At the 11 November meeting, the FASB voted to expose for comment an amendment that would defer the application of Statement 167 for a limited number of entities (principally mutual funds, private equity funds and hedge funds) until the completion of the joint FASB/IASB project on consolidation accounting.
It's good to know that when it comes to the post-crisis regulation (including accounting/transparency regulation)at least some folks are being rational about it.
Update: Looks like CLO/CDO managers are not on the list of entities that would get the FAS167 deferral. That means they would need to consolidate billions in CLOs they manage onto their management company financials.
Currently if you are a bank, a loan you originated will be held at par on the books and accrue interest. The loan makes you one day's worth of interest less the funding cost - every day. No volatility. That is until one morning you walk in and find out that the coupon you've been accruing never came. Now you not only have to reverse out the amount accrued on that last coupon, but also have to take a provision against principal loss. This provision reverses the life-to-date interest income on the loan and then some. This "oops" approach to loan accounting is called the "incurred loss impairment method", and is standard under current accounting rules. As a bank you could be holding a bunch of option arms, and as long as they make the minimum payments you would keep them at par (in fact you would keep them above par to account for the "negative amortization"). That's how many smaller banks that were fine a couple of years ago, all of a sudden became undercapitalized/insolvent.
To address this issue, the International Accounting Standards Board (IASB) has proposed an alternative (see attached document). It's a portfolio approach that requires the lender to continuously project total expected losses. The expected losses are then amortized over the life of the portfolio and netted against interest income. For example if you project a 20% total principal loss on the portfolio over the next 5 years, you would be deducting 4% of the initial portfolio face value from the interest income going forward. It's a constant dollar amount taken out of interest income every year. That means if loans default at some constant rate, interest income will drop off, while the provision will stay constant, creating a possibility of net interest loss.
Here is a comparison of the current method with the "expected loss model":
IASB: Interest revenue that is recognised will reflect the allocation of expected credit losses over the life of the instrument. This is a better reflection of the ‘economic’ interest that the lender expects to earn from an asset over its life than today’s approach. Hence, it avoids inappropriate front-loading of interest revenue.
This approach becomes more problematic when the expectations for credit losses suddenly change. That may mean that the reserve has been "under-accrued", and IASB would say that you have to take that difference into P&L immediately. And this concept makes it the trickiest portion of the proposal.
IASB: Using the proposed impairment method, credit loss expectations are updated each period. Any changes to initial expectations of credit losses will be recognised immediately in P&L. This change could be an increase in expected losses, or a reduction (reversal) of past expected losses (including the initial expected loss estimate).
If one uses CDS spreads for example to imply credit loss expectations, this method amounts to a form of mark to market. It effectively means that rather than holding "banking book" loans at par (current methodology), banks would be required to take a mark to market hit amortized over the expected life of the portfolio. And that could be bad news for banks that are thinly capitalized - these reserve requirements may make them insolvent.
Expect a massive industry (and political) backlash against this accounting methodology going into effect. In addition, if IASB adopts this proposal, it may impact the convergence of the US GAAP and the IAS standards, which has been the ultimate industry goal in recent years.
FAS167 is a new FASB ruling attempting to tease out disclosure on what's called "variable interest entities". It forces consolidation of entities controlled by a corporation. The goal of the ruling was to force banks to disclose their CP conduits holdings, which were generally off-balance sheet. Banks would set up a company and give full ownership to a charity. Then they would have the company set up a commercial paper program which the bank would guarantee. The company would issue commercial paper to finance purchases of various assets, often structured credit tranches. The guarantee required far less regulatory capital than holding the assets directly on the balance sheet.
But this was a failure of regulatory capital rules rather than accounting rules. The 167 approach of "consolidate first, ask questions later" will have some bizarre unintended consequences that will cause more confusion and less transparency. It will force balance sheets to balloon, mixing assets that pose risk to the firm with those that do not. Analysts and rating agencies will end up paying less attention to balance sheet disclosures, as the salad of balance sheet items for complex institutions will become far more difficult to sort out.
As an example, consider asset management firms. A large firm may manage multiple funds with various product mixes. 167 will force the firm to consolidate the fund holdings because the firm controls these funds. Imagine a firm that normally has a $50 million dollar balance sheet forced to consolidate it's funds, creating a multi-billion dollar balance sheet. And if the funds have control of the portfolio companies, those will get consolidated as well. Let's say a portfolio company owns a tour boat - that boat will now show up as an asset of the management company. An analyst will have a real tough time figuring out what a fund management company is doing with a tour boat. And those who invest in the management company (but not in it's funds) will get far less useful information from the bloated financials. This is an example of FASB, zealous regulators, and accounting firms (who love the extra business) actually reducing transparency.
