The Accounting Trick Behind Thirty Years of Scandal

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Brendan McDermid / Reuters

Traders work at the Goldman Sachs kiosk on the floor of the New York Stock Exchange, April 16, 2012.

Once upon a time, New York City’s Times Square was plagued with Three Card Monte dealers who made their living bilking unsuspecting tourists out of their five and ten dollar bills with the aid of paid shills and a little prestidigitation.  These sleight-of-hand artists were mostly chased from the streets in the 1990s during the city’s broader renaissance, but according to a new paper from law professors William Bratton and Adam Levitin, a more sophisticated shell game was just getting going in the skyscrapers that overlooked the financial capitals of the world.

America has been afflicted with one financial scandal after another over the past generation – culminating in the 2008 financial panic, the effects of which we are still suffering under. It has widely been assumed that each of these scandals have had disparate causes, but in their new paper Bratton and Levitin argue that three of the most notorious scandals of the past generation — Michael Milken’s junk-bond-related securities fraud in the 1980s, the Enron scandal of the early 2000s, and the subprime mortgage meltdown of 2007-08 — are all linked by their use of an esoteric accounting mechanism called a “special purpose entity,” or SPE. When used dishonestly, SPEs are nothing more than financial sleight of hand, the clever shifting around of assets to trick regulators and investors into seeing something that isn’t there.

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So what exactly are SPEs? Broadly speaking, they are legal entities that are separate from the firms that have created them. They can hold assets and owe debt, but as Bratton and Levitin write, “they never fully coalesce as independent organizations that take actions in pursuit of business goals.” They are companies running on autopilot that serve one purpose: removing assets and liabilities from the parent company’s balance sheet.

Companies can use SPEs for legitimate purposes. For example, an oil company might want to finance an expensive and risky exploration project without putting the whole firm at risk of its failure. So they’ll set up an SPE with limited resources, put only those resources at risk in pursuance of the new project, and fully disclose the arrangement to potential investors. But as Bratton and Levitin’s paper shows, special purpose entities can be — and frequently are — a recipes for disaster.

Their story begins in the late eighties when junk-bond king Michael Milken and his firm Drexel Burnham Lambert, who fueled the 1980s takeover wars with their seemingly endless issuance of high-yield debt. As the decade drew to a close, however, the firm was running out of demand for their junk bonds. Their solution: deposit the bonds into SPEs and slice and dice them in such a way that the ratings agencies would give them an investment-grade rating — allowing insurance companies and pension funds, which have rules against putting money into high-yield debt, to invest. These special vehicles were, according to the paper, “entwined in the failure of one of the nation’s largest life insurers — and the world’s largest investor in junk bonds — First Executive Corporation.”

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Enron then famously used SPEs to hide underperforming assets and book phantom profits that kept its stock price high even while the firm was imploding. According to Bratton and Levitin, Enron “received its final kick into bankruptcy when those off balance sheet obligations came due.”

And the subprime mortgage crisis was also caused, in part, by excessive and irresponsible use of SPEs. These vehicles allowed banks to hide risky subprime assets off their balance sheets and away from the prying eyes of regulators, freeing them to lever up even more in search of higher profits. Goldman Sachs was one of the more famous users of SPEs, when it created ABACUS, a synthetic collateralized debt obligation, which like most of these collections of subprime mortgages ended up in default. Goldman was fined $550 million by the SEC for not disclosing the true nature of this collection of mortgages to the investors that eventually bought them, but the greater problem with vehicles such as ABACUS were that it enabled banks to appear to regulators and investors as if they had moved the risk of the mortgages off their books, when in reality, many banks (and ultimately the taxpayer) ended up bailing out their special purpose entities when they went under.

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These SPEs have been lambasted in the press for years, but Bratton and Levitin argue that because of their culpability in so many of the most recent financial scandals, they deserved special and immediate scrutinty. The good news, however, is that regulators have made serious strides in addressing the dangers posed by these accounting structures. The Financial Accounting Standards Board, a non-profit organization that is charged by the SEC with writing accounting standards, adopted rules in recent years which forced banks to bring many of their SPEs onto their own balance sheets.

Even more important, the paper argues, is that a “conceptual barrier has been surmounted” rearding how regulators view the non-academic question of what, exactly, a firm is. With these new rules, regulators now understand that just because a firm doesn’t have a formal equity stake in a toxic asset, it isn’t completely walled off from the risk. That alone, write Bratton and Levitin, is “a cause for celebration.”

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39 comments
Robert Ewalt
Robert Ewalt

Could someone explain a valid purpose for SPEs?  In the article's example of a risky oil venture, the investors would have full knowledge and that the venture rises and falls on its own merit - no parent guarantee.  Most SPEs are sold to investors with the assurance (maybe unwritten) that the parent is responsible.  If this is true, any reasonable accounting rule, any informed investor should know that the liabilities belong on the parent's balance sheet. 

Thomas Donovan
Thomas Donovan

The SPE was the legal structure which allowed for the transactional accounting.  Fair value accounting and Gain on Sale accounting starting with SFAS 125 in the late 90s made the recognition of big gains on assets put into SPEs.  These gains were often made with suspect evidence about performance over a 10 to 30 year period.  This included low loss ratios on below prime mortgages and low default expectations on credit default swaps.  There remains significant risks with fair value accounting and gain on sale accounting. 

kumaran
kumaran

as Earl answered I am taken by surprise that a person can make $6166 in 4 weeks on the computer. did you see this webpage http://www.lazycash49.com

HunterST2
HunterST2

Don't look to the Republicans to do anything about these abuses. We are talking about their bread amp; butter. They are the main force standing in the way of re enacting  the Glass-Steagall Act. Just wait til they get their hands on Social Security. You won't believe what happens to you in your old age after that.

Scott03060
Scott03060

"is that a “conceptual barrier has been surmounted” rearding how regulators"

Should that be "regarding"?

Darrel K.Ratliff
Darrel K.Ratliff

Somewhere between the Music man  and guys and dolls  is the Anne Rand Mentality of Wall street  vs the common citizen  Lets just say  if you made money  you made a good bet  and if you survive in wall street  and all the little dollar traps that it has you did  better than most in your bets.

Speculating on an unsure business is bad but with  the lack of inside knowledge  is worse as far as a likelihoods of success and with insider knowledge is Unfair at best and illegal   whether or not you get caught  and punished for it.

We are on this earth to learn and gain faith and judged by what we do  with the knowledge and success we have here as well as what we did to help others survive  here If you do it dishonestly  then you will be rewarded according to what you did  and how you did it..  good and bad  Both.

Ohwoahisme
Ohwoahisme

The citizenry has some responsibility in all this.  For decades they've  continued  electing  politicians willing to distribute largesse from the public treasury, encouraging more spending, borrowing, and printing.  They've been sold a bill of goods that someone else will pay for it. So lousy fiscal policy ensued, allowing more bogus financial instruments to be created to pass any tax and regulatory cost back to the citizenry.  It's a 'shell game' that we've allowed to grow and it's going to kill us.

h rutner
h rutner

great news, the SPE scam may end soon. Next on the agenda: ban program trading that benefits afew select institutions and gamblers while fleecing the majority! Ditto tax ALL financial transactions as another fix and a huge source of much needed revenue from an elective sin tax

HunterST2
HunterST2

 I would be all for Programmed Trading if I had the privilege of my own computer on the trading floor. The whole stock market is rendered into a Quasi- Ponzi scheme by the special positions that the big fish hold.

Palladia
Palladia

The problem with taxing all financial transations is that it would disproportionately affect small traders, and put a burden on pension funds as well as 401(k)s and Roth IRAs held by individuals.

Juliana Db
Juliana Db

The tax could be small enough that it only imacts the high frequency traders who use their co-locations with exchanges to front run orders.  It should also be charged on cancelled trades.  Here is what France has done about it:

http://thedailybanter.com/2012...

ipgrunt
ipgrunt

It is refreshing to see Time come out with an overt criticism of the gluttonous sacred cow-- the financial markets of the world -- that plays a leading role in economic enslavement and the destruction of a free society.  What can  done, short of outlawing greed, about this societal cancer? If we don't act soon, the plebeian base of western democracy will collapse under the weight of debt, unemployment, and inflation.

Fatesrider
Fatesrider

 What's even more satisfying to ME is that those commenting here so far aren't posting a bunch of misguided political ideology that tries to support the status quo.

America is divided on how to best deal with our economy, but we seem to have one point of common agreement: Hang the damn bankers who steal from us.  If we can all agree, and act (in a civilized and legal fashion) on it, then there's hope for our future as a united nation.

premjipmb
premjipmb

Such SPE (Special Purpose Entity) use for hoodwinking would also being used by many other corporates. In India, it may go by some other name like Securitisation of distressed debt in India but this cheating happens and the auditors, chartered a/c certifying firms are aware of this cheating. Regulators and the authorities look the other way. Contigent liabilities should be reflected effectively in all the Balance Sheets. There is no need to support and shelter the cheaters at the cost of the investors and public money.

Jim S.
Jim S.

In short: reagan capitalism!!

And the tools of are still waitin for their 'trickle down' as they get all the charges the public and private companies need to exist and grow!

yodadog
yodadog

Much like military R amp; D, Wall Street is probably employing new scamming techniques that won't be uncovered for ANOTHER 20 years. This is the result when you deregulate greed, and unless we untangle corporate America's grip on what used to be OUR government, nothing will change. The challenge is getting people to understand.

EllenynqLisa
EllenynqLisa

like William answered I'm surprised that a mother able to earn $9300 in a few weeks on the network. did you look at this(Click on menu Home)

Tommyqgj
Tommyqgj

Thomas explained I can't believe that anyone able to get paid $5116 in 4 weeks on the network. did you look at this(Click on menu Home)

Talendria
Talendria

Agreed.  The first thing we need to do is ban corporate executives from serving in government.  You can't be trusted to audit or regulate an industry when you owe allegiance to that industry in the form of friendships and financial benefits.  That's a clear conflict of interest.  We also need to start prosecuting individuals rather than the corporate entity.  Fining a corporation amounts to a slap on the wrist and offers no long-term disincentive to avoid unethical practices.  If you jail the executives and recoup their ill-gotten gains, you give their peers a reason to play by the rules.

asdfasdf123456
asdfasdf123456

No, banning execs will not work.  If a person is corruptable, it does not matter where he/she has worked.  The only answer is to get gov't out of most regulation (other than physical proctection and environment) and let the buyer beware. 

yodadog
yodadog

Amen to that Talendria! Former healthcare insurance execs from United Heathcare and Wellpoint corp appeared as staffers for Max Baucuses negotiations with the WH on Obamacare and re-wrote the bill, to include removing caps on rate increases, according to Howard Dean in a Frontline interview. They also get into departments of the federal branch as regulation writers after bills are passed-it's an insane situation. 

There's a slew of things that have to change if we citizens are ever to regain our government back, including a ban on lobbyists, a new way of campaign funding that levels the playing field so anyone of any means can run, term limits on all three branches and the ending of all Congressional perks, salaries, insurances, retirement etc. It was never intended to be a full time job.

Ohwoahisme down below states we citizens has some responsibility in this. I say not some, but all. We've let it happen and we are the only ones who can change it-we need people to get angry enough as done in the 60's and make it happen. I had hoped OWS was going to be it, but, sadly, they were too focused on fluff and foolishness.

AThoughtfulObserver
AThoughtfulObserver

Corporations and Private Equity: Finding legal ways to do illegal things.  That is what Wall Street is about these days.

Cynthia R. Brown
Cynthia R. Brown

The ones who DO get prison time and a fine generally have made (and get to keep) their substantial profits, anyhow...Millionaire4Project.blogspot.com

Tanishab
Tanishab

like Virginia replied I didn't know that you can earn $9042 in 1 month on the network. have you look this(Click on menu Home)

Palladia
Palladia

If a mugger or pickpocket gets ten or twenty bucks, and is caught, there may well be jail time in his future.

But if some market manipulater gets a few million, and gets caught, he will probably never even see the inside of a courtroom, never mind a conviction and prison time.  The ones who DO get prison time and a fine generally have made (and get to keep) their substantial profits, anyhow.

happydayfortennis
happydayfortennis

It's just so much easier to arrest someone who's powerless and poor than someone who already has too much power and money and abuses the system for more.  

vstillwell
vstillwell

I just don't see how these people get away with this crap. I thought all subs had to report their activities through the parent, but, I guess, if you're Wall Street, rules don't apply to you.

Trajan Saldana
Trajan Saldana

How do they get away with it? They write the frickn rules...cmon now