I did not plan on having a sequel to this post, but I couldn't resist the opportunity presented by Floyd Norris' article on booking problems cropping up from off-balance-sheet items which eventually ended up in the books of a growing number of banks in the present subprime mortgage crisis. Like the risk management lapses which got exposed from irregularities committed by rogue traders, these nagging accounting problems are coming out to spook the markets at the worst possible time. Here's the full article by Mr. Norris, so you won't miss out the details:
Off-the-balance-sheet mysteries
Published: February 28, 2008
Should we blame the accountants? Surprises multiplied as the subprime problem of 2007 grew into the credit crunch 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 multi-billion 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 the off-the-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 of Rhode Island, the 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."
Reed, a Democrat, has sent letters to the Securities and Exchange Commission, as well as to the Financial Accounting Standards Board, which sets U.S. accounting rules, and the International Accounting Standards Board, which does the same for most of the rest of the world. He is asking detailed questions about what went wrong and how it should be fixed.
Getting together answers to his questions could provide the SEC 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 that 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.
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 vehicles off their balance sheets, even if they do not put them on their financial statements.
But those disclosures have often not been made, or have been made in such a general way as to be meaningless. The SEC, 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 State Street Corp., 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 one percent of the assets. After that State Street would be on the hook. But State Street says its model indicates that defaults on the underlying assets will not cost that much.
So long as the conduits stay off State Street's balance sheets, it 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, an amount that is only 3 tenths of a percent of assets - then it would have to put the assets on its balance sheet. And if it did that, it would 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.
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