Should we blame the accountants?
Surprises multiplied as the subprime problem of 2007 grew into the credit disruption of 2008. It is one thing to have a bank report losses because some of the loans on its balance sheet went bad. That is part of the business of banking. It is something else, however, for a bank to report a multibillion-dollar loss from taking some risk that had never been mentioned in its financial statements.
Haven’t we seen this movie before, involving a company called Enron? Didn’t Congress pass a law requiring that the problem of off-balance-sheet mysteries be solved?
"After Enron, with Sarbanes-Oxley, we tried legislatively to make it clear that there has to be some transparency with regard to off-balance-sheet entities," Senator Jack Reed, Democrat of Rhode Island and chairman of the Senate securities subcommittee, said this week. "We thought that was already corrected and the rules were clear and we would not be discovering new things every day."
Senator Reed has sent letters to the Securities and Exchange Commission, as well as to the Financial Accounting Standards Board, which sets United States accounting rules, and the International Accounting Standards Board, which does the same for most of the rest of the world, asking detailed questions about what went wrong and how it should be fixed. Getting together answers to his questions could provide the S.E.C. with a road map to determine where the rules failed, as well as where companies failed to apply the rules properly.
One rule that needs scrutiny now — called 46-R — was passed after Enron. Essentially, it says companies can keep "variable special purpose entities" off their balance sheets if they conclude that the bulk of the rewards, and risks, lie with others.
But companies are supposed to evaluate those estimates regularly, and change the accounting if the conclusions change. A risk that seemed remote last year can seem all too real now, and that explains a lot of the surprising write-offs.
Suddenly, losses are booked. Investors learn that a company has taken a risk only after the risk has gone bad.
That should not happen. The rules require that companies make some disclosures about off-balance-sheet vehicles even if they do not put them on their financial statements. They should discuss factors like the nature of the risk they face and the maximum loss that is possible.
But those disclosures have often not been made, or have been made in such a general way as to be meaningless. The S.E.C., and perhaps the Congress, should ask some companies to explain their earlier lack of disclosures.
They will hear that companies thought the amounts involved were unimportant — "not material" in the jargon of accounting. They may find out that some managements did not understand all the risks that were being taken. And they may find that some companies failed to disclose risks that they should have disclosed.
The 2007 annual report of the State Street Corporation, a Boston bank, is a model of what disclosures should be, in laying out the risks of some special purpose entities it set up to hold assets. Those entities, known as conduits, borrowed money to pay for the assets, with State Street promising to come up with the cash if the conduits could not find other lenders.
In the report, State Street explains why it has not taken any write-off on those conduits, which contain $28.8 billion in what the bank believes to be high-quality assets.
It can avoid consolidation because other investors would suffer the first $32 million of losses — about one-tenth of 1 percent of the assets. After that, State Street would be on the hook. But State Street says its model indicates defaults on the underlying assets will not cost that much.
So long as the conduits stay off its balance sheet, State Street does not have to adjust them to reflect the market value of the assets in the conduits. But if State Street ever concludes that defaults are likely to be a little higher — say $100 million, only three-tenths of a percent of assets — it will have to put the assets on its balance sheet. And if it does that, it will have to write them down to market value.
At the end of last year, State Street estimates that market value was about $850 million below face value. Had it been forced to consolidate the conduits, that loss would have been posted, leaving a write-down of about $530 million after taxes. About 40 percent of the bank’s 2007 profits would have vanished.
As those assets eventually came due, State Street might have been able to recoup some or all of those losses if there were few defaults. But that could happen years later.
The basic strategy with these conduits was to borrow at lower short-term commercial paper rates and lend at higher long-term rates. That has long been one way banks make money, and sometimes lose it if credit markets move in the wrong direction.
This accounting rule let those risks vanish from the balance sheet because somebody else would suffer the first one-tenth of 1 percent of losses if any of the securities went bad. A rule that allows that to happen needs revision.
At least State Street investors now know about those risks, and have an explanation of why State Street thinks the market value of those assets is unreasonably low. Investors in many other banks, including some that have taken big write-offs, know much less about the risks those banks face.
There are many other issues in bank accounting, some stemming from the nature of market value estimates. JPMorgan Chase pointed out this week that it has taken reserves of 4.9 percent against the value of the leveraged loans on its books — twice that of some of its competitors. Maybe that means JPMorgan’s loans are not as good, but maybe it means that other banks are simply using more optimistic estimates. In a market where there are observable market values, the S.E.C. might want to ask how such disparities come to exist.
There are no perfect accounting rules, and forcing banks to consolidate everything might be unreasonable. But banks should have done more to let investors know the nature of the risks that were being taken. If the accountants had forced better disclosures, it is at least possible that managements would have spent more time evaluating the risks they were taking, and then made wiser business decisions.