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.

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 (C) will be adding $159 billion of assets, Bank of America (BAC) $150 billion, JP Morgan Chase (JPM) $130 billion and Wells Fargo (WFC) $109 billion.

Goldman Sachs (GS) and Morgan Stanley (MS) 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 act pre-emptively to raise it now.

The system will certainly be stronger if they do.

Comments

[questioner5000:]

You want the full impact of these changes implemented RIGHT NOW, of course, (while the banks are struggling with a difficult credit market and relatively low current share prices).

And you want the banks to raise the additional capital RIGHT NOW, of course, (with the banks forced to sell shares at low current prices, diluting present shareholders, rather than, say, in a year or so, allowing the banks to supplement capital with future earnings).

But you also want banks to increase their lending NOW, to help this economy get back on track as soon as possible, of course.

Yeah, and I want to date Charlize Theron, but THAT ain't happening either!

Sep 17 12:36 PM

[Gardener:]

It's time that SIV and off balance sheet sheltering be criminalized for the fraud it is. Investor tolerance of this behavior has been stunning. It seems to be a case of, "everyone else is doing it".

Sep 17 12:36 PM

[BerkeleyBob:]

The short response to questioner is that if an investor can not make a fully informed decision on a transparent balance sheet and financials, that investor is not as likely to buy. This applies in spades to GE, which is emphatically not a stock for "widows and orphans" and to AIG, which I characterize as a off shore, unregulated bookie that welches on its bets.

Sep 17 12:44 PM

[Huh??:]

I'd be interested in a real life example of the alleged abuse described here. Evil bank manufactures profits by recording a gain on sale on a transaction where it sells an asset at an inflated price to a new entity formed by the bank, thinly capitalized by the bank and, in fact, owned by the bank. Current accounting rules do not allow this.

Sep 17 01:08 PM

[LKofEnglish:]

Well there "Huh" why would a bank admit to? They'd be admitting to scam or "cooking other people's books." Good stuff Rolfe. Keep up the good work. Methinks your WFC warning is VERY preescient as well. Did you know that in Utah they still use the firing squad for executions? Don't hear of many bankers doing this stuff in Utah, do ya?

Sep 17 03:42 PM

[questioner5000:]

So, though investors in the biggest banks have certainly seen quite a bit of data on the size of their companies' off-balance sheet portfolios, (and, so, are certainly not making a totally "uninformed decisions" in investing), you would prefer that the Government completely refrain from any forbearance, (i.e., by allowing these off-balance sheet assets to be gradually brought onto the bank's financial statements over a year to 18 months), thus forcing those banks that will need to raise captal to do so at prices far below what they could achieve in, say, a year of "economic healing" in the U.S., simply to provide absolutely accurate, "crystal clear transparency", even if its at the cost of restraining bank lending even further than at present, and resulting in further increases in unemployment and business closures.

Interesting!


On Sep 17 12:44 PM BerkeleyBob wrote:

> The short response to questioner is that if an investor can not make
> a fully informed decision on a transparent balance sheet and financials,
> that investor is not as likely to buy. This applies in spades to
> GE, which is emphatically not a stock for "widows and orphans" and
> to AIG, which I characterize as a off shore, unregulated bookie that
> welches on its bets.

Sep 17 05:07 PM

[Between The...:]

Tiny slice of equity and a pile of debt is a recipe for disaster. The biggest mistake by the government is not letting bank bondholders suffer the consequences for management's actions. Add in the moral hazard of guarantees and underfunded FDIC insurance, and the incentives are clear to anyone that banks will lever up and juice returns as much as they can - there is no downside to management or creditors.

Sep 18 03:15 AM

[Free Market...:]

Like "Huh??" above, I would be interested in a real life example of these transactions.

But, even assuming your premise true on a scale that matters, so you want to make the banks hold more capital against these (now on the balance sheet) loans. Banks will respond with further tightening. Govt will wonder why banks aren't lending and they are already trying to stimulate like crazy care of their near 0% fed funds target. What will this accomplish in the end?

Sep 18 10:08 AM

[Econ 101:]

First of all the banks own the government and the poiticians. The outright thieft going on and encouraged by both patties is due to the huge campaign contributions by the banks and GSEs (FNE & FRE) to pols in control (Dodd, Franks & the fromer jr sen from Illinois).

Doing what you suggest would cost the top 5% of the population money so it willl NEVER happen.

Sep 18 11:35 AM

[HBWOW:]

What makes you think these new rules will stop the banks and broker/banks from continuing trades back and forth to achieve the
same results they have been playing before these rules? To correct the problem, the culprits that have created the meltdown/TARP should be removed from the banks/brokers and probably should be in jail for their unlawful actions. When the insiders took banking operations BEYOND regular banking activities, this is where the problems started and such irregular high risk activities (GAMBLING) need to be STOPPED.

Sep 18 11:57 AM

[Angry Banker:]

I too would like Mr. Winkler to provide us real world examples of banks inflating profits at quarter-end by selling assets at a gain to off-balance subsidiaries. Accounting rules would not recognize such a sale as a "true sale" and the bank would thus not be able to recognize the gain.

Separately, how should we interpret your diatribe in terms of investment advice? If SA is a site to share views on investments, this article is sorely lacking in direction.

Sep 19 09:19 AM

[Roger Knights:]

Good article, but there's a typo in the following: "works" should be "doesn't work":

"The trouble with this strategy is that it works in only one direction."

Sep 19 10:14 PM

[Hephasteus:]

Great article!
LOL Roger. Maybe sorta works for a while?

Sep 20 07:37 PM

[Hephasteus:]

On Sep 19 09:19 AM Angry Banker wrote:

> I too would like Mr. Winkler to provide us real world examples of
> banks inflating profits at quarter-end by selling assets at a gain
> to off-balance subsidiaries. Accounting rules would not recognize
> such a sale as a "true sale" and the bank would thus not be able
> to recognize the gain.
>
> Separately, how should we interpret your diatribe in terms of investment
> advice? If SA is a site to share views on investments, this article
> is sorely lacking in direction.

SA published the article so apparently it's not conforming to your expectations of what it is. I don't think specific examples of it are really quite necessary because it's part and parcel of the ENTIRE central banking system from the FED to last central bank no matter what country it is located. It became apparent that such things were really being adopted readily outside the banking industry when Enron occured, and public accounting organizations began getting investigated. Of course it's been spreading for quite some time all the way back to the S&L crisis. The FED and central banks have a great thing going with being able to declare assets without reguard to logic or morality. It's only reasonable that it would infest the entire corporate structure of the US.
en.wikipedia.org/wiki/...
Take your pick for examples.

Sep 20 08:00 PM

[Anthony Har...:]

Since we've been discussing here about Off-balance sheet items and variable interest entities (VIEs), I think it would be helpful if you go through this little excerpt on the Forensic analysis on JPM...

They've discussed quite a few things on the mess that JPM has gotten itself into. Here's the link:
boombustblog.com/Reggi...

Sep 21 02:40 AM