1). 3). Differences in Purpose, Price Structure, and Collateral Requirements Make Direct Comparisons between Prices of Loan Commitments and Loans Difficult

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). 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. Commercial bankers also told us that they considered the maturity of a  loan commitment or loan in establishing the price of these instruments. Loan Commitments Are Rarely Traded, and Available Data from Secondary Market Does Not Support Claims of Systematic Underpricing

We were told that loan commitments rarely trade in the secondary market,  primarily for two reasons. 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

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. 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. Commercial and Investment Banks Follow Different Accounting Models, but There Is No Evidence That Either Model Provides a Consistent Competitive Advantage

Under current accounting standards, designed to reflect their different  business models, commercial and investment banks account for loan  commitments differently. 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. No Evidence That Accounting for Loan Commitments Gives Commercial Banks a Consistent Competitive Advantage over Investment Banks

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. An FASB staff member wrote a paper that summarized the strengths and  weaknesses of fair value accounting. 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. Until these issues are resolved, commercial and investment banks  will continue to follow different accounting models for similar financial  instruments such as loan commitments. 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.
Why GAO Did This Study

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.

What GAO Found

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.