Regular Features

Current Regional Banking Conditions

• Reported earnings, asset quality, and capital continue to improve during the first quarter, boosted not only by positive economic conditions in the Region but also by the adoption of Generally Accepted Accounting Principles (GAAP) for regulatory reporting purposes.

• Regulatory reports in the San Francisco Region were most affected by the adoption of the GAAP accounting standards related to mortgage servicing rights, assets sold with recourse, and the extended amortization period for intangible assets.

• In the first quarter of 1997, unrelated merger candidates in the Region favored the purchase method of accounting. The purchase method may have gained popularity among merger candidates as a result of a recent Securities and Exchange Commission (SEC) ruling that tightens rules on stock buyback programs and a Call Report change that lengthens the goodwill amortization period from 15 to 25 years.

Region's Profit Levels Highest since the Recession

The Region's banks reported record profits despite an increase in loan loss reserves at large credit card banks. These banks increased their allowance for loan and lease losses to cover another uptick in delinquent credit card loans. Credit card loans past due 30 days and over climbed from 4.17 percent of average total credit card loans at year-end 1996 to 4.47 percent as of March 31, 1997, although delinquency rates for total loans in the Region fell below the national level for the second quarter in a row.

Regulators Adopt Generally Accepted Accounting Principles

Institutions in the San Francisco Region were most affected by the adoption of GAAP in the following areas:

• Extension of goodwill amortization from a maximum of 15 years to a maximum of 25 years.

Banking regulators extended the amortization period for intangible assets to achieve consistency with the Securities and Exchange Commission Staff Accounting Bulletins. This change affected both the balance sheet and income statement at several institutions in the Region.

As shown in Table 1, goodwill increased by $1.6 billion during the quarter. This increase stems from two sources: (1) premiums paid for acquired institutions and (2) write-up of previously amortized goodwill. Several institutions retroactively adjusted the life of their recorded goodwill to the new 25-year maximum by writing up their goodwill asset. Evidence suggests that some 40 percent of the increase in goodwill may be attributable to this write-up. Insured institutions reported the cumulative effect of the goodwill write-up as a direct adjustment to their capital accounts.

Table 1

It also appears that the extended amortization period is responsible for the 23 percent decline in intangible amortization expense that occurred despite a 17 percent quarter-over-quarter increase in total intangible assets. Based on historical intangible amortization expense ratios, the extended amortization period boosted the Region's aggregate return on assets during the quarter by approximately six basis points.

• Elimination of the distinction between normal and excess servicing fees receivable (ESFR) and other charges related to servicing of financial assets.

Servicing fees receivable, or servicing rights, as defined in Financial Institution Letter 106-96 dated December 27, 1996, are the contractual obligations undertaken by an institution to provide servicing for loans and other financial assets owned by others, typically for a fee. For regulatory reporting purposes prior to January 1, 1997, servicing rights were divided into the following two categories:

1. Purchased servicing rights, which were servicing rights purchased from others.

2. Originated servicing rights, which generally arose when an institution originated and subsequently sold the financial assets but retained the rights to service those assets. When an institution sold these financial assets with servicing retained and the servicing fees exceeded the normal servicing fee rate, it booked ESFRs.

In the past two years, however, GAAP accounting treatment for servicing rights changed significantly. Effective in 1996, the Financial Accounting Standard Board's Statement No. 122, "Accounting for Mortgage Servicing Rights" (FAS 122), eliminated the distinction between purchased mortgage servicing rights and originated mortgage servicing rights. It required that these assets, together known as mortgage servicing rights, be treated as a single asset for financial statement purposes, regardless of how the servicing right was acquired.

Effective January 1, 1997, FAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," reclassified the interest cash flows associated with normal and excess servicing contracts into the following two categories:

1. Servicing assets, which are measured based on contractually specified servicing fees.

2. Interest-only strips receivable, which represent interest cash flows received on the serviced assets in excess of the contractually specified servicing fees. To qualify as an interest-only strip, the servicer must have the right to retain the excess cash flows if the related servicing asset is sold or the related servicing contract is shifted to a new servicer.

During the first quarter, the adoption of these GAAP guidelines for regulatory reports affected both the balance sheet and the income statements at several of the Region's banks because, prior to 1997, there were significant regulatory accounting differences related to the servicing of financial assets. First, banks were allowed to recognize only gains and book assets on ESFRs for first lien 1 to 4 residential real estate mortgage loans. With the adoption of GAAP and FAS 125 on January 1, 1997, banks can now recognize income and book originated servicing assets on all types of financial assets, not just mortgage loans.

Second, servicing assets were classified differently and, because of their respective classifications, they were treated differently in regulatory capital calculations. Prior to 1997, mortgage servicing rights were classified as intangible assets and limited to 50 percent of Tier 1 capital. Conversely, ESFRs were considered tangible "other assets," and 100 percent of these assets were included for capital adequacy purposes. In addition, any purchased servicing rights on assets other than mortgages were classified as intangible assets for regulatory reporting purposes but were deducted from capital in their entirety.

Although the adoption of GAAP eliminated the balance sheet and income statement differences related to the servicing of financial assets, these assets continue to be treated differently in regulatory capital calculations. As of January 1, 1997, 100 percent of interest-only strips generally are included in capital, while mortgage servicing assets are limited to 50 percent of Tier 1 capital. Servicing assets on financial assets other than mortgages are limited to 25 percent of capital at savings associations but are totally excluded in bank capital calculations. The total of all servicing assets that may be recognized at any savings association is limited to no more than 50 percent of Tier 1 capital.

In the San Francisco Region, most ESFRs were reclassified from tangible "other assets" to intangible "mortgage servicing assets" during the first quarter primarily because the servicers were unable to retain the excess cash flows if the related servicing assets were sold. This reclassification of ESFRs accounted for approximately one-half of the $812 million increase in the mortgage servicing assets outstanding (see Table 1). Although the reclassification did not change asset totals, it did affect capital ratios of individual institutions with large mortgage servicing portfolios, because intangible mortgage servicing assets are limited for regulatory capital purposes.

• Removal of certain loans and other assets sold with recourse from the balance sheet.

With the adoption of GAAP in the first quarter, institutions in the Region reported a cumulative total of over $28 billion in assets sold with recourse. About $4 billion of this total relates to loans sold during the first quarter of 1997. These assets, which were primarily credit card loans, account for the majority of a $4.3 billion decline in loans at the Region's banks during the quarter.

For regulatory accounting purposes prior to January 1, 1997, banks could record a transfer of assets other than residential mortgage loans as a sale only when the transferring institution (1) retained no risk of loss from the assets transferred and (2) had no obligation to pay principal or interest on the assets transferred. With the adoption of GAAP, however, assets sold with recourse prior to 1997 can now be recognized as sales if the amount of recourse can be reasonably estimated and the transferring institution establishes an appropriate reserve for the recourse liability in a separate liability account.

• Retroactive application of GAAP in regulatory reports.

In the San Francisco Region, over 40 institutions elected to amend their financial statements for prior years and adopt the GAAP accounting changes retroactively. These institutions reported the cumulative effect of the nonrecurring accounting adjustment, which totaled $1.1 billion, as a direct adjustment to equity capital, net of applicable income taxes. Although this adjustment is the net effect of several different accounting entries, a large portion relates to the write-up of goodwill discussed above.

Implications: Both financial institutions and industry analysts should benefit from the adoption of GAAP for regulatory financial statements. Financial institutions no longer will have to maintain a separate set of records for regulatory purposes, and analysts will find greater consistency between regulatory reports and the institution's general-purpose financial statements. However, these changes will create challenges for the analysts and regulators who use the 1997 regulatory financial statements and make comparisons to prior periods. Analysts and regulators will need to carefully scrutinize shifts in balance sheet structure and earnings levels to ascertain what effects, if any, are attributed to the 1997 regulatory reporting changes.

In addition, regulators will be analyzing interest-only strips and servicing rights on all types of financial assets, not just residential real estate mortgage loans. The capitalized value of the servicing rights on each of these financial assets is influenced by servicing costs, prepayment speeds, discount rates, and other factors. Assumptions about these factors have an important effect on the related values of these assets and are worthy of attention by regulators and bank analysts.

Merger Activity and Regulatory Changes Renew Debate over Accounting Methods

Unlike national trends, which show a definite preference for pooling, Chart 1 shows that historically the Region's merging banks have shown no clear preference for either of the two accounting methods. In 6 of the past 12 years, merging banks in the Region preferred the purchase method of accounting for mergers. Although 18 of the Region's 27 mergers in the first quarter of 1997 used pooling, the majority of the pooling mergers involved related companies. However, in 70 percent of the mergers involving unrelated entities, the purchase method was favored.

Chart 1

Merger Methods Offer Different Advantages

• Future earnings are not reduced by amortization of goodwill; therefore, reported income, return on assets, and return on equity can be higher.
• Valuation of acquired assets and liabilities, which can be a complicated process, is avoided.
• Assets with significant appreciation are booked at historical cost, so taxes are avoided.
• Regulatory capital ratios are not affected by the need to deduct goodwill.

In comparison, the purchase method accounts for a business combination as the acquisition of one company by another. Assets and liabilities are recorded on the acquiring institution's books at their fair market values. Any amount paid in excess of the net fair market value of the assets and liabilities acquired is recorded as goodwill and amortized against future earnings. The purchase method can be attractive for the following reasons:

• Purchase transactions are not limited to the exchange of stock; for example, a buyer could offer a combination of both cash and stock.
• The method allows more flexibility in disposing of assets for cost-cutting purposes.

Securities and Exchange Commission Closes Stock Buyback Loophole

With earnings reaching historical highs and the industry's focus on earnings per share, many banks involved in mergers have been returning excess capital to shareholders through stock buyback programs. Stock buyback programs also are quite popular when additional stock is issued as part of the merger transaction and the new stock dilutes earnings per share. Although merger candidates using the purchase method can use stock buyback programs, one of the 12 conditions for pooling of interests described in APB Opinion No. 16 prohibits the combined company from repurchasing any of the common stock exchanged in the transaction.

To overcome this restriction, a number of banks merging under the pooling method took advantage of ambiguous language in APB Opinion No. 16 and instituted stock buyback programs. However, in March 1996, the SEC closed this loophole by issuing Staff Accounting Bulletin No. 96. This bulletin clarifies that in most circumstances there can be no planned stock repurchases for a maximum of two years after a pooling of interests merger is consummated.

Purchase Method of Accounting May Gain Popularity

Additionally, some industry analysts believe the Financial Accounting Standards Board (FASB) and the SEC may further limit the use of the pooling method. One reason for this view is that international accounting practices generally allow pooling only when it is impossible to tell which company is the acquiring company, as in a merger of equals. In addition to promoting consistency with international practices, proponents of the purchase method argue that pooling does not reflect the economic substance of a transaction because the fair market value of assets and liabilities is not recognized. Alternatively, the FASB may maintain pooling but make purchase accounting less onerous by eliminating the amortization of goodwill.

Implications: Further restrictions on pooling would likely result in both a greater use of the purchase method of accounting for mergers and an increase in recorded goodwill. Consequently, assessing the potential effects of goodwill may become increasingly important when anilyzing a bank's earnings performance.

Catherine I. Phillips-Olsen, Senior Regional Analyst
Roger Stephens, Financial Analyst
DiAnn Bielaczyc, Examiner, Division of Supervision