"The objective is to move those people who have been the source of the problem or who can't cope with the solution to the problem. We want people in there we feel comfortable with," he said.

Mr. Vigna conceded that the executives and directors of troubled thrifts aren't always willing to leave when asked. In those cases, he said, regulators are more likely to seize a thrift and place it in the management program.

Mr. WOLF. No, sir; that is essentially the problem we're trying to deal with.

Mr. SHELBY. It's false. It's totally false.

Mr. WOLF. You've got it.

Mr. SHELBY. This article goes on to say that having the appearance of a positive net worth has not helped the troubled thrift institutions, because despite the FSLIC notes, many of the thrifts must pay very high rates to maintain the profits. Does this mean that the public does not believe the creative accounting developed by the Federal Home Loan Bank Board is working?

Mr. WOLF. I would hesitate to say that that is the only reason why they have to pay those higher rates. But I think that there is at least some feeling that yes, some people are beginning not to believe that regulatory accounting.

Mr. SHELBY. Mr. Wolf, do you know of any other institutions that this is going on in other than the Federal Home Loan Bank Board, swapping of paper?

Mr. WOLF. Between the Federal Home Loan Bank Board and FDIC. Without getting into the Federal system, no.

Mr. SHELBY. Is this the most blatant that you know about?
Mr. WOLF. This is a fairly significant area.

Mr. SHELBY. Are some of the other banking agencies considering doing the same thing?

Mr. WOLF. Yes. FDIC, in fact, has made some through some mutual savings banks, and there is contemplation of going beyond that.

Mr. SHELBY. Wouldn't you be better off if you faced the truth and faced your problems upfront?

Mr. WOLF. That is the only thing we can do. Hiding has not helped in the savings and loan industry, and it will not help in the banking industry.

Mr. SHELBY. Do you anticipate further trouble in the Midwest, Southwest, farming and energy?

Mr. WOLF. I don't see the oil price going too much lower, but the problems of coming out of that are still to come.

Mr. SHELBY. What about the agricultural sector, the banks?

Mr. WOLF. We have probably seen it. However, there will be a lot more losses that will be continued to be recognized or incurred. It is not going to go away for a while.

Mr. SHELBY. In your prepared statement you say that the GAO has a problem with the underlying theory of Financial Accounting Standard 15 which governs the reporting of restructured loans under generally accepted accounting principles. Was there any controversy surrounding adoption of this standard in 1977?

Mr. WOLF. Like any accounting standard that is adopted, there is, of course, some controversy, and there are difficult decisions that need to be made. The board ultimately voted, and I believe the

vote was 5 to 2 in favor of adopting it but there were two that officially dissented from the decision.

Mr. SHELBY. If you will excuse me, we have a vote on the floor. I am going to recess the hearing for about 10 or 12 minutes and I will be right back.

[Brief recess.]

Mr. SHELBY. The subcommittee will come back to order.

Mr. Wolf, are you ready to proceed?

Mr. WOLF. Yes.

Mr. SHELBY. Do you consider FASB 15 to be a liberal accounting rule?

Mr. WOLF. Yes, I think it is.

Mr. SHELBY. Who were the proponents of the adoption of it, generally?

Mr. WOLF. I would say that the banking community generally was pretty favorable to 15, the way it came out.

Mr. SHELBY. Your statement says that restructuring a loan under the current rule "can result in an institution being substantially less well off than under the original loan agreement, although a loss is not recorded for accounting purposes, and economic loss has been sustained."

Mr. WOLF. That's right.

Mr. SHELBY. Explain that.

Mr. WOLF. Let me use the example that we have in the report— excuse me in our testimony. If you have a $10,000 loan which I owe you and it is due now

Mr. SHELBY. That's substantially less than we exchanged earlier. Mr. WOLF. We can jack it up $2 million. But if I owe you $10,000 repayable in a year at 10 percent interest, and if I get into difficulty and cannot pay you, we can agree to restructure that loan. For example, we would then agree to reduce the principal to $8,000, give you 3 years to pay it, and to charge you 10 percent interest. You have got a new agreement with me for a new loan which is worth substantially less than the old loan was. However, because the total payments that I make to you of $8,000 plus interest is more than the $10,000, you do not have to reflect any loss in your accounting statements. And we think that is a pretty liberal approach.

Mr. SHELBY. You basically then agree that the same factors which caused the need to restructure a loan also result in a real economic loss such as reduced principal and interest or increased risks that are associated with a longer loan payback period.

Mr. WOLF. That's right.

Mr. SHELBY. How can generally accepted accounting principles permit the existence of accounting rules that do not report real economic losses; in other words, do not report the truth?

Mr. WOLF. Accounting rules are put together by a board and there is always some compromise, discussion, and difference of opinion. But this is effectively where we have concern about 15, is the fact that real economic losses have occurred but are not recognized.

Mr. SHELBY. Isn't that what audits are about, to find the real situation, the truth?

Mr. WOLF. That's right. But the auditors are pretty much required to follow whatever generally accepted accounting rules are. So this has become a generally accepted rule. The problem is we think that upon reflection it is too liberal and it takes an approach which does not reflect the losses that have occurred.

Mr. SHELBY. What sorts of subjective judgments must be made by auditors, examiners, and bank management regarding the value and collectibility of loans shown on a bank's financial statement? Mr. WOLF. Well, what you start with is whatever the stated loan is. Then you take a look at how long it has been since somebody paid the interest or made their principal payments on time, how far in arrears they are, what is the financial condition of the person or organization that owes you the money, and what kind of collateral do you have. When you get into collateral today, you get again into problems such as a lot of the loans were for oil rigs and things like that, and the value of an oil rig today is certainly not what it was 5 years ago when you made that loan.

So you have to look at all of those different factors and try to come up with an assessment as to what is my likelihood of getting my money back.

Mr. SHELBY. Are you concerned that the actual auditors on the job will get a message that the Federal banking agencies and the accounting standard-setters believe that it is somehow unpatriotic to make audit judgments which will decrease the reported net worth of banks with agricultural and energy loans?

Mr. WOLF. I don't know whether to consider it unpatriotic, but they are certainly getting the message that we are not as concerned about writing off some of those loans.

There was an article right after some of the pronouncements by the bank regulators, in the Wall Street Journal, and let me quote it: "Federal banking regulators, in a move designed to provide some relief for troubled farm and energy lenders, agreed to allow banks to use a more liberal accounting treatment for renegotiated problem loans."

Those are kinds of the messages and signals which are coming out, and those are exactly the ones that concern us. That perception that we are not interested in taking those write offs. [The newspaper article follows:]

[From the Wall Street Journal, March 12, 1986]

REGULATIONS TO EASE ACCOUNTING Rules, for CERTAIN LOANS

Federal bank regulators, in a major policy change, moved to ease the financial strains on the nation's banks and troubled borrowers by adopting a controversial plan to encourage banks to restructure problem loans.

The plan, originally designed to help agriculture banks, also will benefit banks with many problem loans, particularly in energy and real estate.

Officials from the Federal Reserve Board, Comptroller of the Currency and Federal Deposit Insurance Corp. told the Senate Banking Committee yesterday that they will carry out a three-pronged policy on problem loans "that will assist basically sound, well-managed banks to weather this transitional period."

The changes allow banks to use a more liberal accounting method for renegotiated problem loans, and they modify reporting and disclosure requirements for restructured debt so that banks aren't penalized for restructuring loans. These two steps apply to all types of problem loans from energy loans to international finance, regulatory officials said.

The regulators also said they would permit bank capital to slip temporarily below prescribed levels. The concession will apply only to agricultural banks, but the regulators indicated that they were considering expanding this "capital forbearance" policy to include banks with significant loans to energy concerns.

Currently, regulators require that banks keep on hand capital equal to 6% of total assets. Yesterday, regulators didn't specify how low they will allow capital requirements to fall, and one official said later there wouldn't be a uniform floor. "It will be determined on a case-by-case basis," the official said.

The moves represent a major departure from past bank regulatory practices and were immediately criticized by several banking experts. They suggested that the changes could open up a Pandora's box for banking policy.

"This kind of approach just doesn't make any sense, from the standpoint of a sound banking system," said Paul Horvitz, a finance professor at the University of Houston and a former FDIC research director. "It is a very dangerous precedent," he added.

Banking experts fear that permitting banks to operate with below-normal capital not only eliminates an institution's margin for error but promotes reckless practices as well. "When an institution is operating without any capital of its own, it has every reason to take wild risks" in hopes of striking it big and earning its way out of trouble, Mr. Horvitz said. "There's nothing to lose."

That happened to some savings and loan institutions when federal thrift regulators relaxed capital and accounting standards in the early 1980s in an attempt to help thrifts through a period of skyrocketing interest rates. Some of those thrifts used the relaxed rules to engage in high-risk lending and questionable management practices that have since contributed to a string of costly failures.

PRESSURE FOR RELIEF

The three banking agencies agree to the changes in response to congressional pressure for some relief on farm banks, which have been hurt by a growing number of defaults by farmers. But some energy and real estate lenders also are having difficulties that reflect the decline in oil and real estate prices, and some law-makers yesterday asked whether these banks, too, would benefit from the new policy of capital forbearance.

"There should be one policy applicable to loans made in depressed areas of the country," said Sen. Phil Gramm (R., Texas). “(Capital) reserves are to be used on a rainy day, and it's raining like hell out there for agricultural and energy lenders." Comptroller of the Currency Robert Clarke responded: "The regulators should sit down to see if the capital forbearance guidelines should be broader." Congressional and regulatory sources said regulators already are considering whether to ease capital requirements for banks with loans in other troubled sectors of the economy. And bankers will be encouraging the regulators to do so in the next couple weeks, a spokesman for the American Bankers Association said.

The permission for farm banks to operate below minimum capital requirements is conditioned on each bank's capacity to restore capital within five years, the banking agencies said in a joint statement.

But banks with low capital by definition have an abnormally high ratio of liabilities to earning assets and thus typically have serious trouble generating sufficient earnings to replenish capital.

There are about 4,000 farm banks-banks at which farm loans constitute at least 25% of total loans. A source at the office of the Comptroller of the Currency said that about 1,300 of the banks require some form of special supervision because of above-normal problem credits.

Hundreds of farm banks have more problem loans than capital, a condition considered by banking regulators to be a leading indicator of failure. In Iowa alone, 80 banks have more troubled loans than capital, according to state regulators.

The other two points in the plan announced yesterday will help the financial picture that the banks present to the public. Specifically, the agencies created a classification for restructured loans, which until now have been classified as "nonperforming." They also will accept an accounting practice of giving borrowers easier terms on troubled loans without having to take large write-offs.

TIMING IS ASSAILED

Sen. Alfonse D'Amato (R., N.Y.) criticized the regulators for adopting a policy to help farm banks "after all this pain has already occurred . . . You've done a poor job to wait until now."

In addition, the bank regulators in their joint statement asked Congress to allow troubled banks and small failed banks to be acquired by out-of-state institutions "so as to maintain the banking services in farm communities."

Federal law prohibits acquisitions across state lines of troubled banks before they have failed and of failed banks with assets under $500 million.

Although regulators asserted that they would extend the capital leniency only temporarily and only to "well-managed" institutions that could restore their capital within five years, critics questioned whether they could pull that off.

For one thing, the agriculture and energy sectors face long-term problems that could persist. "Temporarily looking the other way while their capital is chewed up doesn't solve the problem, it only enlarges the ultimate cost," said one New York banking attorney.

Mr. SHELBY. Based on your experience and your testimony here today, what type of message should the Federal regulatory system be sending to auditors at the present time?

Mr. WOLF. I think the message it should be sending is that, first of all, you have got a lot of problem loans out there, you can restructure them where it is appropriate and where you think that the lender, through a restructuring, really is going to be in a position to pay you back the loan or to be able to pay a substantial part of it. When you do that, you need to recognize any loss that the bank has incurred at that point, and not kid yourself that somewhere down the road maybe it will come back. Don't get yourself in a position where you are just papering over those losses. Where you have uncollectible losses, reflect them in your equity and write down those uncollectible loans.

And I guess, finally, then, that the bank regulators need to recognize that if you do this, it will reduce the equity of banks and that they will have to adjust their equity which they require. And that is all right.

Mr. SHELBY. Can I read something, share something with you? "Too often, an institution's management, examiners, and auditors act as if a troubled debt restructuring is akin to a religious experience: The lame begin to walk and the blind to see. In reality, however, troubled debtors continue to limp and stumble along. Restructuring a bad loan does not a good loan make."

Is that basically right?

Mr. WOLF. Right.

Mr. SHELBY. Does FASB 15 and its liberal restructuring provisions apply to all banks, including those with large foreign loans? Mr. WOLF. Yes, it does.

Mr. SHELBY. Does this mean that bankers from small banks to very large banks have an important self-interest in seeing the liberal provisions of FASB preserved in their present form?

Mr. WOLF. I would hope that the bankers would begin to understand that proper reflection of the losses which they have incurred is the better way to go. But, yes, they have a self-interest in keeping it the way it is.

Mr. SHELBY. In view of the tremendous problems which have occurred in the banking industry during the past 10 years, do you believe that it would now be timely to review and possibly change the generally accepted accounting principles used by financial institutions in order to report the industry's problems more accurately? Mr. WOLF. Yes, I think that is our basic feeling that it ought to be looked at.