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MAKING CENTS OUT OF THE NEWS
Blog #14
(April 15th, 2010)
SLEIGHT-OF-HAND ACCOUNTING HURTS EVERYONE
By Tom McAllister, CFP®
Fast-and-loose accounting has been a way of life on Wall Street. Sleight of hand techniques have included off-balance sheet entities called special purpose vehicles, short-term repurchase agreements, securities that banks label "available for sale", and “intent-based accounting."
All of these are ways financial firms can massage the numbers to make themselves appear more profitable, stable and solvent than they really are.
The problem of dubious numbers, unfortunately, didn't die along with Lehman Brothers. Ernst & Young LLP, auditors of banks such as State Street Corp., UBS AG, and Comerica Inc., failed to raise the a red flag on these schemes, despite apparently being aware of the misleading practices.
Ernst & Young was not alone in failing to be whistle-blowers. Federal Reserve examiners failed to catch the maneuvers as well. Making matters worse, the financial rules themselves, always easy enough to get around, were further diluted and defanged when, in 2004, the Securities and Exchange Commission rolled back capital requirements for financial institutions, effectively allowing broker-dealers to set standards of their own.
Rules governing commercial banks weren't much better. The ratings of conflicted agencies such as Standard & Poor's and Moody's Investors Service were used to mark up questionable mortgage securities.
The bottom line of all this laxness consists of quarterly corporate reports and federal filings that have more holes than a golf course. The lesson to be learned is that disclosure might have prevented Lehman's failure. (Imagine if investors knew of Lehman’s off-the balance-sheet games when those were first employed at the end of 2006. (Does anyone think Lehman could have faked its way another twenty months?)
What about capital requirements? Lehman's leverage ratio had reached 30.7-to-1, three times the loan-to-value ratio that most big banks carry today. Had investors been able to actually see which assets Lehman held and independently examine the quality of those assets, could Lehman have reached such over-leveraged status? Would the firm have been able to borrow billions every night to meet its obligations?
In hindsight, it’s only too simple to understand: Disclosure and transparency might have served as tools to prevent the financial crisis. The question is - will there be enough rulemaking in the proposed financial reform bill to ensure adequate disclosure in the future?
The answer is mixed. Sen. Chris Dodd's ( D-Conn) bill includes new rules for rating agencies:
Agencies will be forced to disclose what methods and which data they employ
in determining their ratings.
Precise terms underlying derivative contracts will need to be made public.
But, looking at the Dodd bill, I do not see much by way of accounting rules. Banks continue to operate under pre-crisis rules. If anything, those rules have been softened, as exemplified by last year’s changes in mark-to-market accounting. It was those ruled that allowed banks to "write-up" the values of assets, even if those assets had few, if any, buyers. Critics have pointed out that off-balance-sheet entities are hardly mentioned in the Dodd bill.
Legal and accounting arbitrage hasn’t been, and isn’t now solely a Lehman issue. It's a problem across the financial industry. Are the liabilities of Fannie Mae and Freddie Mac and other government agency debt shown as part of the total debt of the United States. The answer, astonishingly is “No”.
Should it be? Of course! Let the buyer beware! Too many of us have been hurt too severely by sleight-of-hand accounting. Steps must be taken – and now – to be sure we’re not hurt that way again.
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