Goldman Sachs (NYSE:GS), AIG, Magnetar and the credit rating agencies seem to be the favorite whipping boys of our financial crisis. Today’s opinion piece expresses the author’s concern that if we’re focusing solely on imprinting our views on the mindsets of fee-driven, revenue-lusting capitalist parties, we may be missing part of the bigger picture.
As “for-profit” publicly-traded corporations, institutions like Goldman and Moody’s (NYSE:MCO), are in the business of making money. (Indeed, former Moody’s employees have testified to the damaging cultural changes that coincided with its spin-off into a public company.) Shareholders demand revenues and profits. Companies like Moody’s and Goldman went about getting them, albeit sometimes in a manner that may be morally questionable to the extent that it threatens the public good.
While difficult to sympathize with their behavior, it remains pertinent to remember that they’re playing a complex game in which the stakes are high and the competition fierce. They’re long risk in a country known for its forgiving nature – Scholes and Meriweather seem forever able to attract new capital – and its willingness to seek returns from active risk-taking (hence our comparatively well-developed venture capital market which has contributed to the creation of U.S.-based behemoths such as Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT), Bloomberg and Intel (NASDAQ:INTC)).
Now, whether or not the SEC wins the ABACUS case may rest on whether Goldman made material misrepresentations or omissions to its clients – but it’s not about whether or not Goldman put the taxpayer at risk. If we can be honest to ourselves, we might appreciate that if Goldman is trying to sell us a bond, it’s probably not the best bond Goldman has ever seen. Otherwise they wouldn’t sell it. We may criticize Goldman’s willingness to risk their reputation for a few dollars more, but Goldman is a bank and it strives to make money. Don’t misunderstand me – I’m neither advertising nor defending their behavior. All I’m saying is that they’re playing their game according to the rules we’ve created. The Financial Accounting Standards Board (FASB) made those rules. And they turned a blind eye to a multi-billion dollar problem.
Currently, FASB is the highest authority in establishing generally accepted accounting principles (GAAP) for public and private companies, as well as for non-profit entities. To me, FASB is an example of an institution charged solely with the task of enhancing and maintaining market transparency and accountability. As an accounting standards board – rather than a publicly traded for-profit corporation – FASB has none of the overwhelming incentives of public opinion, market share or shareholder pressure to bias them. Its egregious failings however, like the opaque trades its standards empowered, seem somehow to have conveniently escaped the scourge of public scrutiny.
Basel, the NAIC and other similar accords and bodies set regulatory capital requirements that are intended to help mitigate the possibility of companies failing. Banks, for example, will put a portion of capital against each asset they hold, on a risk-weighted basis as typically determined (rather unfortunately) solely on credit ratings. One might suspect, therefore, that the only scenario in which a company like Lehman (OTC:LEHMQ) or Bear could go under (or a Citi (NYSE:C), UBS or RBS would need to indulge its government’s life support system) is if it had failed to reserve levels of capital necessary to offset its balance sheet losses. This eventuality could occur due to ratings inaccuracy or ratings inflation (.pdf). Indeed the ratings were wrong, but the banks’ loss provision shortfalls proved to be many multiples of the capital reserves they had set aside. That’s because the problem wasn’t that the banks were short on their balance sheet reserves, but that they had placed limited if any reserves against their material off-balance-sheet positions.
FASB permitted off-balance-sheet exposures to overwhelm the balance sheets themselves. Worse yet, these off-balance-sheets were authorized to remain invisible to outside parties. Thus, the market freeze was both caused and accentuated by the realization that nobody knew who owned what. Lending consequently dried up when market participants became increasingly skeptical of potentially unexplored counterparty risks.
But before the market collapsed, it was the porous FASB rules that encouraged the perpetuation of a trade that led to the collapse. The negative basis trade: a mechanism by which structuring banks were able to accumulate massive fictitious profits by entering simple carry trades that likely sent at least $300bn into off-balance-sheet oblivion. (By design, we can at best guess at this $300bn estimate: these trades reside in a fantastic mirage far away from the world of transparent disclosure and shareholder verification; if we were able to accurately gauge this number, this opinion piece might be redundant.)
Mechanics and Feasibility of the Negative Basis Trade
The interest lay in the complexities of arbitraging accounting rules. While both banks and insurance companies were technically subject to the GAAP accounting framework, banks typically had to report “mark-to-market” losses on their investments each quarter, even if they were unrealized, but insurers were able to invoke a separate regime that required they take only realized losses, or declare losses only to the extent that the insured securities were deemed to be permanently impaired (in which case they anticipated having to make-whole on their policy written on said impaired securities).
Thus, part of the appeal for the buyer (bank) and seller (monoline insurance company) of an insurance contract of a CDO was derived from the regulatory difference between their two accounting constructs. Another appealing part was the off-balance-sheet treatment enabled by imprudent FASB standards, which importantly led to instant paper profits and incremental trader bonuses.
Even monoline insurer ACA Financial Guaranty’s former chief confessed that “bond insurance was an accounting strategy.” By way of licensing the negative basis trade, FASB authorized risk-lusting parties to stretch generally accepted accounting principles beyond their generally accepted limits – enabling many poorly-incentivized parties to take advantage of the risk-averse U.S. government and ultimately the taxpayer.
UBS notes (.pdf) that
the key to the growth of the CDO structuring business was the development of the credit default swap (‘CDS’) on ABS in June 2005 (when ISDA published its CDS on ABS credit definitions). This permitted simple referencing of ABS through a CDS. Prior to this, cash ABS had to be sourced for inclusion in the CDO Warehouse.
The impressive Partnoy and Turner (2010) (.pdf) describe FASB’s susceptibility to the very bank lobbying that resulted in our taxpayer losses:
… banks foresaw that the burgeoning business of swaps would inflate the size of their balance sheets if they were reported as assets and liabilities. Banks wanted to profit from trading swaps, but they did not want to include swaps in their financial statements. Instead, they argued to the FASB that swaps should be treated as off-balance sheet transactions. In 1985, the banks formed a lobbying organization called the International Swap Dealers Association. That group, now widely known as ISDA, pressed the FASB to exempt swaps from the standard approach to assets and liabilities. The banks argued that swaps were different, because the payments were based on a reference amount that the swap counterparties did not actually exchange. ISDA was a forceful advocate, and the banks persuaded the FASB to abandon its argument.
Thanks to the negligible funding levels required, and the dual benefits of flexibility and leverage that could be achieved by way of the taking assets off-balance-sheet, it became a popular practice for banks to retain the super senior tranche of their CDOs and buy CDS protection from a third party – often a monoline. With the bond paying a higher coupon than the cost of insurance – in other words, the basis was negative – the bank was allowed to report upfront (as a gain on sale) the estimated net present value that would be realized from this negative basis trade over its life: often 10 to 15 years. This prompted the creation of several unnecessary securitization vehicles and the realization of substantial amounts of fake profits.
According to UBS’s shareholder report (.pdf),
[UBS’s] CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate … Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created. … Once hedged, ... the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits).
Magnitude of the Trade
While we do not know the full extent of the negative basis trade, we know that it provided a great source of losses: write-downs on UBS’s hedged super senior positions alone accounted for 5% of all UBS’s losses as of year-end 2007.
The fact that the negative basis trade proved so simple and effective a mechanism for churning short-term profits appealed to UBS’s insatiable appetite for revenue generation: in addition to the approximately $8bn of negative basis trades it entered on UBS-issued super senior CDOs, it placed an additional $15bn of this trade by way of super senior CDO tranches it purchased from third parties (.pdf).
We also know that Merrill at a time held super senior ABS CDO exposure well north of their $15bn exposures to monolines ACA, XL Capital, and MBIA (NYSE:MBI) ($6.7bn, $5bn and $3.1bn respectively), with Merrill having paired up with “a key partner in insurer American International Group Inc. (NYSE:AIG)”
Of Citi’s $10.5bn year-end 2007 exposure (.pdf) to hedged ABS CDO super seniors (reportedly (.pdf) disclosed for the first time in February 2008), $7.6bn was hedged by way of the monolines, primarily with Ambac (ABK) ($5.5bn) but also with ACA ($600mm); significantly undercapitalized, single A-rated ACA had, according to the rating agencies, a higher nominal default probability than the assets it was insuring. When it collapsed in late 2007, it was insuring more than $60bn of debt securities – a third of which were mortgage-related – yet had only about $400mm of capital and few other resources to support possible claims. Ultimately, ACA’s inability to cover its policies led its clients (including Merrill, UBS, CIBC and Australia & New Zealand Banking Group) to suffer large losses on the contracts it had written, many of which were written off. (For a list of related monoline insurers and their rating changes, click here (.pdf).)
Like Citi, HSBC USA Inc. (HBC) and its subsidiaries (collectively, HUSI) began reporting in early 2008 details of their monoline exposures. A small player in ABS CDOs, HSBC's off-balance-sheet exposures are comparatively modest. Their relatively vague quarterly reports (.pdf) (they don’t separate negative basis trades on single-name credits and municipal bonds from those on structured finance CDO securities) remain nevertheless mildly illuminating as they disclose the levels of collateral reserves being set aside:
HUSI maintains a separate reserve for credit risk associated with certain off-balance sheet exposures including letters of credit, unused commitments to extend credit and financial guarantees. This reserve, included in other liabilities, was $152 million, $105 million and $93 million at September 30, 2008, December 31, 2007 and September 30, 2007, respectively.
HUSI entered into basis trades to monetize the basis difference between a bond and a credit default swap (CDS) ... The sponsoring monoline provides financial protection to HUSI if there is a credit event ... The monolines typically do not post collateral. As of June 30, 2008, HUSI had approximately $1,942 million of exposure for CDS under the negative basis arrangements with monolines.
Gorton (2008) (.pdf) estimates that, based on his sources, roughly 26% of all AAA CDO Tranches were ultimately held by the monolines (i.e., via the negative basis trade). If we conservatively assume that (1) negative basis trades were only struck on CDOs structured between 2005-2007, and (2) only 26% of these CDOs were being wrapped by the monolines, my best guess minimum estimates allow for between $297.16 and $344.89 billion of CDO trades going through solely as a result of the imprudent FASB standard which qualified the CDOs to off-balance-sheet treatment. (My estimates rely on data from SIFMA, Asset-Backed Alert and Moody’s Corp., the last of which provides data only on CDOs it rates.)
Consequences of the Trade
While these negative basis trades remained off-balance-sheet for the banks, when PriceWaterhouseCoopers, AIG’s auditor, warmed to the risks of this trade from the perspective of the monoline itself, it reportedly (.pdf) forced AIG to write down its position by $5bn in early 2008, reversing what AIG had hoped to account for as a $3.6bn gain.
The over-production of the trade meant that when credit ratings agencies such as Moody’s, S&P and Fitch rated monoline insurers like ACA, AIG, Ambac and MBIA, they were essentially rating a single-tranche CDO-squared: with the underlying comprising primarily (originally) triple A rated ABS CDO tranches. If those tranches were incorrectly rated and were to go belly-up – as they inevitably did -- so too would the monolines that insured them. The net effect was a superfluous, worthless guarantee for those clients being insured. If and when your (correlated) tranches suffered writedowns, so too did the under-capitalized monolines who sold you protection, and so they went under in tandem with your tranche.
Bob Selvaggio explains that
the large institutions that purchased ABSCDO credit insurance from the financial guarantors could have, should have, and perhaps did understand that the true economic value of these policies at their inception was much closer to zero than to the premiums they paid for them.
He argues further that insurance premiums on these tranches became so cheap – by 2005 and 2006 UBS was paying an average of only 11bps annually (or 0.11%) versus premiums that Citigroup earned in the 19 to 20bp region on issues it guaranteed in 2003 and 2004) – was because the monolines’ insurance protection was “already worthless.”
The failure by monoline insurers to cover their insurance contracts meant that these poor quality assets had to find their way back onto bank balance sheets. Absent reserves sufficient to support the inopportune homecoming of these previously off-balance sheet securities, the banks needed our help to support the balance sheet return of these exposures from their fool’s paradise.
Partnoy and Turner (2010) cogently present the balance sheet illusion (.pdf) created by the off-balance sheet securities:
Anyone looking only at Citigroup’s balance sheet would assume that the bank had experienced a period of relative calm during the financial crisis. Of course, Citigroup’s income and cash flow statements revealed a different story, as the bank recorded massive losses from off-balance sheet transactions. Ultimately, the federal government had to execute its own off-balance sheet deal, effectively guaranteeing a portfolio of $306 billion against losses. Citigroup’s losses on off-balance sheet transactions swallowed up the rest of its balance sheet.
FASB’s lack of responsiveness to the increasing off-balance-sheet exposures resulted in the unhealthy environment in which an investor in large banks’ debt or equity would have to assume substantial accounting risk. With off-balance-sheets overpowering balance sheets and with marked disclosure inadequacy, inaccuracy, and incompleteness (the “Disclosure III”), Partnoy and Turner (2010) concur that investor due diligence became purely academic: “when the value of bank stocks depends, not on transparent information the banks have disclosed, but rather on guesses about what the banks have not disclosed, the basic principles of free markets are no longer working, and major reform is necessary.”
Caveat emptor translated into a general unwillingness to buy; and the only remaining buyers and sellers were range-traders, speculators or insider traders. The government became the final port of call: who else would buy into an undecipherable portfolio?
In sum, FASB allowed the quality of financial disclosures to be undermined. Their poor standards – which entitled both (1) the recognition of gains upon the securitization of pools of assets (“sale accounting”) and (2) the movement off-balance-sheet of several billions of dollars of assets – prompted the mass production of a highly risky trade which created fictitious short-term paper profits at the expense of long-term sustainability. Their failures have jeopardized our ultimate faith in, and the robustness of, our financial economy as a whole.
In essence, FASB empowered the greatest hoax of the century – and authorized it to be perfectly legal.
Disclosure: No positions