Commentaries

from Rolfe Winkler:

Ending the off-balance sheet charade

Investors have more than one reason to celebrate two new accounting rules. Besides forcing banks to fess up to the risks they are carrying on their books, new standards for off-balance sheet assets will make it harder for companies to inflate earnings artificially.

The new rules - FAS 166 and 167 - are desperately needed to prevent banks from hiding assets to increase leverage. Lending that isn't supported by capital is a main ingredient behind unsustainable credit bubbles, and banks' off-balance sheet games played a big role in the most recent one.

But another reason banks like off-balance sheet structures is that it enables them to manufacture profits.

Coming up to the end of a quarter, if a company is a bit short of its earnings target, it can package some assets together into a security and "sell" them to an off-balance sheet entity.

The entity is conjured out of thin air with a small equity investment by the company itself. The entity "buys" the securitized assets at a nice markup, enabling the company to book a profit on the sale.

Is it really a sale if the company still owns the risk? Of course not. If I sell an asset to you, a share of stock for instance, then I transfer all the rights of ownership. Any gains or losses in the stock are yours alone.

With many off-balance sheet entities, however, companies aren't really transferring risk to anyone else. They're just pretending to do so in order to lever up and recognize a gain.

from Rolfe Winkler:

Banks still need bigger cushions (Q2 TCE update)

It was a surreal moment two weeks ago when analysts on Goldman Sachs’ earnings conference call pressed CFO David Viniar to jack up leverage. They seem to think that the worst of the credit crisis is behind us, so Goldman should goose its risk profile to increase returns. This is remarkably short-sighted.

Yes, leverage is down, but only relative to the obscene levels reached a year ago.  Measured by tangible common equity, the biggest banks are still levered over 20 to 1. If banks learn nothing else from the financial crisis, it’s that they should err on the side of prudence, carrying substantially more capital than appears necessary.

(Click table to enlarge in new window)

Tangible common equity remains the crucial measure of bank capital because it’s the primary cushion to absorb losses. When that cushion gets low, creditors panic. Bank runs ensue and the financial system ceases to function.

A nickel of equity for every dollar of assets is a pathetically small capital cushion.  And today, banks substitute federal guarantees for liquid capital.  Policymakers are afraid to remove the guarantees because they don’t want to precipitate another collapse. The financial system can’t stand on its own until its capital cushion is rebuilt.