Loan Commitments: Issues Related to Pricing, Trading, and Accounting
Published: 2005-02-14T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Federal banking regulators reported that commercial banks held about $1.6 trillion in syndicated loans in 2003. Loan commitments--a promise to make a set amount of credit available in the future--represented $1 trillion (about 64 percent) of these loans. Issues have been raised whether commercial banks systematically underprice loan commitments and whether generally accepted accounting principles provide meaningful disclosure of the economics of these commitments. This report discusses (1) differences between the pricing of loan commitments and loans, and assesses data that are available about the trading of loan commitments; (2) the extent to which credit default swaps are used to reduce the credit risk from loan commitments, and what credit default swap prices indicate about the prices of loan commitments; and (3) differences between commercial and investment banks' accounting treatment of loan commitments, and the strengths and weaknesses of fair value accounting.
section_title: What GAO Found
paragraphs: Loan commitments and loans have different characteristics, making it difficult to directly compare the prices of these instruments. First, a loan commitment gives a company the option to borrow a certain amount in the future, while a loan actually provides funds to the borrower. Second, lenders typically charge fees for making credit contingently available through a loan commitment but charge interest on a loan. Third, loan commitments are typically unsecured--that is, borrowers do not have to pledge collateral--while loans are typically secured. Most of those we interviewed told us that loan commitments are rarely traded in the secondary market because selling them could jeopardize relationships with borrowers and because institutional investors were reluctant to purchase them. Some investment bankers expressed concerns that loan commitments were systematically underpriced, but the available information did not support such assertions. Commercial bankers told us that they used credit default swaps--contracts that can transfer the credit risk of a loan or loan commitment to another party--to reduce credit risk on small amounts of their loan commitment portfolios. Some investment bankers contended that credit default swaps and loan commitments were similar instruments and that credit default swap prices could provide information about the appropriateness of prices for loan commitments. We found that it was not possible to use credit default swap prices to determine the appropriateness of prices for loan commitments. Specifically, they differed in triggering events, payment schedule, trading, and financial covenants. Under current accounting standards, designed to reflect their respective business models, commercial and investment banks account for loan commitments differently, causing a temporary difference in the recognition of fee income. Further, revenue from fee income appeared to be relatively small compared with revenue from other bank activity and the difference would be resolved by the end of the commitment period. As a result, we did not find any evidence that following a different accounting model offered the commercial banks a consistent competitive advantage over investment banks. Further, commercial and investment banks have similar fair value financial statement disclosure requirements and, as a result, provide similar information about the fair value of their financial instruments. It appears that the economic substance of loan commitments is recognized in the financial statements and related footnotes in a clear, measurable, and evident fashion under both the historic cost and fair value approach. While some have indicated that fair value accounting might disclose more relevant information than the historical cost model, all the conceptual and implementation issues have not been resolved. Until these issues are resolved, commercial and investment banks will continue to follow different accounting models for loan commitments.

section_title: Letter
paragraphs: In 2003, federal bank regulators reported that commercial banks held about  $1.6 trillion in syndicated loans—those provided to corporate borrowers by  a group of lenders rather than a single lender. These loans are an important  source of credit for large and mid-sized corporations in the United States.  Syndicated loans include both loan commitments (a promise to make a set  amount of credit available in the future under certain terms and conditions)  and funded loans. For 2003, loan commitments represented $1 trillion  (about 64 percent) of the syndicated loans reported by federal banking  regulators.
Issues have been raised about whether commercial banks systematically  underprice loan commitments and whether generally accepted accounting  principles facilitate the meaningful disclosure of the economic implications  of these commitments. In our October 2003 report on bank tying, we  reported that based on our review of specific transactions, information  about underpricing was ambiguous and subject to different interpretations. In addition, we reported that commercial and investment  banks adhere to different accounting rules, causing a temporary difference  in the recognition of the service fees from loan commitments. We further  reported that the volatility of the fair value of loan commitments was more  transparent on investment banks’ financial statements. However, we did  not find any evidence that the accounting rules offered commercial banks a  consistent competitive advantage over the investment banks. Further, we  found that the revenue from loan commitments was relatively small  compared with revenue from other bank operations and the difference in  service fee recognition was temporary. Because of the significant amount  of outstanding loan commitments and concerns about the accounting  treatment for such commitments, we conducted a more in-depth review of  the prices of and accounting for loan commitments.
We discuss the following in this report: (1) the differences between the  price of loan commitments and loans; (2) data that are publicly available  about the trading of loan commitments; (3) the extent to which credit  default swaps are used to reduce the risks associated with loan  commitments, the similarities and differences between credit default  swaps and loan commitments, and what, if anything, the prices of credit  default swaps indicate about the prices of loan commitments; (4) the  differences between a commercial and investment bank’s accounting for  loan commitments and whether there is evidence that these differences in  accounting treatment provide either type of bank with a consistent  competitive advantage; and (5) the strengths and weaknesses of fair value  accounting and the projects that the Financial Accounting Standards Board  (FASB), which sets the private sector accounting and reporting standards,  has underway that may change the way commercial and investment banks  account for loan commitments.
During our review, we obtained the perspectives of officials from six large  commercial banks that arranged about 67 percent of total U.S. syndicated  loan volume in 2003. To obtain the views of other loan market participants,  we also met with officials from two large investment banks that are active  in the syndicated loan market. To determine the differences between the  price of loan commitments and loans, we analyzed data compiled by a loan  pricing data firm, and we interviewed commercial and investment bankers,  federal bank regulators, and officials from credit rating agencies. To  determine what data were publicly available about the trading of loan  commitments, we reviewed secondary loan market trading data compiled  by a loan pricing data firm and other financial literature related to  secondary loan market trading. To determine the extent to which credit  default swaps were used to reduce the risk exposure of loan commitments,  the similarities and differences between credit default swaps and loan  commitments, and what, if anything, the prices of credit default swaps  indicate about the prices of loan commitments, we reviewed data on credit  default swaps compiled by federal banking regulators and a global  derivatives trade association, and we interviewed commercial and  investment bankers, officials from a loan market data collection firm, and  other industry observers. To determine whether the differences between a  commercial and investment bank’s accounting for loan commitments  provide either firm with a consistent competitive advantage, the strengths  and weaknesses of fair value accounting, and the projects that FASB has  underway that might change the way commercial and investment banks  account for loan commitments, we reviewed our previous comparative  analysis of applicable accounting standards and updated our understanding  through interviews with officials from FASB as well as reviewing a recently  issued accounting exposure draft. We assessed all data for reliability and  found them to be sufficiently reliable for the purposes of our reporting  objectives.
subsections: section_title: Background
paragraphs: Since the mid-1990s, large and mid-sized U.S. corporations have  increasingly used syndicated loans as a source of credit. Federal banking  regulators collect data on large loan commitments and loans shared by  three or more commercial banks as part of the Shared National Credit  (SNC) Program. SNC program data show that outstanding loan  commitments held by commercial banks increased from $448 billion in  1990 to more than $1 trillion in 2003 (see fig. 1).
Most loan commitments and loans to large and mid-sized corporations are  made as part of a syndicated loan package. A syndicated loan can include  several components, including a revolving credit line, a 364-day back-up  facility, and a term loan. A revolving credit line or revolver—the equivalent  of a corporate credit card—allows borrowers to draw down, repay, and re- borrow specified amounts on demand. A 364-day facility is a specific type  of revolving credit line that has a maturity of less than 1 year and is  commonly used as a backup line by corporations that issue commercial  paper. A term loan is a loan that borrowers repay in a scheduled series of  repayments or a lump-sum payment at maturity.
Syndicated loans are arranged by a commercial or investment bank, which  is referred to as the “lead bank.” Large commercial and investment banks  compete to lead syndications and offer a potential borrower a syndicated  loan package that specifies various fees for loan commitments and terms  for loans. For large syndicated loans, there may be one or more lead banks.  The lead bank finds potential lenders and arranges the terms of the loan on  behalf of the lending group, which can include commercial or investment  banks and institutional investors, such as mutual and hedge funds and  insurance companies. However, each participating lender has a separate  credit agreement with the borrower for the lender’s portion of the  syndicated loan. In 2003, 3 large commercial banks arranged 59 percent of  U.S. syndicated loans, and 10 large commercial banks arranged 84 percent  of syndicated loans.
Borrowers pay members of the lending group various fees associated with  syndicated loans. For example, borrowers pay the lead bank(s) fees to  arrange and administer the syndication. They also pay an up-front fee to all  participants in the syndicate upon the closing of a loan. Other fees that  borrowers pay the lenders include:  a commitment fee, which is paid to lenders on undrawn amounts under  a revolving credit or a term loan prior to usage;  a facility fee, which is paid against the entire amount of a revolving  credit regardless of usage and is often charged instead of a commitment  fee; and   a usage fee, which is paid when the utilization of a revolving credit falls  below a certain minimum.
Borrowers also make interest and principal payments to the lenders for  amounts that are drawn under loan commitments and loans. Figure 2  illustrates an example of a hypothetical syndicated loan package.
The U.S. syndicated loan market can be divided into two segments,  investment grade and leveraged. The investment-grade segment is confined  to the most creditworthy borrowers. In 2003, most syndicated loans to  investment-grade borrowers were loan commitments that generally  remained unfunded (see fig. 3). The leveraged segment is composed mainly  of lesser quality borrowers, defined either by their credit rating or the  higher interest rate charged on their loans. Figure 3 also shows that  syndicated loans to leveraged borrowers were almost exclusively funded  loans or partially or fully funded loan commitments.
After a syndicated loan is closed and allocated among participating lenders,  these lenders can adjust their loan portfolios by trading these instruments  in the secondary loan market. This trading generally occurs through dealer  desks established by large commercial and investment banks. Commercial  banks and other financial institutions have increasingly used the secondary  market to trade loans. In 2003, the volume of secondary loan market  trading totaled $144.57 billion.
Loan commitments and loans expose lenders to credit risk—the possibility  of loss due to a borrower’s default or inability to meet contractual payment  terms. Commercial and investment banks can use credit default swaps— essentially insurance against borrower default or other credit event—to  transfer to another party (the guarantor) the credit risk from a loan  commitment or loan, without actually selling the asset. When a commercial  or investment bank purchases a credit default swap, they agree to make  periodic payments to a guarantor who is contractually obligated to pay the  bank in the event of a specified credit event, such as loan repayment  delinquency, default, or credit-rating downgrade (see fig. 4). According to  the International Swaps and Derivatives Association (ISDA), global credit  default swap contract amounts totaled $3.78 trillion in December 2003.  However, only a small portion of this amount was used for reducing the  credit risk associated with loan commitments.
Under current accounting standards, designed to reflect their respective  business models, commercial and investment banks account for loan  commitments differently. Commercial banks use a mixed attribute model  to account for their various products and services. As a result, some  financial assets and liabilities, including loan commitments, are measured  at the historical transaction price (cost), some at the lower of cost or  market value, and some at fair value. The historic transaction price (cost)  of a loan commitment is the value of the loan commitment service fees at  the time a firm extends the commitment. In contrast, investment banks  generally follow a fair value accounting model in which they report  inventory, which may include loans or loan commitments, at fair value. The  fair value of a loan commitment is the price at which it can be exchanged  between willing, knowledgeable parties without any compulsion such as a  forced liquidation or distress sale. Changes in the fair value of an  investment banks inventory are included in earnings in the periods in  which the changes occur. FASB has established these different accounting  models because investment and commercial banks have different business  models. For example, commercial banking activities have traditionally  included accepting deposits, originating loans, and holding loans. These  banks generally have the intent and ability to hold the vast majority of their  loan commitments and loan portfolios until maturity and usually have a  relatively small amount of loans held for sale. Investment bank activities  have traditionally included buying, holding as inventory, and selling various  financial instruments. Investment banks generally do not hold loan  commitments and loans until maturity.
The objective of a fair value measurement is to estimate an exchange price  for an asset or liability in the absence of actual transactions. The estimate  is based on a hypothetical transaction between willing parties presumed to  be market place participants representing unrelated buyers and sellers that  have a common level of understanding about factors relevant to the asset  or liability that are willing and able to participate in the same market that  the asset would be traded in. Because fair value presumes the absence of  compulsion or duress, prices derived from a forced liquidation or distress  sale would not be used as the basis for the estimate. Fair value estimates  use various market inputs. In an active market, quoted prices represent  actual transactions that are readily and regularly available to provide  pricing information on an ongoing basis. In determining whether a market  is active, the emphasis is on the level of activity for a particular asset or  liability. Inputs may be also used from other less active markets. Examples  of market inputs that may be considered in a fair value measurement  include, but are not limited to, quoted prices that are adjusted as  appropriate, interest rates, default rates, prepayments, and liquidity.
We conducted our work in Charlotte, N.C.; New York City, N.Y.; Norwalk,  Conn.; San Francisco, Calif.; and Washington, D.C., between November  2003 and October 2004, in accordance with generally accepted government  auditing standards. (See app. I for more details on our objectives, scope,  and methodology.)
section_title: Differences in Purpose, Price Structure, and Collateral Requirements Make Direct Comparisons between Prices of Loan Commitments and Loans Difficult
paragraphs: Although some investment bankers have contended that commercial banks  systematically underprice loan commitments, commercial bankers and  other industry observers told us that the different characteristics of loan  commitments and loans—purpose, collateral requirements, and price  structure—limited direct price comparisons. For example, a loan  commitment gives a company the option to borrow in the future under  certain terms and conditions, while a loan provides borrowers with actual  funds. In addition, lenders typically charge fees for making credit available  under a loan commitment and an interest rate for loans (including loans  drawn under prior loan commitments). Commercial bankers said that they  consider several factors when establishing the price of loan commitments  and loans, including the profitability of the existing business relationship  with the borrower, the maturity of the loan or loan commitment, the  creditworthiness of the borrower, the price of loans to similar borrowers,  the price of existing borrower debt, and financial models.
subsections: section_title: Loan Commitments and Loans Differ in Purpose, Price Structure, and Collateral Requirements
paragraphs: While both loan commitments and loans offer firms access to credit, these  instruments serve different purposes. Investment-grade loan commitments  are frequently used as backup lines of credit for borrowers that issue  commercial paper. Commercial bankers and rating agencies told us that  these lines are not expected to be drawn unless a firm loses access to the  commercial paper market. Because—as we have indicated earlier—access  to the commercial paper market is limited to companies with high credit  ratings, loss of access to this market does not, by itself, mean that a firm  that draws its loan commitment is in danger of defaulting. In most cases  where investment-grade borrowers drew upon their loan commitments,  they repaid the amount borrowed in full or otherwise performed in  accordance with the repayment terms for the amount borrowed. In  contrast to investment-grade borrowers, leveraged borrowers are expected  to partially or fully draw down on their loan commitments. Funded loans  are predominately used by leveraged borrowers that do not have access to  lower cost credit in the commercial paper market. Loan commitments and  loans also have different price structures, with lenders typically charging  one or more fees for making credit available under a loan commitment and  an interest rate on funded loans expressed as a spread or markup over a  benchmark rate. Loan commitments and loans also differ in security. Loan  commitments to investment-grade borrowers are typically unsecured—no  collateral is pledged—and have few restrictive financial covenants, while  leveraged loans are typically secured and have more covenants. While a  loan commitment gives a firm an option to borrow funds under pre- specified terms, a loan actually provides these funds to the firm. These  differences between the purpose of loan commitments and loans, together  with differences in their price structure and collateral requirements, make  it difficult to compare the price of loan commitments with loans.
section_title: Commercial Banks Consider Several Factors to Price Loan Commitments and Loans
paragraphs: Commercial bankers said that they considered several factors in  establishing the price of loan commitments and loans. For investment- grade borrowers, the profitability of the banking relationship a bank has  with the borrower was one factor. Commercial banks establish  relationships with corporate customers and evaluate the overall  profitability of these relationships in terms of the various products and  services customers use and the prospects for additional business in the  future. Commercial bankers said that the extent and profitability of the  existing business they had with an investment-grade borrower would affect  the decision to participate in a syndicated loan and the price they would set  if they were syndicating the loan. As we previously reported, commercial  bankers also told us that they considered the need to set a price that  provided an attractive return to other investors in the syndication. For  leveraged loans, industry experts told us that pricing depended on the  riskiness of the transaction, but one commercial banker told us that  customer relationships also played a role.
Creditworthiness—a measure of a borrower’s ability to meet debt  obligations—was another factor considered in establishing the price of  loan commitments and loans. As table 1 shows, the average fees for  investment-grade loan commitments were lower than for leveraged loan  commitments between 1999 and 2003, which demonstrates that lenders  charge higher fees for leveraged or more risky loan commitments. In  addition, the lower average fees for investment-grade loan commitments  might reflect the fact that lenders generally do not anticipate having to  provide the funds they have committed. Table 1 also shows that the average  fees for investment-grade loan commitments increased around 16 percent  between 1999 and 2003, while the average fees for leveraged loan  commitments decreased around 2 percent during the same time period.
Table 2 shows the average annual charge over benchmark rate for  investment-grade and leveraged loans between 1999 and 2003. Lenders also  charge higher average annual charges over the benchmark rate for  leveraged loans than for investment-grade loans, which reflects the greater  risk of loss for leveraged loans. Between 1999 and 2003, the average annual  charge over benchmark rate increased about 39 percent for investment- grade loans and around 13 percent for leveraged loans. However, in neither  case could we determine whether the increase reflected overall higher  charges for all loans or represented an increase in the proportion of riskier  loans.
Commercial bankers also told us that they considered the maturity of a  loan commitment or loan in establishing the price of these instruments. As  table 3 shows, the average fees for investment-grade loan commitments  with maturities of 1 year or more were higher than for 364-day facilities, a  reflection that the longer the maturity the greater the risk the loan will be  drawn.
Commercial bankers also said that they took into account the recent prices  of syndicated loans to borrowers with similar credit ratings, and the price  of a corporation’s bonds and other debt instruments. However, most  commercial bankers we met with reported that they did not consider the  price of credit default swaps when determining the price of loan  commitments. Further, commercial bankers told us that they used financial  models to predict whether the price of a loan commitment or loan would  meet their minimum profitability target. These models predict how a  particular loan commitment will impact the risk and return of the  institution’s overall portfolio.
During our review, some investment bankers asserted that investment- grade loan commitments were not profitable on a stand-alone basis.  Commercial bankers agreed that the price of these commitments was not  very profitable on a stand-alone basis and that they generally look to the  entire relationship with the customer to meet their profitability hurdles.  Commercial bankers added that competition from other loan market  participants constrained the prices they could charge, since investment- grade borrowers generally had syndication offers from more than one  lender. When determining the price of investment-grade loans, some  commercial bankers noted that competition limited their ability to raise  fees and they described themselves as price “takers” rather than price  “setters.” Further, federal banking regulators told us that loan  commitments are not legally required to be profitable on a stand-alone  basis.
section_title: Loan Commitments Are Rarely Traded, and Available Data from Secondary Market Does Not Support Claims of Systematic Underpricing
paragraphs: We were told that loan commitments rarely trade in the secondary market,  primarily for two reasons. First, commercial banks did not want to  jeopardize their relationship with borrowers that might object to such a  sale, and second, institutional investors—such as the mutual and hedge  funds and insurance companies that are significant participants in the  secondary market—were reluctant to buy instruments that might require  funding in the future. Because loan commitments are rarely traded, the  available data, which showed increases in secondary trading, were mostly  for funded loans. Moreover, we found no comprehensive publicly available  data about the actual prices of loans (or loan commitments) traded in the  secondary market. For example, a loan pricing data firm compiles and  makes some data publicly available about the volume of secondary loan  market trading based on information solicited from key market  participants.
As figure 5 shows, from 1991 to 2003, overall secondary loan market trading  increased from about $8 billion to about $145 billion. Officials from a loan  market trade association said that institutional investors, attracted by the  higher returns provided by loans as compared to bond and equity  instruments, largely contributed to the growth in secondary loan market  trading. The officials added that the development of standardized loan  trade documentation and other market practices also facilitated the growth  in secondary loan market trading by improving market liquidity.
Loan market trade association officials also said that there were no  comprehensive data publicly available about the actual prices for loan  commitments or loans traded in the secondary market. Loans are privately  placed based upon negotiated terms. As such, institutions that buy or sell  these instruments are not required to report actual trade prices. For certain  loans, the trade association independently compiles and makes publicly  available data on dealer quotes. However, the officials noted that the dealer  quotes do not represent actual trade prices or offers to trade; rather, they  are estimates provided by bank loan traders. Because loan commitments  rarely trade, similar dealer quote data are not collected for these  instruments.
Some investment bankers contended that certain loan commitments were  underpriced at origination, as evidenced by the price of these commitments  in the secondary market. However, the available evidence we reviewed did  not support the investment bankers’ contentions. In one case, officials from  one investment bank said that they participated in a revolving line of credit  where the initial trading levels in the secondary market were between 89  and 92 cents on the dollar. They said that, in their opinion, this immediate  decline in value implied an initial loss to the participants and was evidence  that the credit had been underpriced at origination. Commercial bankers,  credit rating agency officials, and other loan market participants told us  that the secondary market for loan commitments was illiquid, compared  with that for other securities. As a result of this illiquidity, officials from  one commercial bank said that investors are able to buy loan commitments  at a discount when large amounts of a syndicated loan are placed on the  market. The officials added that these investors are often able to sell  smaller amounts of these commitments at a later time for a higher price.  Investment bank officials acknowledged that the trading levels for the  revolving line of credit, which had sold for between 89 and 92 cents on the  dollar, had risen to between about 97 and 98 cents on the dollar in the  secondary market. Investment bankers provided information on 3 other  cases where loan commitments that sold at a discount in initial trading had  current trading levels of more than 99 cents on the dollar. This increase in  market value would have significantly reduced any initial loss to the  investment banks and may indicate that the initial decline in value was in  response to other market factors and the commitments were not  necessarily underpriced.
section_title: Although Commercial Banks Use Credit Default Swaps to Reduce the Credit Risk of Their Loan Commitment and Loan Portfolios, Prices of These Instruments Cannot Be Compared Directly
paragraphs: While some commercial banks reported that they used credit default swaps  to reduce the credit risk on their loan and loan commitment portfolios, only  limited information was available on the extent of this practice. Officials at  two investment banks believed that credit default swaps and loan  commitments were similar instruments, but we found that credit default  swaps and loan commitments were substantially different. Commercial  bankers, loan market experts, officials from rating agencies, and other  industry observers also agreed that credit default swaps and loan  commitments were different financial instruments. Based on our analysis  of the characteristics of credit default swaps and loan commitments, we  found that it was not feasible to use credit default swap prices to determine  whether loan commitments were underpriced because of the differences  between the two instruments.
subsections: section_title: Comprehensive Data Are Not Available about the Use of Credit Default Swaps to Reduce Credit Risk
paragraphs: As previously discussed, credit default swaps are essentially insurance  against borrower default, and commercial banks and other financial  institutions use these instruments to reduce or diversify credit risk  exposures. Commercial banks are required to report the total amount of  their credit default swap and other credit derivative contracts in quarterly  reports submitted to federal banking regulators, but banks do not have to  distinguish between amounts they hold to reduce credit risk and amounts  they hold for trading purposes. Officials from the six commercial banks we  visited said that they used credit derivatives to reduce the risk on between  2 and 12 percent of their loan and loan commitment portfolios and held  most of these instruments for trading purposes–primarily customer service  transactions. A credit rating agency report on credit default swaps reached  a similar conclusion.
section_title: Credit Default Swaps and Loan Commitments Are Different Financial Instruments
paragraphs: Officials at two investment banks we visited said that credit default swaps  and loan commitments were similar financial instruments. For example,  officials at one investment bank said that credit default swaps and loan  commitments were similar financial instruments because those who sold  the protection offered by credit default swaps and those who made loan  commitments were exposed to similar risks of credit losses. They added  that a credit default swap and a loan commitment were both similar to a  put option. In a put option, the option purchaser has the right, but not the  obligation, to sell an asset to the put option seller at a specified price on or  before the option’s exercise date, and the purchaser pays a premium to the  seller for the put option. The officials noted that if a swap was triggered by  a credit event, the beneficiary had the right to payment of the swap’s full  value from the guarantor, who would then be exposed to any losses  associated with the credit event. These officials asserted that the same risk  existed in a loan commitment, because the borrower has the right to draw  the full amount of the commitment and would not exercise this right unless  its credit rating had deteriorated to near default levels and it could not raise  funds in the financial markets.
However, we found that credit default swaps and loan commitments were  substantially different. We analyzed the characteristics of each instrument  and sought the opinions of commercial bankers and other industry  observers. As table 4 shows, credit default swaps and loan commitments  differed in terms of the trigger event, pricing, trading, and financial  covenants. For example, the trigger for a credit default swap is a clearly  defined indication of the borrower’s credit impairment, which typically  includes bankruptcy, insolvency, and delinquency, or may even result from  a credit-rating downgrade. However, the trigger for a loan commitment  does not necessarily indicate credit impairment on the part of the  borrower. A loan commitment may serve as a backup for commercial  paper, and the issuer may have to use the line for reasons other than  impaired credit. We also found differences in the payment schedule of  credit default swaps and loan commitments. For credit default swaps, the  beneficiary makes fixed payments—either on a quarterly or annual basis— to the guarantor. For loan commitments, the fees that lenders charge  typically vary based on the credit rating for investment grade borrowers  and financial ratios for leveraged borrowers. As previously discussed,  officials from commercial banks we visited reported holding most credit  default swap contracts for trading purposes, but these same officials also  noted that loan commitments were generally not traded. Finally, loan  commitment contracts typically include financial covenants, or a series of  restrictions that dictate, to varying degrees, how borrowers can operate  and carry themselves. These covenants are designed to protect lenders  against the borrower’s potential future credit deterioration. Credit default  swap contracts do not contain such financial covenants. Commercial  bankers, loan market experts, officials from rating agencies, and other  industry observers also agreed that credit default swaps and loan  commitments were different financial instruments.
section_title: Commercial and Investment Bankers Disagreed about the Relationship between Credit Default Swap and Loan Commitment Prices
paragraphs: According to officials at the two investment banks we visited, credit default  swap and loan commitment prices were similar enough to allow for  meaningful price comparisons. However, as previously discussed, we  found that credit default swaps and loan commitments were substantially  different financial instruments. Commercial bankers and other loan market  participants also told us that prices of the two financial instruments should  not be directly compared without adjusting for differences between the  instruments. For example, officials at one commercial bank told us that  they first adjust for differences in financial covenant protection and  recovery rates before using credit default swap prices in estimating the  value of their total loan commitment portfolio. These officials also told us  that the directional movements in credit default swap prices had  informational value regarding the fair value of their loan commitment  portfolio—that is, as credit default swap prices increased, the fair value of  their loan commitments decreased. However, these officials cautioned that  the adjusted prices for credit default swaps were likely to be different from  the actual sales price of the portfolio if the instruments were to be sold.  Because of substantial differences between credit default swaps and loan  commitments, we found that it was not possible to use credit default swap  prices to determine whether loan commitments were underpriced.
section_title: Commercial and Investment Banks Follow Different Accounting Models, but There Is No Evidence That Either Model Provides a Consistent Competitive Advantage
paragraphs: Under current accounting standards, designed to reflect their different  business models, commercial and investment banks account for loan  commitments differently. We found that following different accounting  standards caused temporary differences in recognizing the fees from loan  commitments. Further, we found that the revenue from loan commitments  was relatively small compared with revenue from other bank operations  and these differences would be resolved by the end of the commitment  period. We did not find any evidence that the differences in accounting  treatment offered the commercial banks with a consistent competitive  advantage over investment banks. Further, both commercial and  investment banks have similar fair value footnote disclosure requirements  and generally provide similar information in their footnotes about the fair  value of various financial instruments, including loan commitments. We  found that the banks included in the scope of this review used similar  methods to estimate the fair value of financial instruments and that the  level of detail in their financial statement disclosures varied. However, all  the financial statement disclosures we reviewed appeared to be in  accordance with current accounting guidance, and we did not identify any  objections to the disclosures by the banks’ independent auditors.
subsections: section_title: Commercial and Investment Banks Follow Different Accounting Models but Have Similar Disclosure Requirements
paragraphs: According to FASB, which sets the private sector accounting and reporting  standards, commercial and investment banks follow different accounting  standards for similar transactions involving loan commitments because of  the differences in their business models. As previously discussed, most  commercial banks use varying accounting models depending on the type of  activity being accounted for—known as a mixed attribute model. With this  model, some financial assets and liabilities are measured at historical cost,  some assets at the lower of cost or market value, and some at fair value. In  contrast, investment banks generally follow a fair value accounting model  in which they report changes in the fair value of inventory, which may  include loans or loan commitments, in income during the periods in which  the changes occur.
FASB officials told us that many believe it is appropriate for commercial  and investment banks to follow different accounting models because the  institutions have different business models. For example, commercial  banking activities have traditionally included accepting deposits,  originating loans, and holding loans. These banks generally have the intent  and ability to hold the vast majority of their loan commitments and loan  portfolios until maturity and usually hold a relatively small amount of loans  for sale. Some commercial bankers told us that the mixed attribute model  more closely reflects the commercial bank’s operations than the fair value  model. Investment bank activities have traditionally included buying,  holding as inventory, and selling various financial instruments. As we  previously reported in our October 2003 report on bank tying, investment  banks often do not hold loan commitments until maturity. Officials at the  two investment banks we spoke with stated that the fair value accounting  model more closely reflects their operations than other models and  asserted that this accounting model should be used by all banks.
When commercial banks make loan commitments, they must follow FASB’s  Statement of Financial Accounting Standards (FAS) No. 91, Accounting for  Nonrefundable Fees and Costs Associated with Originating or Acquiring  Loans and Initial Direct Costs of Leases, which directs them to book the  fees received for loan commitments as deferred revenue (see app. II). The  way this revenue is recognized depends upon the likelihood that the loan  commitment will be exercised. When this likelihood is remote, the bank  will recognize the revenue in equal portions over the loan commitment  period. However, if it is likely that the commitment will be exercised, the  bank will defer recognizing all the fee revenue for this commitment until  the loan is drawn. The fee revenue from the commitment is then recognized  over the life of the loan. If this loan commitment remains unexercised, the  income would be recognized in total when the commitment period expired.  Currently, commercial banks are not allowed to recognize changes in the  fair value of loan commitments in their earnings.
Investment banks are generally required to follow the American Institute of  Certified Public Accountants (AICPA) Audit and Accounting Guide,  Brokers and Dealers in Securities, which directs them to record the fair  value of loan commitments. When using the fair value model, investment  banks must recognize, in income, gains or losses resulting from changes in  the fair value of a financial instrument, such as a loan commitment, during  the period the change occurs.
Although commercial and investment banks follow different models to  account for loan commitments, both firms are subject to the same fair  value footnote disclosure requirements in which they report the fair value  of all loan commitments in their financial statement footnotes along with  the method used to determine fair value. As a result, financial analysts and  investors are presented with similar information about the commercial and  investment banks’ loan commitments in the financial statement footnotes.  According to FAS 107: Disclosures about Fair Value of Financial  Instruments, in the absence of a quoted market price, firms may estimate  fair value based on, among other things, the value of (1) the quoted price of  a financial instrument with similar characteristics, (2) option or matrix  pricing models, or (3) the discounted value of future cash flows expected  to be received.
As we previously reported in our October 2003 report on bank tying,  Securities and Exchange Commission (SEC) officials and the banking  regulators told us the footnote disclosures included with financial  statements were an integral part of communicating risk. They considered  the statement of position and statement of operations alone to be  incomplete instruments through which to convey the risk of loan  commitments. They emphasized that to fully ascertain a firm’s financial  standing, footnotes must be read along with the financial statements.
We found that the banks included in the scope of this review used similar  methods to estimate the fair value of financial instruments and the level of  detail in their financial statement disclosures varied. For example, all of the  commercial bank footnotes we reviewed stated that fair values were based  on quoted market prices, when available. If quoted market prices were not  available, the banks used other methods such as internally developed  models, or based their fair value estimates on the price of similar financial  instruments. Some bank footnotes acknowledged that the fair values were  significantly affected by assumptions used in developing the estimate, such  as the timing of future cash flows and the discount rate, and further  recognized that the estimated fair values would not necessarily be realized  in an immediate sale of the financial instrument. For some of the  commercial bank’s footnotes that we reviewed, the fair value of loan  commitments was not explicitly stated, apparently because these amounts  may not have been material to the financial statements and therefore did  not warrant separate disclosure. Despite the differences in the methods  banks used to estimate the fair value of financial instruments and the level  of detail presented, all of the financial statement disclosures appeared to  be presented in accordance with current disclosure guidance. We found no  instances of independent auditors’ taking exception to these disclosures in  the audit opinions.
As part of our review, we asked bank officials if, for various decision- making purposes, they assigned different values to their loan commitments  than the values reported on the financial statements and related fair value  footnotes. Four of the commercial banks included in our review and both  investment banks included in our sample responded to our request for  information and stated that they consistently used the same values for  internal decision-making purposes that they used in their financial  statements.
During our discussions of accounting disclosures, one investment bank  official we spoke with asserted that the most appropriate method of  determining the fair value of loan commitments and reporting these values  in the financial statement footnotes was to use the value of a related credit  default swap because this official viewed the two financial instruments as  similar. FASB staff told us that generally accepted accounting principles do  not prescribe a specific method to estimate the fair value of financial  instruments that could be universally adopted by all banks. While the price  of a credit default swap could be used under current accounting guidance  as the market price of similar traded financial instruments with a similar  credit rating, interest rate, and maturity date, this was only one possible  method. Some of the other possible methods of estimating the fair value of  a financial instrument that does not regularly trade include option pricing  models or estimates based on the discounted value of future cash flows  expected to be received. Moreover, commercial bank officials and FASB  staff told us that a credit default swap did not exist for every borrower that  had a loan commitment. As previously discussed, the price of the credit  default swap would likely need to be adjusted to account for the various  other differences between it and a loan commitment. One commercial bank  that we spoke with used credit default swaps as a basis for estimating the  fair value of their loan commitments. However, officials at this bank stated  that they first adjusted the swap price for the various differences between  the two financial instruments, cautioned that the resulting estimate was  unlikely to represent the actual sales price of the loan commitments, and  primarily used the adjusted credit default swap price to assess directional  changes in the estimated fair value of their loan commitment portfolio.
section_title: No Evidence That Accounting for Loan Commitments Gives Commercial Banks a Consistent Competitive Advantage over Investment Banks
paragraphs: Because commercial and investment banks follow different accounting  models, they would likely report different values for a similar loan  commitment or a loan resulting from an exercised commitment, and  recognize different amounts of the related deferred revenue. Further,  revenue from fee income would be relatively small compared with revenue  from other bank activity. In addition, because investment banks use fair  value accounting, the volatility of the fair value of loan commitments would  be reflected more transparently in their financial statements than a  commercial bank’s financial statements, because investment banks must  recognize these changes in income as they occur. In contrast, commercial  banks do not recognize changes in the fair value of the loan commitment,  its related deferred revenue, or the related loan if it were drawn.
The differences in accounting between commercial banks and investment  banks are temporary, and, as demonstrated by the examples in appendix II,  whether a commercial bank or an investment bank recognizes more fee  revenue first would depend on various market conditions including interest  rates and spreads. Similarly, any differences between the fair value of a  loan or loan commitment on an investment bank’s books and the net book  value of a similar loan or loan commitment on a commercial bank’s books  would be eliminated by the end of the loan term or commitment period.  Moreover, based on our review of the banks’ financial statements, we found  that the revenue commercial banks earn from loan commitments was  apparently relatively minor compared with other sources of revenue, since  it was not identified separately in the statement of income as source of  income. Thus, differences in the amount and timing of recognizing service  fee income would likely be relatively small. Further, as previously  discussed, both commercial and investment banks are required to make  similar footnote disclosures about the fair value of their financial  instruments. Because these differences are relatively small and temporary,  we found no evidence that following different accounting models provided  the commercial banks with a consistent competitive advantage over  investment banks.
In addition, certain similarities in investment and commercial banks’  accounting treatment of loan commitments help mitigate any advantage  one type of accounting may offer over the other. First, as previously  discussed, both commercial and investment banks are required to make  similar footnote disclosures about the fair value of their financial  instruments. Second, when similar loan commitments held by a  commercial bank and an investment bank are exercised and become loans,  both firms are subject to the same accounting standards if the loan is held  to maturity. In this situation, both commercial and investment banks are  required to establish an allowance for probable losses based on the  estimated degree of impairment of the loan commitment or historic  experience with similar borrowers.
section_title: Fair Value Accounting May Have Certain Advantages, but Significant Implementation Issues Must Still Be Resolved
paragraphs: While current accounting standards do not require fair value accounting for  all financial instruments, FASB has recognized that commercial and  investment banks engage in similar transactions and the board is  concerned about having different accounting for those similar transactions.  As new accounting guidance is issued, the board is considering eliminating  the different business models where appropriate and has indicated a desire  to require all entities to report all financial instruments at their current fair  value where the conceptual and practical issues related to fair value  measurement have been resolved. As we reported in our October 2003  report on bank tying, FASB has stated that it is committed to work  diligently toward resolving, in a timely manner, the conceptual and  practical issues related to determining the fair values of financial  instruments.
An FASB staff member wrote a paper that summarized the strengths and  weaknesses of fair value accounting. In that paper, the staff member  stated that fair value measurement for financial assets and liabilities, such  as loans and loan commitments, provide more relevant information than  the historical cost model. The author also wrote that the mixed-attribute  model cannot cope with today’s complex financial instruments and risk  management strategies and it is time for a better accounting model. In  addition, the article stated that under the mixed-attribute model, few  financial liabilities, such as deposit accounts, are measured at fair value,  which can misrepresent the financial position of an entity that has a  significant amount of financial liabilities. The paper further stated that  changes in the economic environment during the past 20 years have  increased the volatility of prices such as interest rates and the introduction  of derivatives and other complex financial instruments have made the issue  of how to measure financial instruments critical. According to the author, a  market price of a financial instrument reflects the market’s assessment of  the future cash flows that this instrument will provide under current  conditions and an assessment of the risk that the amount or timing of these  cash flows will differ from expectations. The article also stated that  investors and creditors are primarily interested in assessing the amounts,  timing, and uncertainty of future net cash inflows to an entity and,  according to FASB staff, it seems logical that information based on the  market’s assessment, under current conditions, would be more relevant to  investors and creditors. Moreover, the FASB staff paper noted that in  today’s highly fluid economic environment, significant changes often occur  in short periods of time. These changes may influence management’s  decision to hold a particular financial instrument to maturity or sell it and  invest the proceeds elsewhere. The FASB staff concluded that the effects of  these decisions might be important to investors’ and creditors’ evaluation  of the entities’ performance.
Officials at both investment banks that we spoke with asserted that  accounting for loan commitments on a fair value basis was better than the  mixed-attribute model that commercial banks use. Officials at one of these  investment banks stated that the current accounting requirements created  a disincentive for commercial banks to disclose the risks associated with  loan commitments and their fair value. This investment bank official also  stated that fair value accounting forces business discipline and asserted  that commercial banks should not continue to reflect a loan commitment  on their financial statements at a value exceeding its current fair value.
According to the FASB staff paper, while most people agree that fair value  is the most relevant measure for assets and liabilities that are actively  traded, some believe applying this accounting model to all financial  instruments may focus too much on current market information that does  not necessarily reflect management’s intentions. The author noted that  implementing fair value accounting that focuses on current market prices  for all financial instruments would reflect the effects of transactions and  events in which the entity did not directly participate. The author further  stated that some have indicated that if management has the intent and  ability to hold a financial asset or liability until maturity, the current market  price is less relevant than if they were actively considering selling the  instrument. Further, the FASB staff paper points out that opponents of the  fair value model assert that the effects of management’s decisions to hold  or sell a particular financial instrument should become apparent over time  as the entity reports earnings that are higher or lower than the current  market. Thus, the current mixed-attribute model seems to provide  information that may be important to investors and creditors evaluation of  the entities’ performance.
The rating agency officials that we spoke with told us that they were  comfortable with both historical cost and fair value accounting and could  work equally well with either type of accounting information. These  officials told us that the information in the bank’s financial statement  footnotes provided enough information to assess a bank’s financial  performance over time. In our October 2003 report on bank tying, we  reported that a loan market expert told us that, although the discipline of  using market-based measures works well for some companies, fair value  accounting might not be the appropriate model for the entire wholesale  loan industry.
FASB staff that we spoke with acknowledged that progress in  implementing fair value accounting for all financial instruments has not  been required because all the implementation issues have not yet been  resolved. In our October 2003 report on bank tying, we reported that FASB  staff told us that, although measuring financial instruments at fair value has  conceptual advantages, FASB has not yet decided when, if ever, it will  require essentially all financial instruments held in inventory to be reported  at fair value. FASB staff stated that it was important to carefully evaluate all  aspects of fair value measurement to avoid unintended consequences. For  example, in the absence of observable market data, such as the secondary  market for loan commitments, an estimate of fair value would require  significant judgment and the result would be imprecise. FASB staff stated  that many constituents have expressed concerns that estimating fair value  without an active market is too subjective and there is potential for  management to manipulate the fair value of these financial instruments  because of the significant level of discretion involved in choosing the  assumptions that may be used to estimate fair value. As a result, the  amount of revenue or losses from changes in the fair value that banks  would report could be unreliable.
Another significant issue that has not been resolved is the elimination of  the banks’ allowance for loan losses account. This allowance account is  essentially an estimate of the amount of probable loss in a bank’s loan  portfolio. FASB staff told us that eliminating the allowance for loan losses  is currently a controversial issue among commercial banks and the bank  regulators who want to maintain the current accounting model. FASB staff  also told us that commercial banks have asserted that the mixed attribute  model more accurately reflects their operations than fair value accounting.  FASB staff told us that the bank regulators use the allowance for loan  losses as one of several factors that are considered in assessing a bank’s  asset quality. As discussed previously, under fair value accounting, all  financial instruments would be carried at a market price that reflects the  market’s assessment of the future cash flows this instrument will provide  under current conditions and an assessment of the risk that the amount or  timing of these cash flows will differ from expectations. While market  values for some portions of banks’ loan portfolios may be readily obtained,  such as residential mortgages where there is an active secondary market,  other segments of some banks’ portfolios, including loans to small and  medium--sized businesses, are more unique and obtaining reliable fair  values could be more problematic. As previously discussed, fair value  estimates of these loans would require a significant amount of management  judgment and the results would likely be imprecise. Until these issues have  been resolved and more comprehensive guidance has been issued by FASB,  the current mixed-attribute model will likely continue to be used by some  entities while others use fair value.
subsections: section_title: FASB Plans to Revise Fair Value Accounting Guidance
paragraphs: According to the FASB staff that we spoke with, the board is taking steps to  improve the accounting guidance for fair value measurements and, on June  23, 2004, issued an exposure draft regarding fair value measurements.  Prior to issuing this exposure draft, FASB noted that there was limited  guidance for measuring assets and liabilities on a fair value basis and this  guidance was dispersed among several accounting pronouncements.  Differences in this guidance created inconsistencies, and concerns were  raised about the ability to reliably estimate fair value, especially in the  absence of quoted market prices.
This exposure draft includes guidance that investment banks would follow  to determine the fair value of loan commitments. Further, the exposure  draft provides guidance that both commercial and investment banks would  follow in determining the fair value of loan commitments and presenting  this information in their footnote disclosures including the extent of fair  value measurement, how fair value was determined, the amount of  unrealized gains/losses, and the extent of market inputs that were used. In  addition, the exposure draft provides examples of the financial statement  footnotes to encourage more consistency in presentation. The exposure  draft, among other things, also clarifies the definition of fair value and  provides guidance on the hierarchy of techniques that can be used to  determine fair value. FASB is currently re-deliberating the exposure draft  and considering comments received from constituents during the comment  period. According to FASB staff members, they expect to release the final  guidance during the first half of 2005.
FASB staff told us that they had other projects under way that could affect  how commercial and investment banks account for loan commitments  including revising revenue recognition guidelines and coordinating with the  International Accounting Standards Board in an attempt to eliminate  differences in accounting standards. In addition, FASB staff is also looking  at the relevance and reliability of some attributes used to estimate fair  value. The goal of this effort is to provide guidance for determining at what  point an estimate becomes too unreliable to be reported in the financial  statements.
section_title: Conclusions
paragraphs: Although some investment bankers have contended that commercial banks  systematically underprice loan commitments, the available evidence did  not support these contentions. Because of fundamental differences in the  purpose and structure of loan commitments and loans, commercial  bankers, officials at credit-rating agencies, and other industry experts told  us that price comparisons between these financial instruments are difficult.  In addition, the evidence we reviewed from the secondary loan market did  not indicate underpricing of loan commitments. In cases we reviewed  where loan commitments had traded at a discount in initial trading, the  same commitments had current trading levels closer to face value, which  may indicate that the commitments were not necessarily underpriced.  Further, because of the substantial differences between loan commitments  and credit default swaps, it was not possible to use credit default swap  prices to determine whether loan commitments were underpriced.
Because commercial and investment banks currently follow different  accounting standards, designed to reflect their different business models,  there are differences in the financial statement presentation of some  similar transactions such as loan commitments. Unlike commercial banks,  investment banks recognize changes in the fair value of loan commitments  in income during the period when the changes occur. As a result, the  volatility of these fair value changes is reflected more transparently in an  investment bank’s financial statements. We found that following different  accounting rules caused temporary differences in recognizing the fees from  loan commitments. We also found that revenue from loan commitment fees  appeared to be relatively small compared with revenue from other bank  activity. We did not find any evidence that the differences in accounting  treatment offered the commercial banks a consistent competitive  advantage over investment banks. It appears that the economic substance  of loan commitments is recognized in the financial statements and related  footnotes in a clear, measurable, and evident fashion under both the  historic cost and fair value accounting approach. Further, both commercial  and investment banks have similar fair value disclosure requirements and  generally provide similar information on their financial statements about  the fair value of various financial instruments, including loan  commitments. Although one FASB staff member indicated that fair value  accounting may offer advantages over the mixed-attribute model, in some  instances, such as providing more relevant information than the historical  cost model, significant implementation issues must be resolved before it  can be applied to all financial instruments. It is important for FASB to  continue working diligently toward resolving these issues to help ensure  that financial statement users are provided with the most relevant and  reliable financial information and to keep pace with today’s financial  markets. Until these issues are resolved, commercial and investment banks  will continue to follow different accounting models for similar financial  instruments such as loan commitments.
section_title: Agency Comments
paragraphs: We requested comments on a draft of this report from FDIC, Federal  Reserve, OCC, and SEC. FDIC, Federal Reserve, OCC, and SEC staff  provided technical suggestions and corrections that we have incorporated  where appropriate.
We will provide copies of this report to the appropriate congressional  committees. In addition, the report will be available at no charge on the  GAO Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or hillmanr@gao.gov or Daniel Blair, Assistant  Director at (202) 512-9401 or blaird@gao.gov.
section_title: Objectives, Scope, and Methodology
paragraphs: During our review, we sought the perspectives of commercial banks that  were significant participants in the syndicated loan market. Officials from  six large commercial banks agreed to meet with us as part our review. In  2003, these banks arranged about 67 percent of total U.S. syndicated loan  volume. We also interviewed officials from two investment banks to obtain  the perspectives of other loan market participants.
To determine the differences between the price of loan commitments and  loans, we examined data on loan commitments and loans compiled by a  loan pricing data firm, analyzed the various characteristics of each  instrument, and reviewed other financial literature related to the  syndicated loan market. We also discussed the price of loan commitments  and loans with commercial banks, investment banks, federal bank  regulators, officials from credit rating agencies, officials from a loan pricing  data firm and loan market trade association, and other industry observers.
To determine what data were publicly available about the trading of loan  commitments, we analyzed data on secondary loan market trading  compiled by a loan pricing data firm and reviewed other financial literature  related to secondary loan market trading. We also interviewed commercial  bankers, investment bankers, and officials from a loan pricing data firm  and loan market trade association to obtain their perspectives on  secondary loan market trading. In addition, we discussed the trading of  loan commitments with federal bank regulators, officials from credit rating  agencies, and other industry observers.
To determine the extent to which credit default swaps were used to reduce  the risk of loan commitments, the similarities and differences between  credit default swaps and loan commitments, and what, if anything, the  prices of credit default swaps indicate about the prices of loan  commitments, we analyzed data on credit default swaps compiled by  federal banking regulators and a global trade association for derivatives  and reviewed the financial statements of the 6 commercial banks for  information on credit default swap usage. We also interviewed commercial  bankers and investment bankers to obtain their perspective. In addition, we  discussed the use of credit default swaps by commercial banks with federal  bank regulators, officials from a global trade association for derivatives,  officials from credit rating agencies, officials from a loan market data  collection firm and trade association, and other industry observers.
To determine whether the differences between commercial and investment  bank’s accounting for loan commitments provide either firm with a  consistent competitive advantage, we reviewed our previous comparative  analysis of applicable accounting standards. We also updated our  understanding of the accounting standards for loan commitments through  interviews with officials from the Financial Accounting Standards Board  (FASB). In addition, we obtained the perspectives of commercial bankers,  investment bankers, federal banking regulators, officials from credit rating  agencies, and other industry observers regarding the current accounting  standards for loan commitments.
To determine the strengths and weaknesses of fair value accounting, and  the projects that FASB has under way that might change the way  commercial and investment banks account for loan commitments, we  reviewed a recently issued accounting exposure draft and conducted  interviews with officials from FASB. We also discussed the merits of fair  value accounting in interviews with commercial bankers, investment  bankers, federal banking regulators, officials from credit rating agencies,  officials from a loan market data collection firm and trade association and  other industry observers.
We assessed all data for reliability and found them to be sufficiently reliable  for the purposes of our reporting objectives. We conducted our work in  Charlotte, N.C.; New York City, N.Y.; Norwalk, Conn.; San Francisco, Calif.;  and Washington, D.C., between November 2003 and October 2004, in  accordance with generally accepted government auditing standards.
section_title: Differences in Accounting between Commercial and Investment Banks for Loan Commitments
paragraphs: Because commercial and investment banks follow different accounting  models, there are differences in the financial statement presentation of  some similar transactions. This appendix summarizes the differences,  under generally accepted accounting principles in how commercial banks  and investment banks account for loan commitments—specifically  commercial paper back-up credit facilities—using hypothetical scenarios  to illustrate how these differences could affect the financial statements of a  commercial and investment bank. We use three hypothetical scenarios to  illustrate the accounting differences that would occur between the  commercial and investment banks for similar transactions if (1) a loan  commitment were made, (2) the loan commitment was exercised by the  borrower and the loan was actually made, and (3) the loan was  subsequently sold. This appendix does not assess the differences in  accounting that would occur between a commercial and investment bank if  one entity decided to hold a loan to maturity while the other had the loan  held for sale because these are not similar transactions.
The examples in this appendix demonstrate that, as of a given financial  statement reporting date, differences would likely exist between  commercial and investment banks in the reported value of a loan  commitment and a loan resulting from an exercised commitment, as well  as the recognition of the related deferred revenue. In addition, the volatility  of the fair value of loan commitments and the related loan, if the  commitment were exercised, would be reflected more transparently in an  investment bank’s financial statements, because an investment bank must  recognize these changes in value in earnings as they occur in net income.  In contrast, commercial banks are not allowed to recognize changes in the  fair value of the loan commitment, its related deferred revenue, or the  related loan (if drawn and held to maturity). The differences in accounting  between commercial banks and investment banks are temporary, and, as  the examples in the following sections show, whether a commercial bank  or an investment bank recognizes more fee revenue first would depend on  various market conditions including interest rates and spreads. Similarly,  any differences between the fair value of a loan or loan commitment on an  investment bank’s books and the net book value of a similar loan or loan  commitment on a commercial bank’s books would be eliminated by the end  of the loan term or commitment period. Further, both commercial and  investment banks are required to make similar footnote disclosures about  the fair value of their financial instruments. Thus, neither accounting model  provides a clear and consistent advantage over the life of the loan  commitment or the loan if the commitment were exercised.
subsections: section_title: Background
paragraphs: Since 1973, the Financial Accounting Standards Board (FASB) has been  establishing private sector financial accounting and reporting standards. In  addition, the American Institute of Certified Public Accountants (AICPA)  Accounting Standards Executive Committee also provides industry- specific authoritative guidance that is cleared with FASB prior to  publication. Where FASB guidance is nonexistent, as is currently the case  in fair-value accounting for loan commitments, firms are required to follow  AICPA guidance.
Most commercial banks generally follow a mixed-attribute accounting  model, where some financial assets and liabilities are measured at  historical cost, some at the lower of cost or market value, and some at fair  value. In accounting for loan commitments, banks follow the guidance in  Statement of Financial Accounting Standards (SFAS) Number 91,  Accounting for Nonrefundable Fees and Costs Associated with  Originating or Acquiring Loans and Initial Direct Costs of Leases.  Broker-dealer affiliates and investment banks whose primary business is to  act as a broker-dealer follow the AICPA’s Audit and Accounting Guide,  Brokers and Dealers in Securities, where the inventory (that may include  loan commitments) are recorded at the current fair value and the change in  value from the prior period is recognized in net income. Further, FASB  currently has a project on revenue recognition that includes, among other  things, the accounting for loan commitment fees by investment banks and  others. The purpose of that project includes addressing the inconsistent  recognition of commitment fee income and may eliminate some of the  accounting differences that exist between commercial and investment  banks described in this appendix.
FASB has stated that it is committed to work diligently toward resolving, in  a timely manner, the conceptual and practical issues related to determining  the fair values of financial instruments and portfolios of financial  instruments. Further, FASB has stated that while measurement at fair value  has conceptual advantages, all implementation issues have not yet been  resolved, and the Board has not yet decided when, if ever, it will be feasible  to require essentially all financial instruments to be reported at fair value in  the basic financial statements. Although FASB has not yet issued  comprehensive guidance on fair-value accounting, recent literature has  stated that the fair-value accounting model provides more relevant  information about financial assets and liabilities and can keep up with  today’s complex financial instruments better than the historical cost  accounting model. The effect of the fair-value accounting model is to  recognize in net income during the current accounting period amounts  that, under the historical cost model, would have been referred to as  unrealized gains or losses because the bank did not sell or otherwise  dispose of the financial instrument. Further, proponents of the fair-value  accounting model contend that unrealized gains and losses on financial  instruments are actually lost opportunities as of a specific date to realize a  gain or loss by selling or settling a financial instrument at a current price.  On the other hand, a disadvantage of fair value accounting exists when  there is not an active market for the financial instrument being valued. In  this case, the fair value is more subjective and is often determined either by  various modeling techniques, based on the discounted value of expected  future cash flows, or based on the value of credit derivatives.
section_title: Hypothetical Scenario for Unexercised Loan Commitments
paragraphs: On the first day of an accounting period, Commercial Bank A and  Investment Bank B each made a $100 million loan commitment to a highly  rated company to back up a commercial paper issuance. This loan  commitment was irrevocable and would expire at the end of three quarterly  accounting periods. Because the loan commitment was issued to a highly  rated company, both banks determined that the chance of the company  drawing on the facility was remote. Both banks received $10,000 in fees for  these loan commitments. Commercial Bank A followed the guidance in  SFAS No. 91 and recorded this transaction on a historical cost basis, while  Investment Bank B, subject to specialized accounting principles that  require fair-value accounting, reported changes in fair value included the  effect of these changes in earnings.
subsections: section_title: Revenue Recognition for the Commercial Bank
paragraphs: Upon receipt of the loan commitment fee, Commercial Bank A would  record the $10,000 as a liability, called deferred revenue, because the bank  would be obligated to perform services in the future in order to “earn” this  revenue. In practice, because of the relatively small or immaterial amounts  of deferred revenue compared with other liabilities on a bank’s statement  of position (balance sheet), this amount would not be reported separately  and would likely be included in a line item called “other liabilities.”  Commercial Bank A would follow the accounting requirements of SFAS  No. 91 and recognize the revenue as service fee income in equal portions  over the commitment period, regardless of market conditions—a practice  often referred to as revenue recognition on a straight-line basis. Thus, at  the end of the first accounting period, Commercial Bank A would reduce  the $10,000 deferred revenue on its statement of position (balance sheet)  by one-third or $3,333 and record the same amount of service fee revenue  on the statement of operations (income statement). The same accounting  would occur at the end of the second and third accounting periods, so that  an equal portion of service revenue would have been recognized during  each period that the bank was obligated to loan the highly rated company  $100 million. Commercial Bank A would not report the value of the loan  commitment on its balance sheet. However, the bank would disclose in the  footnotes to its financial statements the fair value of this commercial paper  back-up facility as well as the method used to estimate the fair value.
section_title: Revenue Recognition for the Investment Bank
paragraphs: Although AICPA’s Audit and Accounting Guide, Brokers and Dealers in  Securities does not provide explicit guidance for how Investment Bank B  would account for this specific transaction, the guide provides relevant  guidance on accounting for loan commitments in general. This guide states  that Investment Bank B would account for inventory, including financial  instruments such as a commercial paper back-up facility, at fair value and  report changes in the fair value of the loan commitment in earnings. When  changes occurred in the fair value of the loan commitment, Investment  Bank B would need to recognize these differences by adjusting the balance  of the deferred revenue account to equal the new fair value of the loan  commitment. Generally, quoted market prices of identical or similar  instruments, if available, are the best evidence of the fair value of financial  instruments. If quoted market prices are not available, as is often the case  with loan commitments, management’s best estimate of fair value may be  based on the quoted market price of an instrument with similar  characteristics or may be developed by using certain valuation techniques  such as estimated future cash flows using a discount rate commensurate  with the risk involved, option pricing models, or matrix pricing models. A  corresponding entry of identical value would be made to revenue during  the period in which the change in fair value occurred. Once the  commitment period ended, as described in the previous paragraph, the  deferred revenue account would be eliminated and the entire balance  recorded as income because the fair value of the expired loan commitment  is zero.
If market conditions changed shortly after Investment Bank B issued this  credit facility and its fair value declined by 20 percent to $8,000, Investment  Bank B would reduce the deferred revenue account on its statement of  position (balance sheet) to $8,000, the new fair value. Investment Bank B  would recognize $2,000 of service fee income, the amount of the change in  value from the last reporting period, in its statement of operations (income  statement). Investment Bank B would also disclose in its footnotes the fair  value of this credit facility, as well as the method used to estimate the fair  value.
If during the second accounting period there was another change in market  conditions and the value of this credit facility declined another 5 percent to  $7,500, Investment Bank B would decrease the balance in the deferred  revenue account to $7,500 and recognize $500 in service fee revenue.  Further, Investment Bank B would disclose in its footnotes the fair value of  this credit facility.
During the accounting period in which the commitment to lend $100  million was due to expire, accounting period 3 in this example, the balance  of the deferred revenue account would be recognized because the  commitment period had expired and the fair value would be zero. Thus,  $7,500 would be recognized in revenue and the balance of deferred revenue  account eliminated. In this accounting period, there would be no disclosure  about the fair value of the credit facility.
section_title: Differences in Revenue Recognition are Temporary
paragraphs: Table 5 summarizes the amount of revenue Commercial Bank A and  Investment Bank B would recognize and the balance of the deferred  revenue account for each of the three accounting periods when there were  changes in the value of the loan commitments. Commercial Bank A would  recognize more service fee income in accounting periods 1 and 2 than  Investment Bank B. However, this situation would be reversed in period 3,  when Investment Bank B would recognize more revenue. Thus, differences  in the value of the loan commitment and the amount of revenue recognized  would likely exist between specific accounting periods, reflecting the  volatility of the financial markets more transparently in Investment B’s  financial statements. The magnitude of the difference is determined by the  market conditions at the time and could be significant or minor. However,  these differences would be resolved by the end of the commitment period,  when both entities would have recognized the same amount of total  revenue for the loan commitment.
section_title: Hypothetical Scenario for Exercised Loan Commitments
paragraphs: Commercial Bank A and Investment Bank B issued the same loan  commitment described previously. However, at the end of the second  accounting period, the highly rated company exercised its right to borrow  the $100 million. The accounting treatment for this loan would depend  upon whether the banks intended to hold or sell the loan. In practice, this  loan could be either held or sold, and as a result, the accounting for both is  summarized in the following sections.
subsections: section_title: Loans Held to Maturity
paragraphs: At the time the loan was made, Commercial Bank A would record the loan  as an asset on its statement of position (balance sheet) at its principal  amount less the balance of the deferred revenue account ($100 million -  $3,334). Investment Bank B would initially record this loan at its historical  cost basis, less the loan commitment’s fair value at the time the loan was  drawn ($100 million - $7,500). Further, based on an analysis by the banks’  loan review teams, a determination of “impairment” would be made.  According to SFAS 114, Accounting by Creditors for Impairment of a  Loan, “a loan is impaired when, based on current information and events, it  is probable that a creditor will be unable to collect all amounts due  according to the contractual terms of the loan agreement.” If the loan were  determined to be impaired, SFAS 114 states that, the bank would measure  the amount of impairment based on the present value of expected future  cash flows discounted at the loan’s effective interest rate, except that as a  practical expedient, the amount of impairment may be based on the loan’s  observable market price, or the fair value of the collateral if the loan were  collateral dependent.
SFAS 114 directs both banks to establish an allowance for losses when the  measure of the impaired loan is less than the recorded investment in the  loan (including accrued interest, net of deferred loan fees or costs and  unamortized premium or discount) by creating a valuation allowance that  reduces the recorded value of the loan with a corresponding charge to bad- debt expense. When there are significant changes in the amount or timing  of the expected future cash flows from this loan, the banks would need to  adjust, up or down, the loan loss allowance as appropriate so that the net  balance of the loan reflects management’s best estimate of the loan’s cash  flows. However, the net value of the loan cannot exceed the recorded  investment in the loan.
If the loan were not impaired under FAS 114, both banks would still record  an allowance for credit losses in accordance with FAS 5, Accounting for  Contingencies, when it was probable that a loss from impairment of the  loan had occurred and the amount of the loss was reasonably estimable.  Thus, both banks would establish an allowance for loss in line with  historical performance for borrowers of this type. Because the loan was  performing, both banks would receive identical monthly payments of  principal and interest. Generally, these cash receipts would be applied in  accordance with the loan terms and a portion would be recorded as  interest income, and the balance applied would reduce the banks’  investment in the loan. At the end of the loan term, the balance and the  related allowance for this loan would be eliminated.
SFAS 91 also directs both banks to recognize the remaining unamortized  commitment fee over the life of the loan as an adjustment to interest  income. Because the borrower’s financial condition had deteriorated, both  banks would likely have charged a higher interest rate than the rate stated  in the loan commitment. As a result, at the time it became evident that the  loan was to be drawn, Investment Bank B would record a liability on its  balance sheet to recognize the difference between the actual interest rate  of the loan and the interest rate a loan to a borrower with this level of risk  would have been made at—in essence the fair value interest rate.  Investment Bank B would also amortize this liability over the life of the  loan as an adjustment to interest income.
section_title: Loans Made Available for Sale
paragraphs: If Commercial Bank A and Investment Bank B’s policies both permitted the  firms to only hold loans to maturity when the borrowers were highly rated,  it is unlikely that the banks would keep the loan in the previous scenario  and would sell the loan in the hypothetical scenario soon after it was  made. The banks would follow different guidance that would provide  similar results. Commercial Bank A would follow the guidance in the  AICPA Statement of Position 01-6, Accounting by Certain Entities  (Including Entities With Trade Receivables) That Lend to or Finance the  Activities of Others that was issued in December 2001. According to this  guidance, once bank management decides to sell a loan that had not been  previously classified as held-for-sale, the loan’s value should be adjusted to  the lower of historical cost or fair value and any amount that historical cost  exceeds fair value should be accounted for as a valuation allowance.  Further, any subsequent changes in the loan’s fair value that would be  required to be adjusted through the valuation allowance, such as a further  decline in fair value, would be recognized in income. However, if the fair  value increased to the point where it exceed the historical carrying value,  this gain would not be recognized in income unless the loan were sold.  Investment Bank B would follow the guidance in the AICPA’s Audit and  Accounting Guide, Brokers and Dealers in Securities, as it did with loan  commitments, and account for inventory at fair value and report changes in  the fair value of the loan in net income.
For example, if bank management decided to sell the loan soon after it was  drawn when some payments had been made to reduce the principal  balance and the net book value of this loan was $88,200,000 (unpaid  principal balance of $90,000,000 less the related allowance of $1,800,000)  and the fair value was 97 percent of the unpaid principal balance or  $87,300,000, both banks would recognize the decline in value of $900,000 in  earnings. While the loan remained available-for-sale, any changes in its fair  value would be recorded in income. For example, if the loan’s fair value  declined further to $85,500,000, both banks would recognize the additional  decline in value of $1,800,000 in earnings.
Table 6 summarizes the accounting similarities between Commercial Bank  A and Investment Bank B for the loan sale. Although the two banks  followed different guidance, the effect of the loan sale is the same for both  banks.
section_title: GAO Contacts and Staff Acknowledgments
subsections: section_title: GAO Contacts
section_title: Acknowledgments
paragraphs: In addition to those individuals named above, Emily Chalmers, Marshall  Hamlett, Robert Pollard, and John Treanor made key contributions to this  report.