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(photo: Bindaas Madhavi)
When health insurance companies triumphantly announced they had found a loophole which would permit them to deny coverage to children with pre-existing conditions, Jon Stewart asked the right question: why were you looking for loopholes? Why are you screwing over the children? We all know the answer. These companies are in the money-making business, and health insurance is just a sideline operation. Gaming the system is a profit center.
The report (.pdf) of the court-appointed Examiner in the Lehman Brothers case gives an excellent example a finance company gaming the system. The issue is proper accounting treatment of what Lehman called Repo 105 transactions. A repo, short for repurchase agreement, is a short-term financing vehicle. Lehman sells securities to another company under a contract that requires Lehman to buy the securities back a short time later at the same price plus interest. Repos are commonly used by brokers to finance their securities inventories. The borrower gets cash, and uses it to pay for the securities it is transferring. Typically, the borrower transfers securities with a market value slightly higher than the amount of cash it gets, so that the lender is protected from short-term loss.
In repo transactions, assets decrease by the value of the securities transferred, and increase by the amount of cash received. Liabilities increase by the amount borrowed, but the borrowed money is used to pay an equal amount of debt. That returns the balance sheet close to its prior position. After the transaction, the net worth of the transferor is unchanged. Leverage is the ratio of assets to net worth. If the repo is properly recorded, leverage doesn’t change.
One of the relevant accounting rules says that a transaction in which a transferor surrenders control over assets is to be accounted for as a sale. The Examiner explains this rule as follows.
SFAS 140 also states that “The transferor has surrendered control over transferred assets if and only if all of the following [three] conditions are met”:
….
● The transferor does not maintain effective control over the transferred assets through either (1) an agreement that both entitles and obligates the transferor to repurchase or redeem them before their maturity or ….
Report, Vol. 3, 773. The first two conditions, which are omitted, are no-brainers. That third one looks exactly like a repo, now doesn’t it? But Lehman figured out a loophole. Lehman claimed that if the amount of collateral transferred was more than 105% of the amount received, the transaction is a sale. Lehman used that loophole to reduce the amount of leverage it reported.
As an example, suppose Lehman did a repo with Fannie Mae preferred stock. It gives stock with a value of $105 to lender and gets $100 back. It records the transfer as a sale, meaning its securities inventory goes down $105. It records an increase in an asset called “derivatives” of $5 to reflect the profit it will make when it pays off the repo at $100 and gets securities worth $105 back. Cash goes up $100. It uses the $100 to repay a short-term loan with its bank. Its liability to repurchase the securities is not recorded. After the repayment, assets are lower by $100, and liabilities are lower by $100, so net worth is unchanged.
With the same net worth but lower assets, leverage is lower than it was before the transaction. The Examiner says the effective reduction in leverage ranged from about 10% to about 13%. The Examiner asserts that this is a material difference, and gives rise to colorable claims against several Lehman employees. The Examiner also asserts that it creates a colorable claim against Lehman’s auditors, Ernst and Young. In general terms, these claims relate to the obligations of these parties to insure that the financial statements accurately reflect the financial position of the company.
The Examiner acknowledges that both the individuals and the accountants may have valid defenses. They’d better have defenses: it looks like the cops may have woken from a deep slumber, probably because the screaming from every side has been pretty loud.
Whatever those defenses are, they need to be removed. Congress has to impose liability for company management and professionals who aid and abet gaming the systems set up to protect investors and the whole economy. There isn’t any point in regulating if people can escape liability by creating fake technical compliance.
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And just look at the Obama’s take on ‘leverage’.
“Take for instance debt-to-equity ratio requirements for big banks. The bill that passed the House would require institutions to set aside a fixed amount of capital as a way to ensure they’re on stable footing. The Senate bill doesn’t include mandatory limits on leverage. Instead it establishes an oversight council with “the sole job to identify and respond to emerging risks throughout the financial system.”
“Congress has to impose liability for company management and professionals who aid and abet gaming the systems set up to protect investors and the whole economy. There isn’t any point in regulating if people can escape liability by creating fake technical compliance.”
Then Congress and the White House would have to hold themselves accountable. Obama’s whole MO is to have the corporations determine their own regulations and then go and pat himself on the back.
If corps are people, then people should be going to jail…
It seems like Congress doesn’t want to use that awful “J” word, but it’s a safe bet that a thorough and proper investigation would disclose plenty of jail-worthy incidences. I say, Supermax the sonsabitches…
I didn’t explain the rationale for the loophole, in the interest of length. From page 778 (fn omitted):
The FASB goes on to say that typically that means that the collateral must be within 2% of the amount borrowed. Even then, you have to use judgment. It is an odd loophole from my perspective, but then many lawyers have an old-fashioned view of rules: we try to counsel clients to stay within the intent of the rule, not to stretch for some alternate interpretation that will let the client do what it wants to do.
“Here’s what we want to do. Make it legal.”
Let me take another look at my bill, and my malpractice policy.
Masaccio: In your view, just exactly how compromised is the FASB?
For an honest person, the way you did it was the proper one in all ways.
But too many folks go along for the bucks.
The trouble is that the lobbyists who are writing the legislation are deliberately including the loopholes, and the officeholders who are in effect taking money from the lobbyists and elsewhere, in order to allow the lobbyists to write the legislation, are deliberately voting for the loophole’d legislation. So when you write:
you are in essence asking for a system (the legislative system) that is dominated by officeholders and the lobbyists who pay them to voluntarily stop doing something that they base a good amount of their political economy on. Quit thinking of legislation as “the process by which laws best serving the broad public are created” and starting thinking of legislation as “the process by which deep-pocketed special interests use connections and vast financial leverage to co-opt or coerce officials to pass laws favorable to the interests”.
I’m afraid that we can’t have a lot of confidence in it anymore. There are too many instances of political influence, for one thing. In addition, accountants do not have as much professional independence as they did when 40 years ago when I started working. They sacrificed their professionalism to a large degree in the hunt for money, just as lawyers did. But that’s another story.
Of course, I don’t think my call for Congressional action will even echo outside the FDL walls.
The point is that without serious penalties, corporations and people we used to call professionals will game the system, and no reform will work.
I believe that jail works. Even short sentences, six months at a work farm in Nevada, will deter the average chief of financial operations. That is why I would have simple strict liability crimes with light but determinate sentences, and moderate fines.
But that’s another story.
I remember back in the “public” days. It was always about billable hours, CYA and finding new clients (and/or finding additional opportunities for extracting revenue from existing clients). Rarely, it seemed, was it about the quality of the work – cosmetics and window-dressing on the final reports notwithstanding.
I was once on a jury where a man was convicted of pushing his wife down on the ground. He was given a one year sentence. Yep a whole year for pushing her down to the ground. It makes the rampant spousal abuse cases seem destined for life sentences, but we know that won’t happen. Needless to say I don’t have a high opinion of the judge who gave the sentence.
Now, if a person deserves a year in jail for that then what does a large corporation and it’s top executives deserve for nearly destroying the world’s economy, throwing millions out of work and/or their homes and destroying the value of trillions in assets?
There’s clearly a double standard and the Rich don’t live in the same world as most people. It isn’t fair.