Everything We Learned about the Financial Crisis, Again

The nation's top accounting guru gets back to basics with a list of financial lessons we must remember not to forget.

At the last big accounting industry conference of 2008, Robert Herz, chairman of the Financial Accounting Standards Board, reiterated what he has been saying all year: It was not fair-value accounting that worsened the credit crisis, but rather a capital markets house of cards built on complex and risky securitization structures linked to subprime mortgages.

Though Herz’s speech to the American Institute of Certified Public Accountants was not entirely new (he first rolled out a version of it September), it represents a significant review of what went wrong with the nation’s economy from the perspective of the nation’s top accounting standard setter. And while peppered with the FASB chairman’s trademark dry wit, the speech is a serious one. “I hope I don’t offend anyone with my frank assessments,” Herz began, before condemning the behavior that led to the current crisis — as well as much of the finger-pointing that occurred afterwards. Few players were spared criticism, which he leveled at investors, regulators, credit rating agencies, boards of directors, bankers, Wall Street, and even some of FASB’s own accounting standards.

In some sense, Herz won one of his main arguments before he actually walked up to the podium. Speaking shortly before Herz, SEC chairman Christopher Cox strongly implied that an upcoming SEC report to Congress will not recommend rolling back FAS 157, the standard that defines how to make fair-value measurements. The banking industry has been lobbying hard for such a rollback, but Cox rebuffed those calls, noting that “Accounting standards aren’t just another financial rudder to be pulled when the economic ship drifts in the wrong direction.”

Yet Herz’s speech was more than a defense of fair value — it was a withering assessment of the national economy. While much of his critique was aimed at Wall Street, he also criticized “misplaced investor enthusiasm” for securitized loans, which he said was the result of “widespread financial illiteracy in our country.”

But Herz also noted how dependent the investing public has become on the financial markets. With Social Security and Medicare “overextended and in danger of becoming insolvent,” and with employers “increasingly shifting the responsibility for [healthcare and retirement] to employees, said Herz, “people are understandably looking for promising investment opportunities to grow the largest nest egg possible.” But such an approach can only work, he said, if the population is more financially literate and the financial markets don’t experience a crisis every 6-7 years.

Herz also said that balkanized regulatory systems both here and abroad, “coupled with a deregulatory philosophy by some key folks in Washington, D.C., may have made it difficult, if not impossible, to rein in the exuberance driving the markets.” That comment, which did not appear in a similar, pre-election speech Herz gave in September, was a clear swipe at the Bush administration, banking regulators, and possibly at SEC Chairman Cox as well.

Herz naturally focused much of his speech on the intersection between the crisis and accounting, and particularly what he called corporate America’s “continued addiction” to off-balance sheet treatment, particularly via securitization.

Indeed, he said, a “basic problem” of securitization is one of duration mismatch — borrowing short term to fund long-term assets. Duration mismatch was also one of the causes of the S&L crisis, he noted. “Eventually the whole system becomes frozen, requiring government intervention.”

FASB has struggled with securitization accounting throughout Herz’s tenure as FASB chairman, and he admitted that “neither FAS 140 on transfers of financial assets nor FIN 46(R) on variable interest entities are God’s gift to accounting.” At the same time, he said, banks and other companies routinely violated the concept of the qualified special purpose entity, or QSPE. Originally intended to exempt financial securitization from the more stringent rules for special purpose entities put in place in response to Enron, QSPE’s were “meant to be passive pass-through type entities — essentially a lock-box: the money from the collateral comes in, gets collected and distributed to the security holders.”

But, said Herz, the concept of a passive entity was “stretched and stretched and stretched” to the point where QSPEs became “ticking time bombs.”

Indeed, Herz said he long ago said at a public FASB meeting that “my worst nightmare is that I’m walking down Wall Street and I look up at a 70-story building . . . and at the top a sign reads’XYZ Corporation — a QSPE’ . . . And inside that building there are 10,000 people managing a supposedly passive entity.”

That experience, said Herz, is a lesson for accounting standard setters: don’t make industry exceptions. They are invariably abused, which ultimately forces standard setters to eliminate them, which happened with pooling of interests, fixed price employee stock options, and QSPEs.

Herz’s speech is available at the FASB website by clicking here.

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