The portfolio accounting controversy: can financial service companies continue managing interest rate risk without incurring accounting risk?

THE PORTFOLIO ACCOUNTING CONTROVERSY

Can financial service companies continue managing interest rate risk without incurring accounting risk?

The setting is the weekly meeting of Global Financial Corp.'s assets and liabilities committee; the time is the near future. In attendance are the chief financial officer, the treasurer, the investment portfolio manager and the controller. Also present on this particular morning is the chief executive officer. The treasurer has just finished reviewing the dramatic increase in interest rates that's occurred over the past week.

"I've been evaluating the effect of this spike in interest rates on our mortgage portfolio," explained the portfolio manager. "Because of the expected decline in the rate of loan prepayments, the effective maturities of our mortgage assets now exceed those of our liabilities. We need to move quickly to rematch the maturities of the two portfolios or risk losses in the future when the cost of maturing debt increases faster than the yield on our assets."

"I can lengthen the effective maturity of our debt by executing interest rate swaps," offered the treasurer, "but to rebalance our portfolios fully, we also may need to shorten asset maturities by selling some of our longer-term mortgage investments.

"Selling assets may be necessary for another reason," he continued. "Because of the sharp increase in rates, we are losing funds from depositors seeking higher yields from money market mutual funds. If we don't sell off some of our assets, it will be very expensive to replace their funding."

"That's no problem," asserted the portfolio manager. "We purchased a large block of Ginnie Mae securities backed by 30-year mortgages last Friday after interest rates had started to peak. We can sell them today without incurring a significant loss."

"Well," concluded the CFO, "it appears we have an effective plan for dealing with these latest interest rate developments."

"Good work," said the CEO. "Now let's get to it before conditions change."

"Excuse me, but this strategy may cause an accounting problem," cautioned the controller.

"What kind of an |accounting' problem?" the CEO asked.

"Under current accounting rules, we can do whatever we want on the liability side, but we can't touch the assets. If we do, we may be deemed to have a |trading' or |held for sale' portfolio, which must be marked to market or adjusted to the lower of cost or market. Because of the recent spike in interest rates, that would mean recording big losses. If those losses are large enough, the impact on stockholders' equity could mean we would no longer be in compliance with regulatory capital requirements."

"Wouldn't those accounting losses on the asset side be offset by accounting gains when the liabilities are marked to market? After all, we manage our interest rate risk by monitoring the effect of interest rate changes on both sides of our balance sheet, don't we?"

"We certainly do manage our business that way," interjected the CFO. "So what's the accounting problem?"

"The problem is that current accounting rules offer no provision for marking liabilities to market; they're always recorded at cost, regardless of how assets are recorded."

"Let me see if I have this right," said the CEO. "If we manage our investment portfolio in a prudent manner and minimize interest rate risk by selling off some long-term assets to reduce maturity mismatches, we may have to write down the remainder of the portfolio to market. And because we can't write the liabilities down to market, we risk running afoul of minimum capital requirements. On the other hand, if we blindly hold assets until their scheduled maturity, ignoring interest rate risk and sound portfolio management policies, we are allowed to continue carrying them at cost, even if our portfolio's future profitability is damaged in the process."

"That's about the size of it."

CHANGING CONDITIONS

This dialogue illustrates part of the controversy over portfolio accounting. When interest rates were relatively stable, managing a portfolio of long-term investments was much simpler. It could be financed with short-term funds, producing a profitable spread. Matching the effective maturities of assets and liabilities was not a concern, because there was no significant interest rate risk to the mismatched portfolios. Thus, most portfolio managers acquired investments for the long term.

When interest rates increased dramatically in the early 1980s, red ink flooded the financial statements of institutions holding long-term investments funded with short-term liabilities. Mismatched portfolios became the cement shoes that pulled many financial institutions beneath the surface of financial solvency. It was during this period of financial stress and volatile interest rates that many institutions began to manage their asset and liability portfolios actively to reduce interest rate risk.

But generally accepted accounting principles for investments in debt instruments are based largely on guidance developed in the 1960s and 1970s. They were designed to distinguish between trading and investing activities that were relatively clear and straightforward. To qualify for the cost method of accounting for debt instruments, GAAP requires the investor to have both the ability and the intent to hold them to maturity, or at least for the foreseeable future. In practice, it was considered acceptable to forgo the intent to hold to maturity if there were compelling business reasons to sell certain debt instruments early. Hence, holding for the "foreseeable future," which is a term used in certain accounting literature (for example, Financial Accounting Standards Board Statement no. 65, Accounting for Certain Mortgage Banking Activities) became the operative practice. As a result, sales usually didn't raise questions about the continued use of the cost method of accounting for the remaining investment portfolio.

PERCEIVED ABUSES

During the volatile interest rate cycles of the 1980s, however, the volume of sales increased and they were not being done solely for interest rate risk management. By changing investment intent on a very selective basis, some portfolio investors sold high-yielding loans and recorded gains but retained low-yielding loans without writing them down to market value. This practice, which came to be known as "gains trading" or "par capping," was a way of accelerating income recognition at the expense of the investment portfolio's future earnings power. By selling the higher-yielding assets, the overall portfolio yield was reduced, which created a narrowed or negative interest spread relative to the cost of funds. Combining this strategy with substantially mismatched portfolios of assets and liabilities can imperil an institution's future viability.

Because of perceived accounting abuses and unsound portfolio management policies at savings and loans, the Federal Home Loan Bank Board (FHLBB) in 1988 issued a proposal, Investment Portfolio Policy and Accounting Guidelines. Although the proposal tightened up portfolio accounting policies in some ways, it endorsed the foreseeable future concept of investment intent. Foreseeable future was considered appropriate because it reflected economic reality for soundly managed institutions seeking to avoid interest rate risk and, consequently, the way GAAP was actually being applied in practice.

FASB STAFF INTERCEDES

While some may have considered the FHLBB's proposal a significant tightening of accounting rules for investment portfolios, the FASB staff found the "foreseeable future" concept to be totally out of line with its interpretation of existing GAAP. A September 1988 comment letter from the FASB's director of research and technical activities made the following key points:

"The staff believes that accounting literature focuses primarily on the intent and ability to hold investment securities to maturity. . . . While the term |for the foreseeable future' is used in [FASB Statement no. 65], we believe that the Board's intention and the substance of the literature require much more than the absence at the present time of a specific plan on the part of management to sell a particular security; in fact, we believe it requires a positive intent and ability on the part of management to hold a security to maturity. We also do not believe that a positive intent to hold investment securities to maturity subject to external factors outside management's control meets this standard."

What started out as an FHLBB regulatory action to rein in management and accounting abuses by certain thrift institutions has prompted an interpretation of GAAP by the FASB staff that is substantially more restrictive than current practice. Marking an institution's investment portfolio to market or the lower of cost or market while reporting liabilities with similar maturities at cost removes financial statements from the realm of economic reality and, arguably, makes them meaningless. The risk of losing the cost basis of accounting for long-term investment portfolios under a literal application of the FASB staff's position and the potential adverse effect on stockholders' equity together effectively preclude the management of interest rate risk on the asset side of the balance sheet.

Concerned with this unexpected turn of events, the FHLBB chairman in November 1988 asked the FASB staff for clarification on a number of points, including whether a letter from the staff represented "consensus views of the FASB board members." In December 1988, the FASB's director of research and technical activities responded that significant comment letters written by the FASB staff are reviewed by board members and are not sent if there is significant disagreement with their substance.

"However," he continued, "official positions of the FASB are determined only after extensive due process and deliberations. . . . Within the text of the [American Institute of CPAs] Professional Standards, the letter would fall under AU Section 411.05d, other accounting literature. Without due process, the FASB cannot change existing GAAP."

ACCOUNTING CATCH-22

What all this seems to be saying is that the FASB staff cannot change GAAP of its own accord. But if the comment letter from the FASB staff was simply clarifying existing GAAP, then due process isn't required. This creates an accounting Catch-22, because current practice is substantially different from the staff's interpretation and general acceptance also can constitute GAAP. In fact, prevalent industry practices are usually considered to constitute a higher level of GAAP than a nonauthoritative source, such as a letter.

While the FHLBB was proposing its new accounting policies and corresponding with the FASB staff, the AICPA accounting standards executive committee (AcSEC) was developing a statement of position on accounting for debt instruments that would apply to all investors. An SOP from AcSEC clearly would have more authority than the FASB staff's letters to the FHLBB but less than an official pronouncement from the FASB itself.

In April 1989, the chief accountant of the Securities and Exchange Commission sent a letter to the AcSEC chairman giving the SEC staff's position on institutions selling securities designated as held for long-term investment. His comments generally supported the FASB staff's interpretation but appeared to allow for the exercise of some judgment in determining whether an investment portfolio is in substance a trading, or held for sale, portfolio.

A BIG DILEMMA

In issuing its final guidelines in May 1989, the FHLBB apparently opted for the course of least resistance and adopted the highly restrictive view of GAAP articulated by the FASB staff. The accounting requirements in the guidelines make it extremely difficult to sell virtually any debt instruments held for investment without calling into question use of the cost method of accounting. The new guidelines have provided thrifts with a big dilemma. If they manage interest rate risk and sell investment assets in the process, their financial and regulatory net worth might be threatened by an accounting method that could generate book losses. But preserving cost basis accounting by not managing investment assets would mean additional interest rate risk, endangering future profitability.

The FHLBB, aware of the problem created by its new guidelines, said it "continues to be frustrated by the pace at which the accounting setting bodies develop guidance reflective of economic transactions and, specifically, sophisticated securities activities. Thus, the Board again takes the opportunity to encourage the accounting standards setting bodies to quicken their deliberations on these significant issues." If financial statements are intended to present an entity's activities fairly, it continued, "it is difficult to accept an outdated accounting convention that differs significantly from the economic reality of an institution."

If the FASB and SEC staffs' interpretation of GAAP for investments in debt instruments prevails for thrifts, it would be difficult to preserve current practice for other financial institutions. As a result, banks, insurance and consumer finance companies, credit unions and many other entities may be affected by the outcome of this issue. Because of concern over the accounting disparity created between thrifts and banks by the FHLBB guidelines, the newly created Office of Thrift Supervision delayed their effective date from August 30, 1989, to January 1, 1990.

PROGNOSIS UNCLEAR

The underlying reason for the portfolio accounting controversy is, in fact, the accounting model's failure to keep pace with the current economic environment. Much attention has been focused on the original intent of accounting standards that may not be relevant to today's business activities. This issue is just one aspect of the explosion in financial instruments and financial management strategies that ultimately should be dealt with by the FASB as part of its multiyear financial instruments project. If ever there was an issue that deserved due process, it is this one.

AcSEC now has the portfolio accounting hot potato in its hands. It must decide either to accede to the FASB and SEC staffs' position or to issue accounting guidance using a less restrictive interpretation of existing GAAP that allows for prudent interest rate risk management but prevents gains trading activities in an investment portfolio.

The latter option has much to recommend it. First, it would allow the FASB to deal comprehensively with the portfolio accounting issue as an integral part of its financial instruments project, which ideally will address both the asset and liability sides of the balance sheet. Second, it would stop accounting abuses without forcing prudently managed institutions to choose between meaningful financial reporting and sound portfolio management.

WAITING FOR GUIDANCE

Meanwhile, back at Global Financial Corp., the controller is still trying to explain how the Catch-22 of portfolio accounting came about and how to get around it. It's likely to be a very long meeting. Stay tuned, because this issue could have a big impact on all financial service companies.

JAMES T. PARKS, CPA, is vice-president for financial standards and corporate taxes at Fannie Mae (the Federal National Mortgage Association) in Washington, D.C. He is a member of the American Institute of CPAs and the Financial Executives Institute. The views expressed in this article do not necessarily reflect those of Fannie Mae.