Planet Ponzi

by Mitch Feierstein

  Well, quite. I agree.

  The Financial Accounting Standards Board (FASB) is the outfit which lays down the rules for generally accepted accounting practice in the US. The rules are intended to help accountants draw up accounts which will be:

  objective‌—‌accounts need to be based on objective evidence;

  material‌—‌accountants don’t need to worry about items that are of no real consequence to the company or its stakeholders;

  consistent‌—‌accounts can’t vary their rules from year to year;

  conservative‌—‌when accountants have a choice of two alternatives, they should opt for the one which is least likely to overstate assets or income.

  There’s nothing to argue with in those ambitions. And for the most part, FASB (and IASB, its international cousin) does an excellent job of developing rules that investors around the world can rely on implicitly. Trouble is, ‘for the most part’ isn’t good enough, not remotely‌—‌and at the moment, with the support of FASB and IASB, international banks are preparing their accounts according to rules that more or less invite irresponsibility.

  Here’s the issue. In the old days, if a bank made a loan of $100, it figured on the bank’s books as an asset worth $100. If the borrower ran into any kind of trouble, the bank’s management would make a provision against expected losses. So if a bank thought it might stand to lose 20 cents on the dollar, it would take a $20 hit and report a loan value of $80. All sweet and simple‌—‌but it relied on the good faith and commercial sense of the managers in charge of making the loss provisions. Although the bank’s auditors would need to approve the bank’s valuations of its assets, they would recognize that they were not expert in credit evaluation, so‌—‌in the absence of gross error or evident manipulation‌—‌those auditors would likely agree with the bank’s assessment. In any case, since bank loans weren’t tradable, there was no other option available.

  But that was banks. Wall Street brokerages were different. The assets that generally filled their balance sheets were securities: bonds, stocks, and so on. Since those things were openly traded, the rules applying to them were simpler, and tougher. If a brokerage bought a security for $100, but that security came to trade at just $80, the security would be valued at $80 on the broker’s books. There was no room for argument. All the broker’s financial assets would be assessed on their market value at each balance sheet date, a process called ‘marking-to-market.’ Simple. Smart. Tough. Objective.

  As credit markets developed, however, loans too became tradable. Even when the loan itself wasn’t traded there were traded derivatives‌—‌credit default swaps‌—‌which implied a price for each loan. So, in this new world, and taking account of FASB’s stipulations about objectivity and conservatism, banks were told that they had to mark their loan portfolios to market. If that loan portfolio deteriorated in quality, perhaps because of a general economic slowdown, the market would dictate precisely what losses had been suffered and the balance sheet would reflect that new valuation. Simple. Smart. Tough. Objective.

  But banker-kind cannot bear too much reality. In spring of 2009, when that reality was becoming too hot for banks to handle, they begged for, and were granted, a change in the rules. The new mark-to-market accounting was scrapped for banks, and in its place the older loan loss provisioning system was reinstated. The change meant reintroducing management discretion into the valuation of loan portfolios and removed the brutally objective measurement of the market.

  If we lived in a world full of honor and sound judgment, the change wouldn’t have made too much of a difference. The two approaches should, on balance, give more or less the same answers. But we do not live in that world. We live in a world where the easiest way for banks’ management to avoid the consequences of lousy lending decisions is to ignore them completely.

  For example, banks that have lent money to Greece typically hold some of those assets on their banking book, and some on their trading book. Same assets, same appalling credit situation, same losses. On the market at the moment, Greek debt is trading at 40 cents on the dollar. If my math is correct, that tells me that banks have made losses of at least 60 cents on the dollar. Hideous, huge, horrendous losses brought about by an astonishing degree of laziness and complacency when it came to judging the credit in the first place.

  But are banks fessing up to those losses? Of course not! The debt held on their trading books‌—‌a tiny fraction of the whole‌—‌is valued at market prices. All the rest of it, the debt held on their banking books, is carried at something much closer to 100 cents on the dollar. But please don’t take my word for these things. (To repeat: I don’t want you to take my word for anything in this book; I invite you to check out any piece of data, any factual claim you like.) Here are the Financial Times’s comments on this very topic:

  Up until now, most banks have not written down the value of the bulk of their Greek sovereign bonds. Bonds can be held in two buckets on banks’ balance sheets: trading books, which routinely mark the value of bonds to market, only hold a fraction of banks’ sovereign bond investments; the balance is in so-called banking books, which are routinely held to maturity and are therefore not traditionally marked to market, ignoring plunges in bond values as a result.

  Of the €82.7bn in aggregate net exposure to Greek sovereign debt revealed in last week’s European stress tests, just €3.9bn‌—‌or less than 5 per cent‌—‌is held in banks’ trading books, according to an analysis by the Financial Times.

  Nearly €79bn, however, is held in institutions’ banking book assets, which are not adjusted for swings in market value. A 21 per cent write-down or ‘haircut’ on Greek sovereign debt held in those portfolios would trigger losses of nearly €17bn across the 90 banks surveyed in this year’s widely discredited tests.19

  These comments come from Europe’s most prestigious financial journal, and one whose language has a tendency to be somewhat dry and technical. But the composure of its style belies the gravity of what it is reporting. This whole article should really be printed in 48-point capitals and studded with exclamation points. European banks have made losses of €17 billion and they are openly lying about them. People even know that they’re lying and yet nothing happens. Right now, the fraud police ought to be marching into management suites and snapping handcuffs on the occupants. And what do we have instead? A dry article in the Financial Times which implies a slightly eggy disapproval‌—‌and that’s all. Nothing else‌—‌in the face of €17 billion of losses that have arisen in one tiny little corner of the financial world; €17 billion of losses created by a country with a GDP about the same as Maryland’s.20 Since, in fact, the latest EU restructuring plan seeks to impose losses on private creditors equal to 50% of those creditors’ Greek assets, the destruction of value has been painfully real – no accounting fiction, but sober, painful fact.

  But these problems aren’t unique to Europe. Here’s another example from the US, specifically the Bank of America. The BoA is, like many of its peers, in a bind. New rules are coming into force which will require it to hold a larger quantity of core capital. You can acquire that capital in one of two ways. You can earn good profits and retain a substantial proportion of them (i.e. you can’t give too much of your profit to shareholders by way of dividend). Or you can issue new shares and raise fresh funds direct from the market. That’s the good news. The bad news is that BoA’s shareholders don’t want to put their hands into their wallets for fresh capital and they don’t want the BoA to restrict dividends while it concentrates on building up capital.

  And there’s another issue. BoA has made a hideous mess of its mortgage book and has huge losses to write off. But the more it acknowledges those losses, the more it reduces its capital. On the other hand, you can’t not acknowledge those losses, because everyone knows they’re there and people have started (not before time) to fret over them.

  Pressure on every front. A circle that can’t be squared.

&n
bsp; Except it can. Because we live in a world where managements can simply manipulate their reported figures. A recent note from Bloomberg documents exactly how that process works.21 Here’s the four-step sequence that Bank of America followed:

  Acknowledge a huge writedown on your mortgage book, driving that business $14.5 billion into the red. (Just pause a moment to contemplate that figure. Can you even imagine running a business so badly that it loses almost $15 billion? If you ran a business that badly, could you even imagine you would be in a job receiving lavish salary and bonuses and the respect of your peers? I’m guessing ‘no.’ Yet by one calculation, the bank has written off over $30 billion in this one business segment in the course of a calendar year and may need to write off tens of billions more.22)

  Deny any possibility that you will need to raise fresh capital from shareholders.

  Identify an area where you can juggle your figures‌—‌let’s say, the nonmortgage loan portfolio, which hasn’t come under scrutiny the way the mortgage book has done.

  Start juggling. In BoA’s results, the provisions for future credit losses dropped 60%. In fact, in the quarter ending June 30, 2011, the bank undid provisions it had previously made, thereby magicking over $400 million of profit into the quarter that the previous year had seen a $600 million loss.

  Now obviously, in a benign economic climate you would expect loan losses to come down. There’s nothing in principle strange about seeing loss provisions rise and fall. But we are not in a benign economic climate. To pick just a few issues: (a) borrowers are currently experiencing bizarrely and unsustainably low interest rates; (b) the real economy is weak, joblessness high, and the outlook deteriorating; (c) the eurozone crisis is impairing countless European financial institutions, many of which do business with Bank of America; and (d) under any deficit reduction plan at all, the fiscal stimulus is about to be ripped away from the American economy and replaced with fiscal tightening of unprecedented severity, while (e) the scope for further economic support from the Fed is minimal. Under these circumstances, I personally would consider beefing up my loan loss provisions. I certainly wouldn’t start undoing the ones I’d already made.

  Although I’ve singled out the BoA in this discussion, I don’t mean to imply that its standards are any different from those generally prevailing in the industry. The same basic point holds true for any number of other global banks. Instead of providing clear, objective measurements of value, our current accounting system does the exact opposite. It invites manipulation. It causes sane investors to stop trusting the balance sheets placed under their noses. Twenty years ago, Japan made a similar choice to eliminate truth from its banks’ balance sheets and the result has been catastrophic. Western economies are currently following suit.

  These issues are hugely significant. They matter because they go to the heart of this book’s central claim. I’m claiming that we’re living in the dying days of the biggest Ponzi scheme in history. If that’s the case, I need to prove at least two things. First, that there has been a mountain of phony profits. Secondly, that there is an equal or larger mountain of buried losses.

  We’ve already looked (in chapter 7) at the US financial system’s totally disproportionate share of total profits. Given that the sector is a highly competitive one, economic theory has no way of explaining how those huge profits seem to arrive year after year after year. If the whole thing is just a Ponzi scheme, economic theory can breathe a sigh of relief.

  But if the phony profits are hidden in plain view, where is the mountain of buried losses? The yawning gaps in the accounting rules laid down by FASB and IASB give you part of the answer. You tell banks they only have to fess up to losses if they feel like it … and what do you know, banks decide that their Greek debt is in tip-top shape and that their commercial loan portfolios have never been better. As for their mortgage books‌—‌why, they’ve cleared away all the embarrassments from the past and that book too is in the pink and feeling fine.

  The simple fact is that we can no longer trust the balance sheets of banks. Or rather: we can trust every word they tell us about their mountainous debt obligations‌—‌those things are unfortunately only too real‌—‌but we have to stop trusting anything they tell us about their assets. The cold objective truth of the market is just too cold, too objective for most bankers today.

  Oh, and finally, in case you’re tempted to think that at least brokerages‌—‌firms that deal in securities rather than loans‌—‌have honest accounts, please recall my earlier comments on risk management. When market prices are scarce (as they often are), brokers end up marking their assets not to market, but to their models of the market. Yet as we saw in the collapse of the mortgage market, those models often bear absolutely no relation to reality‌—‌in effect, the big investment banks have been marking-to-magic: numbers plucked (with lots of mathematical fireworks) from thin air and presented to auditors. Auditors do not have the expertise to judge whether those models are accurate or not, so they’ll ask a few questions, challenge a few details, then accept everything. That’s not their fault. They don’t have the knowledge or the authority to do otherwise‌—‌and, of course, final responsibility for any set of accounts lies with the management who sign them, not the auditors who verify them.

  Either way, the result is the same‌—‌some impressive-looking numbers, and losses multiplying like termites out of sight.

  Legal risk

  Let’s move on: from accountants to lawyers.

  In the old days, a bond was a physical piece of paper. If a company‌—‌General Motors, let’s say‌—‌wanted to raise $100 million, it might issue 10,000 bonds with a face value of $10,000 each. Those old bonds had coupons down the side which investors would physically cut out and present for payment each time an interest payment was due. These days, those fancily printed bits of paper have largely given way to electronics, but those old-fashioned certificates were a nice reminder that bonds are little more than fancy IOUs, the most ancient form of borrowing you can imagine.

  At the same time, the physical piece of paper only ever mattered because it represented something: a contract between borrower and lender. The things that the borrower could and couldn’t do. The things that the lender could and couldn’t expect. Naturally enough, judges in the US, Britain, and elsewhere long ago evolved a sophisticated case law to handle any disputes. What happened if the bond issuer went bankrupt‌—‌the order in which creditors were paid out, how collateral was allocated‌—‌all these things and more were worked out in such a way that ordinary borrowing and lending became a smoothly operating machine.

  In the last ten or fifteen years, things have become vastly more complicated. Most of the financial innovation in that period has been driven, in the first instance, by mathematical possibility‌—‌the kind of thing that looks smart on a spreadsheet. But those spreadsheets are meaningless unless they turn into enforceable contracts and the contracts which emerge are often insanely complicated.

  Take, for example, the CDO-squared, a CDO backed by CDOs. Bearing in mind that many SIVs were created with multiple different tiers of debt, the legal language was forced to become ludicrously complex. If you don’t believe me, take a look for yourself. Here is just one sentence taken from a 300-page 2007-vintage prospectus for a CDO-squared:

  Unless notified by a Majority of any Class of Secured Notes or Composite Notes or a Majority-in-Interest of Subordinated Noteholders that such Class of Secured Notes, Composite Notes or the Subordinated Notes could be materially and adversely affected (or in the case of the Class A-1 Notes, unless notified by a Majority of the Class A-1 Notes that such Class of Notes could be adversely affected), or by each applicable Short Synthetic Counterparty that it would be materially and adversely affected, or by the TRS Counterparty that it would be materially and adversely affected, the Trustee may rely in good faith with the written advice of counsel or an officer’s certificate of the Issuer or the Collateral Manager delivered to the Trustee
as to whether or not such Class of Secured Notes or Composite Notes, the Subordinated Notes, each applicable Short Synthetic Counterparty or the TRS Counterparty (or with respect to any Short Synthetic Counterparty or the TRS Counterparty, an opinion of counsel only) would be materially and adversely affected (or in the case of the Class A-1 Notes, could be adversely affected) by such change (after giving notice of such change to the holders of the Secured Notes, the Composite Notes and the Subordinated Notes and to each applicable Short Synthetic Counterparty and the TRS Counterparty).23

  These things weren’t deliberately designed to confuse and bamboozle‌—‌but contracts, remember, are essentially tools for the battlefield. They’re there to tell you what needs to happen if things go wrong. When Lehman blew up, all of a sudden the scale of the likely battlefield appeared in view for the first time. Lehman stood at the center of thousand upon thousand of these contracts. Each one was meticulously written. The intricate legal clockwork at the heart of each offering made perfect logical sense. But the idea of testing all this stuff in a bankruptcy court …! For all the theoretical perfection of the clockwork, when it actually came to the crunch creditors realized they had no idea what the hell was going to happen, or when. In place of the old certainties there was only a radical uncertainty, a realization that they didn’t actually know anything at all. The Lehman bankruptcy is estimated to have cost‌—‌so far‌—‌a staggering $2.4 billion in legal, advisory, and other fees, with huge issues remaining unsettled. Two years and billions of dollars later, the uncertainty remains.24