Investors have more than one reason to celebrate two new accounting rules. Besides forcing banks to fess up to the risks they are carrying on their books, new standards for off-balance sheet assets will make it harder for companies to inflate earnings artificially.
The new rules - FAS 166 and 167 - are desperately needed to prevent banks from hiding assets to increase leverage. Lending that isn’t supported by capital is a main ingredient behind unsustainable credit bubbles, and banks’ off-balance sheet games played a big role in the most recent one.
But another reason banks like off-balance sheet structures is that it enables them to manufacture profits.
Coming up to the end of a quarter, if a company is a bit short of its earnings target, it can package some assets together into a security and “sell” them to an off-balance sheet entity.
The entity is conjured out of thin air with a small equity investment by the company itself. The entity “buys” the securitized assets at a nice markup, enabling the company to book a profit on the sale.
Is it really a sale if the company still owns the risk? Of course not. If I sell an asset to you, a share of stock for instance, then I transfer all the rights of ownership. Any gains or losses in the stock are yours alone.
With many off-balance sheet entities, however, companies aren’t really transferring risk to anyone else. They’re just pretending to do so in order to lever up and recognize a gain.
It’s the acknowledgment of risks that is most important. Pushing assets off balance sheet — into the “shadow banking system” — put them beyond the reach of regulators, whose job it is to make sure banks have enough capital to absorb losses.
For their part, banks like to fly as close to the sun as possible, operating with as thin a capital cushion as regulators will allow. This is the essence of leverage. The more assets a firm controls relative to the equity on its balance sheet, the higher its potential returns on equity.
If you put down 20 percent to buy a house, and the house’s value appreciates 10 percent, then the return on your equity is a tidy 50 percent. But if you put down 5 percent, that same 10 percent increase in price is a 200 percent return.
The trouble with this strategy is that it works in only one direction. If asset prices fall, banks with smaller equity cushions go horizontal rather quickly.
At the height of the bubble, big banks were operating with equity cushions in the range of 2 to 3 percent. And that was before accounting for off-balance sheet assets.
Since then, banks have raised more capital, putting them in the range of 4 to 5 percent, but bringing assets back on balance sheet will have a meaningful impact. Citigroup will be adding $159 billion of assets, Bank of America $150 billion, JP Morgan Chase $130 billion and Wells Fargo $109 billion.
Goldman Sachs and Morgan Stanley haven’t yet disclosed how much they will be bringing back on, according to their most recent quarterly filings with the SEC.
Unfortunately, and contrary to recent comments about the importance of raising capital from President Barack Obama and Treasury Secretary Timothy Geithner, regulators are considering giving banks a year to phase in these assets for regulatory capital purposes.
This seems foolish. With equity markets nice and bubbly again, it’s not very difficult for banks to sell stock. If regulators make clear that additional capital will be required soon, banks may act pre-emptively to raise it now.
The system will certainly be stronger if they do.
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