losses that are likely to occur due to the probable uncollectibility of a significant portion of its loans that are owed or guaranteed by foreign Governments. Rather than recognize that a loan has gone bad, the Eximbank proceeds through rescheduling after rescheduling.

Fair presentation of loans receivable requires a recognition in the accounts of the diminished value of loans through a charge against current year's income and a corresponding increase in an allowance for loan losses. Eximbank has not recognized that its loans are impaired-even when the foreign Governments repudiate the debt.

The result, in our opinion, is a loan balance which is not fully collectible and, accordingly, is overstated. As of September 30, 1984, we estimated the loss in the Eximbank's $17.5 billion loan portfolio to be $1 billion to $1.5 billion. How can we expect the private sector auditors to take a hard line on uncollectible loans if we, as Eximbank's auditors, do not set this kind of example?

In the case of FSLIC, our 1984 audit also revealed problems with asset evaluation. In GAO's opinion, FSLIC's 1984 financial statements were subject to uncertain net realizable values for claims against assets acquired from three large institutions-Empire Savings and Loan, Mesquite, TX; Knox Federal Savings & Loan, Knoxville, TN; and San Marino Savings & Loan, San Marino, CA—that were closed in 1984. At December 31, 1984, FSLIC held $1.3 billion in claims against the assets of the three institutions, and had established a $470 million allowance for loss based on a preliminary estimate that did not include all possible costs. The recency of the San Marino and Knox Federal failures in late 1984, along with inadequate loan records and pending and possible litigation affecting the three institutions, precluded determining a better estimate of the ultimate collectibility of the claims. Given these uncertainties, we were not able to satisfy ourselves that FSLIC's allowance for loss estimate was reasonable.

To understand the problems encountered in evaluating the net realizable value of these assets, one should bear in mind the conditions that existed at these institutions prior to their failure. A common problem at poorly managed institutions is inadequate or nonexistent recordkeeping, questionable accounting, and overvalued collateral. These conditions make it nearly impossible to quickly determine the true value of an institution's assets.

As part of our audit of FSLIC's 1985 financial statements, which is currently in progress, we have continued to question the value of assets acquired through default prevention and liquidation activities. In response to our management letter to Chairman Gray at the conclusion of our 1984 audit, FSLIC officials have made many of the improvements in their estimation techniques that we had suggested.

Considering better estimation techniques, as well as more current information or asset quality, we found that FSLIC officials had, in 1984, underestimated the problem loss in liquidating the failed institution's assets. This was the case for all three institutions we expressed concern about in our 1984 opinion. The losses were understated by 21 to 91 percent. For the three institutions taken collectively, FSLIC estimated a loss percentage of 36 cents on

the dollar for their 1984 financial statements. As of December 31, 1985, the loss is estimated to be 68 cents on the dollar.

With respect to the management consignment program, when placing an S&L in the MCP, FSLIC has often provided capital assistance, generally in the form of ICC's, to eliminate the negative net worth. The ICC transaction involves FSLIC purchasing a certificate from the troubled S&L which is repayable, with interest, when the S&L has resumed profitable operations and attained a specified net worth level. In return, FSLIC issues a promissory note to the sick thrift on which it makes interest payments in cash. Both the certificate and note are recorded on FSLIČ's books at cost. FSLIC then establishes an allowance for possible future loss on the certificate-an asset valuation allowance-to reflect that the value of the asset is impaired.

The MCP cases, of which Beverly Hills is one example, are probably the most troubled group, and others in States with liberal lending practices must be considered further likely candidates for the program.

We are closely examining the potential losses from MCP cases. In 20 of 25 MCP cases during 1985, FSLIC issued $1.5 billion of assistance in the form of ICC's. The other five cases are still being evaluated. Some would argue that the ultimate cost to FSLIC only begins with this amount. In fact, the total expense to the insurance fund may be much larger. The 25 MCP cases during 1985 had total assets of $17.7 billion and combined negative net worth of $1.6 billion.

On our current audit we are closely analyzing this asset valuation allowance. Our initial feeling is that it does not reflect the true impairment in the value of ICC's purchased from MCP cases. Certainly, there are numerous arguments to be made either for or against FSLIC's use of the MCP concept to handle the disposition of these problem thrifts over an extended period. To the extent that the program is effective it may be less costly to FSLIC than liquidation would be. In contrast, the potential exists for problems to worsen while the institutions continue to operate, thus resulting in a larger loss to FSLIC. What is not in debate is that the S&L's in this program are extremely weak and the likelihood of full repayment is remote.

Determining the amount of loss to be recognized for these MCP cases is not as simple as some would have you believe. A critical factor is deciding at what point to recognize a loss. Historically, FSLIC has recognized a loss only when an institution is provided financial assistance or is closed. To date, FSLIC has recognized no losses related to MCP cases, except for the small valuation allowance on ICC's. Yet, 19 of the 25 S&L's were in fact closed by their chartering authorities prior to being reopened as Federal mutuals by the Bank Board.

So while the usual event which triggers recognition of loss-the failure of an S&L-has occurred in most cases, the Bank Board has performed a resurrection which obviates loss recognition.

GAO believes that losses should be recognized when they are both likely and subject to reasonable estimation. Such an estimate for MCP cases, as well as other S&L's where financial assistance in the near future is unlikely, is probable and should be recorded on

the financial statements both by FSLIC and the institution. Without such a recognition of known contingencies, the financial statements would be misleading and the true financial health of FSLIC and the individual institutions would be obscured.

The total exposure to the FSLIC insurance fund presented by the MCP cases and other troubled thrifts is enormous. As previously stated, GAO noted in a recent report that 461 thrifts would be insolvent if their records were maintained on a GAAP basis. Another 833 thrifts would have less than 3 percent net worth on a GAAP basis. A total of 239 thrifts were both insolvent on a GAAP basis and still losing money as of December 31, 1985.

Let me now turn to our audits of FDIC. I will first discuss the assistance provided to Continental Bank and then FDIC's accounting for this assistance.

FDIC's 1984 financial statements significantly overstated the value of assets acquired from Continental Bank. On May 17, 1984, the FDIC, Federal Reserve, and Comptroller of the Currency announced a temporary assistance plan for Continental Bank that also included loan participations-partial ownership in a loan or group of loans-by a number of major U.S. banks. After FDIC attempted unsuccessfully to find a merger partner, Federal regulators concluded that the only practical resolution to the problem was to have Continental Bank continue as an independent institution.

To achieve this, a permanent assistance program was announced on July 26, 1984. The major components of that program included: the installation of a new management team; infusion of $1 billion in new capital; transfer of $3.5 billion in problem loans to FDIC; and continuation of the lines of credit from the Federal Reserve and commercial banks.

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 uncollectable loans reserved;

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

And 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.

Mr. Chairman, that concludes my remarks, and I would be pleased to answer any questions from you or the committee.

[Testimony resumes on p. 35.]

[The prepared statement of Mr. Wolf follows:]

Mr. Chairman and Members of the Subcommittee:

I want to thank you for the opportunity to offer testimony today concerning problems in reporting by depository institutions and their relationship to accounting practices prescribed by federal regulatory agencies and the responsibilities of independent auditors.

Recently, a great deal of attention has been directed at the problems of the bank and S&L industries and actions to resolve them. This morning, I would like to discuss one aspect