Breakthrough on Reform Bill

Posted on June 28, 2010 by Michael Stocker

After a 20-hour marathon session, legislators reached agreement last Friday on a final version of a financial reform bill that, if enacted, will transform financial regulation in the U.S. It is expected that there will be enough support to for the bill to pass in both chambers later this week.

In some respects, the agreement is tougher on the banking industry than the bill drafted by the Treasury department last summer. Lawmakers agreed to a provision known as the “Volcker rule,” named after former Federal Reserve Chairman Paul Volcker, which restricts the ability of banks whose deposits are federally insured from trading for their own benefit. In order to win wider support for the legislation, Democrats agreed to allow financial companies to make limited investments in areas such as hedge funds and private-equity funds, although banks can invest no more than 3 percent of a fund’s capital and those investments could also total no more than 3 percent of a bank’s tangible equity. This would have a significant impact on many Wall Street firms such as Goldman Sachs and Morgan Stanley that have long engaged in amounts of trading for their own accounts.

The final version of the financial reform bill also includes a provision restricting banks’ derivative trading. However, it is not as strict as Senator Blanche Lincoln’s proposal which would have required banks and their parent companies to segregate much of the derivatives trading business. The agreed-upon version of the bill would allow banks to trade in derivatives to hedge their own risk, but would forbid banks from speculating in highly risky credit default swaps and other exotic instruments. As an additional safeguard, the Commodity Futures Trading Commission would be given greater oversight of derivative trading.

Contributed by Yoko Goto

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FASB Strikes Back

Posted on June 16, 2010 by Michael Stocker

A left to the jaw - POW!In 2009, the Financial Accounting Standards Board (“FASB”) caved to immense pressure from financial sector lobbyists when it eliminated a requirement that companies disclose market-related losses on asset values.  In the furor that followed, scholars and institutional investors pointed out that these changes are likely to set the stage for a repeat of the market catastrophe of 2007-2008. FASB now appears to agree, and is showing the backbone necessary to do something about it.   

On May 26, 2010, FASB issued an Exposure Draft of a proposed Accounting Standards Update (“ASU”), Accounting for Financial Instruments, that improves the accounting for financial instruments by updating rules for classifying, measuring and recognizing impairments for financial instruments. The ASU is designed to provide greater transparency in financial statements reporting financial instruments. 

Under the proposed accounting standard, almost all financial instruments, including loans, would be reported at fair value. For example, a bank’s portfolio of loans previously classified as held-to-maturity or held-for-investment and reported at amortized cost would now be reported at fair value with any fair value adjustments recorded in other comprehensive income on the balance sheet. 

Most likely to be affected by the rule change are traditional banks, which have large loan portfolios that under current accounting rules are reported at amortized cost, net of impairments for credit losses. Under the FASB’s proposed rule, the traditional banks would value their loan portfolios using fair market value, reporting the loans at amortized cost and fair value on the balance sheet and recording any fair value adjustments in other comprehensive income in the equity section of the balance sheet.  

These traditional banks are also likely to be affected by a related proposed amendment concerning the threshold for recognizing credit impairments. Under the proposed guidance, FASB would eliminate the rule that credit impairments need only be recorded when they are probable. The “probable” threshold under current accounting rules results in delayed recognition of credit losses. Instead, the new rule would require banks to record a credit impairment charge in net income when the bank doesn’t expect to collect all contractual amounts due under a loan. With a lowered threshold for credit losses, entities will provide more timely information about expected credit losses on financial assets.

In the near term, FASB’s Exposure Draft is open to comment from the public. However, if the ASU were to be approved, the financial landscape of banks will forever change. Under the new rules, banks will be required to fair value large portfolios of loans that were once carried at cost on their balance sheets. Further, FASB’s proposed amendments will make it difficult for banks to ignore impairments caused by credit losses in loan portfolios. As the financial crisis still shadows the financial markets, the FASB’s new push for transparency will be welcomed by many investors.

Contributed by Craig Martin

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Band-Aid for Flash Crash

Posted on June 1, 2010 by Michael Stocker

On May 6, beginning at approximately 2:30 p.m., the stock market plunged 1,010 points in just 16 minutes. In what is now being called the “Flash Crash,” the Dow plummeted 998.50 points, the biggest intraday drop in the history of the index. During the brief drop, at least eight stocks in the Standard & Poor’s (S&P) 1500 index fell to a price of one cent per share – essentially a 100% decline. Although the market quickly rebounded, the speed of the plunge left Wall Street stunned and concerned.

On May 18, the Securities and Exchange Commission and U.S. Commodity Futures Trading Commission issued a preliminary report on the flash crash, in which the regulators stated that they had not yet been able to determine any definitive cause for the incident. However, the report suggested that the crash had been accelerated by a lack of uniform rules to slow or halt trading in extremely volatile stocks.

Despite the lingering mystery over the crash’s origins, the SEC and CFTC are wasting no time in putting temporary safeguards in place to prevent similar trading crises. They announced a six-month pilot program, starting June 14 and ending December 10, that will create trading “circuit breakers” for the stocks listed in the S&P 500 index. The circuit breakers will pause trading in those stocks for five minutes if share prices move by at least 10% --whether up or down--in a five-minute period. This band-aid will have will have to suffice until the real causes of the crisis are better understood.

Contributed by Vicky Ku

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