Financial Instruments and Institutions

This book is an authoritative guide to the accounting and disclosure rules for financial institutions and instruments. It provides guidance from a “fair value” perspective and demonstrates the simplest and most natural measurement basis for reporting financial instruments, as is relevant for thrifts, mortgage banks, commercial banks, and property-casualty and life insurers.

Preface ix

Acknowledgments xvii

Chapter 1 Financial Instruments and Institutions 1

Main Ingredients of the Analysis of Financial Instruments 4

Activities and Risks of Financial Institutions 11

Valuation of Financial Institutions in Practice 16

Chapter 2 Nature and Regulation of Depository Institutions 19

Activities of Depository Institutions 19

Bank Regulation 22

Bank Subtypes 35

Recent Trends 38

Chapter 3 Thrifts 45

Financial Statement Structure 46

Main Risk-Return Trade-Offs and Financial Analysis Issues 56

Chapter 4 Interest Rate Risk and Net Interest Earnings 63

Views of Interest Rate Risk 64

Interest Rate Risk Concepts 66

Analysis of Net Interest Earnings 78

Rate-Volume Analysis 81

Repricing Gap Disclosures 84

Chapter 5 Credit Risk and Losses 93

Economics of Credit Risk 95

Accounts for Loans and Loan Losses 97

Accounting and Disclosure Rules for Unimpaired Loans 100

Accounting and Disclosure Rules for Impaired Loans 107

Loan Portfolio Quality and Loan Loss Reserve Adequacy 110

Research on Banks’ Loan Loss Reserves 118

Appendix 5A: SunTrust Banks—After the Restatement 119

Chapter 6 Fair Value Accounting for Financial Instruments: Concepts, Disclosures, and Investment Securities 131

Fair Value Accounting for Financial Instruments 133

Disclosures of the Fair Value of Financial Instruments 141

Investment Securities 149

Appendix 6A: Washington Federal’s Big Gap 158

Chapter 7 Mortgage Banks 161

Mortgage Banking Industry, Major Players, and Activities 162

Financial Statement Structure 167

Main Risk-Return Trade-Offs and Financial Analysis Issues 174

Accounting for Fees and Costs 186

Chapter 8 Securitizations 189

Why and What? 192

Securitization Structures 196

SFAS No. 140 204

Financial Analysis Issues 216

Empirical Research on Securitizations 221

Servicing Rights and Prepayment-Sensitive Securities 222

Appendix 8A: Doral Financial’s Interesting Interest-Only Strips 224

Chapter 9 Elements of Structured Finance Transactions 235

Special-Purpose/Variable-Interest Entities 236

Related Transactions 244

Hybrid Financial Instruments 248

Financial Guarantees 251

Recent SEC Decisions Regarding Structured Finance Transactions 253

Chapter 10 Commercial Banks 255

Balance Sheet 257

Income Statement 261

Cash Flow Statement 265

Chapter 11 Derivatives and Hedging 269

Derivatives 272

Hedging 282

SFAS No. 133 (1998), as Amended 285

Framework for Assessing Financial Institutions’ Derivatives and Hedging 308

Chapter 12 Market Risk Disclosures 311

Overview of FRR No. 48 (1997) 312

Tabular Format 315

Sensitivity Approach 322

Value-at-Risk Approach 326

Comparison of Disclosure Approaches 331

Effect of SunTrust’s Derivatives and Hedging on Its Market Risk 332

Research 337

Appendix 12A: Bank of America’s Derivatives, Hedging, and Market Risk 337

Chapter 13 Lessors and Lease Accounting 347

Competitive Advantages of Leasing 350

Lease Structures and Contractual Terms 352

Lessors’ Risks 355

Lease Accounting Methods 357

Analysis Issues Regarding Lease Accounting Methods 366

Special Lease Transactions 369

Lessors’ Financial Statements 374

Lease Disclosures 379

Possible Future Changes in Lease Accounting 387

Chapter 14 Insurers and Insurance Accounting 389

Products 391

Risk-Return Trade-Offs 396

Regulation 403

Primary Insurance Accounting Standards 405

Accounting Standards Governing Embedded Derivatives and Other Life Insurance Policy Features 421

Financial Statements 423

Line of Business Disclosures 428

Other Insurance Accounting Systems 429

Chapter 15 Property-Casualty Insurers’ Loss Reserve Disclosures 435

Loss Reserve Footnote 438

Loss Reserve Development Disclosures 440

Calculating Loss Reserves by Accident Year 444

Calculating Loss Reserve Revisions by Accident Year 446

Calculating Claim Payments by Accident Year and Tail 448

Constructing Accident Year Loss Reserve T Accounts 452

Property-Casualty Expense Ratios 453

Chapter 16 Reinsurance Accounting and Disclosure 457

Accounting and Analysis Issues 459

Reinsurance Contracts 462

Accounting for Reinsurance Contracts 472

Reinsurance Disclosures and Analysis 487

Evolution of Financial Reporting for Reinsurance 493

Index 497

Stephen G. Ryan is an Associate Professor of Accounting and Robert Stovall Faculty Fellow at the SternSchool of Business, New York University. Prior to that position, he was an assistant professor of accounting at the Yale School of Organization and Management and has been an associate consultant with Bain & Company. He has written numerous articles that have appeared in such publications as Accounting Horizons, Financial Analysts Journal, the Accounting Review, and the Journal of Financial Statement Analysis. He is an Editor of the Review of Accounting Studies. In addition, he is on the FASB's Financial Institutions Advisory Group and its Liabilities and Equity Resource Group.

Financial Instruments & Institutions

Accounting and Disclosure Rules

Second Edition

Financial reporting for financial instruments and institutions is undergoing a period of unprecedented change and relevance for financial analysis. In the past decade, the Financial Accounting Standards Board (FASB) has issued major standards on derivatives and hedging, transfers of financial instruments including securitizations, servicing of financial assets, consolidation of special purpose/variable interest entities, hybrid financial instruments, financial guarantees, and fair value measurements.

Now in a Second Edition updated to reflect the many significant changes in financial reporting rules, regulations, and economic conditions that have occurred since the publication of the first edition, Stephen Ryan's Financial Instruments and Institutions: Accounting and Disclosure Rules provides users and preparers of financial reports with the tools necessary to construct as coherent a story as possible about how firms generate or destroy value using financial instruments.

This book equips professionals to fully exploit the various sources of information about the fair value and risks of financial instruments and explains how "fair value" provides the most natural measurement basis for reporting financial instruments. It contends that users of financial reports do not need to know all of the myriad details involved in each financial reporting rule, but rather only the critical features that make or break the representational faithfulness of the reports.

Precise, clear, and helpful, Financial Instruments and Institutions, Second Edition examines six types of financial institutions in detail:

• Thrifts

• Mortgage banks

• Commercial banks

• Lessors

• Property-casualty insurers

• Life insurers

These institutions were chosen because each reflects specific financial transactions in a clear fashion and/or because each has distinctive accounting or disclosure requirements. Financial Instruments and Institutions describes the activities and risks of each in an economically grounded yet intuitive fashion, using numerous cases from actual financial institutions' financial reports to illustrate when fair value accounting for financial instruments works well and when it is fragile.

Praise for Financial Instruments & Institutions Accounting and Disclosure Rules, Second Edition

"Financial Instruments and Institutions is a superbly informative integrated treatment of institutional, analytical, and financial reporting issues for financial institutions. I strongly recommend the book for analysts, investors, regulators, educators, and anyone with an interest in a coherent, intellectually rigorous discussion of issues encountered in reporting on and analyzing financial institutions and their commercial arrangements, including fair value measurements, risk reporting, and structured finance."
—Katherine Schipper, Thomas F. Keller Professor of Business Administration, Duke University

"When you combine the unique risk attributes of financial institutions with the complex transactions they enter into, it can make even the most seasoned investor shudder. Dr. Ryan provides a well-structured and logical approach to the analysis of these companies, layering on explanations of the transactions they enter into and how they impact your analysis. Seasoned investors will find the book an important reference tool, especially on securitizations and derivatives and the new chapter on reinsurance."
—Janet L. Pegg, CPA, Accounting & Taxation Research, Bear, Stearns & Co. Inc.

"Stephen Ryan's book is indispensable for anyone involved with financial institutions, whether it be bankers, insurers, investment advisors, or the student. There is no better book for understanding how these institutions work and how one handles their financial statements to gain that understanding. The detailed coverage of financial instruments—and the accounting for financial instruments—is outstanding."
—Stephen Penman, George O. May Professor and Morgan Stanley Research Scholar, Columbia Business School

Praise for the First Edition

"To any professional engaged in hands-on analysis of financial institutions' financial statements, this exhaustive text is an indispensable resource."
—Martin S. Fridson, CFA, Financial Analysts Journal