Capital Markets

Accounting Guidance Smiles on Banks

Financial institutions are excused, once again, from fair value accounting.
Marie LeoneNovember 5, 2008

Without fully suspending fair value accounting to help banks weather the credit crisis, regulators and standard setters are now making it clear that financial institutions can avoid the so-called mark-to-market methodology — at least some of the time.

The latest clarification released by the Securities and Exchange Commission and the Financial Accounting Standards Board points out that banks that issue stock warrants to the government, as part of the Treasury Department’s Capital Purchase Program, will not have to value the warrants using fair value accounting. As a result, banks won’t have to absorb potential losses if the market value of the instruments decline.

The Capital Purchase Program, which is part of the broader federally-mandated Troubled Asset Relief Program (TARP), allows banks with liquidity problems to recapitalize their balance sheet by selling warrants to the Treasury Department in exchange for a cash infusion. So far, nine banks have signed up to participate in the warrant program, including Bank of America, Bank of new York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, Wells Fargo, and Merrill Lynch (see chart).

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The warrants have 10-year terms and are immediately exercisable. But the Treasury Department has agreed not to exercise its related voting power. According to the program’s terms, the Treasury Department can buy warrants from “qualified financial institutions,” that give it the right to purchase shares of common stock in the institutions. The aggregate market price of the warrants will equal 15 percent of the senior preferred amount on the date of the investment.

“The accounting authorities, as expected, have rendered a favorable opinion with respect to the classification of these warrants,” tax expert Robert Willens told Willens, who heads tax consultancy Robert Willens LLC, cites an Oct. 24 letter sent by SEC deputy chief accountant James Kroeker and FASB technical director Russell Golden, as evidence that the two agencies “will register no objections” if the warrants are classified as permanent equity under U.S. generally accepted accounting principles.

Treasury’s Capital Purchase Program
All purchases were made on October 28, and comprised preferred stock with warrants. Bank City Price paid Bank of America Charlotte $15 billion Bank of New York Mellon New York $ 3 billion Citigroup New York $ 25 billion Goldman Sachs New York $10 billion JPMorgan Chase New York $25 billion Morgan Stanley New York $10 billion State Street Boston $ 2 billion Wells Fargo San Francisco $25 billion Merrill Lynch New York $10 billion Source: U.S. Department of the Treasury, November 5, 2008

By classifying the warrants as permanent equity rather than as derivatives, on the balance sheet, the banks can avoid measuring the instruments at fair value. In practical terms, that means that any resulting gains or losses are not recognized in earnings, contends Willens.

To garner permanent equity status for the warrants, the clarification letter laid out conditions: The issuer must have sufficient authorized, but unused, shares of the class of stock that may be required upon settlement, and obtain any other shareholder approvals needed, explained Willens. Even if the two conditions are not satisfied by the time the warrants are issued, the SEC and FASB agreed to give banks a second chance to claim permanent equity status by taking “necessary action” to secure shareholder approvals prior to the close of the fiscal quarter in which the warrants are issued.

This is not the first accounting guidance released to help banks bolster their liquidity. Last month, the Treasury Department revealed that a provision of the Emergency Economic Stabilization Act — the law that established TARP — gives participating banks more leeway than usually permitted under U.S. GAAP to recognize tax benefits sooner. The law allows banks that invest in the beleaguered mortgage lenders Fannie Mae and Freddie Mac to get a tax break on the preferred shares they get in exchange for the investment. Specifically, banks can treat the subsequent gains or losses thrown off by the preferred shares as ordinary income or losses, rather than as capital gains or losses.

That is an important incentive because ordinary losses are more easily offset than capital losses, which can only be offset by capital gains. Ordinary losses may be offset by any income generated by the company’s business.

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