Debt and Accounting Gimmicks

Isn’t it interesting that highly leveraged institutions and organizations seem to bring out very innovative accounting strategies?

It is in times like these that were learn just how creative accountants can be. 

“Weekend elections that threaten to drive Spain’s ruling Socialist party from power in several regions and cities also promise a potentially nasty surprise: the revelation of piles of undisclosed debt in local governments that could undercut the country’s drive to avoid an international bailout.” (See “Spain Vote Threatens to Uncover Debt,” http://professional.wsj.com/article/SB10001424052748704281504576331280001740702.html?mod=ITP_pageone_2&mg=reno-wsj.)

“Five months ago, a government change in Spain’s Catalonia region revealed a budget deficit more than twice as big as previously reported.  Now a growing chorus of economists, local politicians and business leaders say that new governments are likely to discover, as Catalonia did, piles of ‘hidden debt’ owed to health clinics and other suppliers.”  It is suggested that “there is widespread, unrecorded debt among once-free-spending local governments.  Some companies are complaining that fiscally frail administrations are pressuring them to do business off the books and not immediately bill for goods and services…”   

“Such bills could add tens of billions of euros to the official debt figures reported by local and regional governments.  If such skeletons come out of the closet in coming weeks, Spain’s cost of funding could continue to rise—throwing the country back into the limelight after it has struggled to demonstrate it doesn’t need to be bailed out like Greece, Ireland, and Portugal.”

Wait a minute…didn’t the renewal of concern over the debt situation in Greece come about because it was discovered that the amount of debt owed by the Greek government was worse than had been previously accounted for. 

We don’t need to just keep picking on European states.  What about state and local governments in the United States?  Pension funds grossly underfunded?  Off-balance sheet financing?  And more?

But, why stick with governments?  What about Lehman Brothers?  What about AIG?  What about Citigroup?  The amounts of off-balance sheet tricks used by these organizations fill the current library of books about the recent financial crisis.  The story is about CDOs and SUVs and so forth.  Trying to disguise liabilities is not just a gimmick of the public sector. 

To me, however, this mis-accounting goes even further.  The question really is one about where do you draw the line.  That is, what types of accounting efforts are meant to evade discovery and hence are not exactly kosher…and which ones are of little or no harm? 

For example, how do you value an asset on the balance sheets of financial institutions?  If you hold a marketable security you must be concerned with the liquidity of that security when valuing the asset.  If interest rates rise and the market price of the security goes down, do you mark-to-market the value of the security on your balance sheet?  If the security is a part of the trading portfolio of the institution then the general answer is that the value of the security on the balance sheet should be marked down.

But, if the institution bought the security to hold then the question becomes more difficult for some people to answer because the intention is to hold the security to maturity at which time the full amount of the principal would be repaid to the institution.

Now, what if the credit quality of the security comes into question?  There are really two questions here: the first has to do with the credit quality of the security; the second has to do with the liquidity of the security?  If the credit quality of the security declines, then, given the value of the asset should decline…its price should fall.  Thus, the market price of the security should decline.  However, if the market is uncertain about how to price the asset, given the decline in its quality, the market for the security may “dry up” and the security may not be able to be sold immediately.

Thus, the value of the asset on the balance sheet should be adjusted downward, but without any market judgment about what the price of the security should be…how do you determine the amount the asset should be written down?

Here we have a problem that was addressed by the US government’s Troubled Asset Recovery Program (TARP) during the financial crisis.

Many in the financial industry have argued that the assets should not be marked-to-market in such cases because there is really no market for the asset.  Hence, these securities should be retained on the balance sheet at book value.

Now, what about the direct loans a financial institution makes?  Almost all of these do not have markets in which they can be sold.  So, the loans are totally “illiquid”.  Furthermore, bankers consider that most of the problems the borrowers face are “cyclical” and all that is needed when economic times are not good is for the economy to improve and the loans will work themselves out.  That is, the financial institutions must hold the loans “to maturity” and, thus, they can be held on the balance sheet at book value. 

The question is…what should be the accounting treatment of these assets of financial institutions?

Of course, this problem only occurs during bad times after most of the economy has become excessively leveraged and loan value are under attack.  For example, currently, in terms of residential real estate loans, mortgages, we see that seriously delinquent loans (90 days or more delinquent) are declining but still near historic highs, the number of borrowers in foreclosure remain near record highs, and the sale of houses and housing prices continue to decline. (http://professional.wsj.com/article/SB10001424052748704816604576333222700445278.html?mod=ITP_moneyandinvesting_1&mg=reno-wsj) The commercial real estate area remains depressed.  The loans of these two kinds of loans continue to plummet. (http://seekingalpha.com/article/270074-fed-continues-to-pump-reserves-into-foreign-related-institutions-in-the-u-s)  But, has the status of these loans been changed on the books of the banks?

The concern, in these cases, is not with the liquidity of the asset.  The concern is with the solvency of the financial institutions.  Have accounting practices not given investors…and others…a true picture of the financial condition of the institutions under review? 

My concern in all these cases is that we really don’t find out the truth until too late…until it is “after-the-fact.”   Then we blame speculators or others, who take advantage of the situation, of preying on the innocent, of creating the crisis, and, of course, we don’t want to reward speculators. (http://professional.wsj.com/article/SB10001424052748704904604576333393150700686.html?mod=ITP_pageone_2&mg=reno-wsj)  

The bottom line: the pressure to use accounting gimmicks to cover up the “real picture” grows as high degrees of leverage come to dominate an economy.  This is because debt requires contractual payments.  Debt requires an obligation and a responsibility. 

And, so we see a pattern.  Just as credit inflation is the foundation for greater risk-taking, higher degrees of leverage, and more financial innovation, we see that greater risk-taking, higher degrees of leverage, and more financial innovation is the foundation for more creative accounting practices. 

In both cases, we all ultimately lose in the end!