Accounting Standards: Treatment of Asset-Backed Securities

Published by the Government Accountability Office on 1999-04-14.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

      United States

GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division


      April 14,1999

      The Honorable Tom Bliley
      Chairman, Committee on Commerce
      House of Representatives

      Subject: Accounting Standards Treatment of Asset-Backed Securities

      Dear &fr. Chairman:

      This letter responds to your request for information on whether the greater discretion
      allowed to banks as opposed to securities broker/dealers under accounting standards and
      practices may have resulted in less transparency in the value of asset-backed securities held
      by banks.’ Your concern stemmed from the fact that banks, unlike broker/dealers, are
      allowed to carry some securities at amortized cost, which is less transparent than carrying
      them at fair value.’ As a result, if there were a decline in the fair value of securities carried at
      amortized cost, investors would not see it reflected in the related financial statement
      balances. Your letter also suggested that a movement of these securities into banks may have
      contributed to a loss of liquidity in the marketplace this past fall. Because the largest portion
      of asset-backed securities are securities whose underlying assets are residential mortgages,
      called mortgage-backed securities @ IDS), we agreed with your office to focus on MBS.3
      Specifically, we agreed to provide information on (1) the accounting treatment applied to
      securities (including MBS) held by banks and broker/dealers and (2) the accounting for
      securities holdings by the six largest bank holding companies and whether such holdings
      might have affected the transparency of financial statements.

      To meet these objectives, we reviewed the accounting standards and practices for reporting
      securities held by banks and broker/dealers. In addition, we examined data in the December
      31,1997, and September 30,1998, annual and quarterly investor reports filed by the six largest
      bank holding companies in order to assess whether banks’ accounting for securities might
      have resulted in less transparency to investors. These bank holding company (BHC) reports
      provided consolidated data for the holding company and all of its subsidiaries, both banks
      and nonbanks, and showed the accounting treatment of securities held. As of September 30,

      ‘Asset-backed securities are bonds or debt securities backed by the cash flow from pools of underlying assets, such as
      mortgages, car loans, or credit card receivables.

      *Amortized cost is the face value of the securities plus the unamortized premium or less the unamortized discount. Fair value is
      defined as the amount at which an item could be exchanged in a current transaction between willing parties, other than in a
      forced or liquidation sale. Because fairvah~e generally represents a more current value than amortized cost, reporting securities
      at fair value is more transparent to securities investors.

      “As of September 30,1998, there was a total amount of $3,156 billion of asset-backed securities outstanding in the United States;
      Ml3S accounted for 81 percent of this amount

      Page 1                                                                            GAO/GGD-99-63R Asset-Backed Securities

1998, the 6 largest BHCs accounted for 49 percent of the total assets of the top 50 BHCs in the
United States. They accounted for an even larger share+61 percent-of the top 50 BHCs’
trading and investment accounts4 We also examined data that showed the 50 largest
concentrations of MBS held in BHCs and the banks’ accounting treatment of mortgage pass-
through securities.5 In addition, we interviewed officials at the Federal Reserve Board to
obtain their views on what the large BHCs had done in their securities activities in 1998.

We obtained oral comments on a draft of this letter from Federal Reserve officials, and their
comments are discussed at the end of this letter. We did our work in February and March
1999, in accordance with generally accepted government auditing standards.

Results in Brief
Accounting standards allow banks and most other companies to report their securities
holdings at either fair value or at amortized cost, depending on the nature of the securities
and the purpose for which the securities are held. Because fair value reporting generally
represents a more current value of reported assets than amortized costs do, assets reported
at fair value offer readers of financial statements greater transparency. A review of the
securities holdings at the six largest bank holding companies showed that they were
reporting the bulk of their securities holdings at fair value. F’urther, between December 1997
and September 1998,these companies’ combined holdings of securities reported at amortized
cost had declined, and the securities holdings reported at fair value had substantially
increased. As a result, the transparency of their securities holdings improved during this

At the Federal Reserve, officials had reviewed developments in the financial markets through
the fourth quarter of 1998 and data on individual entities’ securities transactions through the
third quarter of 1998.They said their review revealed two instances in which account
balances changed in a way that might indicate intracompany securities transactions, but they
pointed out that the changes could also be attributable to other causes. They also observed
that the reduced liquidity in certain markets in late 1998 was part of a more general
phenomenon in which market participants had become very risk averse at that time.

 ‘Securities that banks have bought for short-term resale at a profit are placed in the trading account; other securities are placed
 in the bank’s own investment portfolio, which is commonly called the investment account

 SMortgage-backed securities consist of mortgage pass-through securities and collateralized mortgage obligations (CMOS).
 Mortgage pass-through securities entitle investors to share on a pro rata basis in all principal and interest payments received
 from a mortgage pool. CMOSdivide the principal and interest payments from the underlying pool into classes with different risk
 characteristics and issue securities for each class. In September 1998,all commercial banks in the United States held $277 billion
 of pass-through mortgage securities compared to $156 billion of CMOS

 Page 2                                                                               GAOIGGD-99-63R Asset-Backed Secnrities

    Accounting Standards and Practices for Securities Held by Bank
    Holding Companies
    The following accounting standards and practices apply to holdings of securities (including
    MBS) by bank holding companies and their subsidiaries.

l   Broker/dealer subsidiaries (called Section 20 subsidiaries)6 are to utilize specialized
    accounting practices in which substantially all securities held are to be reported on the
    balance sheet at fair value, with unrealized gains and losses reflected in net income.
l   Securities held in the bank subsidiaries of a bank holding company are subject to the
    accounting standards set forth in F’inancial Accounting Standards No. 115, Accounting for
    Certain Investments in Debt and Equity Securities (FAS 115).
      l  Similar to the accounting treatment for broker/dealers, securities that are held for
         trading purposes are to be reported in the trading account line of the balance sheet at
         fair value, with unrealized gains and losses reflected in net income.
      l  Securities that are held for longer term purposes are to be reported in the investment
         account and designated either as “held-to-maturity” or “available-for-sale.” Securities
         may be designated as held-to-maturity only if the entity has the intent and ability to hold
         them to maturity, in which case they are to be reported in the balance sheet at amortized
         cost, with disclosures in the notes regarding fair market value and unrealized gains and
         losses. Securities designated as “available-for-sale” are to be reported in the balance
         sheet at fair value. Unrealized gains and losses are not to be reported in earnings but
         reported in the notes to the financial statements and reflected in equity as an adjustment
         to net income.
      l  A security may not be classified as “held-to-maturity” if that security can be
         contractually prepaid or otherwise settled in such a way that the holder of the security
         would not recover substantially all of its recorded investment. MBS that meet this
         criterion must be classified as “available-for-sale” or trading and are to be reported on
         the balance sheet at fair value.

    Accounting for Securities Holdings by the Six Largest Bank
    Holding Companies
    We analyzed the quarterly reports to investors (known as FormlO-Qs)~ and the annual reports
    of the six largest bank holding companies, focusing on the areas where securities are
    reported-namely the trading and investment accounts. The data indicated that as of
    September 1998 the bulk-98.2 percent-of their holdings in these accounts were recorded at

    ‘Banking organizations that are members of the Federal ReserveSystem are permitted to conduct broker/dealer business only if
    they are authorized by the Federal Reserve Board to have a Section 20 subsidiary, which is a nonbank subsidiary of a bank
    holding company. This name refer to Section 20 of the Glass-SteagallAct (12 U.S.C. set 377). A Section 20 subsidiary can
    function as an investment bank by underwriting (publicly distributing new issues of securities) and as a broker/dealer by buying
    and selling securities for its own account or for other.

    ‘Quarterly Report Ftnsuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

    Page 3                                                                           GAO/GGD-99-63R Asset-Backed Securities

fair value. (See table 1.1.) These data encompass not only MBS but also all other types of
securities, as well as derivatives held for trading.’

Because bank holding companies are to carry all assets in the trading account at fair value,
we focused on the investment account portfolios of these six BHCs. The Form 10-Q reports
for these companies indicated that 95.7 percent of their investment account securities were
reported at fair value in September 1998, up from 93.8 percent in December 1997. The lowest
percentage reported at fair value among the six companies in September 1998 was 94.2
percent. For the six BHCs, their combined holdings of securities reported at amortized cost
declined $2.4 bilhon between December 1997 and September 1998, notwithstanding a $33.8
billion increase in the total holdings of securities in their investment accounts. Thus, even if
there were any intracompany shifts of securities, by the end of the period the transparency of
their securities holdings was probably greater than at the beginning of the period.

Banks’ Holdings of MBS
On September 30,1998, banks held $483.6 billion of MBS, compared to the nationwide total
amount of $2,458 billion of outstanding MBS. Within banks’ holdings of MBS, 64 percent were
pass-through securities. Table I.2 presents the accounting treatment of the 50 largest
portfolios of pass-through MBS held at banks. (The data in table I.2 do not show the holdings
of the largest 50 banks; instead, they show the largest 50 portfolios, regardless of the size of
the company.) In these 50 portfolios, 91 percent of the dollar volume was available for sale,
i.e., carried at fair value; and 9 percent was carried at amortized cost. For all banks in the
United States, the figures were 88 percent at fair value and 12 percent at amortized cost.
Thus, for this one important part of the securities portfolio, transparency did not appear to be
a significant issue at the end of September 1998.

Federal Reserve Board O fficials’ Observations on Bank Holding
Companies’ Activities
Officials at the Federal Reserve Board provided us with their observations on BHCs’ activities
concerning trading and investment accounts in 1998. In general, they saw strong growth in
banks’securities holdings in both accounts in the fourth quarter of 1998. Within bank holding
companies, the officials looked at the overall data for Section 20 subsidiaries through the
third quarter of 1998 but did not see anything they viewed as signnicant While in two cases
sizable changes in securities holdings were noted, they said that these data did not provide a
sufficient basis from which to draw conclusions. For one thing, the officials stressed that
trading account balances are very volatile and that data are available for only the four call
report dates each year. For another, they noted that decreases and increases in such accounts
could reflect transactions with third parties, rather than intracompany transactions. The

 %erivatives are fiuancial products that enable risk to be shifted from one party to another; their value is based on an underlying
 reference rate, index, or asset, such as stocks, bonds, commodities, interest rates, fore&u currency exchange rates, and various
 market indexes.

 Page 4                                                                             GAOKGD-99-63R Asset-Backed Securities

officials said that discovery of the specific causes for changes in the trading and investment
account totals would require close bank-by-bank examination.

Regarding the reported loss of liquidity in MBS markets, the Federal Reserve officials
attributed this to the fact that dealers had become very risk averse. They said this was a
general phenomenon, present in different types of dealers and in various financial

Agency Comments
We requested comments on a draft of this letter from the Federal Reserve. On April 1,1999,
we received oral comments from the Deputy Associate Director, Division of Banking
Supervision and Regulation. He generally agreed with the contents of our letter and made
technical comments, which we incorporated as appropriate.

We will send copies of this letter to Representative John Dingell, Ranking Minority Member,
House Committee on Commerce; Alan Greenspan, Chairman of the Board of Governors at the
Federal Reserve System; Arthur Levitt, Chairman, Securities and Exchange Commission;
John D. Hawke, Jr., Comptroller of the Currency, Office of the Comptroller of the Currency;
and other interested parties. We will also make copies available to others on request.

We hope that this information is useful; if more information is desired, we will be glad to
assist. If you have any questions, please call me or John Treanor at (202) 512-8678.

Sincerely yours,

Thomas J. McCool
Director, Financial Institutions
and Markets Issues


Page 6                                                       GAO/GGD-99-63R Asset-Backed Securities
Enclosure I

Selected Financial Data on Banks’ Holdings of

Table 1.1: Assets in the Trading and lnvestment Accounts of the Six Largest Bank Holding Companies
Dollars in millions
Accounts                                                           December 1997                   September 1998                         (decrease)
A. Trading account’                                                        $337,888                         $352,723                         $14,835

6. Investment account                                                       209,515                          243,342                           33,827
of which:

B.l. Reported in balance sheet at amortized cost                              12,894                           10,475                          (2,419)

8.2. Reported in balance sheet at fair value                                 196,621                         232,867                           36,246
Share of investment account held at fair value                                 93.8%                           95.7%

C. Total assets in the two accounts (A plus B)                               547,403                         596,065                           48,662

C.1. Reported at amortized cost (B. 1)                                        12,894                           10,475                          (2,419)

C.2. Reported at fair value (A plus B.2)                                     534,509                          585,590                            51,081
Share of total held at fair value                                              97.6%                            98.2%
                                                 Note: Ranked bv assets as of SeDtember 1998, the six largest bank holding comDanies were
                                                 BankAmerica Cbrporation; Cha& Manhattan dorporation:Citicorpp; J.P. M&gan k Co., Incorporated;
                                                 First Union Corporation; and Bankers Trust Corporation.
                                                 ’The trading account includes both securities and the positive value of derivatives held for trading
                                                 Sources: GAO analysis of the companies’ quarterly reports on Form 1 O-Q and annual reports.

                                                  Page 6                                                  GAO/GGD-99-63R Asset-Backed Securities”
Enclosure I

                                                Selected   Financial   Data on Banks’ Holdings           of Securities

Table  1.2: Top 50 Portfolios of Pass-Through MBS at Banks as of September               30,1998
Dollars in millions
                                                                                                                                                 Portion    available    for
Bank holding companies                                                 Total       Held to maturiw                 Available for saleb                     sale (percent)
Chase Manhattan Corporation                                        $35,017                   $987.4                         $34,029.3                                   97%
Bar&America Corporation                                             31,173                  1,573.6                          29,599.5                                     95
First Union Corporation                                             23,459                    835.7                          22,623.6                                     96
Nonvest Corporation                                                 16,005                       0.0                         16.005.4                                    100
Republic New York                                                   12,550                  6,714.4                           5,835.2                                     46
ABN Amro Americas                                                    7,909                     99.8                           7.809.0                                     99
Fleet Financial Group                                                7,525                       0.0                          7.525.2                                   100
Bane One Corporation                                                 6,720                     62.8                           6,657.5                                     99
Fifth Third Bancorp                                                  6,001                       0.0                          6,000.5                                   100
Mellon Bank Corporation                                              5,061                  1,605.2                           3.455.4                                     68
Wachovia Corporation                                                 3,359                    525.7                           2,832.8                                     84
BankBoston Corporation                                               3,296                    137.8                           3,157.7                                     96
National City Corporation                                            2,851                      0.0                           2,850.5                                   100
U.S. Bancorp                                                         2,622                      0.0                           2,622.l                                    100
  .-..-   Fan-in
          . -.= - R
                  ---_Go.                                              2.530
                                                                       _)___                    0.0
                                                                                                 -.-                          2.530.3
                                                                                                                              -,---_-                                    100
                                                                                                                                                                         .--      .
Ly-mp                                                                  3A7R.m-
                                                                       k,                                on
                                                                                                         -.-                  3A7Rn
                                                                                                                              -, . .      -.-                           Inn
Crestar Financial Comoration                                           2.410                            20.1                  2.390.1                                     99
L”,II~ll~cl Illb”l~“‘~Lcw                                              T;,L.JY                                                C,~..Kz.”                                  I””
Bank of Montreal                                                       2,004                    ii;;                          2,003.8                                    100
Commerce Bancorp                                                       1,975                  977.3                             997.6                                     51
AmSouth Bancorp                                                        1,899                  975.1                             923.9                                     49
Bankers      Trust
               .--.- Comaratinn
                       -. -.- _.-..                                    1.860
                                                                       .,---                             0.0
                                                                                                         -.-                  1.859.5
                                                                                                                               .I-----                                   100--
Allied Irisi., Rlrhba
               --     I-.-.
                         trl                                           .,,.a.
                                                                       1 7.14                            nn
                                                                                                         “.”                  17RAn
                                                                                                                               .,s v ..-                                 1flf-l
 _-_. Cornoration
PRRT    --.r -.--.- --                                                 1.677                             0.0                  l-676.7
                                                                                                                                 k4.1                                    100_-
i TfYF
   -, .Finannial
                 --.r-.- _._..
                 Cnmnration                                            .,__.
                                                                       1.664                             0.0
                                                                                                         -.-                  1 , - - .. .                               1fM.l
CNB Bancshares Incorporated                                            1,541                   58.4                           1,482.6                                     96
North Fork Bancotp                                                     1,467                  638.8                             827.6                                     56
SunTrust Banks Inc.                                                    1,416                    0.0                           1,416.0                                    100
Cullen/Frost Bankers Incorporated                                      1,413                  115.2                           1,298.2                                     92
SouthTrust Corporation                                                 1,401                  351 .o                          1,050.5                                     75
Summit Bancorp                                                         1,303                  986.9                             316.5                                     24
Star Bane Corporation                                                  1,302                    0.0                           1,302.l                                    100
Regions Financial Corporation                                          1,287                   50.1                           1,236.6                                     96
Mercantile     Bancon,
_._.-- .._.. - --...- - .~                                             1.224
                                                                       ~I-~                    73.3                           1,151.l                                     94
   0 1,111,   “I uty CL.+ PI-lA.l...mn
                     r113&“cLllnaIIcIIci3                              , Q,tc
                                                                       I,LIcl                   0.0                           1,214.5                                    100
HSBC Holdinos. Plc                                                     1.195                      0.0                         1.195-o                                    100
F. dQ,,,,b wslll”ly TIIIa,ucIIQI ““lfJ”l~~WCl                          l,l=3L                 -rJ”.-v                            I G3il.i)
;;ntJ;r       Bancshares lncomorated                                   1.082                       0.0                         1.082-l                                   l”o’o
    Y      I,\ “1 VIW..W. .w                                           .,---                       1.w                         . ,‘W”.W                                   I””
Firstar Corporation                                                    1,049                     906.3                            142.6                                    14
Marshall & llsley Corporation                                          1,044                       0.0                         1,044.2                                   100
US Bancorn          lnanmnrded                                           775                     289.1                           485-s                                    674
Union Plainters Corporation
              ‘.r   . ..--.   r   -.----                                 %iJ                     ---.     0.0  .                 768.6
                                                                                                                                  .--.-                                  100
M&TBa    ncorporation                                                    732                              0.0                    732.3                                   100
         ------I:--                                                      -r,-%rl
                                                                         Iad                              nr\
                                                                                                         ‘V.V                    7-4    n                                ..-.n
Hibernia Corporarlon                                                                                                             I.3I.Y                                   IVU

                                                -Page 7                                                            GAOIGGD-9943R                Asset-Backed    Securities
Enclosure I

                                  Selected   Financial   Data on Banks’ Holdings   of Securities

Dollars in millions
                                                                                                                 Portion available for
Bank holding companies                                   Total     Held to maturity”      Available for saleb           sale (percent)
Centura Banks Incorporated                                  726                        0.0                   726.3                     100
First Security Corporation                                  705                        0.0                   705.2                     100
Fulton Financial Corporation                                660                      133.7                   526.5                       80
UST Corporation                                             612                        0.0                   611.7                     100
Valley National Bancorporation                              587                       64.3                   522.7                       89
Totals for the top 50                                 $212,545                   $18,638                 $193,907                     91%
Totals for all commercial banks                       $277,192                    $32,506                $244,686                     88%
                                  Note 1: Pass-through MBS are mortgage-backed securities in the form of pass-through securities,
                                  which entitle investors to share on a pro rata basis in all principal and interest payments received from
                                  a mortgage pool.
                                  Note 2: This list is the 50 largest portfolios of pass-through MB.8 not the 50 largest bank holding
                                  companies (BHC) by asset size. Totals may not add because of rounding.
                                  ‘Held to maturity securities are recorded on the balance sheet at amortized cost.
                                  bAvailable for sale securities are recorded on the balance sheet at fair value.
                                  Source: Copyright 1999, American Banker. Reproduced with permission; unauthorized reproduction

                                    Page 8                                                   GAO/GGD-99-63R      Asset-Backed    Securities
Page 9   GAO/GGD-99-638   Asset-Backed   Securities
Page 10   GAO/GGD-99-63R   Asset-Backed   Securities
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