Coercing Regulators to Create Fictitious Profits

The previous post described how Congress coerced the FASB to change accounting methods to make banks look healther.

Floyd Norris at the NY Times gives an aggregate investment of the profits that Wall Street desired accounting changes made possible. The following Bloomberg article gives some estimates about the effects on Citi's and Wells Fargo's profits.

Norris concludes "Both the banks and their regulators see virtue in opacity."

Norris, Floyd. 2009. "Seeking Reality in Bank Balance Sheets." New York Times Blog (5 June).
http://norris.blogs.nytimes.com/2009/06/05/seeking-reality-in-bank-balance-sheets

"David Zion, the accounting analyst at Credit Suisse, is out with a report today on fair value accounting, in which he calculates how many billions of dollars were added to bank "values" by the changes that the Financial Accounting Standards Board (FASB) was forced to make: "We estimate first quarter pretax earnings improved by $4.9 billion as a result of the new other-than-temporary impairment (OTTI) rules for the 20 Financials sector companies that early adopted them, including eight companies where the new rules may have increased pretax earnings by more than 5%. In addition, the FASB's mark-to-market clarification resulted in five of the 20 companies marking assets up from $27 million to $4.5 billion"."



Onaran, Yalman. 2009. "Bank Profits From Accounting Rules Masking Looming Loan Losses." Bloomberg Markets (July).
http://www.bloomberg.com/apps/news?pid=20601109&sid=alC3LxSjomZ8

"Analysts who have examined the quarterly profits and government tests say that accounting rule changes and rosy assumptions are making the institutions look healthier than they are."

"Citigroup's $1.6 billion in first-quarter profit would vanish if accounting were more stringent, says Martin Weiss of Weiss Research Inc. in Jupiter, Florida. "The big banks' profits were totally bogus," says Weiss, whose 38-year-old firm rates financial companies. "The new accounting rules, the stress tests: They're all part of a major effort to put lipstick on a pig." Further deterioration of loans will eventually force banks to recognize losses that their bookkeeping lets them ignore for now, says David Sherman, an accounting professor at Northeastern University in Boston. Janet Tavakoli, president of Tavakoli Structured Finance Inc. in Chicago, says the government stress scenarios underestimate how bad the economy may get."

"FASB also let companies recognize losses on the value of some debt securities on their balance sheets without counting the writedowns against earnings. If banks plan to hold the debt until maturity, they can avoid hurting the bottom line. At Citigroup, the recipient of $346 billion in fresh capital and asset guarantees from the government, about 25 percent of the quarterly net income came thanks to the debt securities rule change, the bank said."

"Another $2.7 billion before taxes came from an accounting rule that lets a company record income when the value of its own debt falls. That reflects the possibility a company could buy back bonds at a discount, generating a profit. In reality, when a bank can't fund such a transaction, the gain is an accounting quirk, Weiss says."

"Without those accounting benefits, Citigroup would probably have posted a net loss of $2.5 billion in the quarter, Weiss estimates. In the five previous quarters, Citigroup lost more than $37 billion."

"Wells Fargo also took advantage of the change in the mark- to-market rules. The new standards let Wells Fargo boost its capital $2.8 billion by reassessing the value of some $40 billion of bonds, the bank said in May. And the bank augmented net income by $334 million because of the effect of the rule on the value of debts held to maturity .... The higher valuations Wells Fargo put on its securities probably won't last, as defaults increase on home mortgages, credit cards and other consumer and corporate lending, Northeastern's Sherman says."

"The Federal Reserve, which designed the stress tests, used a 21 percent to 28 percent loss rate for subprime mortgages as a worst-case assumption. Already, almost 40 percent of such loans are 30 days or more overdue, according to Tavakoli, who is the author of three primers on structured debt. Defaults might reach 55 percent, she predicts. At the same time, the assumptions on how much banks can earn to offset their losses are inflated, partly because of the same accounting gimmicks employed in first-quarter profit reports, Weiss says."

Mark-To-Market or Marching to Wall Street's Drummer?

Congress coerced financial regulators to let Wall Street redefine the way it measured profits -- allowing the big banks to show profits and pass the highly vaunted stress test. In the next post, I will indicate how effective this technique has been in creating an illusion of profitability. Then in a third post, I will offer some more comments.

Pulliam, Susan and Tom McGinty. 2009. "Congress Helped Banks Defang Key Rule." Wall Street Journal (3 June): p. A 1.
http://online.wsj.com/article/SB124396078596677535.html

"Not long after the bottom fell out of the market for mortgage securities last fall, a group of financial firms took aim at an accounting rule that forced them to report billions of dollars of losses on those assets. Marshalling a multimillion-dollar lobbying campaign, these firms persuaded key members of Congress to pressure the accounting industry to change the rule in April. The payoff is likely to be fatter bottom lines in the second quarter. The accounting issue lies at the heart of the financial crisis: Are the hardest-to-value securities worth no more than what the market is willing to pay, or did the market grow too dysfunctional to properly set values?"


"The rule change angered some investor advocates. "This is political interference on a major issue, and it raises questions about whether accounting standards going forward will have the quality and integrity that the market needs," says Patrick Finnegan, director of financial-reporting policy for CFA Institute Centre for Financial Market Integrity, an investor trade group."

"The rules had required banks, securities firms and insurers to use market prices to help assign values to mortgage securities and other assets that don't trade on exchanges -- to "mark to market." But when markets went haywire last fall, financial firms complained that the rules forced them to slash the value of many assets based on fire-sale prices. That contributed to big losses that depleted their capital and left several of the nation's largest firms on the brink of failure. Earlier this year, financial-services organizations put their lobbyists on the case. Thirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues, according to a Wall Street Journal analysis of public filings. They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of whom pushed for the rule change, the filings indicate."

"Rep. Paul Kanjorski, a Pennsylvania Democrat who heads the House Financial Services subcommittee that pressed for the accounting change, received $18,500 from coalition members in the first quarter, the second-highest total among committee members, according to Federal Election Commission records. Over the past two years, Mr. Kanjorski received $704,000 in contributions from banking and insurance firms, the third-highest total among members of Congress, according to the FEC and the Center for Responsive Politics."

"During a March 12 hearing before the House subcommittee, FASB came under intense pressure from committee members. "If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself," Rep. Kanjorski said in his opening remarks. "We want you to act," Rep. Kanjorski told Robert Herz, FASB's chief. Mr. Herz waffled about how quickly the standards board could act. Rep. Kanjorski leaned over the dais. "You do understand the message that we're sending?" he said."

""Yes," Mr. Herz replied. "I absolutely do, sir." FASB made speedy revisions to its rules. In an interview, Mr. Herz said FASB merely accelerated the matter on its agenda, and tried to be responsive to input from investors and financial-services firms."

"The change helped turn around investor sentiment on banks. Financial firms had the option of reflecting the accounting change in their first-quarter results; they will be required to do so in the second quarter. Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first-quarter earnings. The Federal Home Loan Bank of Boston said the shift boosted its first-quarter earnings by $349 million. Robert Willens, a tax and accounting analyst, estimates that the changes will increase bank earnings in the second quarter by an average of 7%."

"Mark-to-market accounting has been around for decades. Many banks were content with the rules when the markets were going up. But the rules became a big problem in late 2007. As markets turned down, FASB clarified the rules and established how certain financial instruments, including mortgage securities, should be valued. The guidelines said valuations should reflect "observable" input such as market prices whenever possible. They required banks to disclose extensive information about assets they were unable to value based on market prices. Financial firms last year reported losses or write-downs totaling roughly $175 billion, according to Michael Mayo, an analyst at the CLSA unit of Credit Agricole SA."

"Rep. Gary Ackerman (D., N.Y.) and Rep. Kanjorski pushed Mr. Herz to agree to a speedier timetable. They repeatedly cited Rep. Perlmutter's legislation to broaden oversight of FASB. "It will be done in three weeks. Can and will," Rep. Ackerman instructed Mr. Herz. "Yes," Mr. Herz replied. "Can and will," Rep. Ackerman repeated. Rep. Ackerman declined to comment through a spokesman. A FASB director, Lawrence Smith, said at the time that FASB had little choice but to act. "We can't ignore what's going on around us," he said."

The Waxman-Markey Disaster: Offsets for Every Purse and Purpose

Willem Buiter has noticed another flaw with Waxman-Markey: its carbon reduction targets are purely hypothetical, since virtually all of them, from now to 2050, can be “met” with offsets. Buiter mentions my favorite argument against the offset trade: it relies on an epistemological impossibility, comparing the emissions reductions purchased by offsets against a hypothetical universe in which no such purchases take place. He doesn’t bring up the incentive nightmare, on the other hand: the inducement for every party along the offset value chain to deceive the others and any agency set up to supervise the process. All in all, it seems beside the point to describe carbon offsets as a loophole; they exist precisely because they generate profits for a wide swath of businesses.

As horrible as the offset giveaway is, and the permit giveaway as well, they are not the worst. In theory, both could be fixed if the political system were suddenly to become more responsive to the public interest. Future amendments could require permit auctions and shut down the offsets. What can’t be fixed without overhauling the entire system is the absurdity of issuing permits on a sector-by-sector basis for actual carbon emitted, as if that could actually be monitored and enforced. Environmentalists may think this is a grand idea because, well, those who emit carbon into the atmosphere are bad people and must be kept on some sort of leash. Never mind that it will take an incorruptible army of inspectors to determine just who is behaving how badly, that most small emissions will have to be left outside of such a system altogether, and that parceling out emission budgets this way is an open invitation to rent-seeking.

The simple, effective, non-moralistic solution is to cap the extraction of fossil fuels from the earth, or their importation from other countries. That will make these fuels scarce and expensive, and we can all decide how much we are willing to pay for them according to any reason, noble or base, that moves us. Why is this not on the table?

European vs. U.S. Unemployment Explained

European vs. U.S. Unemployment Explained

When Jaimie Galbraith is good, he can be very good. Here is an example, explaining European unemployment as a result of inequality rather than social democracy. After explaining the close association between inequality and unemployment, he goes on:


97: "The European economy is no longer a collection of separated national systems. Spain, Germany, and France are not independent, mutually isolated national economies. There are no barriers to trade or capital flow, in fact, no formal barriers to the movement of labor throughout Europe. There is now a single currency unit across most of the region. The integration of the European economy in practice -- from the standpoint of a large multinational corporate employer, for instance -- is nearly complete. From every analytical point of view, it is necessary to start thinking of Europe as a single unit. It is therefore necessary, from a statistical and practical point of view, to measure inequality and employment at the European, and not the national, level."

97: "When this is done, the notion of Europe and the United States at the opposite ends of an employment-equality spectrum disappears. Pay inequality within countries of Europe is relatively low, but inequalities between them are very high: much higher than across comparable distances in the United States. Adding the two components, the inequality within and the inequality between countries, one finds that overall inequalities of pay are actually higher in Europe than in the United States. Thus, the standard perception of a European/American counterpoint is simply incorrect. So far as pay is concerned, Europe now is both more unequal and less fully employed than the United States. It is, by the same token, less efficient, but not for the reasons usually given. Rather, the United States wins the efficiency contest -- not because it is less egalitarian but because it is more so than the ungainly ensemble of countries that now make up the European Union."

Galbraith, James K. 2008. The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too (New York: Free Press).

Entelechial Property

by the Sandwichman

Am I the only one who uses far-out puns as a research aid?

Before his famed career as moral philosopher and economist, Adam Smith (1723-1790) was well known for a series of public lectures on rhetoric that he gave in Edinburgh and Glasgow. In this volume, Stephen J. McKenna provides the first book-length treatment of Smith's rhetorical theory, focusing on his theory of rhetorical propriety-the means by which effective communication is adapted to the variables of subject, audience, speaker or writer, purpose, and moment-and the centrality of this concept to his thought.

The word 'entelechial' occurs frequently in Laurence Coupe's book, Kenneth Burke on Myth. I'll be saying more about Burke in subsequent posts, specifically with regard to the relationship between myth, rhetoric and economy. But I'm delighted that my punning Google search turned up the unexpected rhetorical connection between Burke and Smith.

Palin’s D in Macroeconomics: Grade Inflation

We have known for some time that Sarah Palin does not know very much with respect to public policy issues in general and even she admitted to having received a D in macroeconomics. But I bet her college instructor is wandering how he gave her such high marks after seeing this.

Alaska governor Sarah Palin let loose Wednesday on the Obama administration for enacting fiscal policies that "fly in the face of principles" and "defy Economics 101." … "Since when can you get out of huge national debt by creating trillions of dollars of new debt?" Palin asked. "It all really is so backwards and skewed as to sound like absolute nonsense when some of this economic policy is explained."

We are in the midst of the worse recession in our lifetime with the employment to population ratio dropping to 59.7% - and NOW this Republican wants fiscal restraint?

Fear of Inflation – Ferguson v. Krugman

Niall Ferguson notes:

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months.

Ferguson goes onto argue that this settled a debate between him and Paul Krugman where Ferguson has been arguing that the Federal deficits will have to be monetarized and the reason that nominal rates have increased is that inflationary expectations have jumped. The Federal Reserve is reporting that the long-term real interest rate currently was 1.8% on June 1, which means the 3.7% nominal rate represents expected inflation near 1.9%. Back on December 18, 2008, nominal and real interest rates on 10-year government bonds were about around 1.8% - that is, zero expected inflation.

Daniel Gross agrees with Krugman who writes:

Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices. But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all. Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell ... Some economists have argued for moderate inflation as a deliberate policy, as a way to encourage lending and reduce private debt burdens. I’m sympathetic to these arguments and made a similar case for Japan in the 1990s. But the case for inflation never made headway with Japanese policy makers then, and there’s no sign it’s getting traction with U.S. policy makers now.

Ferguson is basically arguing that we have seen a modest increase in expected inflation. Maybe so – but as long as we have only modest inflation, that may be a very good thing for the economy. After all – today’s labor market news is that the employment-population ratio fell to 59.7 percent. So why this silly worry that aggregate demand may be too strong?

Employment Shocker

by the Sandwichman

May nonfarm employment fell by 345,000, much less than even the Sandwichman's revised prediction (between 570,000 and 635,000). Moreover, the April and March employment totals were both revised upward, resulting in reduced job losses for those months of -504,000 (-539,000 preliminary) and -652,000 (-699,000 first revision) respectively. Taking these revisions into account nonfarm employment now stands at 132,200,000, or 214,000 below the preliminary April number.

The BLS birth/death adjustment added in 220,000 jobs in May, compared to 176,000 for May 2008.

Meanwhile, the number of UNemployed persons increased by 787,000 in May, compared to 563,000 in April. And the unemployment rate increased to 9.4% from 8.9%

Stock Market Mirage

How can it be that a company that employs 250,000 filing for bankruptcy is actually good for the stock market and makes the DJIA rally so strongly? The easy answer is the stock market no longer reflects the economic reality on main street. [1]

Or is it that stock markets today are being used to hide the usury on Wall Street: hedge fund manipulation [2] the plunge protection team [3] tax haven secrecy [4] transfer pricing (organised balance sheet losses) [5] global monopoly capitalism, looting [6].

There's a good article by Dr Housing Bubble" on 'Stock Market Dissonance, though his national economy comparison with China is now alarmingly obsolete.


[1] Stock Market Dissonance: Why the Stock Market no Longer Reflects Main Street Economics. The Dow Jones Industrial Average. June 3rd, 2009

[2] Hedge Funds and Stock Market Manipulation. Friday, March 24, 2006

[3] Bush convenes Plunge Protection Team By Ambrose Evans-Pritchard, International Business Editor
Last Updated: 12:05am GMT 08/01/2008

[4] British Tax Haven’s Safety, Secrecy Face Brown, Obama Challenge
By Simon Clark. 16th January 2009

[5] Transfer Pricing Tax System and Its Development in China
State Administration of Taxation (.pdf)
People’s Republic of China

[6]Looting and How It Came to Pass
Naked Capitalism. 4th June 2009

Revised Preliminary Updated Prediction!

by the Sandwichman

Sandwichman previously predicted a job loss of between 775,000 and 835,000 jobs in the May employment report. This morning, however, when parsing the CNN Money happy talk about signs of improvement, I realized a wrinkle I had overlooked. Ken Houghton also called attention to the wrinkle in a comment. Am I comparing a preliminary report for May to a revised one for April? That hadn't been my intention. But I did make a mistake. I was carelessly thinking of the April job report as if it was static and the May one as if it was the "final edition".

From last September to February, as the employment situation has hemorrhaged, the average adjustment from first preliminary to final revision has been 136,800 per month. Comparing this month's preliminary with last month's first revision could thus handicap the reported job loss by an average of 205,250 jobs. So I'm going to make a revised prediction of a NOMINAL job loss of between 570,000 and 635,000 jobs in May. Because the April job losses will likely be revised upward by, say, 60,000 to 70,000 (to 599,000 to 609,000), CNN Money can even report the preliminary May figure as an "improvement."

It may not be obvious that the 570,000 figure represents the SAME estimate of jobs lost as the original 775,000, the difference being that an estimated 205,000 of them are split between one upward revision of the April report and two future revisions of the May report. Phew!

Michael Perelman's Peace Plan For Iraq

I'm not much of a fan of Milton Friedman, but he once offered a very interesting suggestion to rid society of crime.

"The first and most obvious [way to reduce the amount of crime] is to reduce the range of activities that are designated as illegal. Surely, one reason for the growth in crime is that the number of activities that are classified as such, has multiplied in recent decades."

Friedman, Milton. 1997. "Economics of Crime." The Journal of Economic Perspectives , Vol. 11, No. 2 (Spring): p. 194.

Following Friedman's logic the Defense Department found a simple strategy for evacuating the cities.

"On a map of Baghdad, the US Army's Forward Operating Base Falcon is clearly within city limits. Except that Iraqi and American military officials have decided it's not. As the June 30 deadline for US soldiers to be out of Iraqi cities approaches, there are no plans to relocate the roughly 3,000 American troops who help maintain security in south Baghdad along what were the fault lines in the sectarian war. "We and the Iraqis decided it wasn't in the city," says a US military official. The base on the southern outskirts of Baghdad's Rasheed district is an example of the fluidity of the Status of Forces Agreement (SOFA) agreed to late last year, which orders all US combat forces out of Iraqi cities, towns, and villages by June 30."

Arraf, Jane. 2009. "To Meet June Deadline, US and Iraqis Redraw City Borders." Christian Science Monitor (19 May).

http://www.csmonitor.com/2009/0519/p06s05-wome.html

Here is my suggestion: just redefine Iraq to be the Green Zone. Declare victory now that U.S. government has conquered the country. The rest could be disputed territory, such as Israel defines the West Bank. The United Nations, Iraq's neighbors, or even the Iraqi people could sort out what to do with this disputed.

Republicans should be delighted to be able to claim that Bush's policy is vindicated. Democrats could crow about how they achieved peace. And the Defense Department could find a less dangerous land to bomb.

"Signs of Improvement"?

by the Sandwichman

Parse this:

NEW YORK (CNNMoney.com) -- The pace of U.S. job losses -- while still fairly strong -- may be abating, according to a couple of reports released Wednesday.

Automatic Data Processing, a payroll-processing firm, said private-sector employers cut 532,000 jobs in May, a 2.4% improvement from the revised 545,000 drop in April.

Economists surveyed by Briefing.com expected a more modest loss of 525,000 jobs last month. ADP originally reported a loss of 491,000 private-sector jobs in April.

First, a cut of 532,000 jobs is not an "improvement." Second, even the "abating pace" is based on comparing a revised April figure with a preliminary May one. The revised April figure was 11% lower than the preliminary figure, in itself not an improvement. The April revision was more than four times as large as the difference between the (revised) April result and the (preliminary) May result. And, of course, the May loss came out of an already reduced private employment total, so the percentage by which the "pace abated" (a derivative of a derivative of a derivative) was less than 2%, not the reported 2.4%.

Another consideration that the data don't show is that layoffs typically proceed in reverse order of seniority, competence, specialization and/or (more cynically) political favor. So a half a million workers let go in May can be assumed to be, on average, more entrenched and more vital to the operations of a firm than a half-million laid off in April. This is a qualitative difference that could easily swamp the (minuscule and questionably computed) reported quantitative change.

Ezra Klein on the Tyranny of Economists

Confession – I’m a big fan of the writings of young Ezra Klein and he has point here:

Matt Yglesias has an interesting post on "prestige cross-pollination," which he defines as "the habit of distinguished economists using prestige acquired within their field to pass off sloppy work in other fields." ... Peter Orszag is probably the most powerful voice on health-care policy. Larry Summers, by most accounts, has a hand in literally everything. Economists, in other words, are the prime movers on not only the economy, but health care, climate change, housing policy and much else. The argument for this, of course, is that these issues have heavy economic components. Cap and trade, for instance, is based around the construction of a new market for carbon. And it's not as if there aren't issue specialists -- think climate czar Carol Browner -- around the table. But these issues also have heavy political components, and there aren't mega-powerful political scientists in the White House. And these issues have heavy behavioral components, but though the economists often bring behavioral studies to bear, there aren't research psychologists wandering the West Wing. All these disciplines have skill sets that could be applied broadly, but only economists are given these massive portfolios.

But I have to differ with Ezra on this claim:

You don't see sociologists being asked to write op-eds on the Federal Reserve, or biologists being given a forum to talk about health-care policy.

I guess Ezra missed the CNN show where Sanjay Gupta tried to lecture Michael Moore on health-care policy. Or all the times some right-wing nutcase told us laissez-faire works perfectly or how tax cuts cure all evils. No, there are lots of non-economists who write all sorts of silly things about economic policy. By the way, sometimes non-economists say some perfectly reasonable things. Which reminds me – time to catch-up on some reading.

Let's Play Blame the Teacher

California keeps cutting billions of dollars from education. The real problem is the teacher's union, yeah? So the answer is a simple prescription of multiple doses of multiple choice tests. The rationale of these tests takes me back a few decades to the Cold War when proponents of the free market used to ridicule Soviet planning techniques. These same people sometimes referred to a cartoon from the Soviet humor magazine Krokodil showing a nail factory which had fulfilled its output plan by producing one single nail, the size of the plant. Screwing up nails is bad; screwing up kids is inexcusable. Blaming the teacher's union, while refusing to raise sufficient taxes to support the educational system and the educators -- that's easy.

Reality Check

by the Sandwichman

On May 10, Sandwichman predicted the May BLS Non-farm payroll employment would decline between -775,000 to -835,000 jobs lost.

In a Bloomberg News survey of 60 economists, the median estimate of decline in the May payroll report is -521,000, compared with -539,000 in April.

It's getting close to report card time. The ADP survey will come out Wednesday morning giving an early indication of the direction and magnitude of job losses in May. The BLS report comes out on Friday.