How Bailout Loosens Accounting, Tax Rules

While the new law works to ease the credit crisis, it lets banks sidestep tax and accounting rules.

Banking regulators may not have suspended fair-value accounting to benefit the balance sheets of ailing financial institutions. But they did bend generally accepted accounting principles in the name of increased liquidity and the public good. What’s more, Congress gave banks permission to ignore a tax code provision for the same reason.

The rule-bending stands to benefit a wide swath of corporations by pushing banks to build up cash cushions and start lending again, at least one tax and accounting expert says.

Tucked into the Emergency Economic Stabilization Act of 2008, the rule relaxation could increase their banks’ regulatory capital, also called Tier 1 capital. “I suppose I’m in the camp that believes some relaxation of the rules was necessary in order to help cure the liquidity crisis,” says tax expert Robert Willens. “That said, it strikes me as a dangerous precedent to set. If the rules can be ignored, or reshaped, based on a Treasury or IRS or Fed official’s perception of ‘exigent circumstances,’ then it will be difficult to reinstate the rules &#8212 that were reshaped or ignored — once the crisis passes.” adds Willens.

One provision of EESA is designed to bolster failing mortgage finance companies Fannie Mae and Freddie Mac, two federally backed mortgage-finance companies severely hampered by subprime mortgage. Congress, through EESA, permitted “applicable” financial institutions to invest in Fannie and Freddie preferred stock to help the mortgage lenders raise much needed capital.

The law relies on the U.S. tax code’s definition of a financial institution, which includes any bank, mutual savings bank, domestic building and loan association, cooperative bank, small business investment company, and business development corporation. Further, the law requires that the Fannie and Freddie preferred stock had to be in the hands of the participating bank on or after January 1, 2008 and before September 7, 2008.

But holding the Fannie and Freddie shares in the current bear market could prove dangerous to banks that are suffering through liquidity problems of their own. So as an incentive, EESA allowed qualified banks to sidestep U.S. tax code provisions and GAAP in exchange for pumping capital into Fannie and Freddie, says a new report by Robert Willens LLC. On the tax side, EESA permits any gain or loss from the sale or exchange of the preferred shares to be treated as ordinary loss or ordinary income.

Under normal circumstances, the owners of the Fannie and Freddie preferred shares would treat the income or loss as a capital asset or liability, respectively, notes Willens. Further, he says, the switch from capital to ordinary losses is good news for companies because capital losses are “exceedingly difficult” to offset.

Indeed, capital losses may only be offset against capital gain income. But ordinary losses — also known as net operating losses — may be offset by any income generated by the company’s business. In fact, the Internal Revenue Service allows companies that have posted an NOL to save up to two years’ worth of the losses and use them to offset income generated over the next 20 years. By applying the NOLs to future periods, a company’s taxable income is decreased, and the corporation pays less to Uncle Sam. Essentially, the NOL rule takes some of the sting out of current losses.

In contrast, net capital losses may only be carried back to the three taxable years preceding the year in which the loss was sustained. What’s more, a capital loss is only carried forward to the five taxable years (to offset the capital gain income) following the taxable year in which the loss was sustained.

From an accounting perspective, EESA gave participating banks more leeway than that permitted under U.S. GAAP recognition rules. The Willens report explains that EESA was not enacted until October 3, which is “shortly after the close” of the 2008 third quarter. As a result, GAAP would not have allowed the participating banks to recognize the ordinary loss and related tax benefit until the fourth quarter. That’s because the law’s passage would have been characterized as a “subsequent event” in accounting parlance, and the related tax break would have been pushed to the next quarter.

Consider that subsequent events exist in an accounting limbo. Such events or transactions take place after the date listed on the balance sheet but before the financial statements are issued. Further, subsequent events are split into two subcategories. “Recognized” subsequent events provide additional information about conditions that existed at the balance-sheet date. “Non-recognized” subsequent events provide additional information about conditions that did not exist as of the balance-sheet date.

The difference is that under GAAP, companies don’t recognize subsequent events that didn’t exist as of the balance sheet date until the following period. That’s why the EESA-related tax benefits should be booked during the fourth quarter, Willens notes. Sometimes an event is deemed “so significant” that GAAP allows pro-forma financial data to be recognized during the same period. However, he adds, it’s unclear whether the EESA event would fit the criteria.

The key to allowing banks to skirt GAAP, asserts Willens, is that bank regulators are not bound by the accounting principles. As a result, they gave the go-ahead for “banking organizations” — defined as banks, bank holding companies, and thrift institutions — to recognize the effect of the tax change in their third quarter regulatory capital calculations.

This isn’t the first time during the current credit crunch that regulators have eased the rules to fix the broken banking system. Several weeks ago, the Federal Reserve and other regulators announced that member banks could increase Tier 1 capital by the amount of any deferred goodwill tax liabilities related to a taxable merger. “The Fed is doing its part to insure that the banks under its jurisdiction present the best possible portrayal of their capital positions,” wrote Willens in the report. That portrayal may make “the rumored elimination or curtailing of ‘mark to market’ accounting for financial assets and liabilities ÂÂÂÂ… infinitely easier to achieve,” he wrote.

The EESA’s Capital Purchase Program was another instance of rule- bending for a reputed public good. Under the program, the Treasury Department will buy senior perpetual preferred stock (SPPS) from “eligible banking organizations” to infuse the banks with capital. Ordinarily, bank holding companies are banned from including in Tier 1 capital any SPPS that has a dividend “step-up” rate, says Willens. In addition, the amount of cumulative SPPS that a bank holding company may include in Tier 1 capital is limited to 25 percent.

But the Fed suspended those rules after the purchase program was announced. For example, bank holding companies may include SPPS in their Tier 1 calculation “without limit.” In addition, Willens points out, the step-up feature is designed to “compel” a stock issuer to redeem the shares as promptly as possible.

As a result, the Fed believes that the stock is properly reflected in Tier 1 capital, and the banks should see a “substantial” increase in their regulatory capital ratios, reckons the consultant. “Generally, comparable rules and regulations will be taken less seriously because of the possibility — when the next crisis takes hold — that those rules can be suspended or terminated,” he asserts.

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