Can Companies Smooth-Talk Investors?

Investors Prove Wise at Judging Self-Serving Earnings Explanations

Investors have proven to be sophisticated enough to dismiss implausible explanations from companies of their quarterly earnings results, according to a new study.

For example, a utility company might attribute their lower earnings to “warm weather and higher propane products costs,” while an insurance company might explain a good quarter by touting its “continued efforts on cost containment and operational efficiencies.” Self-serving attributions such as these, which typically blame outside factors for negative developments and claim that their own internal initiatives led to positive results, are a traditional part of corporate earnings reports and press releases. But that doesn’t mean investors generally believe them.

According to a new study in The Accounting Review, a journal of the American Accounting Association, market response to self-serving attributions depends in large part on two key tests of plausibility—how badly the company’s industry peers are doing and what the study calls “commonality,” the extent to which market or industry forces drive a company’s earnings.

The difference proved to be dramatic when those two key tests were applied to the 94 companies in the study, which was conducted by Michael D. Kimbrough of the University of Maryland and Isabel Yanyan Wang of Michigan State University. Firms with average positive earnings surprises who made the highest-plausibility attributions had three-day above-market returns of 4.77 percent on average, whereas those that offered the lowest-plausibility reasons actually averaged a slight decline of 0.79 percent. Meanwhile, among firms with average negative surprises, those with the lowest-plausibility attributions sustained average declines of 5.11 percent, while those with the highest-probability excuses had declines of only 1.42 percent.

“Firms which provide defensive attributions to explain earnings disappointments experience less severe market penalties when 1) more of the their industry peers also release bad news, and 2) their earnings share higher commonality with industry- and market-level earnings,” said the paper. “On the other hand, firms that provide enhancing attributions to explain good earnings news reap greater market rewards when 1) more of their industry peers release bad news, and 2) their earnings shares lower commonality with industry- and market-level earnings.”

 “Collectively, our results suggest that investors neither completely ignore seemingly self-serving attributions nor accept them at face value, but use industry- and firm-specific information to assess their plausibility,” the professors added. “Further analyses reveal that investors’ use of industry peer performance and earnings commonality information appears justified because investors’ perceptions are consistent with the association between the plausibility measures and the ex post actual persistence of earnings surprises.”

In sum, “investors are somewhat sophisticated when interpreting these narrative disclosures,” Kimbrough and Wang wrote:

“Our findings ought to be of value to both investors and corporate leaders,” said Wang in a statement. “Hopefully it will disabuse those executives who are counting on the naiveté of investors to let them get away with empty words or phony excuses in their public communications. For investors, it provides standards they will need to meet to keep up with the investment community at large.”

“The tools needed to apply those standards are certainly available to institutional investors, even though determining commonality is probably beyond the reach of individual stock-pickers,” said Kimbrough. “Still, even they should have the means to stack up the claims of a given company against its industry peers, which can go a long way in assessing the plausibility of the firm's performance narrative.”

The study's findings are based on an analysis of press releases and earnings reports of 94 randomly chosen firms, a roughly equal mix of small, medium and large, over a seven-year period. Sufficient data was obtained for a total of 1,790 firm quarters, 1,023 of which featured self-serving attributions and 767 of which did not. The self-serving classification was assigned to quarters when companies attributed their success in meeting or beating consensus forecasts to internal factors, such as management strategies or introduction of new products, or blamed a negative earnings surprise on external factors, such as bad weather or rising costs or regulatory actions. Firm-years in the self-serving category featured at least one such attribution and an average of three to four in a given earnings press release.

The authors found a significant relationship between the plausibility of self-serving attributions, as determined by industry performance and commonality, and the market-adjusted cumulative return of firms' stocks in the three days centered on earnings announcements. In reaching that conclusion, they controlled for an array of factors likely to affect the market’s response to earnings announcements, including the size of companies, the volatility of their stock, and their book-to-market ratio.

What kind of companies are likely to issue suspect attributions? Preliminary evidence suggests, in the words of the study, “Firms which provide less plausible attributions are larger and have higher likelihood of insider trading around earnings announcements, higher analyst following, higher institutional ownership, higher return volatility, and lower book-to-market ratio. These findings imply that managers with insider trading incentives and those facing greater capital market scrutiny are more likely to offer seemingly self-serving attributions even if they lack plausibility, consistent with the ‘opportunistic behavior’ view of capital markets.”

This view, according to the paper, finds “that capital-market scrutiny combined with the linking of manager compensation with stock prices creates pressure for managers to prop up prices by biasing financial reporting. To the extent capital-market pressure is greater for firms with higher analyst following and/or institutional ownership, the ‘opportunistic behavior’ argument suggests that greater analyst following and/or institutional ownership may increase managers’ tendency to provide implausible attributions to either mitigate market reactions to negative earnings surprises or to increase market rewards to positive surprises.”

Still, given the hazards of implausible attributions, as revealed by the new study, why would managers make them? It’s a matter of what they believe, Wang and Kimbrough wrote. “If managers believe there is a chance that investors might be persuaded by their implausible seemingly self-serving attributions, they are more likely to offer them even if ex post it turns out that investors can see through them.”

This article is by Michael Cohn in Accounting Today. The study, “Are Seemingly Self-Serving Attributions in Earnings Press Releases Plausible? Empirical Evidence,” appears in the March/April issue of The Accounting Review, published six times a year by the American Accounting Association.

The Beginning of the End of a Single Set of High-quality, Global Accounting Standards

A year and a half ago, the G-20 leaders called on international accounting standard setters to redouble their efforts to achieve a single set of high-quality, global accounting standards through their independent standard-setting processes and complete their convergence project by June 2011.

Before we even have a converged set of global accounting standards, the EU has hammered a nail into its coffin. If the EU can decide to opt in or out of a given part of IFRS standards then the door is open to home-country versions of IFRS similar to those that have existed for years.

The European Union has refused to adopt a new accounting rule that could ease fallout from the euro zone's sovereign debt crisis on banks.

The International Accounting Standards Board (IASB), following up on pressure from policymakers at the height of the financial crisis, has eased its "fair value" or mark-to-market rule that was known as IAS 39.

The first completed part of the new IFRS 9 standard allows banks to price some government debt held on their books at cost rather than at current depressed prices.

This avoids the "cliff effect" of many banks needing to recognize large losses and top up regulatory capital buffers.

IFRS 9 would allow European banks to exclude some of the broader markets effects of the current financial crisis in Europe.

Under IFRS 9 impairments will still exist, but would be more timely.

The EU has stated that it wants to see how two other elements of IFRS 9 will be finalized before making up his mind on the complete rule.

Joint Proposals Push Toward IFRS/GAAP Convergence in Issues Affecting Banks

FASB and the IASB announced moves toward convergence of IFRS and GAAP through joint proposals on offsetting transactions and impairment of financial assets.

The two main changes are 1) an exposure draft released last week on a common approach to offsetting financial assets and financial liabilities. This would end a major difference between IFRS and U.S. GAAP. 2) A supplementary document with a new impairment model for financial assets like loans managed in an open portfolio. The proposal would replace the incurred loss model with a more forward-looking expected loss model--a response to complaints in the financial crisis.

The issue with offsetting is that companies can, in some instances, report IFRS balance sheet figures that are 100 percent greater than their U.S. GAAP numbers. This is confusing to the global capital markets and the proposals would eliminate the difference.

U.S. GAAP would only net in more limited circumstances, with note disclosure of other netting arrangements in footnotes.

Offsetting/netting is required when company presents in net amounts on their balance sheet. As it stands now, financial assets and financial liabilities may show up on a balance sheet as one net amount, or as two gross amounts, depending on whether the balance sheet is in IFRS or U.S. GAAP.

The above netting arrangements cause the largest difference between balance sheets using IFRS and U.S. GAAP. Derivative assets and related liabilities are the most common area where this occurs. Balance sheets of financial institutions generally have the largest derivative positions.

The new proposed rules apply only when the right of setoff is enforceable at all times, including in default and bankruptcy, and the ability to exercise this right is unconditional—i.e. offsetting only occurs after a future event. A company must intend to settle net, i.e. with a single payment, or simultaneously. If all of these requirements are met, offsetting is mandatory. This would also change industry conventions.

The Exposure Draft is Offsetting Financial Assets and Financial Liabilities [FASB Proposed Accounting Standards Update, Balance Sheet (Topic 210): Offsetting]. Comments are due April 28.

On Impairment, changes introduce an expected loss model that is more forward-looking in accounting for credit losses, and is said to better reflect the economics of lending decisions. IFRS and U.S. GAAP currently account for credit losses using an incurred loss model, which requires evidence of a loss (known as a trigger event) before loans can be written down.

“The FASB and IASB are seeking comment on the changes, i.e. whether they agree conceptually and whether the changes can be practically applied.

Some advocate that a more forward-looking approach to loan losses would have made loan provisions show up earlier than before, and may have held off or mitigated the credit crisis by giving earlier warnings about the health of financial institutions.

Comments on the document Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities, are due April 1.

If you need a nap, the IASB is hosting a webcast on the impairment of financial assets proposal on Friday, Feb. 4, with sessions timed for Europe and the U.S. Also “FASB in Focus” has overviews on the new rules netting on FASB’s website and another FASB in Focus on the impairment model.

FASB Chairman: Fair Value Not Cause of Crisis; Separate Banking Regulation from Accounting

Journal of Accountancy is monitoring the AICPA SEC PCAOB conference this week.
They report here on a speech by FASB Chairman Robert Herz on Tuesday that addressed head on criticism of the role of accounting standards in the financial crisis and called for GAAP to be “decoupled” from bank regulation.

Herz, speaking at an AICPA conference, contended that many of FASB’s critics simply do not understand its mission. “There seems to be some confusion in the media and elsewhere about the relationship between the accounting standards we set and regulation of financial institutions,” said Herz. He explained that FASB does not determine the capital levels banks are required to maintain, but under laws enacted in the wake of the savings and loan crisis, bank regulators determine regulatory capital caccstarting with GAAP numbers. But bank regulators can adjust the GAAP figures, and they also have other tools to address capital adequacy, liquidity issues, and concentrations of risk at regulated institutions, Herz said.

He said that while FASB has a deep interest in the strength and stability of the financial system and the economy, its public policy mission and focus is designed to be different from that of banking regulators. “Our focus as accounting standard setters is on the communication of relevant, reliable, transparent, timely, and unbiased financial information on corporate performance and financial condition to investors and the capital markets,” he said. “The transparency provided by external financial reports contributes to financial stability by reducing the level of uncertainty in the system—and a lack of transparency can hide the extent of risks facing financial institutions from both investors and regulators.”

The mandate of the Federal Reserve and other banking regulators, according to Herz, differs in that it relates to ensuring the soundness of banks and the overall stability of the financial system. He says most of the time FASB and banking regulators can find common ground, but in some situations they’re actually in conflict. “In dire situations, bank regulators may be appropriately concerned that public release of data on severe losses and asset impairments could spark a run on a bank,” said Herz. “But investors would likely want to know the extent of the problems on a timely basis.”

The answer to this problem, according to Herz, is to “decouple” bank regulation from U.S. GAAP reporting requirements. “Doing so could enhance the ability of both the FASB and the regulators to fulfill our critical mandates,” he said.

And Herz, citing a 1991 GAO report following the S&L crisis, seemed to indicate that he believes that although GAAP and specifically much-criticized fair-value accounting did not cause the financial crisis, a GAAP unencumbered by pressure from banking interests would have done a better job of alerting investors and other stakeholders of an impending crisis. “The [1991] GAO report found that regulatory call reports significantly overstated the values of loans and debt securities (and hence the financial condition and capital) of failed banks,” he said.

He pointed out that the stress tests banking regulators recently conducted of the 19 major U.S. bank holding companies also found that the bulk of the $600 billion of potential additional losses revealed under the more adverse scenario related to loans and other receivables carried on a historical cost basis such as that used in the 1980s and not to items carried on a mark-to-market or fair value basis. In other words, fair value accounting, which is currently applied to only some financial assets, has done a better job of indicating the true financial condition of those assets than the cost basis.

Addressing another criticism of fair-value accounting, Herz admitted that reporting fair values can have procyclical effects on behavior. But he contends that “timely recognition of problems at financial institutions can have countercyclical effects through lessening the impact of financial downturns by providing an early warning of developing problems.”

This year both FASB and the IASB, under pressure from political influences, have struggled to agree on changes to accounting for financial instruments, which involves the fair value applications that have been most widely criticized. Herz provided assurances that FASB and the IASB would continue to work together on these issues, while acknowledging that the two boards have recently had differences in approach and timing. “Next year, once we have received comments and other input on our proposal, we will redeliberate at public board meetings all the key issues identified including discussing them with the IASB and making changes as appropriate,” he said. “Only after having completed this very extensive and thorough public due process will we issue a final standard carefully considering effective dates and transition.”

Original Journal of Accountancy article by Matthew G. Lamoreaux

Accountants to Politicians, Bankers: Hands Off Accounting Standards

Leaders of the American Institute of CPAs and the Center for Audit Quality told legilators that bankers should not regulate accounting.

The accounting and auditing organizations are worried about proposed legislation setting up a systemic risk regulator for the financial sector. The legislation proposes creation of an oversight council that would have the ability to change accounting standards in the event of a crisis—replacing the FASB as SEC’s acconting standard-setter.

The Centre for Audit Quality states that standards are for the benefit of investors so that they can get the information that they need so that they can make valid investment decisions, and that the SEC acts as an investor advocate and is the right oversight party for helping the FASB maintain independent standard setting. Having financial and banking regulators be part of that process with veto power over accounting and auditing standards is not a good model. Particularly in this time of financial crisis, it is a bit ironic that we would be talking about watering down the process that’s designed to protect investors.”

AICPA president and CEO Barry Melancon noted that banking regulators already have the ability to adjust capital requirements and the SEC can suspend accounting rules when needed, as the SEC has the ability to suspend accounting rules, even without a crisis situation. Accountants fear a circumvention of the rule of due process in the accounting standard-setting process.

The legislation would go against SEC chair Mary Schapiro’s recent warning against interfering with the independence of the accounting standard-setting process, which seh referred to as “race for the bottom”.

Accounting Rules Mess Up Lending Market

New accounting rules on securitizations have messed up the market for bonds backed by credit-card debt.

No new credit card securities have been issued since the beginning of October. Such securities are created when card loans are packaged into bonds and sold to investors.

The new rules (FAS 166 and 167) require banks issuing the securities to account for them as if they were on their balance sheets. Previous treatment allowed off-balance sheet treatment for the securities.

On-balance sheet treatment gives federal regulators the right to claim those assets should the institution file for bankruptcy, effectively diminishing bondholders' claim to the assets.

On-balance sheet treatment also may increase banks’ capital requirements.

The Federal Deposit Insurance Corp. plans to discuss the issue at a board meeting Thursday and may make a ruling that clears up the confusion. The rule takes effect on the date companies begin their 2010 fiscal years.

From the start of the year until October, issuers had sold an average of about $3.5 billion worth of credit-card deals each month.

Under the old accounting standard, card issuers -- such as Citigroup, Bank of America, American Express, Capital One, J.P. Morgan Chase, and Discover packaged up pools of credit-card loans and sold them to investors.

Citigroup' said on Friday that the result should be an addition of about $154 billion to its assets, based on Sept. 30 figures.

If the Federal Deposit Insurance Corp does not change the rules regarding how it treats debt from these securities when a bank collapses, rating agencies may downgrade the securitized debt. The debt may not be rated triple-A securities.

The new debt could potentially be rated no higher than Citigroup's own ratings. That would likely lift the bank's borrowing costs when funding new credit card loans or other debt.

Until the accounting rule was changed, these securities didn't have to be included on the banks' balance sheets, so they weren't subject to the same accounting standards and disclosures required for on-balance-sheet items.

Critics of the old treatment argued this rule allowed companies to hide risky assets in these off-balance-sheet items. The new rule will force card issuers to bring off-the-book credit-card loans onto their balance sheets and set aside additional reserves to account for potential losses in these securities.

No new credit-card-backed bonds have emerged in the market since Bank of America issued a $300 million deal on Oct. 2.

Year-to-date issuance of securities made up of credit-card loans has fallen 41% to $32.3 billion from $55.2 billion a year ago, according to a Deutsche Bank note published Nov. 5.

The FDIC could issue guidelines Thursday on the accounting-rule change, which will include the grandfathering of existing credit-card securities so as to minimize the disruption caused to the issuance of such deals.

New IFRS Fair Value Standard will be released In November

International Accounting Standards Board chairman, Sir David Tweedie, said thath the IASB will release a new fair value accounting rule by November.

In an address to a meeting of European Finance Ministers, which have in the past been critical of the IASB’s response to the financial crisis, Tweedie has sought to ease concerns by announcing that he is on track to deliver a new fair value standard by the end of this year.

“I gave a commitment to deliver on this timetable. We will publish the new standard in November,” he said.

Fair value accounting came under fire from banks and governments in the European Union and the U.S. after the financial crisis.

Tweedie said he will not require loan books to be held at fair value which has now become a potential sticking point between the IASB and the FASB.

FASB's proposal will see all assets measured at fair value. The IASB's mixed measurement model would see banks' loan books valued on an amortized cost basis.

The two standard setters are trying to converge US and international accounting rules, in the hope that the US will eventually adopt the new rules. But the fair value standard has now emerged as a significant obstacle, highlighted by Tweedie who said he simply did have the time to co-ordinate efforts with FASB in the revision of fair value, in the wake of the financial crisis.

“As I said in June, given the urgency of the fundamental issues surrounding IAS 39, none of us can afford the potential protracted back-and-forth resulting from piecemeal changes in international and US standards that would undermine the comprehensive and desperately needed reform that is under way,” he said.

“In our discussions with the FASB aiming to reach a common global approach, we will emphasise our position in favour of a mixed measurement model over one that requires full fair value measurement on the balance sheet… I remain optimistic that we can overcome our current differences.”

FASB Succumbed to Political Pressure: High Powered Investment Committee

An advisory panel of investors has accused the US accounting standard setter of losing its independence after it succumbed to political pressure over mark-to-market accounting changes in a fiery letter.

The group said the Financial Accounting Standards Board should have fought off pressure from politicians and lobbyists who sought special treatment for banks with toxic assets on their books.

The panel, the Investors Technical Advisory Committee was set up by FASB to act as a barometer for investors on accounting rules.

The group said the governance structure of the Financial Accounting Standards Board has been "insufficient" in fighting off pressure from special interests and politicians seeking more flexibility for banks with toxic assets on their books, and asked that the FASB board be restored to seven members from its current five.

The panel, called the Investors Technical Advisory Committee (ITAC), was set up by FASB to give investors' perspectives on accounting rules.

Its members include 13 investment professionals from suchorganizations as the Council of Institutional Investors and the CFA Centre for Financial Market Integrity; a former regulator; and analysts from Moody's, Standard & Poor's, Goldman Sachs & Co, J.P. Morgan Securities and CALPERS, the California Public Employees' Retirement System.

The said it had "grave concerns about what we believe to be a substantial erosion in the independence of the accounting standard setting process."

The group questioned whether "weaknesses" in FASB's structure and governance would undermine the quality of accounting rules issued by the board in the future.

The Committee said in the letter that it believes that poor transparency in accounting is partly responsible for the lack of investor confidence during the financial crisis and that FASB's inability "to assert its independence in the face of onslaught" was "exacerbating" the current problems.

"Many investors responded negatively to the reduced quality of information, as reflected in their investment decisions, but that response cannot compensate for the loss of information and, perhaps more importantly, the loss of trust and confidence in financial reporting and accounting standard setting," the group wrote.

To help FASB better fend off political attacks, the advisory panel urged the Financial Accounting Foundation to reverse changes made to its governance structure last year. It asked that the five-member board be restored to seven members, with the two additional members coming from investor groups.

The group also said because of "very public threats and intimidation" by Congress against FASB's chairman, another of the recent changes -- giving the chairman sole authority over what accounting projects end up on the board's agenda -- should be reversed.

In February 2008, the foundation downsized FASB and increased the chairman's power, saying the changes would help U.S. and international accounting standards converge. But plans to have U.S. companies switch to International Financial Reporting Standards as soon as 2014 are now being reevaluated by the U.S. Securities and Exchange Commission.

The investor advisory panel said in its letter that while FASB's governance issues were troubling, the situation "appears to be if anything even more dire outside the U.S." as the London-based International Accounting Standards Board has also faced threats from regulators and politicians abroad.

From Accountancy Age and Reuters

Politics and Accounting

This article, from an anti globalization rabble-rouser, does contain some interesting stuff.

The Obama administration’s good offices have encouraged the big banks to launch a multi-front offensive to block any measures that would limit their profit-making, and to weaken already existing regulations.

Last February, for example, financial firms and banking organizations launched a multi-million-dollar lobbying drive to change mark-to-market accounting rules that forced banks to report losses or write-downs totaling $175 billion in 2008. Mark-to-market essentially requires banks to value their assets according to prevailing market prices. The banks have balked at this standard, demanding instead the right to assign their own values to their bad debts, using "internal models."

With the aid of $286,000 in campaign donations to the 33 members of a key House subcommittee, the Fair Value Coalition, the lobby group set up by the banks, succeeded in getting the industry rule-making body, the Financial Accounting Standards Board, or FASB, to give the banks immense latitude in suspending mark-to-market rules.

The Wall Street Journal on June 3 published an investigative report detailing the banks’ use of campaign fund monies to get their way. The Journal reported that the banking coalition spent a total of $27.6 million in the first quarter of 2009 on its lobbying effort.

It focused its drive on a House Financial Services subcommittee chaired by Rep. Paul Kanjorski, a Pennsylvania Democrat. Kanjorski received $18,500 from Fair Value Coalition members in the first quarter. Over the past two years, Kanjorski has received $704,000 in contributions from banking and insurance companies, the third-highest among members of Congress.

Barney Frank of Massachusetts, the Democratic chairman of the Financial Services Committee, received $8,500 from the coalition.

Kanjorski and other recipients of the bankers’ largess from both parties grilled the head of FASB, Robert Herz, at a committee hearing on March 12, demanding that he expedite a review of mark-to-market rules and threatening him with a bill to broaden government oversight of his board if he failed to comply.

Herz got the message, and on April 12, in advance of the stress test results and early enough to enable the banks to pad their first-quarter financial reports, FASB announced the changes demanded by the lawmakers.

According to the Journal, the American Bankers Association was the biggest contributor to the campaign funds of committee members in the weeks before the March 12 hearing. The newspaper quotes ABA President Edward Yingling as boasting, "We worked that hearing. We told people that the hearing should be used to talk about the big problems with ‘mark to market,’ and you had 20 straight members of Congress, one after another, turn to FASB and say, ‘Fix it.’"

The Journal notes: "The change helped turn around investor sentiment on banks.... Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings." The newspaper cites a tax and accounting analyst, who estimates that the accounting changes will increase bank earnings in the second quarter by an average of 7 percent.

The Journal quotes Lynn Turner, the former chief accountant of the Securities and Exchange Commission and a former FASB member, as saying "he doesn’t think the banking industry will be satisfied until mark to market accounting is dismantled completely. ‘Despite efforts by FASB to give ground to the banks, enough is never enough, he says."

Financial Statement Prepares, Beware

Association of Certified Fraud Examiners (ACFE) has stated that the challenging economic climate is, unsurprisingly, leading to an increase in corporate fraud.

The Association however, in a report highlights how company layoffs are "leaving holes" within control systems and firms are not using enough resources to combat these increased risks.

The study shows that 88% of Certified Fraud Examiners (CFEs) expect a slight or significant rise in fraud over the next 12 months while only 22.2% have increased spending in the last year on preventative controls.

The Finance News Line of the Controllers' Leadership Roundtable has done resarch indicating that slow economic times bring increased incidences of fraud and employee misconduct, so it is important to make explicit where there is zero tolerance for bending the rules.

Five indicators in particular are the best predictors of likely misconduct at most large companies: 1) A culture of retaliation and discomfort raises concerns;
2) colleagues willing to compromise values for power and control;
3) direct manager lacks trust in and respect for employees;
4) percentage of variable compensation (an increased percentage increases the likelihood of misconduct, especially for senior executives);
5) employees' commitment to job greater than commitment to company.

See:
The report by the Association of Certified Fraud Examiners
Controllers' Leadership Roundtable

CEO of Goldman Sachs: Fix System; Keep Mark-to-Market Accounting

Lloyd C. Blankfein, CEO of Goldman Sachs Group, recently endorsed mark-to-market accounting and transparent financial reporting.

In a speech in Washington, Blankfein took a shot at critics of fair value accounting and those who claim that mark to market accounting caused or made worse the current financial crisis.

Blankfein stated: “If more institutions had correctly valued their positions and commitments at the onset, they would have been in a much better position to reduce their exposure,”

“To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?”

The full text of his speech is a good read and is reproduced below.

Good morning. I appreciate the opportunity to speak with you today. For more than two decades, the Council of Institutional Investors has committed itself to the values of accountability, transparency, and responsible ownership. I'm pleased to be able to speak to those principles in front of a group that has played such a powerful role in advancing them over the years.

To begin with an obvious point, much of the past year has been deeply humbling for my industry. We held ourselves up as the experts, and the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild. Worse, decisions on compensation and other actions taken and not taken, particularly at banks that rapidly lost a lot of shareholder value, look self-serving and greedy in hindsight.

Financial institutions have an obligation to the broader financial system. We depend on a healthy, well functioning system, but we collectively neglected to raise enough questions about whether some of the trends and practices that became commonplace really served the public's long-term interests.

Meaningful change and effective reform are vital and should naturally emanate from the lessons learned. I will discuss a few of the more important lessons from this crisis. I'd also like to highlight some of the regulatory guideposts that may help us to improve the broader systemic management of risk, increase the level of institutional accountability, and enhance investor confidence.

Without trying to shed one bit of our industry's accountability, we would also further our collective interests by recognizing other contributing causes to the severity of the cycle we are living through.

As a matter of policy, we allowed housing prices to be subsidized, including through implied government support of Fannie Mae and Freddie Mac. We watched as high consumption and low savings rates as well as entitlement spending were increasingly encouraged and financed through the twin deficits.

Factors from both Main Street and Wall Street contributed to today's circumstances. Neither part of our economy acted completely independent of the other. So, any examination of how we got to this point must begin with an understanding of some of the global economic and financial dynamics of the last two decades.

Certainly, what started in a localized part of the U.S. mortgage market spread to virtually every corner of the global financial markets. But the genesis of the problem wasn't in sub-prime. Instead, the roots of the damage to our financial system are broad and deep. They coalesced over many years to create a sustained period of cheap credit and excess liquidity. The resulting underpricing of risk led to massive leverage across wide swaths of the economy -- from households to the corporate sector to the public sector.

I see at least three broad underlying factors:

First, there has been enormous growth in the amount of foreign capital, much of it held in large pools, and a very significant shift in the balance of payments of many emerging markets;

Second, and linked to this, nearly ten years of low long-term interest rates; and

Third, the official policy of subsidizing homeownership in the United States.

Let's take each in turn, beginning with the growth in foreign capital.

Between 1992-2007, the U.S. current account deficit increased by more than 1,300 percent. During the same period, China's current account surplus increased by over 5,700 percent, as did the surplus for the oil exporting nations.

After previous financial crises, emerging economies began to self-insure against a repeat of those events by building up their foreign currency reserves. Their primary objective was to reduce their dependence on dollar-denominated domestic debt.

Of course, the other, perhaps more significant factor in the growth in current account surpluses had been the record run-up in oil prices since 2000. Increases in global savings run almost parallel with the increase in petrodollar flows.

The growth in foreign capital had a profound effect on the global economy. Foreign holdings of U.S. government and corporate debt skyrocketed. China's monthly average purchases of U.S. long-term securities went from less than $2 billion in 2001 to over $15 billion in 2007.

The flood of foreign capital into safe and liquid assets, particularly U.S. Treasurys, helped push relatively low long-term interest rates down even further. And they stayed low, even after the Federal Reserve began raising short-term rates in 2004.

This was accompanied by a significant reduction in inflation. Between the period 1985 and 1995 versus the next 12 years, inflation in advanced economies fell by more than one-half.

Enormous excess liquidity, strong global economic growth, and low real-interest rates created a desire to find new investment opportunities. Many of the best were thought to be in the housing market. The reasons are threefold.

First, governments, particularly the U.S., explicitly supported homeownership through a variety of government programs and initiatives. Second, mortgage assets were considered relatively impervious to sharp downturns. And lastly, the creation of more flexible and varied mortgage products attracted even more capital in search of higher returns.

These factors, to varying degrees, contributed to a housing bubble -- not just in the U.S. but in many other countries as well. While real home prices increased nearly 50 percent in the U.S. between 1998 and 2006, they increased more than 130 percent in Ireland, 120 percent in the U.K. and Spain and over 100 percent in France.

Not surprisingly, in the U.S., mortgage origination as a percentage of total mortgage debt outstanding rose from an average of 6.3 percent between 1985 and 2000 to 10 percent between 2001 and 2006. Subprime debt, in particular, grew from just over 2 percent in 2002 to 14 percent in 2008. In a sustained environment of cheap capital, lending standards for residential mortgages simply deteriorated.

As I have thought about our industry's understanding of the previous years' risks, it is important to reflect on some of the lessons.

At the top of my list are the rationalizations that were made to justify that the downward pricing of risk was different. While we recognized that credit standards were historically lax, we rationalized the reasons with arguments such as: The emerging markets were more powerful, the risk mitigants were better, there was more than enough liquidity in the system.

We rationalized because our self-interest in preserving and growing our market share, as competitors, sometimes blinds us -- especially when exuberance is at its peak.

A systemic lack of skepticism was equally true with respect to credit ratings. Too many financial institutions and investors simply outsourced their risk management. Rather than undertake their own analysis, they relied on the rating agencies to do the essential work of risk analysis for them. This was true at the inception and over the period of the investment, during which time they did not heed other indicators of financial deterioration.

This overdependence on credit ratings coincided with the dilution of the coveted triple A rating. In January 2008, there were 12 AAA-rated companies in the world. At the same time, there were 64,000 structured finance instruments, like CDO tranches, rated AAA. It is easy to blame the rating agencies for their credit judgments. But the blame is not theirs alone. Every financial institution that participated in the process has to accept part of the responsibility.

More generally, risk management will come to define the events of 2007 and 2008. First, models, particularly those predicated on historical data, were too often allowed to substitute for judgment.

In the last several months, we have heard the phrase, "multiple standard deviation events" more than a few times. If events which were calculated to occur once in twenty years in fact occurred much more regularly, it doesn't take a mathematician to figure out that risk management assumptions did not reflect the distribution of actual outcomes. Our industry must do more to enhance and improve scenario analysis and stress testing.

Second, size matters. For example, whether you owned $5 billion or $50 billion of (supposedly) no-risk super-senior debt in a CDO, the likelihood of losses would appear to be the same. But the consequences of a miscalculation were obviously much bigger if you had a $50 billion exposure.

Third, a lot of risk models incorrectly assumed that positions could be fully hedged. After LTCM and the crisis in emerging markets in 1998, new products like basket indices and credit default swaps were created to help offset a number of risks. However, we didn't, as an industry, consider carefully enough the possibility that liquidity would dry up, making it difficult to apply effective hedges.

Fourth, risk models failed to capture the risk inherent in off-balance sheet activities, such as Structured Investment Vehicles. It seems clear now that managers of companies with large off-balance sheet exposure didn't appreciate the full magnitude of the economic risks they were exposed to; equally worrying, their counterparties were unaware of the full extent of these vehicles and, therefore, could not accurately assess the risk of doing business. Post Enron, that is quite amazing.

Fifth, complexity got the better of us. The industry let the growth in new instruments outstrip the operational capacity to manage them. As a result, operational risk increased dramatically and this had a direct effect on the overall stability of the financial system.

Lastly, financial institutions didn't account for asset values accurately enough. I've heard some argue that fair value accounting -- which assigns current values to financial assets and liabilities -- is one of the major reasons for exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in positions that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions. We mark-to-market, not because we are required to, but because we wouldn't know how to assess or manage risk if market prices were not reflected on our books.

While this is not an exhaustive list of what went wrong, our focus is on learning from these lessons and others that will undoubtedly emerge as we work our way through this period.

The administration, legislators, and regulators have begun to consider the important regulatory actions to be taken and our firm pledges to be a constructive participant in that process. In that vein, I believe it is useful, in light of the lessons we take away from this crisis, to consider important principles for our industry, for policy makers and for regulators.

For the industry, we can't let our ability to innovate exceed our capacity to manage. Given the size and interconnected character of markets, the growth in volumes, the global nature of trades and their crossasset characteristics, managing operational risk will only become more important.

Risk and control functions need to be completely independent from the business units. And clarity as to whom risk and control managers report is crucial to maintaining that independence. Equally important, risk managers need to have at least equal stature with their counterparts in revenue producing divisions.

If there is a question about a mark or a disagreement about a risk limit, the risk manager's view should prevail.

Understandably, compensation continues to generate a lot of controversy and anger. We recognize that having TARP money creates an important context for compensation. That is why, in part, our executive management team elected not to receive a bonus in 2008, even though the firm produced a substantial profit. Beyond TARP, public scrutiny, a renewal of common sense and, perhaps, regulation will naturally affect compensation practices going forward.

More generally, we should apply basic standards to how we compensate people in our industry. Compensation should reflect an individual's ability to identify and create value, including his or her contribution to the client franchise, enhancing the firm's reputation and contributing to the better functioning and efficiency of markets.

Equally important, compensation should take into account strict adherence to a firm's management and controls, especially with respect to a person's judgment and exercising that judgment in terms of risk in all of its forms. That evaluation must be made on a multi-year basis to get a fuller picture of the effect of an individual's decisions.

And, individual performance must not be viewed in isolation. Individual compensation should not be set without taking into strong consideration the performance of the business unit and the overall firm. Employees should share in the upside when overall performance is strong and they should all share in the downside when overall performance is weak.

No one should get compensated with reference to only his or her own P&L. Compensation should encourage real teamwork and discourage selfish behavior, including excessive risk taking, which hurts the longer-term interests of the firm and its shareholders.

We also believe it is important to set forth specific guidelines on how we compensate in our industry.

Compensation should include an annual salary plus deferred compensation, which is appropriately discretionary because it is based on performance over the entire year.
The percentage of compensation awarded in equity should increase significantly as an employee's total compensation increases.

For senior people, most of the compensation should be in deferred equity. Only the firm's junior people should receive the majority of their compensation in cash.

As I mentioned earlier, an individual's performance should be evaluated over time so as to avoid excessive risk taking and allow for a "clawback" effect. To ensure this, all equity awards should be subject to future delivery and/or deferred exercise over at least a three-year period.

And, senior executive officers should be required to retain the bulk of the equity they receive until they retire. In addition, equity delivery schedules should continue to apply after the individual has left the firm.

At Goldman Sachs we believe attracting and retaining the best people is vital to our effectiveness and that incentives are an important element in that process. But we also recognize that, misapplied, they can also encourage excess. As an industry, we need to do a better job of understanding when incentives begin to work against the social good rather than for it and take action to redress the balance.

For policymakers and regulators, it should be clear that self-regulation has its limits. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

While all of us in the industry have a common responsibility to ensure the system's operational integrity, it is not realistic to expect that one firm alone can fix a system-wide problem like unsigned trade confirmations or the establishment of a central clearing facility.

Capital, credit and underwriting standards should be subject to more "dynamic regulation." Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates upward to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated.

To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk. How can one justify that the same instruments or risks are priced differently because they reside in different parts of the balance sheet within the same institution?

As recognized at the recent G20 summit, the level of global supervisory coordination and communication should reflect the global interconnectedness of markets. Regulators should implement more robust information sharing and harmonized disclosure, coupled with a more systemic, effective reporting regime for institutions and major market participants. Without these, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system, and are large enough to be a burden on it in a crisis, should be subject to some degree of regulation. Yes, that includes large hedge funds and private equity funds.

After the financial shocks and unsettling developments of recent months, I understand the desire for wholesale reform of our regulatory regime. And, in many cases, it is warranted. But we also should resist a response that is solely designed to protect us against the 100-year storm.

As long as human emotions influence decisions, this won't be the last financial crisis the world has to contend with. But, most of the last century has been defined by markets that fund innovation, reward entrepreneurial risk taking and act as an important catalyst for economic growth.

History has proven that a vibrant, dynamic financial system is at the heart of a vibrant, dynamic economy. The U.S. brand of that system has produced growth nearly one-third higher than the rest of the industrialized world over the last two decades.

The events of the last year have put into stark relief the tension between innovation and stability. But, if we abandon, as opposed to regulate, market mechanisms created decades ago, like securitization and credit default swaps, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.

Certain developments of recent decades, like changes in the structure of financial institutions post Glass-Steagall, have brought the risk of less frequent but more intense upheavals. The diverse income streams of mega financial conglomerates reduce the effects of the 10-year storm, but their size and ubiquity exacerbate the consequences of the 20- or 30-year storm.

Over the last several months, there have also been a number of broader policy lessons. Many had previously accepted the bifurcation of Wall Street and Main Street as well as the decoupling of the United States from the international economy. Both have proven false. In 2007, there were pitched debates over whether policy was being geared towards Wall Street at the expense of Main Street. Today, Wall Street remains destabilized, impeding the broader economy.

In terms of international implications, we have also seen actions that, for all intents and purposes, are protectionist and self-defeating. For instance, recent legislation constrains the ability of financial institutions to hire employees through the H-1B visa program. This program helps bring the most highly trained and technical people into our labor market.

The U.S. has always been a magnet for many of the most talented, hungry and qualified people in the world. Especially at this time in our economy, do we really want to tell individuals who will help companies to grow and innovate -- ultimately creating more jobs -- that they should go work elsewhere?

Equally significant and using Goldman Sachs as an example, we have approximately 200 employees who are in the U.S. because of the H-1B program. But, we have 2,000 employees who are working overseas and pay U.S. taxes. Do we want to invite other countries to take punitive measures against us?

This may be a relatively minor issue in the midst of the significant challenges we face, but I think it speaks to a potentially dangerous trend of withdrawing at a time we should do the opposite. While I don't dismiss political considerations, short-term salves like the "Buy America" provision or mandating a certain level of domestic lending will only end up harming the process underlying economic growth.

All along, we have known that market events and economic trends are interwoven on a global basis. But the events of the last year have shown that the connections are more direct and immediate than perhaps we previously appreciated.

In times of economic distress, the relationships between creditor and debtor countries take on even more complex dynamics ... especially as we are the largest debtor. We have learned that when a major financial institution fails in a debtor country, a creditor country is likely to pull back from its financing relationship in one way or another and, maybe, in every way.

For the United States at this time, the relationship is not just a matter of here and abroad; it is also a relationship between a debtor and its creditors. Certain of our economic decisions that have implications for our international partners could reverberate back to us very quickly and with great consequences in the current environment.

I want to conclude today with the following thought: We are fighting for nothing less than the immediate health and security of every person. We can never forget the products of economic growth -- more accessible health care, better education, less crime, tolerance of diversity, social mobility and a commitment to democracy.

In so many respects, change is the order of the day. We have much to do to repair our financial system and reinvigorate our regulatory structure. At the same time, our financial system, rooted in the belief of putting risk capital to work on behalf of ideas and innovation, has helped produce a long-term record of economic growth and stability that is unparalleled in history.

We have to safeguard the value of risk capital, which is at the heart of market capitalism, while enhancing investor confidence through meaningful transparency, effective oversight and strong governance. But, there should be no doubt: Markets simply cannot thrive without confidence.

Though honest disagreements will occur, the best companies don't shy away or selfishly frustrate efforts to compel better industry practices. These companies recognize that they are the first to benefit from better standards, especially if their business requires extensive dealings with partners or counterparties. But, we have to recognize a higher responsibility: to speak up, to draw attention to potentially destabilizing trends and to act like an owner responsible for the integrity of the system.

I, for one, know we have not done the best job in the recent past but working with you, as many of the world's most important investors, Goldman Sachs pledges to recommit itself to this fundamental obligation.

Thank you very much.

New York Times: ‘Integrity’ and Standard Setting

Floyd Norris is an astute writer at the New York Times—you know something is up when the New York Times comments on accounting issues.

Commenting on the most recent changes to mark-to market accounting rules by the FASB, Norris states in his blog:

“the change came after a subcommittee of the House Financial Services Committee made clear that FASB could be destroyed if it did not knuckle under to the banking lobby.

“Arthur Levitt and Bill Donaldson, two former chairmen of the Securities and Exchange Commission, bemoaned the politicization of the board, but the current chairman of the commission, Mary Schapiro, does not appear to have resisted the political pressure. That is understandable, but not necessarily admirable.”

Barney Frank, the chairman of the U.S. Congress Financial Services Committee stated after the changes were fast-tracked through the FASB rule-changing process that : “The integrity of the standard-setting process is preserved, while avoiding the pro-cyclical effects of improper valuation practices.”

Norris questions “Just how was the “integrity of the standard-setting process” preserved by using political pressure to force the board to do something it did not want to do? And how does Mr. Frank know that markets are now producing “inaccurate asset valuations,” but that the banks that created and bought these assets know what they are really worth?

“If the disclosures the FASB will now require really provide useful information, this could be a pyrrhic victory for the banks, much as the win on stock option accounting might have been.”

“Then, as now, those putting pressure on the banks wanted to keep reported profits from being changed by something they deemed unreasonable. But the FASB, in backing down, forced disclosure of what the impact would have been if options were expensed. The information that accumulated helped make it possible for the board to eventually impose the rule it had wanted to pass in the first place.”

“Could it be that these disclosures will work in the same way, by making it clear to those who read the footnotes just how much profits are being pumped up by the banks assuming that they know the real values of assets, even though nobody will pay that price for them right now?”

“In the long run, such disclosures might make it possible for us to track just how right (or wrong) the banks were in their confidence that they knew better than the market.”

“Or maybe my innate optimism is showing, and the new disclosures will not provide much useful information at all.”

WSJ Says Banks Making Bogus Claims about Mark-to-Market

At times Wall Street Journal articles almost seem to be written by bank lobbyists. Below is an opinion piece that refutes the banks' claims that MTM is wrecking the banking system and the economy.

Accounting Rules Should Avoid Impairment

Plenty of banks have succumbed to the credit crunch. Now, accounting rules look set to join the list of casualties.

Accounting rule makers will vote Thursday on proposals to soften "mark-to-market" accounting, the controversial rules requiring companies to peg their investments' value to the market's ups and downs. Many banks blame the rules for worsening their current problems, by locking in losses that they say are merely temporary.

The banks' claims are largely bogus -- after all, no accounting rule forced them to create and invest in the toxic securities that helped cause this crisis. But the Financial Accounting Standards Board is being pressured to water down the rule.

And one of the proposals that the board will vote on Thursday, to relax the standards under which companies must take impairment charges on their "available-for-sale" investments, would be particularly worrying for investors.

Companies record declines in their value of these securities as "unrealized" losses that get assessed on the balance sheet but don't affect earnings or regulatory-capital levels.

If the losses are later determined to be "other than temporary," however, companies must take impairment charges that lower net income and regulatory capital.

FASB's proposal makes it much less likely that stressed banks would take those charges in a timely fashion. Under the plan, all banks would have to do is say they don't intend to sell an "available-for-sale" investment that has incurred mark-to-market losses and probably won't be forced to sell before it recovers. Then, only "credit losses," the amount a company expects to lose if it holds an investment to maturity, would have to be recognized in earnings. The other declines in market value would only go onto the balance sheet, as now.

The loophole is big enough to fit a bloated bank balance sheet through: The risk is that banks wouldn't admit to a major credit loss on such securities unless the losses really were so obvious they simply couldn't be ignored. Banks could instead try to explain away low market values because of external factors such as liquidity risk, and many losses would never get recognized on the income statement.

That could be very important for some banks where toxic securities, with serious mark-to-market losses, comprise a big part of the capital structure. The unrealized losses on "available-for-sale" securities in effect for at least a year are equivalent to 6.6% of risk-weighted capital at U.S. Bancorp and 3.2% at Wells Fargo. That is another reason why investors should focus on tangible common equity as a capital measure instead, which does include such unrealized losses.

A rule change would be good for the banks -- not good for investors who need accurate valuations of companies' assets, reported clearly, on which to base their investment decisions. In fact, making things easier on the banks may only make already-cynical investors even more suspicious of the numbers that the banks are reporting.

This is happening now because of pressure on FASB Chairman Robert Herz from politicians who, at a recent hearing, threatened to eviscerate fair-value accounting if the changes didn't happen. So it isn't just the fair-value rules that are at stake here -- it is FASB's independence in setting all accounting rules. The risk is that plans to water down mark-to-market rules are only the start.

By Michael Rapoport at the Wall Street Journal.

Levitt Speaks to the SEC; Defends Mark-to-Market

Artheu Levitt, former chair of the SEC recently testified to Congress and vigorously defended mark-to- market.

Statement of Arthur Levitt, former Chairman, Securities and Exchange Commission
Before the Senate Committee on Banking, Housing, and Urban Affairs

March 26, 2009

Core Principles

Regulation needs to match the market action. If an entity is engaged in trading securities, it should be regulated as a securities firm. If an entity takes deposits and holds loans to maturity, it should be regulated as a depository bank. Moreover, regulation and regulatory agencies must be suited to the markets they seek to oversee. Regulation is not one size fits all.

Accounting standards serve a critical purpose by making information accessible and comprehensible in a consistent way. I understand that the mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of market participants. That principle supports mark‐to‐market accounting, which should not be suspended under any condition.

The proper role of a securities regulator is to be the guardian of capital markets. There is an inherent tension at times between securities regulators and banking supervisors. That tension is to be expected and even desired. But under no circumstance should the securities regulator be subsumed – if your goal is to restore investor confidence, you must embolden those who protect capital markets from abuse. You must fund them appropriately, give them the legal tools they need to protect investors, and, most of all, hold them accountable, so that they enforce the laws you write.

And finally, all regulatory reforms and improvements must be done in a coordinated and systemic way. The work of regulation is rarely done well in a piecemeal fashion. Rather, your focus should be to create a system of rules that comprise a complete approach, where each part complements the other, and to do it all at once.

Specific Reforms

Mark to market or fair value standards should not be suspended under any circumstance. Some have come forward and suggested that these are unusual times, and we need to make concessions in our accounting standards to help us through it. But if we obscure investor understanding of the value of assets currently held by banking institutions, we would exacerbate the crisis, and hurt investors in the bargain. Unfortunately, recent steps taken by the FASB, at the behest of some politicians, weaken fair value accounting.

Those who argue for a suspension of mark‐to‐market accounting argue this would punish risk‐taking. I strongly disagree. Our goal should be to make sure risk can be priced accurately.
Failure to account for risk, and failure to present it in a consistent way, makes it impossible to price it, and therefore to manage it. And so any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake, and contribute to greater systemic risk.

I would add that mark‐to‐market accounting has important value for internal management of risk within a firm. Mark‐to‐market informs investment bank senior managers of trading performance, asset prices, and risk factor volatilities. It supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for risk‐taking. If treated seriously by management, mark‐to‐market is a force for internal discipline and risk management, not much different than a focus on internal controls. Yes, valuing illiquid or complex structured products is difficult. But that doesn’t mean the work should not be done. I would argue that it has to be done, both inside the firm and by those outside it, to reduce risk throughout our system.

And so I agree with the Chairman of the Federal Reserve, and the heads of the major accounting firms, that the maintenance of mark‐to‐market standards is essential.

Supporting all these activities will require an appropriately funded, staffed and empowered SEC. Under the previous administration, SEC funding and staffing either stayed flat or dropped in significant areas – enforcement staff dropped 11 percent from 2005 to 2008, for example. We have seen that regulators are often overmatched, both in staffing and in their capacity to use and deploy technology, and they can’t even meet even a modest calendar of regular inspections of securities firms. Clearly, if we are to empower the SEC to oversee the activities of municipal bond firms and hedge funds, we will need to create not only a stronger agency, but one which has an adequate and dedicated revenue stream, just as the Federal Reserve does.

My final recommendation relates to something you must not do. Under no condition should the SEC lose any of its current regulatory responsibilities. As the primary guardian of capital markets, the SEC is considered the leading investor representative and advocate. Any regulatory change you make that reduces the responsibility or authority of the SEC will be viewed as a reduction in investor protections. That view will be correct, because no agency has the culture, institutional knowledge, staff, and mission as the SEC to protect investors.

Conclusion

These actions would affirm the core principles which served the nation’s financial markets so well, from 1933 to 1999 – regulation meeting the realities of the market, accounting standards upheld and strengthened, regulators charged with serving as the guardians of capital markets, and a systemic approach to regulation. The resulting regulatory structure would be flexible enough to meet the needs of today’s market, and would create a far more effective screen for potential systemic risks throughout the marketplace.

Financial innovations would continue to be developed, but under a more watchful eye from regulators, who would be able to track their growth and follow potential exposure.

Whole swaths of the shadow markets would be exposed to the sunlight of oversight, without compromising the freedom investors have in choosing their financial managers and the risks they are willing to bear.

Most importantly, these measures would help restore investor confidence by putting in place a strong regulatory structure, enforcing rules equally and consistently, and making sure those rules serve to protect investors from fraud, misinformation, and outright abuse.

These outcomes won’t come without a price to those who think only of their own self-interest. As we have seen in the debate over mark- to-market accounting rules, there will be strong critics of strong, consistent regulatory structure. The self-interested have reasons of their own to void mark-to-market accounting, but that does not make them good reasons for all of us. Someone must be the guardian of the capital market structure, and someone must think of the greater good. That is why this committee must draw on its heritage of setting aside partisanship and the concerns of those with single interests, and maintain a common front to favor the rights of the investor, whose confidence will determine the health of our markets, our economy, and ultimately, our nation.

Selling Your Soul for $186,000 a year

The SEC complaint against Bernie Madoff's auditor, alleges that David Friehling enabled Bernard Madoff's Ponzi scheme by falsely stating, in annual audit reports, that F&H audited Madoff's financial statements. In fact, the complaint alleges, the defendants did not conduct anything remotely resembling an audit.

Friehling & Horowitz is enrolled in the program but hasn't submitted to a review since 1993, says AICPA spokesman Bill Roberts. That's because the firm has been informing the AICPA -- every year, in writing -- for 15 years that it doesn't perform audits.

Meanwhile, Friehling & Horowitz has reportedly done just that for Madoff. For example, the firm's name and signature appears on the "statement of financial condition" for Madoff Securities dated Oct. 31, 2006.

New York state is one of only six states that does not require accounting firms to be peer-reviewed. Recently, the New York State senate passed legislation that requires such a process.

F&H also allegedly made false representations that BMIS financial statements were presented in conformity with GAAP. Finally, Friehling allegedly falsely stated that he had reviewed internal controls at BMIS, including controls over the custody of assets, and found no material inadequacies.

If properly stated, the Madoff financial statements, along with related disclosures regarding reserve requirements, allegedly would have shown that the firm owed tens of billions of dollars in additional liabilities to its customers and was therefore insolvent. The complaint alleges that Friehling and F&H obtained ill-gotten gains through compensation of $186,000 per year from Madoff. They are also accused of withdrawing $5.5 million from Madoff funds held in the name of Friehling and his family members (with a balance of $14 million as of November 2008).

The Old Fake Auditor Trick

Following is the story of a hedge fund that allegedly defrauded investors and eluded regulation over several years by having a non-existent auditor.

In the Westgate case, the SEC charged that James M. Nicholson and his company, Westgate Capital Management, an investment management firm based in Pearl River, N.Y., defrauded investors of millions of dollars by significantly overstating investment returns and misrepresenting the value of assets under management in 11 unregistered hedge funds.

The SEC's complaint alleges that Nicholson and Westgate solicited new investors with sales materials that claimed a nearly impossible record of investment success, including one Westgate fund that claimed positive returns in 98 of 99 consecutive months.

Nicholson also allegedly created a fictitious accounting firm and provided some of his investors with bogus audited financial statements. By late 2008, the funds had sustained such losses that Nicholson and Westgate could no longer honor redemption requests.

They allegedly hid the losses from investors with misrepresentations, false sales brochures and other deceptive devices. Nicholson closed one fund that was heavily invested in bankrupt Lehman Brothers and folded its assets into another Westgate fund.

Nicholson allegedly issued bad checks to some investors seeking to cash out, and ultimately suspended all investor redemptions due to what he called investors' "irrational behavior." Nicholson was already barred from the brokerage industry in 2001 for failing to reply or supplying false information in response to inquiries.

The SEC is prosecuting the case.

G--20 to Mess with Accounting Standards?

On April 1, the richest 20 nations in the world--the G20 nations will meet in London to deliberate on the current state of world financial affairs in an attempt to find solutions to the global financial crisis. Given the political attention to mark to market rules in the U.S. and the EU, can political demands to relax the fair value accounting rules to allow banks more lending leeway be far off?

Over the past few months, accounting for financial instruments has been controversial with opposing views circulating. Bankers and their lobbyists continue to push lawmakers to force accounting standard setters to relax the rules as to whether financial instruments in inactive or distressed markets should be recorded on balance sheets at fair value. Current rules force mark-to-market accounting in illiquid/distressed markets, even for securities that are being held to maturity. The rules also provide guidance on how to use inputs other than trading prices — including internal models in situations where no other information is available.

Bankers hate fair value and are receiving more support from U.S. and international lawmakers, who say financial instruments that are held to maturity should be allowed to be valued without reference to current market prices.

The U.S. Congress last week pressured the FASB to fast track a proposal that would provide added guidance on fair value requirements to generally give the banks what they want. The comment period for the IASB/FASB proposal ends on April 1, after being out for an unusually short 15-day period. The comment period on the IASB's proposal is 30 days.

In addition to the fair value rules, banks also want action on reserve rules. Banks are limited in what they can lend based on their asset and equity positions. Lawmakers may want to change these rules to loosen up lending practices. Banks and lawmakers blame the current credit crisis on mark to market and bank reserve rules. International rules on the current regulatory capital ratios for banks were set up in the Basel II agreement.

Different ideas exist on this:

• IASB chairman David Tweedie has suggested using the insurance company model of catastrophic reserves, i.e. banks would establish a non-distributable reserve on the balance sheet, i.e. not on the income statement. The balance sheet asset would be clearly marked as being non-distributable so investors understood its purpose. If catastrophe hit — such as a credit crisis — the company would be allowed to tap the reserve to keep the event from decimating company earnings.
• Other experts have suggested using what is known as dynamic provisioning, a reserve technique used by banks in Spain. In this case, reserves are increased during good times so they can be drawn down when losses pile up. Dynamic provisioning, also referred to as the "cookie jar" method, smoothes earnings when cash is released from the reserve and fed through the profit and loss statement. However, some companies have used earnings smoothing to manage and inflate earnings, as the release of reserves can be masked on financial statements.
• A third method, involving two net income lines, has also been discussed. The concept here is to create a second line representing regulatory net income to show a company's profit minus its capital reserve. Along with separating the cash reserve from the earnings calculation, a company could use this line to calculate performance-based executive compensation. In that way, executives would not be getting rich off of inflated profit numbers.

With information from Maria Leone at CFO.com

Arthur Levitt: FASB Caved in to Banks and Political Pressure

Arthur Levitt, former chair of the SEC doesn't like the FASB/IASB changes to mark to merket rules. Some of his comments:

The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds.

Such a subjective judgment is bound to decrease investor confidence in reported income.

In a strange twist of fate, the FASB's proposals may create even greater opportunities for short sellers who are adept at digging into numbers that do not tell the whole story.

The real scandal here is not the decision by the FASB, rather it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection.

In seeking to protect its independence, the FASB has surrendered some of it in the bargain.

Independence from public pressure has a value, and when you give some of it away, you've lost something that takes years to rebuild.

The rule change agreed to by the FASB on Tuesday followed only one public meeting on this topic, and the board is giving investors just two weeks to comment, with a final vote the next day. This is a rush job.

The FASB should rethink its approach to these rules.

Above all, the Securities and Exchange Commission should take a firm stand on the side of investors and vigorously resist all political efforts to reduce the independence of financial rule-making agencies and boards.

Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies -- some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened.

Full article here.

Obama Package to Change Mark to Market Rules?

Several news sources have stated that mark-to-market accounting rules for U.S. banks may be changing after this week's release of the Obama administration's plan to dole out the second $350 billion of the $700 billion financial rescue fund.

Banks have been facing steep write downs of troubled assets as a result of the accounting standard. Speculation exists that the charges will preserve the existing standard but allow banks to preserve capital.

Chairman of the Senate Banking Committee Sen. Christopher Dodd spoke to reporters last week that they are considering an approach that modifies but does not abandon the mark-to-market standards.

The SEC has already relaxed standards by allowing banks to reclassify assets that are difficult to value because of lack of market comparable information. The changes preserved value in what otherwise might have been fire-sale values applied to bank assets.

The SEC and the Financial Accounting Standards Board are working on more guidance to help banks determine the value of an asset when there is little or no market trading.

The SEC has not posted any response to the statements.

The Brakes on IFRS

SEC Chairman Mary Schapiro Not following Cox on IFRS

Incoming chair Mary Schapiro, approved by the Senate as SEC Chairman in January, will not follow Christopher Cox on IFRS. She wants a slower approach to U.S. adoption of international accounting rules.

During Schapiro’s confirmation hearings she was asked several questions, including questions about IFRS, Sarbanes Oxley and other topics. She made oral responses, and releases a letter in January providing her written responses. In her she said that she won’t let the International Accounting Standards Board make accounting rules for U.S. companies—yet.

In Schapiro's opinion, the IASB has not shown it can resist political pressure—as became obvious when Sir David Tweedie, IASB chair threatened to resign if there was a recurrence of the IASB caving in to pressure by banks and politicians to change the rules on fair value reporting standards.

Schapiro also has said that she is concerned about IFRS standards quality and the fast tracking of the adoption in 2014. The SEC extended the deadline for comments on the 2014 adoption date by 60 days to April. The previous deadline was February 19.

Schapiro wants FASB and whatever standard-setting authority that succeeds it to not be influenced by political pressure. She wants the SEC to have a high level role in oversight of The FASB to ensure that they are diligent in keeping up with needed accounting changes.

Schapiro also stated that accounting rules were not responsible for the recent market crash.

You can read the written responses here.