In light of Silicon Valley Bank’s (SVB) failure, speculation has surfaced about whether the FASB’s accounting rules for held-to-maturity (HTM) debt securities should be revised, an old issue that was put to rest about seven years ago.
SVB held bonds that they deemed to be “held-to-maturity” which lost value when interest rates increased, creating losses for the asset side of their balance sheet.
Under current accounting rules in Topic 320, Investments-Debt and Equity Securities, bonds that are HTM are not required to be measured at fair value on the balance sheet. Therefore, if a bank has a lot of unrealized losses, investors would not have been aware of the extent of those losses because the balance sheet would not show them, accountants said on March 14, 2023.
“The way we account for held-to-maturity bonds is based on the original interest rate when the bond was issued, which we call ‘amortized cost’ on the balance sheet,” Kurt Gee, assistant professor of accounting at Pennsylvania State University, said.
“And because that bond’s interest rate is fixed and contractually specified, if the real world’s interest rate changes we ignore those changes in accounting and they are not reflected on the balance sheet,” he said. “So when interest rates have increased dramatically relative to when the bonds were issued, the bonds the bank holds are worth less to potential buyers. And if the bank suddenly needs capital to be able to repay depositors and they have to sell those bonds, the price they sell them at will be less than the price recorded on the balance sheet. That can be a problem when there’s a liquidity issue and banks need to access funds, because they’re going to have to sell at a much lower price than investors think they’re worth based on the balance sheet.”
Gee, a former FASB staff member, said that in light of the SVB event, the board should consider revisiting the accounting rules for HTM debt securities, or at least studying the pervasiveness of the issue.
Specifically, 320-10-35-1 paragraph c states that HTM debt securities are to be reported at amortized cost and all other financial assets at fair value. “This is the one last piece I’m not sure we’ve gotten right, especially when you see the example of SVB where their assets are falling and they need to have assets to be able to cover deposits but the accounting hasn’t revealed that their assets have decreased in value until they start selling, and then the world starts freaking out,” he said. “We could have potentially known earlier if the accounting had recognized the unrealized losses on those held-to-maturity debt securities.”
The Federal Deposit Insurance Corporation (FDIC) recently transferred all deposits—both insured and uninsured—and substantially all assets of SVB to a newly created, full-service FDIC-operated ‘bridge bank’ in an action designed to protect all of the bank’s depositors. Signature Bank, a New York-based bank, which also recently failed, was also put under the FDIC and six other regional banks are reportedly under close watch.
HTM Debt Securities Put to Rest in 2016
Accounting for HTM debt securities surfaced during the FASB’s discussions that lead to the development of Accounting Standards Update (ASU) No. 2016-01, Financial Instruments—Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities, which was published in 2016. Two FASB members at the time – Harold Schroeder and Thomas Linsmeier – dissented to the standard, stating, among other reasons that the board’s “decision to retain existing classification and measurement guidance represents a significant lost opportunity to provide users with the information necessary to understand the potential risks in financial instruments that have caused significant issues in past economic crises.”
This concern is exacerbated further by the failure of the ASU “to require additional disclosures that provide users with a better understanding of the duration risk, interest-rate risk, and liquidity risk of financial instruments, which they believe have led to significant market uncertainty in past financial crises,” they wrote. Both have since left the FASB due to term limits.
“The guidance updates in 2016 allowed for the continued classification of certain investments as held-to-maturity,” Rhead Hatch, senior product manager at Clearwater Analytics, said. But the FASB also introduced the recognition of allowance for expected credit losses to HTM securities reported under ASU No. 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, “which requires these investments to be reported at the amount net expected to be collected,” he said. “If market value movements reflect circumstances that do not impact the amounts expected to be collected in the future, they would not directly impact the carrying value of those assets on the financial statements of the holder, whether positive or negative.”
Not a CECL Issue?
Others said that the FASB’s current expected credit losses (CECL) standard (ASU 2016-13), was likely not that relevant to SVB’s demise but stressed that it is not yet clear.
As of Dec. 31, 2022, SVB had about $120 billion in investments, primarily bonds (the bank only had $74 billion of loans to borrowers), according to its 10-K filed in February. It’s investments book was significantly larger than its loan book. Of the $120 billion in investments, $91 billion were in HTM investments and were not reported at fair value in each reporting period. Instead, they were reported at amortized cost, net of any reserves for credit losses.
“Note that reserves for HTM investments also need to be accounted for under [FASB’s] CECL standard,” Scott Ehrlich, President of Mind the GAAP, LLC, said on March 13.
Ehrlich, who qualified his remarks as speculative, said it is possible that SVB’s reserves for its HTM investments were light. “It looks like they didn’t establish any reserves for credit losses on investments issued or guaranteed by the U.S. government, which is pretty typical. But on the remainder of the portfolio, SVB established reserves of just $6 million,” he said. “That seems awfully light, especially given that (a) these securities were “underwater” by $15.6 billion as of December 31, 2022, and perhaps even in a greater loss position as of last Friday given movements in interest rates and credit spreads and (b) the bank announced a $2.1 billion loss on investments they did sell last week. So, perhaps where a criticism of CECL might be warranted is in how the bank applied the CECL guidance to its HTM securities portfolio.”
Currently, ASU No. 2016-13 is under the FASB’s post-implementation review (PIR), its process to determine whether a standard worked as intended.
The standard was developed in response to the 2008 financial crisis to replace the old incurred loss model for reporting credit losses which was said to have precluded banks from recognizing loan losses that were not yet probable. This feature some said amplified the depth and duration of the financial crisis.
The new CECL model requires companies to estimate and recognize lifetime expected credit losses at the origination or acquisition of a loan. In 2020, legislators pushed for a delay of the rules for public companies, but most large public banks adopted it on time, according to FASB discussions almost three years ago. (See Banks, Other Large Public Companies Already Adopted Credit Loss Rules, FASB Chairman Says in the May 14, 2020, edition of Accounting & Compliance Alert.)
Private companies were however granted a delay to this year, starting on Jan. 1, 2023, for calendar year-end filers.
This article originally appeared in the March 15, 2023 edition of Accounting & Compliance Alert, available on Checkpoint.
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