Enron Accounting

A few years back, Congress did a hearing on the smoldering remains of the once bright burning Enron. In one session, a couple of boys from Wall Street were up describing the various vehicles and structures they had used to make Enron the paper tiger it was. At one point, one of the Senators even stumbled on the fact that they were creating these structures inside an American corporation in deals with other American corporations in offshore accounts in the Caribbean. Ho-Ho, thought I, this will be good. But that was it, just the fact, no further digging on why American corporations were running their internal books off-shore. Instead, we got Sarbanes-Oxley, and we've all seen how much good that was in keeping the books straight on Wall Street and the banks.

The fact is Enron type, and actually more creative accounting, remains the norm across the financial sector. The ability to account one dollar as two, three, or even ten, but best when you can count a dollar loss as a couple dollars gain. FT Alphaville(tx yves) describes one of the latest flicks of the accounting pencil with Barclay's just released results:

If the reclassifications had not been made, the Group’s income statement for 2009 would have included net losses on the reclassified trading assets of £49m (2008: £2m).

After reclassification, the reclassified financial assets contributed £192m (2008: £4m) to interest income.

Meanwhile, Enron accounting was, and remains, in full use with the Fed and Treasury, especially in using your taxpayer dollars to buy the banks schlock. The FT has a piece showing Bear Stearns "assets", now on the Fed's books, are worth at best half for what we purchased them. Just a reminder why Chairman Bernanke stated last week the well over trillion dollars of bank garbage on the Fed's books would be staying on the Fed's books for a very long time -- more Enron accounting.

In a related piece, John Hussman has a good write-up of what's happening at Fannie and Freddie. While the Fed may be winding down their purchase of bad bank paper, Fannie and Freddie have stepped into the breach. Hussman writes, "Over 60% of the U.S. foreclosure market now falls under the umbrella of these two entities."

How long can as system function and continue with creative accounting standards and the so-called regulators are the leading artists? That indeed is the question. With a partial answer is Richard Koo, with an excellent interview here. Koo has been influential in promoting the not so new idea of a "balance sheet recession", which is actually more or less looking at things from a non-monetarist's view of the world. Too much bad debt clogs the system, as in the case of Japan, and thus people spend years paying down the debt, while the government steps in to at least keep the economy flat. Koo gives a succinct explanation to understanding why the banks aren't lending:

In these cases, after an asset pricing shock, after a bubble bursts, the private sector’s balance sheets are under water. When that happens, the first priority of people in the private sector becomes to minimize debtsinstead of to maximize profits and if there are enough under water balance sheets around, even if you bring interest rates down to zero, still nothing happens. People with balance sheets under water will not be increasing their borrowings and there won’t be too many willing lenders to those guys, either. So the effectiveness of monetary policy goes out the window, exactly as happened during the Great Depression in the U.S. and in Japan during the 1990s —and as is happening in the U.S. this time around.

Koo also points to the developing world's massive debt problem in the 80s and the Fed's and Treasury's reaction, which as I recently pointed out is very much the playbook now being followed. The public swallows a great deal of the loss and the rest is extended to be paid over time. Koo is right about a lot, but not enough. Japan showed there's problem "extending and pretending" in a mature industrial society. Over time, the debt simply ties you to the past and inertia becomes dominant. Without destroying, writing down, call it what you want, a great deal of this bad debt, the American economy is fated to be stagnant for years to come. However, unlike Japan, the political reaction will be quicker and more volatile, though that certainly remains to be seen.