Ending the off-balance sheet charade

September 17, 2009

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.

It’s the acknowledgment of risks that is most important. Pushing assets off balance sheet — into the “shadow banking system” — put them beyond the reach of regulators, whose job it is to make sure banks have enough capital to absorb losses.

For their part, banks like to fly as close to the sun as possible, operating with as thin a capital cushion as regulators will allow. This is the essence of leverage. The more assets a firm controls relative to the equity on its balance sheet, the higher its potential returns on equity.

If you put down 20 percent to buy a house, and the house’s value appreciates 10 percent, then the return on your equity is a tidy 50 percent. But if you put down 5 percent, that same 10 percent increase in price is a 200 percent return.

The trouble with this strategy is that it works in only one direction. If asset prices fall, banks with smaller equity cushions go horizontal rather quickly.

At the height of the bubble, big banks were operating with equity cushions in the range of 2 to 3 percent. And that was before accounting for off-balance sheet assets.

Since then, banks have raised more capital, putting them in the range of 4 to 5 percent, but bringing assets back on balance sheet will have a meaningful impact. Citigroup will be adding $159 billion of assets, Bank of America $150 billion, JP Morgan Chase $130 billion and Wells Fargo $109 billion.

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Goldman Sachs and Morgan Stanley haven’t yet disclosed how much they will be bringing back on, according to their most recent quarterly filings with the SEC.

Unfortunately, and contrary to recent comments about the importance of raising capital from President Barack Obama and Treasury Secretary Timothy Geithner, regulators are considering giving banks a year to phase in these assets for regulatory capital purposes.

This seems foolish. With equity markets nice and bubbly again, it’s not very difficult for banks to sell stock. If regulators make clear that additional capital will be required soon, banks may actpre-emptively to raise it now.

The system will certainly be stronger if they do.

Comments

The banks should not be given time to ammend anything. After receiving bailout money they proceeded to buy smaller banks and small credit card companies and raise interest rates for no reason except GREED. This has not helped the everyday people by stimulating the economy, which was the purpose of the bailout as I recall. They used the time they Knew they had before rules on credit changed. The rules put puny limits on their ability to raise rates at their whim.

Posted by Arlene Duncan | Report as abusive
 

Please explain to me why ANYTHING legitimate should be off balance sheet.

Posted by eyekew | Report as abusive
 

Fed Flow of Funds report has shown Total Debt decrease for the first time since the 30′s I believe even with Govt spending.Also the biggest private sector contraction ever according to my reading of the data. Quite horrible, horrible figures. The economy is imploding and it appears we will reach a tipping point soon that will cascade us downwards.

Posted by VK | Report as abusive
 

This seems foolish. With equity markets nice and bubbly again, it’s not very difficult for banks to sell stock. If regulators make clear that additional capital will be required soon, banks may act pre-emptively to raise it now.Haha, well, Rolfe, if they sell stock, then the existing stockholders get devalued and then how do the CEOs and CFOs collect fat bonuses if the stockholders take a hit? Banks don’t want to raise capital because it exposes just how bad their businesses are being run, and then the old boy network of board members and executive officers might be fired… that might be good for the company but it has long since stopped being about what’s good for the company… its now about what’s good for the people in charge… and what’s good for them right now is to keep this green-shoots charade going as long as possible, preferably with tax dollars.

Posted by Ed | Report as abusive
 

Though it may be a year off, this is the best news I’ve read in quite a while and gives me a reason to look forward to the future!However, there’s many a lobbyist ‘twixt proposals and implementation. But, what the heck, I’m going to try being an optimist as it has been a trying two years.

Posted by CB | Report as abusive
 

Now! This is ridiculous, the banks have had two years now. With TARP it’s been what 9 months? They don’t need another year, especially “TARP for life” BofA. Come clean now before the economy falls further.

Posted by Jas | Report as abusive
 

Didn’t a bunch of guys at Enron go to prison for this type of thing? Where is the Justice Dept? Where is the outrage?

Posted by Rick | Report as abusive
 

Housing boosters have forecast turnarounds repeatedly since the market peaked in 2006, only to be proven wrong by plunging prices. And skeptics say they’re wrong again now.They argue that a deeply indebted consumer, a weak job market, expiring incentives and rising foreclosures spell a quick end to any housing rebound.http://www.housingnewslive.com/u s-housing-news-articles.php

Posted by daveinfo | Report as abusive
 

I am with “eyekew”I hate to confess such ignorance, but what is the rationale or philosophy for “off balance” sheet accounting?does anyone have a link to a site or article that defends “off balance” sheet accounting? Seriously – I would be interested in the pros and cons of this idea.

Posted by fresno dan | Report as abusive
 

I am so glad somebody understands this, because I don’t.

Posted by Casper | Report as abusive
 

“but bringing assets back on balance sheet will have a meaningful impact.”It will only have its _proper_ impact if they bring those assets back to the balance sheet at their real values instead of the government approved imaginary values now used to hide the fact that most of them are technically insolvent.

Posted by Winston | Report as abusive
 

Jeffrey Skilling and Andy Fastow must be livid right now. These two are in jail for the exact same accounting shenanigans that are being allowed by the current administration. Ken Lay is spinning in his grave. Is it too late to hire Arthur Andersen as auditors of all this? I only fear that this will all end (again) someday in spectacular failure, with the little people being out their 401(k)’s.

Posted by brewcrew | Report as abusive
 

it said banks or gloden–s were in so..lvency, suddenly, all banks started making money, is there anything wrong, I am really happy someone else knows more than I do..

Posted by jerry | Report as abusive
 

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