Re:Balance -- Jim Peterson

Accounting for Subprime -- Scoring the Scorekeepers

This audit season the skeletons just refuse to stay in the closets. Latest this month, but far from last, are AIG’s $4 billion loss estimate increase and Credit Suisse’s $2.85 billion write-down in its asset-backed securities.

Both examples read directly on a question put by a friend and regular reader -- a business school professor in Paris: “How much of the subprime thing is related to the accounting?”

Not that she needs my help with a lesson outline for her MBA students. But having been a guest in her classroom, I’m happy to offer. If I were teaching her class, I’d get there in three steps:

At the level of human behavior, subprime in its origins was first about the disconnect between incentives and risks: the mortgage originators took their fees immediately, but repackaged and laid off the future stream of payment obligations. Then the bankers, abetted by the ratings agencies, gamed the credit rating system by pushing untestable valuation models onto their credulous customers.

Second, as after-effect, subprime is now about legal responsibility. With the filing of new investor lawsuits back to Enron-era levels (for which, see the helpful running count being kept by the D&O Diary,here ),  the roster of defendants includes not only the banks and mortgage companies, but also the three dominant credit rating agencies and, at last count, three of the Big Four accounting firms.

But third, with the global harm extending from villages in the Norwegian Arctic to counties in rural Florida to bush hamlets in Australia, we should go back to basics: accounting principles and methods for the recording and reporting of transactions are as old and pervasive as trade itself.

As soon as commerce moved beyond one-to-one barter, conventions were required to quantify such inherently judgmental issues as the hazard of re-payment in future periods, the time value of money to change hands at a later time, or the transfer of performance to a third-party.

So viewed, subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.

So the accounting for mortgage-based assets and their off-spring should be seen as a proxy for the reckoning of financial reality in all aspects:

For a family buying its first home with an adjustable-rate mortgage, the expense entry for housing cost changes from rent to mortgage payment. Its balance sheet now has an asset, the house, with the associated mortgage debt as a liability. When a depressed housing market erodes any equity, and the payment escalates beyond the family’s means, the accounting confirms the reality – red ink and foreclosure.

An investment bank that sponsored and sold exotic tranches of financial products now has the task of re-assuming them back onto its balance sheet and marking their value to a collapsing market rather than a discredited black-box model, which means filling the accounting holes. Costly new rescue capital, opportunistically supplied to the likes of Citi and Merrill, Northern Rock and the monoline insurers, may provide a lifeline but dilutes or even destroys the prior shareholders.

As for investors – whether an individual shareholder of the banks or a pension or retirement fund that bought the exotic products – their losses may not yet be realized for accounting purposes, unless they have sold out the positions, but they can plainly feel the real-world loss of wealth, and unsurprisingly are taking advice from the plaintiffs’ lawyers.

As shown already by AIG and Credit Suisse, the accounting challenges pinpointed by the professor are fraught both for the financial institutions and also for any investor who heard the siren song of higher rates and traded off for unknown future risks.

That’s because the more candor and rigor are brought to this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality. And therein lies a ghastly liability implication -- that the well-controlled and smoothly operating systems required under Section 404 of the looming Sarbanes-Oxley law simply weren’t there.

In the end, to wrap up for the good professor’s class, the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”   

Credit Rating Agencies -- Submerged by Subprime?

A pal of mine in Washington, keeping watch on the legislators and regulators, is asking what to name his pied-a-terre, with its balcony facing the nation’s capitol.

With a familiar old blame game now roiling in the credit markets, we’re suggesting he call the place “Déjà Vu.”

It’s not only Enron all over again for the beleaguered banks that wrapped up and sold the exotic mille-feuilles of debt securities concocted out of subprime mortgages. It’s even more ominous for the three dominant credit rating agencies – Standard & Poor’s, Moody’s and Fitch – under scrutiny for their own multiple and well-compensated roles.

To summarize: this trio advised on the creation and design of these complex instruments. They then proceeded to issue their ratings on the same paper, which was peddled around to hedge funds, local government cash managers, and institutional investors worldwide. The ratings – required by the offerors to be of defined grades -- were carefully couched as “opinions” strictly limited to credit risk. Yet they were viewed by the purchasers not only as measuring expected credit loss, but as proxies for over-all investment quality. That is, they were issued under a “but-for” test: no rating meant no deal.

But reality eventually intruded: no established markets meant that nobody really had a clue about the value of these one-off instruments – not the buyers, not the issuers who paid for the ratings, and not the ratings agencies themselves.

Any wonder at the intensity of the heat? With cries of “conflict of interest” ringing loud, the ratings agencies are assailed across the globe, from EU markets commissioner Charlie McGreevy to the Attorneys General of Ohio and California. And along with the issuing banks, they are being named in lawsuits by their own shareholders and investors as well.

Should any of this feel surprising? Whatever the defensive spin and the persistent denial of the deepening conditions of adversity, problems yet to ripen mean that we are not yet even approaching what Winston Churchill termed the “end of the beginning.” Still to come in the next year or so:

•    Upward interest rate re-sets on the subprime mortgages themselves, ballooning the homeowners’ payments and default rates and deepening the gloom in the housing sector.

•    Legislators’ tinkering for the sake of the poor homebuyers, with uncertain but real effects on the value of the investment portfolios where the mortgages came to reside.

•    Exposure during this audit season of the still-hidden skeletons in the closeted portfolios of the institutional investors who are still exploring and discovering their exposures.

•    Further blood-letting in the executive suites, as the blown-up careers of Merrill’s Stan O’Neal, Citigroup’s Chuck Prince and Bear Stearns’s Jimmy Cayne foretell a parade of CEO sacrifice.

•    And finally, several more rounds of loss provisions – witness the $24 billion at Merrill and the three-stage total of $18 billion at UBS -- as the subprime debt-holders struggle, along with their auditors and lawyers, to supplant their discredited valuation models and mark their positions to market reality. 

Eventually these will play out. But dozens of new lawsuits already disprove the claim of the academic scorekeepers, that the post-Enron dip in the case-count represented a systemic cleansing of the corporate stables. The bad old days are indeed here again – Sarbanes-Oxley was never to be a one-time fix for corporate financial misbehavior.

Ratings agencies confronting their antagonists have historically invoked the virtually sacred American right of free speech. But the security blanket of the First Amendment must be feeling threadbare, limited as is its coverage to the journalistic role of publicizing ratings data at no cost to the end-using consumers.

Rather, critics point to the three large ratings agencies’ cartel control of the sector, their allegedly corrupting consulting practices and client-based fee structures, their opaque opinions, and above all their inability, under market stress, to foresee or prevent their clients’ financial debacles.

The agencies themselves are touting a menu of fixes, from Moody’s proposal to replace letter ratings with numbers – arguably no more than a switch from illiteracy to innumeracy – to massive downgrades of mortgage-backed securities with knock-on effects for other debt portfolios and the entire bond insurers speciality, to the blame-the-user invocation by Standard & Poor’s of more “investor education.”

But should the ratings agencies feel confident of dodging the bullets? Two lessons in history suggest not. First, the closely analogous model of the auditors’ participation in the securities marketplace has brought them to grief, with multi-billion dollar litigations threatening their very survival. Second, both plaintiffs’ lawyers and legislators, inspired by Sarbanes-Oxley, will pick on proximate targets. That’s where they will both fix the blame and aim their fire.

So once again, the phrase “It’s different this time” can be chiseled on the gravestones of those who speak it. In fact, it’s the same all over again.