An Interview on Off-Balance Sheet Reform

Interview Friday. Tim Fernholz has interviews with Senator Ted Kaufman and Senator Mark Warner on financial reform.

Last week I told you about 6 things to fight for in the Dodd Bill, including three amendments. One of them was Senator Menendez’s Off-Balance Sheet amendment.

In order to learn more about the issue, as well as what the language proposed could accomplish, I spoke with Jennifer Taub.Jennifer Taub is a lecturer and coordinator of the Business Law Program at the Isenberg School of Management at the University of Massachusetts Amherst.

Mike Konczal: What does off-balance sheet mean? What does it mean to put something off the balance sheet?

Jennifer Taub: Before we talk about off-balance sheet transactions, let’s talk about on-balance sheet. The purpose of a balance sheet is to provide a full disclosure of a firm’s assets and liabilities. It’s easiest to explain the function of a balance sheet in the context of one’s personal finances.

You draw a T on paper and on the left side of the T, you list your assets and their values. Assets are the things you own. They also include payments you are entitled to. For example, if you loaned a friend $100, this would also be an asset. On the right side, you identify your liabilities and their amounts. Liabilities are what you owe, such as your debts. On that right side you also include an amount representing the difference between your assets and your liabilities. That remaining amount is called equity or net worth.

This chart is called a balance sheet because both sides balance. Assets equal the sum of liabilities and equity. So, equity is essentially the cushion that you have as the things that you own, decline in value. Conversely, your equity grows if either your assets increase in value or you pay down the debt you owe.

A balance sheet is an important financial statement if it accurately reveals how much leverage a business has. To explain leverage, imagine that the only asset you owned was a newly purchased million dollar home, and you had put ten percent down. Your balance sheet would look like this: on the left side, a $1 million asset, and on the right side, liabilities of $900,000 and below that, equity of $100,000. This would reveal a 10-1 assets-to-equity, leverage ratio. This ratio communicates the potential for gain and level of risk you have. Imagining we record assets at fair value, if housing prices immediately rise by 10 percent, you will have a home worth $1.1 million and you will have doubled your equity to $200,000. However, if that million dollar house immediately declines in value by ten percent, meaning the house declines to $900,000 you will have wiped out your equity. This illustrates the magnifying affect of leverage.

So that’s a simple illustration of what a balance sheet is meant to portray. Not just how much risk a firm is taking on, the leverage ratio should reveal a potential return on equity.

M.K.: Right and it’s important in some sense, it’s good to be able to tell how good one firm or person is doing but it’s also fairly standardized so it’s easy to compare two firms and decide who’s a better risk and etc. Correct?

J.T.: Yes. Investors rely on a standardized balance sheet. This is similar to a retail shopper looking to choose between products who reads the food label to compare the nutritional values. Essentially the balance sheet is the risk equivalent of nutritional value from firm to firm so it’s really important that every firm in one industry and across all issuers plays by the same rules in terms of being honest about the debt they’re taking on and the quality and value of their assets.

M.K.: Right, because if someone’s lying on a balance sheet its bad in and of itself. The people who look at that balance sheet won’t have a good sense of what’s going on with the firm and it’s also bad for distorting the market because if you can hide liabilities or increase assets money will come to you because they think you’re very smart and a good businessman when you’re actually just deceiving them.

J.T.: Yes. Investors rely on a balance sheet to make the determination whether to buy or sell shares, or lend money to a firm. If the balance sheet is falsely making a more positive portrayal of the firm’s health than it really should, an investor might make a purchase decision and pay more than he or she should for that stock. Or if the investor who loaned money to the business likely accepted a lower interest rate or less collateral if the firm is made to look less debt-ridden. The financial markets depend upon transparency. We really need to promote transparency and avoid camouflage. Anything that encourages the masking of debt or the hiding of significant liabilities is not good for the markets, it’s not good for investors, and it’s not good for regulators.

M.K.: Right, so obviously if we’re going to regulate something this is an important thing to get right because every individual has an incentive to lie about how they’re doing and it’s like lying on any type of legal form in that it’s very detrimental.

J.T.: Good point. One would think that the likelihood of getting caught would deter this type of fabrication. However, we have seen, how perverse incentives sometimes encourage this behavior. For example, if executives of a firm can make this firm look more healthy either by manipulating the balance sheet or by manipulating the income statement then they might be able to get the board to increase their pay, and if they’re paid in stock options or grants, then they get an unfair windfall associated with this manipulation of their financial statements.

Consider that some investment banks were leveraged at 30 to 1. In simple terms, this would show that an overall increase in asset values of 3.3% would result in doubled equity. Conversely an overall decline of 3.3% would render such a firm insolvent. This helps to explain why being highly leverage while assets are rising is an attractive strategy — until prices decline. What happened in the recent crisis was that individuals in firms ignored the fact that asset prices could not keep going up. It personally benefitted them to do so. Here’s why. They could show increased returns on equity given the high leverage, draw huge salaries and bonuses. Then, when the asset prices collapsed, they had either left the firms or faced no consequences, having no obligation to pay back the millions they had earned.

M.K.: Excellent, so let’s talk about balance sheets what are some things people should have in mind about them and how can they be used for abusive purposes.

J.T.: A few examples include quarter-end window dressing, swaps, and off balance sheet conduits, known as “variable interest entities” or VIEs. Let’s cover window-dressing first. In March, the examiner in the Lehman bankruptcy issued a report revealing that Lehman was treating certain short-term financial transactions as if they were sales. Lehman’s, just-before-the-quarter-end transactions gave the impression that the firm had reduced its balance sheet by $50 billion and significantly lowered its leverage ratio. Similarly, the Wall Street Journal revealed that 18 banks had been lowering their short-term borrowing before the end of the quarter. From the peak of their borrowing to the low point at quarter’s end, their debt levels would drop on average 43 percent. Both of these tactics can be considered off-balance-sheet type activities in that they are designed to move debt off the balance sheet just before the quarter end “snap shot” is taken for purposes of reporting.

Regarding swaps, firms are permitted to exclude their full exposure to swaps from their financial statements. Instead they are permitted to just report the fair value changes over time. Lynn Turner, the former chief accountant at the SEC, has compared the current recording of swaps to an individual reporting only the change in his or her debt balance instead of the full amount of debts themselves.

Another example is the variable interest entity or VIE. This is very similar to the off-balance-sheet entities abused by Enron. The purported benefit of these entities is to help a company to transfer the risk associated with financing assets away from shareholders and onto other investors. A collateralized debt obligation is a type of VIE. Here’s how they work. A sponsoring bank sets up a new legal structure or entity. The purpose is to buy some of bank’s assets. The sale to the entity can result in a nicer looking balance sheet for the bank, because the bank can use the sale proceeds to pay down liabilities. The new entity gets the money to make these purchases by issuing debt to investors. If properly constructed, it becomes a stand-alone entity, off the balance sheet of the bank that sponsored it. These off-balance-sheet transactions become deceptive when the sponsoring bank retains obligations. In other words, it’s a problem where the assets are not truly sold, but instead the sponsor remains obligated to the conduit or its investors. In such a situation, that payment from the conduit starts to look like a hidden loan. If so, then an investor looking at the balance sheet might be misled. And, the leverage that appears on balance sheet is understated. Thus the firm has more risk than the investor would be able to see when looking at the balance sheet.

M.K.: Let’s do an example.

J.T.: Okay. There’s a great example that was at the heart of the financial crisis. AIG did not disclose the actual or potential amount of liabilities associated with the credit default swaps it sold. Recall that AIG received a $180 billion bailout. More than $60 billion of that went to pay liabilities to swap counterparties. Another good example from Lynn Turner and Frank Partnoy from the Roosevelt Institute “Make Markets be Markets” event is Citigroup. Citi held over $100 billion in credit derivative payables, and $292 billion in variable interest entities that did not appear as liabilities on its balance sheet.
Citigroup’s VIEs were also recently highlighted during Financial Crisis Inquiry Commission hearings. Citi had set up some off balance sheet entities and sold mortgages bonds and other assets to them. The funding to buy the assets came from investors who bought short-term debt securities (commercial paper) of the VIEs. In order to help attract investors, Citi’s traders gave investors a “liquidity put.” This guarantee required Citi to buy back the securities at face value if they became illiquid. As a result, in 2007, Citi had to buy back $25 billion worth of the commercial paper at face value when it was trading at about 33 cents on the dollar. This cost the firm $14 billion. Even though Citi had offered this guarantee, the entities were off-balance-sheet when created.

M.K.: So what would an ideal bill do here? What’s the way to move forward in this area?

J.T.: There’s been language proposed that would require that companies provide a detailed written disclosure as part of their annual reports of all off-balance sheet activities. In addition to full, detailed disclosure, they would have to provide justification for failing to put these activities on balance sheet.
In addition, it would address the “repo 105 problem” and the practice of quarter-end and year-end window dressing by financial firms. It would require financial institutions to disclose in quarterly and annual reports, the daily average leverage ratios and daily average liabilities. Presently, firms show liabilities and assets as of quarter end and year-end. The daily average would help investors understand how much debt the firm was truly using to finance its assets, and as you noted earlier it would provide a fairer comparison from firm to firm. The language also addresses the “repo 105” issue and other pseudo-sale transactions. It does so by requiring firms to disclose information on transactions that were accounted for as sales by the issuer, but have implications for future liquidity. I am looking forward to seeing how this language may end up in the final bill.

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4 Responses to An Interview on Off-Balance Sheet Reform

  1. Pingback: Matthew Yglesias » Off Balance Sheet Explained

  2. Pingback: FT Alphaville » Further reading

  3. Ted K says:

    I think you and James Kwak found yourselves a shooting star here. Jennifer Taub Rocks!! Hope you and Kwak make her a regular. Great work Mike, as usual.

  4. Pingback: deceptive by design: derivatives as secret liens | theParetoCommons

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