Dr. Epstein is the author of The Handbook of Accounting and Auditing, published by RIA, the tax and accounting business of Thomson Reuters.

He has been associated with this comprehensive reference work, and its semi-annual updates, for over 18 years.

Dr. Epstein served as the lead author of 26 annual editions of Wiley GAAP (1985 through 2010), 14 annual editions of Wiley IFRS (1997 through 2010), and several other works on U.S. GAAP and international accounting standards, all published by John Wiley & Sons.

The Bank Accounting Time Bomb in the Mortgage Bail Out Plan

By Barry Jay Epstein, Ph.D., CPA
Partner, Russell Novak & Company LLP
Chicago IL and

Todd J. Ohlms, Esq.
Partner, Freeborn & Peters LLP
Chicago IL

One of the many proposals that have been advanced to deal with the current economic crisis, to provide relief to homeowners who are "upside down" in their mortgage loans – owing loan balances greater than the depressed value of the property – is now being considered by the Senate after being passed by the House. The plan (the Helping Families Save Their Homes Act of 2009) is to give bankruptcy judges the power to "cram down" reductions in home loan balances, thus forcing lenders to absorb the loss of value in the homeowner’s property.

President Obama and the Democratically-controlled House and Senate appear willing to proceed down this path despite some fairly significant red flags. As recently as 1993, a unanimous Supreme Court, in Nobelman v. American Savings Bank, 508 U.S. 324, held that provisions of Chapter 13 of the Bankruptcy Code (specifically 11 U.S.C. § 1322(b)(2)) prohibited bankruptcy judges from modifying mortgages on principal residences. In that case, one of the more liberal Supreme Court justices, Justice Stevens, specifically noted that the prohibition on modifying mortgages on principal residences was "explained by the legislative history indicating that favorable treatment of residential mortgagees was intended to encourage the flow of capital into the home lending market." [Nobelman, 508 U.S. at 332.] Thus, as recently as the Clinton administration, it was deemed indisputable that prohibiting the modification of rights of lenders and obligations of borrowers serves the collective greater good of providing access to mortgages on principal residences at reasonable rates.

We are now being told that the current crisis requires contravening Justice Stevens' specific admonition, a unanimous Supreme Court ruling, and the legislative history upon which it was based, to instead embrace the ability for some debtors to demand that the principal amount of their mortgages be rewritten or crammed down. While this would ameliorate the current financial plight of some debtors, it appears that little thought is being given to future consequences, intended or not, of this machination.

The proposed cram-downs would force lenders to acknowledge the uncollectibility of a portion of the eligible loans, and thus recognition of a loss for financial reporting purposes. Given the other problems (e.g., losses on investment securities) currently affecting banks, even a modicum of write-offs could certainly trigger capital impairment of a magnitude that would threaten these institutions with regulatory sanctions, or even seizure. While some versions of the proposed program would have the government compensate banks for a portion of their losses, current thinking (made necessary by government resources shrunken by other bail-outs it has already dispersed or promised) would be for banks and thrifts to shoulder all or most of these burdens.

Whatever the intended social equity underlying this idea, it would obviously precipitate bank losses and the depletion of bank capital, thus impeding recovery in bank lending activities and economic recovery. But a further, thus far unnoted "time bomb" is hidden in the plan that could have even graver consequences for banks and taxpayers. Fortunately, the savings and loan and banking crises of the late 1980s and early 1990s is instructive regarding this threat and offers an object lesson on how to avoid it.

Those who lived through the 1970s, 1980s and 1990s should immediately recognize the scenario that could well play out, and its very negative consequences for the government and the taxpayers. Briefly, by the 1980s a combination of political and economic factors – including rampant inflation, low regulatory ceilings on interest rates payable on thrift and bank deposits, and growing disintermediation of funds from deposit gathering and mortgage lending institutions – had imposed on most lenders an unsustainable negative interest spread situation, which caused enormous losses and the drying up of lending, including that for home and commercial mortgage loans.

Growing numbers of thrifts and banks became insolvent on a mark-to-market (i.e., real economic) basis, and were subject to seizure. Certain accounting and regulatory manipulations, however, were deployed to allow many of these institutions to continue, for a time, to appear solvent on their balance sheets, without altering the fundamentals or likelihood of recovery.

As more institutions failed, FDIC and FSLIC recognized that the insurance funds would be insufficient to resolve all the impending collapses. The government then hit upon a scheme to encourage the relatively stronger institutions to acquire those more immediately facing their demise. Inasmuch as it would have been irrational for another bank to assume the assets and obligations of having a negative (market value) equity, thus imperiling its own balance sheet, a range of inducements was offered. The most dubious of these, from an accounting principles perspective, was granting the right to pretend that the negative net assets acquired represented "supervisory goodwill," an asset subject to long-term (usually at least 15 years) amortization. This was to be treated as a "good asset" for regulatory capital computation purposes.

This accounting fiction was at first opposed by the accounting profession, but was ultimately legitimatized by Congress and grudgingly accepted by FASB with the issuance of Statement 72, Accounting for Certain Acquisitions of Banking or Thrift Institutions. By the late 1980s, after many assisted mergers involving supervisory goodwill recognition had taken place, it became clear that the thrift and bank problems could no longer be disguised through fanciful financial reporting. Congress took action to end this abuse, first by enacting FIRREA, in 1989, and then FDICIA, in 1991. This left the acquiring banks and thrifts, in many instances, insolvent on a balance sheet basis and subject to immediate seizure, as the formerly allowed asset supervisory goodwill was eliminated.

Hundreds of institutions suffered precisely that fate. Litigation ensued, and ultimately, in the 1995 Winstar decision, the Supreme Court held that the regulatory flip-flop constituted breach of contract by the Government, and many scores of failed institutions and their former investors sought damages in the Court of Claims, in the end recovering billions of dollars, adding significantly to the debt burden placed on future generations by the initial round of resolutions of failed banks and thrifts. The use of accounting chicanery to grant temporary reprieve to institutions that had been mortally wounded by dint of earlier governmental policy missteps thus only added to the harm done.

But what is the lesson for the current crisis? It is that, if government social and economic policies demand such draconian actions as authorization of mortgage loan cram-downs, there should be full and fair – and immediate – accounting recognition of its effects. Thus, if bankruptcy laws are amended, and large numbers of homeowners predictably then seek such relief – and that assistance comes at the expense (partially or entirely) of the lending institutions – the imposition of financial reporting legerdemain should not be permitted.

If accounting gimmickry is again tolerated, in order to obscure the injury afflicted on those lenders forced to accept loan reduction cram-downs, as with supervisory goodwill in the 1980s, it is reasonably predictable that a future policy reversal or statutory flip-flop, or court decision, will again create chaos, with huge additional costs ultimately to be borne by the taxpayers. If it becomes necessary to "save" the banks and thrifts wounded as a result of mortgage loan cram-downs, other tactics such as lowering reserve requirements should be employed (which actions would, of course, carry their own risks).

Only the first footstep down this slippery slope – mortgage relief – has been widely discussed, but as the Administration pushes for final approval lawmakers would do well to remember the recent past and not embark on another such misguided exercise. If it is the will of Congress to place onto lenders some or all of the burden of bailing out unfortunate or imprudent borrowers, then financial reports should clearly reveal the losses suffered, so that, inter alia, investors can evaluate the political risks of ownership of such institutions. The accounting standard-setters must resolve, this time, to resist adding its imprimatur to any rule that would facilitate nonsensical financial reporting by banks and thrifts.

Note: This article was first published on Law360.com on April 17, 2009.

ABOUT THE AUTHORS: Barry Jay Epstein, a certified public accountant, is a litigation director at the Chicago office of SS&G FInancial Services, Inc. He served as lead author of Wiley GAAP and Wiley IFRS, with a practice concentrating on technical consultations on Generally Accepted Accounting Principles and International Financial Reporting Standards. Todd J. Ohlms is a partner and co-chairman of the litigation practice group at Chicago’s Freeborn & Peters LLP.