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The outlook for the thrift industry: a survivor's guide; big challenges and changes face American S & Ls - and their accountants.

The savings and loan industry is under fire. In the wake of the S&L crisis, regulators are challenging accounting procedures, lending practices and even the regulatory structure set up to oversee the industry. Congress is reacting to the exorbitant amounts required to satisfy insured deposits in failed institutions. The public, incensed over reported excesses committed by the industry, is demanding action to prevent the same problems from recurring.

A large portion of America's S&Ls will not survive--they will be either liquidated or merged with other financial institutions. Those that will survive and regain public confidence must do what all successful management groups hopes to accomplish:

* Define their market.

* Serve their market effectively and efficiently.

* Earn an economic profit.

The following examines the forces that will transform the S&L industry over the next five years, highlighting what auditors and internal accountants should be focusing on during this evolution.


The Financial Institutions Recovery and Reform Enforcement Act (FIRREA), signed into law in August 1989, eliminated the Federal Home Loan Bank Board (FHLBB) and replaced it with the Office of Thrift Supervision (OTS). While the FHLBB was an independent agency, OTS is a division of the U.S. Treasury Department. The adoption of FIRREA, along with new capital rules enacted by the OTS and the adaption of bank examiners' methods in thrift examinations, will fundamentally alter the structure of the industry.

The new capital rules adopted for S&Ls have three themes:

* Increasing minimum regulatory capital levels.

* Placing institutions that fail to meet the higher capital requirements under a regulatory microscope.

* Bearing capital levels on the perceived risk of a thrift's assets.

Capital levels. In the 1970s, when the industry first encountered losses, thrift regulators lowered the required level of capital in two ways. First, the absolute percentage of capital required was reduced to permit institutions to grow and enhance profitability. Second, the accounting concepts used to measure periodic income were changed to permit recognition of greater profits.

Both changes have been entirely reversed under the new OTS rules. Capital levels have been increased drastically, while certain accounting practices have been eliminated (for example, appraised equity capital, deferred loan losses and loan fees). The impact on the industry has been dramatic as thrifts seek ways to raise regulatory capital and/or shrink their assets in an effort to meet the new capital guidelines.

There are now three capital requirements:

* A tangible capital requirement of 1 1/2% of assets.

* A core capital requirement of 3% of assets.

* A risk-based capital requirement of 8% of risk-weighted assets.

Effects of noncompliance. If an institution fails to meet one of its capital requirements, it must submit to its regulator a capital plan demonstrating how it will meet the requirement. In addition, the regulator may impose on the institution a series of restrictions designed to curb its actions until it is once again in capital compliance.

Risk classification of assets. The regulatory risk classification of assets (used to calculate the risk-based capital requirement) requires segregating assets into one of a number of groups. Depending on the group, the capital requirement could range from 0% (for cash) to 16% (for real estate acquired through foreclosure).

The actions that result from this procedure demonstrate just how serious these requirements are. Specifically, the risk classification scheme probably will have the folliwing effects:

* Assets with high capital requirements will be avoided.

* Institutions will seek ways to shift assets from high- to low-capital requirement group (by securitizing mortgage loans, for example).

* Competition for low-risk classification assets, such as single-family home loans, will increase as thrifts seek to hold assets with low capital requirements.

* A larger pricing differential will develop between the rates charged on loans with lower capital requirements and those with higher capital requirements. The difference in pricing of home loans versus shopping center loans (for example, commercial loans with an 8% capital requirement) will increase due to this risk weighting.

* Thrifts trying to meet the capital standards may choose to shrink or maintain their current size.


Aside from the new capital requirements, the most interesting aspect of the new regulatory scheme has been the oversight of and influence on the OTS by the Federal Deposit Insurance Corporation (FDIC). This influence is reflected in the OTS examination approach to a thrift's real estate loan portfolion.

Bank examiners and bank management groups generally have focused their attention on the borrower's credit quality first and then on the collateral for the loan. Thrifts, on the other hand, have placed the primary emphasis on the quality of the collateral and then considered the credtiworthiness of the borrower. The recent examinations of thrist have seen interesting issues raised in the area of real estate lending or income property collateral.

A commercial real estate loan portfolio generallly contains long-term mortgages on income-producting property. The collateral consists of apartment houses, hotels, office buildings and regional and neighborhood shopping centers. At the time the loan is originated and underwritten, the lender normally

* Inspects the property.

* Appraises the property.

* Reviews feasibility studies.

* Studies the demographics of the area.

* Reviews construction plans.

* Reviews the property's operating statements.

* Reviews the borrower's financial statements.

Based on the thrift's lending criteria, a loan may be made for up to 80% of the value of the property.

Once made, the loan is monitored on "autopilot" -- that is, unless the loan becomes delinquent or the borrower wants to renegotiate its terms, the lender rarely reviews it, inspects the property or looks at operating statements or the borrower's financial information.

In an inflationary era when property values were escalating, little monitoring of the income property portfolio may have been appropriate. Today, however, the autopilot status of the loan portfolio is being challenged by the examiners. More current information about the loan, the borrower and the real estate market is being sought. In the uncertain times lenders face, these loans will require lenders to take a much more active monitory role, including

* Obtaining and analyzing operating statements to detect potential cash flow or operating concern.

* Inspecting property periodically to determine if the borrower is maintaining it in good condition.

* Analyzing area data to identify overbuilding situations.

* Conducting spot appraisals to detect problems.

* Reviewing the borrower's financial condition on an ongoing basis.

The thrifts that prosper in the future will take these steps and document them in their records. For the lender, there will be long-term economic benefits despite the costs incurred as the process is implemented and maintained. As problems are detected, lenders will begin to work early with their borrowers to solve problems and minimize losses to the institution.


Changes in the thrift industry will lead to new auditing techniques and financial statement disclosures in areas that include

* Evaluating loan-loss reserves.

* Assessing interest-rate risk management.

* Understanding regulatory relationships and financial instruments.

* Communicating financial results.

Loan-loss reserves. The managements of thrift institutions and their auditors must recognize and adjust to the risk inherent in their loan portfolios. One critical area continually evaluated by management and an outside auditor is the allowance for losses on loans--an evaluation hampered by accounting principles that are unclear and uneven in application. While this can be said about generally accepted accounting princiles, the approach taken by thrift examiners also has lacked consistency and now is moving closer to the bank examiner's approach.

In the past, thrift auditors have focused loan-loss reserve work on delinquent loans. This process included reviewing the value of the collateral securing the loan (value generally based on appraisals) and the borrower's history with respect to the property and probably to past loans. Appreciation of properties is now more uncertain and regional real estate problems are leading to change.

In light of this evolution, auditors must consider the following in setting the audit scope in the loan-loss area:

* Loan classification by type. This includes single-family loans, commercial loans and construction loans.

* Loan underwriting standards used by the company. Standards that produce lower quality loans will cause greater losses. The auditor needs to factor this into the scope-setting process.

* Geographic concentrations of loans.

* Management's system to monitor the loan portfolion. Loans can no longer be originated and held in the loan portfolio on autopilot. Risk changes over time, and management must monitor the collateral supporting a loan to protect its investments.

Significant problems with single-family loans have not been a major concern. However, problems and losses on income property real estate loans have become routine and are leading to increased audit time.

Auditors probably will spend significantly more time reviewing operating statements from properties securing income property loans. Properties with insufficient cash flow to support debt service payments will cause the auditor and management to seek more information, which may entail property inspections and reviews of the borrower's financial condition--not just one but throughout the life of the loan. What's more, management's failure to develop systems to monitor the loan portfolio may cause the auditor to conclude there is a serious deficiency in the system of internal controls.

As a result of the increasing awareness of the risks inherent in income property real estate lending, time and attention placed on auditing these portfolios will increase in the 1990s.

Interest-rate risk management. Interest-rate risk arises if a lender does not match the maturity of its assets and liabilities. If one side of the balance sheet reprices--that is, experience an upward or downward change in interest rates--before the other side, then the thrift is exposed to some degree of interest-rate risk. The thrift industry was protected from interest-rate risk by law and regulation through the 1970s, until these controls gradually were removed in the 1980s. Thrifts now find they face interest-rate risk on a regular basis.

While it is a business consideration faced by financial intermediaries, interest-rate risk is ignored in accounting procedures. When a long-term, fixed-rate asset is purchased and funded with a short-term liability, the purchaser is faced with interest-rate risk: If interest rates increase, the cost to fund the fixed-rate asset will increase, and the spread earned between the asset and liability will decline. (Spread is the difference between the interest earned used to purchase an asset and that paid on the liability of the asset.)

In addition, the market value of the fixed-rate asset will decline. This event is not recognized at the time interest rates increase if the asset is held for investment purposes, yet the value of the enterprise has declined and future income will decline (unless and until interest rates decline).

Regulators now recognize this risk and will propose higher capital standards to compensate for it. Accountants and auditors recognize the risk but do not reflect it in historical cost basis financial statements. Good discussion of and tables supporting interest rates and maturities of assets and liabilities evolved over the past few years for publicly reporting thrifts. Even so, it is imperative that the auditor and management use the footnotes to the financial statements to communicate the potential impact of interest rate changes on the thrift's financial position.

At present, footnotes disclose the repricing characteristics of individual line items, such as the loan portfolio or the deposit accounts. What is needed is one footnote that combines line-item data and explains, in user-friendly terms, the impact of interest rate changes on the thrift's future operations. While future results cannot be projected with total accuracy, the general nature of the thrift's income sensitivity--the difference between interest earned and interest paid--to changes in interest rates should be discussed.

Regulatory evaluation. The enactment of FIRREA and the public's negative perception of the thrift industry have caused regulators to take a much tougher stance with thrift institutions. This has taken the forms of lower regulatory ratings and insistence on higher levels of loan-loss reserves.

Actions by regulators can cause institutions to fail capital ratios or can delay approval for applications by thrifts to engage in specific activities. Since a failure to meet capital standards can have serious results, the auditor needs to be conversant with the requirements and issues raised by regulators in their examinations. Failure to deal with these issues may lead the auditor to reach incorrect conclusions about the "regulatory health" of the thrift. The auditor, in short, must be familiar with the regulator's view of his client.

Financial instruments. The 1980s saw an explosion in the development of financial instruments and products, many evolving in response to accounting, regulatory or tax considerations in the thrift industry. These instruments have been used to hedge interest-rate risk and improve the overall yield on the asset portfolio. Today it is common for a thrift to hold one or more of the following:

* Interest-only securities.

* Principal-only securities.

* Collateralized mortgage obligations (CMOs).

* Real estate mortgage investment companies (REMICs).

* Interest-rate swaps.

* Interest-rate caps.

* Future contracts.

* Option contracts.

The list of financial instruments continues to grow. Both the auditor and management must understand the risks and rewards associated with these instruments to ensure the accounting reflects the economics of the transaction. For the auditor, this may require consulting an expert; for management and a board of directors, it may entail attending courses before making investment decisions.

These instruments are identical to the loans held by the thrift in one very important manner: Their risk profile changes on a regular basis, requiring continual monitoring by management. To put it simply, autopilot management is neither sufficient nor prudent. Failure to develop a system to monitor these assets may cause the auditor to comment on a weakness in the system of internal controls.

Business plans. In the thrift industry, the accounting basis for the asset portfolio depends on management's plans. For example, a thrift holding a portfolio of fixed-rate loans may plan to sell the portfolio in the near term as part of its plan to restructure the balance sheet. Since plans call for the assets to be sold, lower-of-cost or market-value accounting probably is required. The auditor would be unable to assess the proper accounting for the assets without reviewing the business plan or discussing future operations with management.

To complete the audit of a thrift institution, the auditor should

* Review the business plan to assess the impact of future actions on current accounting decisions.

* Assess whether future compliance with regulatory capital requirements will be met.

* Determine if management has in place the infrastructure to support future business plans.

Each question has an impact on the accounting and reporting and should be resolved.

Auditor opinions. In the current regulatory environment, the opinion issued by the auditor on a thrift's financial statements takes on increased importance. Failure to meet one of the capital tests may cause the regulator to take action, ranging from the restriction of a specific activity to the forced merger or liquidation of an institution. Morever, as a result of an examination, the regulator may decide that increased reserves must be recorded for regulatory purposes or that certain actions expose the entity to great risk and must be curtailed.

Eliminating an activity may result in a charge to equity that in turn may cause the institution to fail a capital requirement. Dramatic actions then may be taken by the regulator. To prevent this, auditors are giving greater weight to communicating these possible consequences to the users of thrift financial statements. This has lead to an increased use of emphasis paragraphs in auditor's reports in 1990, which probably will increase in 1991 as regulators aggresively seek to resolve the future of the undercapitalized segment of the thrift industry.


The forces confronting the thrift industry today will cause change, and many entities will not survive. Those that do will have quality management as well as size or a specialized niche to maximize profits and build capital. This evolution also places a burden on auditors and accountants who must focus on thrift balance sheets in the 1990s.

This focus translates into the need to communicate and explain results, since the industry may be one of the most complicated to understand and manage due to the regulatory, tax and accounting requirements. The successful thrift institution manager and effective auditor will recognize these changes and adopt strategies to meet these challenges.

DOUGLAS J. McEACHERN, CPA, is a partner of Deloitte & Touche in Los Angeles. He is past chairman of the American Institute of CPAs savings and loan committee.
COPYRIGHT 1990 American Institute of CPA's
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Author:McEachern, Douglas J.
Publication:Journal of Accountancy
Date:Nov 1, 1990
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