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TUESDAY MAY 11, 2010Seven Dirty Words!Back in 1971, the late comedian, George Carlin, introduced us to the Seven Dirty Words You Can't Say On TV. I am sure we are all familiar with them, so I won't go into the details! However, I would like to add another word, or more specifically, a phrase to the list of dirty words. At a minimum, it should be added to the dirty words of investing and accounting. My nomination for the latest dirty word is "off-balance sheet." A quick look at the scandals and severe bear markets of the last decade finds that the phrase "off-balance sheet' played a prominent role. The king of the "off-balance sheet" accounting was Enron. The high-flying company was the poster child for the equity bubble of the late 1990's. Quarter after quarter, Enron posted mind blowing earnings and never seemed to post a loss. Of course, we now know it was CFO Andrew Fastow's creative and liberal use of "off balance sheet" limited partnerships and joint ventures (many named after his children!) that allowed "the smartest guys in the room" to hide all of their losses. By October, 2001, the collapse of Enron provided one of the pins that popped the equity bubble. Enron's Chairman, Ken Lay, its CEO, Jeffrey Skilling and Andrew Fastow were all convicted of various felonies associated with the accounting fraud. Despite the convictions based on already existing laws, the whiz kids in Washington responded to the bubble (after it burst!) and gave us the regulatory monster known as Sarbanes-Oxly (Sarbox.) This was the latest and greatest regulatory policy that was going to "prevent this from ever happening again." Fast forward to 2008. One of the most amazing and befuddling aspects of the "Subprime Crisis" was the prominence of "off-balance sheet" in a post Sarbox world. Recall that the downfall of Bear Stearns in the spring of 2008 began when Bear was required to take two failing "off-balance sheet" hedge funds on to its balance sheet which instantly created a previously unknown and massive loss. This event shocked the markets and compelled analysts to sharpen their pencils. Soon it was apparent that many of the largest Wall Street firms, specifically Citibank, Merrill Lynch and Lehman Brothers, had their own "off-balance sheet" problems with hedge funds and structured investment vehicles (SIVs). Even today, we are still learning how Lehman utilized a creative accounting gimmick called Repo 105 to mask the amount of leverage that was being applied to the firm's balance sheet. How these firms were permitted to utilize these off-balance sheet gimmicks in the post Sarbox world remains one of the great mysteries to me. Clearly, the boards of these companies, their auditors and the regulators were asleep at the switch. Naturally, the gang in DC is once again going to provide us with regulatory reform that will "prevent this form ever happening again." Meanwhile, the pious and indignant politicians hammer away at Wall Street while they are blatantly ignoring their own "off-balance sheet" issues. U.S. Public Debt is roughly $8 trillion and is projected to grow to $12 trillion by 2012. That is a debt-to-GDP ratio of 60%+ on its way to 100%. Greece would be proud! As bad as that seems, the debt numbers do not reflect the true outstanding debt of the nation because the "off-balance sheet" wonders known as Freddie Mac and Fannie Mae are not included in the numbers. As "off-balance sheet" companies in conservatorship, their $1.7 trillion in outstanding debt and $5 trillion in mortgage-back security guarantees are not counted in the U.S. Public debt numbers. How Lehman like! By the way, these two off-balance sheet companies asked for an additional $19 billion this week to cover their most recent losses. This brings their total taxpayer "funding" to $145 billion! To say the least, it seems odd that Fannie and Freddie are not even mentioned in the current Financial Reform debate! Of course, we can not forget the other minor "off-balance sheet" items that we commonly refer to as Social Security, Medicare and Medicaid. As off-balance sheet entities, these massive unfunded liabilities also don't count in the current debt calculations. How can three entities that currently consume 57% of all Federal revenue be considered "off-balance sheet?" And what is Washington's answer to the unfunded liabilities? Add another $1 trillion to the pile! Brilliant! And not to be out done, our states have been equally slick with their "off-balance sheet" entities. Most state public pension plans are considered "off-balance sheet." Unfortunately, 40 states have underfunded pension plans. Not bad, 80%! Experts estimate the collective underfunded public pension liability at nearly $2 trillion! The mere mention of "off-balance sheet" in the context of any accounting report should be a sign of trouble for any investor. Regardless of whether its is associated with a company like Enron or a government entity like Social Security, it is a warning that accounting gimmickry is at hand. I hope the recent experience of Greece and Europe will shed some light on our own "off-balance sheet" issues. For the U.S. government, it is already a dirty word, and getting dirtier by the minute! I will leave to your imagination what George Carlin would say about "off balance sheet" accounting? A dirty word indeed! POSTED AT 1899-12-30 13:11:00.0 |
KEN ENTENMANN, CFA
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The opinions expressed here do not represent the views of Alliance Financial Corporation and Alliance Bank, N.A. This communication is not an offer or solicitation for the purchase or sale of any security, is for general informational purposes only and does not provide personalized investment advice. When making personal investment decisions you should consult your investment adviser or rely on your own research. Copyright 2008.