OBSERVATIONS

Mr. Chairman, in reviewing this entire area, I would like

to provide a few concluding remarks about what we have observed:

--The recent, controversial regulatory accounting
techniques began as a means of providing time for
troubled financial institutions to regain financial
stability without any immediate cost to the deposit
insurance funds.

--Changing the accounting methods, however, does not
cure the problems of troubled institutions.

--Accounting methods are also not a substitute for the responsibilities of an institution's management, or its regulators or auditors, to ensure that assets are properly valued and uncollectible loans reserved.

--In any case, financial statements and the notes thereto must provide users (investors, regulators, the Congress, and the public with a complete view of the "true financial condition" of the entity.

--Failure to recognize the true financial condition only makes a difficult situation worse for investors,

depositors, regulators and other policymakers, including Congress, to respond effectively.

We believe that it is imperative that financial institutions, their auditors and their regulators avoid

artificial accounting gambits designed to inflate reported

equity and take a hard look at the collectibility of problem loans in their portfolios.

77.2 78.1 78.2 79.1 79.2 80.1 80.2 81.1 81.2 82.1 82.2 83.1 83.2 84.18 84.2 84.3 84.4 85.1 85.2

period

#Note change in report frequency.

Mr. SHELBY. Thank you. I have several questions, Mr. Wolf. In your prepared statement you describe net worth certificates as a regulatory program that involves a swap of promissory notes which does not create equity capital under generally accepted accounting principles. Is that correct?

Mr. WOLF. Yes, that's correct.

Mr. SHELBY. Can you explain how the swap of promises between the Federal regulators and troubled financial institutions creates net worth for regulatory purposes?

Mr. WOLF. Actually, it doesn't create equity. That is one of the basic concerns that we have got.

Mr. SHELBY. That is misleading, then.

Mr. WOLF. It adjusts the equity to a different number. But it's sort of rose is a rose: unless you change the name, it is still a rose. You don't create equity just with this transaction.

Mr. SHELBY. It is just a paper deal, isn't it? Do the net worth certificates provide any additional assistance to a financial institution beyond the Federal Government's insurance program that pays off depositors if the institution fails?

Mr. WOLF. Because there is an interest payment made in there, there is a modest subsidy which in effect occurs. But that is the only thing that occurs.

Mr. SHELBY. You say "modest." How large?

Mr. WOLF. The interest rates on those papers vary. Most of them, I think, are market rates.

Mr. SHELBY. Do net worth certificates have any value at all?

Mr. WOLF. As a tool for a regulator to buy some time, they do

serve a purpose.

Mr. SHELBY. They don't have any value in the marketplace.

Mr. WOLF. In terms of a monetary value, no, sir, there's not a whole lot.

Mr. SHELBY. In your statement you describe income capital certificates as a regulatory program which involves a swap of promises to pay between the Federal regulators and troubled financial institutions. How do income capital certificates differ from net worth certificates?

Mr. WOLF. They really don't differ.

Mr. SHELBY. It's a different name?

Mr. WOLF. There is a different name and there are a couple of technical differences, but in practice there is really not a difference in substance.

Mr. SHELBY. Do income capital certificates qualify as equity capital under generally accepted accounting principles?

Mr. WOLF. Do they qualify?

Mr. SHELBY. Yes.

Mr. WOLF. The Financial Accounting Standards Board in the last 3 or 4 weeks has issued some letters which would imply, and which say fairly strongly, they are not part of capital. However, a number of institutions have included them over the years as capital. So general practice tends to be moving in one direction; the Financial Accounting Standards Board is trying to take a position saying no, they are not.

Mr. SHELBY. Do income capital certificates provide any additional assistance to a financial institution beyond the depository protection offered by the Federal insurance program?

Mr. WOLF. Not really. There is the modest cash subsidy, but basically not, no.

Mr. SHELBY. I have difficulty understanding the logic behind some of the accounting techniques used by the Federal Home Loan Bank Board. I want to make every effort to understand these swap transactions, since the Bank Board has issued $1.5 billion of assistance in the form of income capital certificates. I would like your assistance here today in helping me with a little experiment.

I am going to write you an IOU for $1 million on a piece of paper if you will write me a similar IOU for $1 million. We will ask the subcommittee staff to exchange our promissory notes.

Mr. WOLF. Do you want it in pencil or in pen?

Mr. SHELBY. Since we don't have a printing press, you know, we've got it here. We can exchange that.

Mr. WOLF. If I get my hands on it first and run

Mr. SHELBY. We have a staff. They're going to control us.
When I get mine back, and yours, too.

[Documents exchanged.]

Mr. SHELBY. What I have in my hand is an IOU for $1 million, the same thing you have on a piece of paper. We have exchanged IOU's. Mr. Wolf, now that you have my promise to pay you $1 million and I have your promise to pay me $1 million, do you feel any wealthier now than you did before we exchanged IOU's?

Mr. WOLF. Not a great deal.

Mr. SHELBY. Not a bit. Do you believe that any banker with a sound mind would extend either of us additional credit on the basis of these notes here today that we just exchanged?

Mr. WOLF. I know he would not loan you any on my note.

Mr. SHELBY. I am sure that he would not lend anything on mine that you have. Have we actually increased our net worth by this transaction, in your opinion?

Mr. WOLF. No.

Mr. SHELBY. Would it make any difference if the notes we exchanged were for $10 million instead of $1 million?

Mr. WOLF. No.

Mr. SHELBY. Or $100 million or $1 billion or $1.5 billion as they have issued?

Mr. WOLF. No, not really.

Mr. SHELBY. To make us all feel better, we better give those to counsel and have them tear them up. I would feel better.

I have before me here a newspaper article that came out of the Wall Street Journal. The dateline, Los Angeles. And it quotes a former general counsel of the Bank Board as saying, "It is just a simple fact of life that people like to see a balance sheet with a positive net worth if you are going to do business with an institution."

Does presenting an image to people they like to see justify accounting used for income capital certificates, even if the image is not real?

[The newspaper article follows:]

[From the Wall Street Journal, March 31, 1986]

BANK BOARD BACKS OFF DISPUTED POLICY OF INJECTING Capital Into Failed

THRIFTS

LOS ANGELES.-The Federal Home Loan Bank Board has backed off from its controversial policy of injecting capital into failed thrifts. The move is designed to preserve the dwindling Federal Savings and Loan Insurance Corp. insurance fund.

Last year the Bank Board seized 25 failed thrifts and assigned new management teams. In most cases, the FSLIC provided what it calls income capital certificates, totaling $1.5 billion, to give the thrifts a positive net worth (assets minus liabilities). The FSLIC, in turn, is supposed to be repaid from future earnings of the insolvent thrifts.

However, this year the Bank Board has seized 10 thrifts but has allowed them to continue to operate with negative net worth. The FSLIC hasn't provided certificates to any of them, and hasn't recorded any potential liability from the thrifts. The most recent thrift seized was Westwood Savings & Loan Association in Los Angeles, which was seized by regulators on Thursday. In February, the thrift reported a negative net worth of $32.8 million.

The certificates are costly for regulators to issue, because they reduce the unobligated balance of the FSLIC fund on a dollar-for-dollar basis. That balance consists of short-term assets minus liabilities, and at the end of last year, it stood at only $2.7 billion; total reserves were $6.1 billion.

COST TO THE FSLIC

Regulators have estimated that trouble thrifts may cost the FSLIC as much as $22.5 billion over the next five years as it sells the bad assets and have proposed a plan to inject that amount in the fund.

Industry executives have criticized the issuance of certificates on the ground that it is unlikely they will ever be repaid. In addition, the Government Accounting Office has raised questions about the rate of the certificates.

In an interview, Edwin Gray, chairman of the Bank Board, said the board hasn't formally changed its policy on issuing the certificates. However, he said. "Obviously we would prefer not to issue them. But our policy is to look at each case and make a decision."

INFORMAL POLICY DECISION

However, a spokesman for the Bank Board added: “It's a conscious effort to save the fund for as long as we can, and it seems a better way to go. It's an informal, not a formal, policy decision."

The main reason for injecting the capital certificates was to build depositor confidence and avoid a run on a failed institution. "It's just a simple fact of life that people like to see a balance sheet with a positive net worth if they are going to do business with an institution," says Thomas Vartanian, a former general counsel of the Bank Board.

However, the appearance of having a positive net worth doesn't seem to have done the troubled thrifts much good. Despite the FSLIC notes, many of the thrifts in the program claim they have to pay very high rates to maintain deposits. The high rates have drawn criticism from healthy thrifts that are forced to compete in the

same areas.

A much larger number of thrifts are managing to operate despite the fact that they are insolvent. There are more than 160 insolvent thrifts that are currently operating because regulators can't afford to close them.

That may change soon. Earlier this month, the Bank Board proposed a plan to raise the FSLIC fund by as much as $22.5 billion, primarily through the issuance of debt by the regional Home Loan Banks. If the plan is implemented, industry executives expect to see a rash of federally assisted mergers and takeovers.

REQUESTED RESIGNATIONS

In the meantime, Angelo Vigna, acting director of the FSLIC, said supervisory agents have been asking executives at troubled thrifts to resign with increasing frequency, a tactic which has been used by regulators in the past. In those cases, he said, the changes aren't announced and the thrift isn't formally placed in the so-called management consignment program.