statements. Critics warned that the change could further damage the credibility
of financial institutions by enabling them to avoid recognizing losses from bad
loans they have made.
During the financial crisis, the market prices of many securities, particularly
those backed by subprime home mortgages, have plunged to fractions of their
marked-to-model prices, forcing banks to report huge losses because such
securities must be reported
at market value each three months, with the banks showing a profit or loss
based on the change.
Bankers bitterly complained that current market prices were the result of
distressed sales and that they should be allowed to ignore those prices and
value the securities instead at their potential value in a normal market. The
measure in the latest guidelines that drew the most dissent will allow banks to
keep part of such declines off their income statements, although the decline
would still show on the institutions' balance sheets. Since old accounting
rules already allowed the fiction that all banks are well capitalized, the
changes would make banks appear better capitalized than they actually are. Bank
shares soared in price the day the changes were announced.
FASB had at first resisted making the changes but yielded within a few days of
a Congressional hearing at which legislators from both parties demanded the
FASB act. Ironically, the erosion of the integrity of rating agencies has been
generally recognized as one of the causes of the financial crisis.
The application of an accounting rule had become a political issue. The
International Accounting Standards Board held an emergency meeting to change
its rule after such a move was demanded by the president of France. In the
United States, the FASB acknowledged investor criticism of its rule changes
after the Congressional hearing.
While it was the banks who pressed for the new rules, the change will affect
all non-bank financial institutions as well. The FASB said it would make small
changes to make sure that they would avoid affecting accounting in mutual funds
which must mark their assets to market value every day. Bank regulators already
have the power to adjust accounting in computing capital, and some investor
groups argued they should do that, rather than give the banks more freedom to
value assets at what they think they should be worth, rather than what someone
will pay for them. The FASB vote drew condemnation from the Investors Working
Group headed by two former SEC chairmen, George W Bush appointee William H
Donaldson and Clinton appointee Arthur Levitt Jr.
Back in an unusually heavily attended 2002 annual Bond Market Association
meeting in New York featuring then Treasury secretary Paul O'Neill, Securities
and Exchange Committee chairman Harvey Pitt, and former Fed chairman Paul
Volcker, a swarm of reporters, looking for the next Enron fiasco, turned up to
ask questions about special-purpose entities (SPEs) and other means of moving
risk off corporate balance sheets. One association member asked Pitt how the
market could distinguish between how SPEs were now and those used by Enron that
had been deemed legally fraudulent. Enron had filed for bankruptcy in November
2001. Pitt had no ready answer. The off-balance-sheet genie had been let out of
the bottle, and there was no easy way to put it back in.
New rules on off-balance-sheet obligations
The FASB adopted new rules for consolidating SPEs and disclosing
off-balance-sheet activities. SPEs can no longer be all-purpose entities,
especially not the kind of debt-hiding entities that Enron used and abused to
puff up its profits. Interpretation No 46, "Consolidation of Variable Interest
Entities", expands on existing rules to specify more precisely under what
conditions a parent company must consolidate an off-balance-sheet SPE. Now, the
question of consolidation is a matter of who takes the risks and who reaps the
rewards of the enterprise.
Hundreds of US companies keep trillions of dollars in debt in off-balance-sheet
subsidiaries and partnerships, skirting the consolidation rules of FASB 94,
FASB 125 and FASB 140. If a company creates a legal structure, called a
special-purpose entity (SPE) with a 3% minimal equity infusion, it does not
have to consolidate the transaction under SEC and FASB rules. Banks arrange
many of the devices and are big users themselves.
JP Morgan revealed in the Enron bankruptcy that it had nearly $1 billion in
potential liabilities stemming from a single 49%-owned Channel Islands entity
called Mahonia that traded with Enron. Dell Computer had a joint venture with
Tyco called Dell Financial Services (DFS) that originated $2.5 billion in
customer financing, mentioned only as a footnote to Dell's accounts. Dell owned
70% of DFS, but did not control it and therefore could keep DFS debts off its
own balance sheet.
To move assets off its books, a company typically sells them to an SPE, funding
the purchase by borrowing cash from institutional investors. As a sweetener to
protect investors, many SPEs incorporate triggers that require the parent to
repay loans or give them new securities if its stock falls below a certain
price, if credit-rating agencies downgrade its debt or in the event of other
triggering events. However, IASB, which covers regulations in many country's
outside the US, resisted this type of treatment. Under pending European Union
legislation, all listed companies in the EU had to report under IASB by 2005,
except those that report under US Generally Accepted Accounting Principles
(GAAP), which would have to move to IASB by 2007.
Moving debt off the balance sheet is more difficult in Europe than in the US
under IASB rules, which use the standard of whether a company participates in
the risks and rewards attached to that debt in deciding whether debt can be
off-balance-sheet. By contrast, US GAAP uses the standard of what legal form
such an entity takes. In the post-Enron world, the rules on off-balance-sheet
debt have tightened up, but new loopholes have been exploited.
Under existing accounting rules, the assets of SPEs must be consolidated when
outside investors' stakes are protected in that fashion. Yet some 42% of
off-balance-sheet debts provide guarantees for outside investors in indirect
ways to get around the rules. (See
PATHOLOGY OF DEBT Part 5: Off-balance-sheet debt, Asia Times Online, December
1, 2007.)
Much of the losses came from mortgage-related investments as the housing market
began to collapse. Yet the bottom appears to be a long way off. Home
foreclosures in the US surged 81% in 2008 to 2.3 million, the highest on
record. More than 274,000 homes received at least one foreclosure-related
notice in January 2009, down 10% from December 2008, but still 18% higher than
a year ago. Insolvency is spreading throughout the US and global financial
systems like a wildfire beyond the housing sector to the entire economy.
The market has so far been showing disappointment after disappointment on
Obama's disjointed approach to stopping the economic hemorrhage, let alone at
the absence of a comprehensive strategy for recovery. Imprecise information and
policy indecision continue to plague the credit market bailout, the bank
bailout, the housing bailout, the auto bailout, and the coming commercial real
estate bailout, while a general consensus is building that the bottom is not
yet in sight by a long shot. US policy initiatives presented at the G-20 London
summit on April 2, 2009 met with resistance from European allies.
US economy weakens US diplomatic initiatives
On her first overseas trip to Asia, which included China as a final stop,
Secretary of State Clinton acted like a salesperson, peddling US sovereign debt
to reluctant Chinese buyers and promoting joint efforts to develop clean energy
as the way out of the financial crisis, an issue on which China holds
fundamentally different views from the US.
The US promotion of clean energy as a way to revive the global economy rests on
keeping oil prices high in order to justify investment in alternative energy,
while China at this stage of her development needs not just clean but also
low-cost energy, oil or otherwise. The US intents to use alternative renewable
energy to replace its fully developed, massive fossil fuel network, while China
can take advantage of alternative renewal energy to fulfill her growing energy
needs without having to amortize massive sunk investment in fossil fuel
network.
The global economic crisis is sapping US influence around the world and
weakening the foundation of US foreign policy.
Next:G-2 and the Shanghai Cooperation Organization
Henry C K Liu is chairman of a New York-based private investment group.
His website is at http://www.henryckliu.com
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