Wednesday, January 13, 2010

Media Incompetence: AIG's necessity and Banker Bonuses

 
These stories both appeared in the Wall Street Journal this morning. For a newspaper that is ostensibly focused at least somewhat on issues important to finance, these were egregious errors.
 
The AIG bailout article questions whether AIG was systemically necessary and accuses the government of bailing out AIG as a shadow mechanism of bailing out its counterparties. While I don't love that the government functionally bailed out the counterparties at 100 cents on the dollar, instead of a discounted rate, you couldn't let AIG fail because AIG functionally insured a massive number of the AAA-rated securities out there, and many of the AAA-rated securities were only rated AAA because of AIG's insurance. If AIG fails, and all those securities get downgraded, they lose value, and every single bank at once has a capital call. The government has to step in and bail out all of the banks anyway, or else all of them fail, except it has to do that without a) the functioning operations of AIG making everything faster and more efficient and b) an overdiscounted valuation of AIG's assets as it goes through bankruptcy, meaning the government needs to pay more in bailout money.
 
Again, this was one of those situations where the government didn't really have a choice. They could have purchased securities at less than par, to avoid moral hazard, but they would have needed to pay enough to keep AIG afloat and its credit rating somewhat intact.
 
 
The second article, on how bankers are getting massive bonuses amid "record profits" despite the economy being in a recession, is even dumber, but to understand why requires some knowledge of accounting. The way GAAP works (Generally Accepted Accounting Principles, the accounting system used in the US) is that when you have a reasonable certainty that an asset is impaired, you have to "write down" its value on your balance sheet. So say I have a mortgage on my balance sheet, and its value is the total set of payments I'll receive for lending that mortgage. If all of a sudden I don't think I'm gonna get the full value of those payments, I have to adjust the value of the mortgage on my balance sheet to the value I think it's going to be now. This has to happen as soon as you think the stream of payments (or resale value of the bond) has changed - you don't wait until the mortgage actually defaults. The change in balance sheet value gets booked as a loss against your profits, even though the mortgage hasn't actually defaulted yet. Additionally, if the mortgage doesn't actually default, in the US, you don't write up the value of the mortgage again... you just book all of the "additional" payments, that you thought you weren't going to get, as additional profit. (This is slightly different to how the European accounting system works - called IFRS - so the losses of US banks and European banks aren't apples-to-apples - Europe's banks have gotten hit much harder than US ones, but it doesn't always look like it, depending on the timing)
 
For the simplest illustration, if I have a 100 dollar, 0% 2 year mortgage, and we're in the middle of a financial crisis and I don't know how bad it's going to get but I think it's possible in an awful but probable case that I'm only going to get payments valued at 30 dollars, then I take a 70 dollar "loss" immediately - so I look as if I'm highly unprofitable. Next year, it turns out that the market wasn't quite as bad as I thought, and the payments actually should have been valued at 60 dollars. At the end of each of the next two years, I then book an additional PROFIT of 15 dollars (70/2 - 40/2).
 
Cash Flows:
 
yr 0: -100 (the initial payment of the mortgage)
yr 1: 30
yr 2: 30
total: -40
 
Accounting Profit:
yr 0:
Net Income (profits): -70 in writedowns (the amount reported in the news)
Balance Sheet value (assets): 30
 
yr 1:
Revenue: 30
Depreciation: -15 (to account for the fact that my asset has paid out some of its value and thus isn't worth what it used to be)
Net Income (profits): 15 (the amount reported in the news)
Balance Sheet value (assets): 15
 
yr 2:
Revenue: 30
Depreciation: -15
Net Income (profits): 15 (the amount reported in the news)
Balance Sheet value (assets): 0
 
Total profits: -70 + 15 + 15 = -40
 
 
If, instead, the banks had estimated the size of the crisis properly and didn't overdo their writedowns:
yr 0:
Net Income (profits): -40 in writedowns
Balance Sheet value (assets): 60
 
yr 1:
Revenue: 30
Depreciation: -30 (to account for the fact that my asset has paid out some of its value and thus isn't worth what it used to be)
Net Income (profits): 0
Balance Sheet value (assets): 30
 
yr 2:
Revenue: 30
Depreciation: -30 (to account for the fact that my asset has paid out some of its value and thus isn't worth what it used to be)
Net Income (profits): 0
Balance Sheet value (assets): 30
 
Total profits: -40 + 0 + 0 = -40
 
You can see from this that the so called "profits" were entirely fictional - each year, the bank is 20 dollars SHORT of where it should have been, without defaults. However, the banks all just took "big baths" in the first year - where they just wrote down their assets to worst-case scenarios so they didn't keep perpetually having to find sources of replacement capital and face their shareholders (banks need to maintain a certain set of debt and equity ratios, and writedowns reduce equity without reducing debt, so with every writedown, a bank needs to go out and find more assets that reflect in equity - like deposits or bailout money).
The problem is now they LOOK like they lost a ton in year 0 but had big profits in years 1 and 2, when their reality was more likely reflected by a combination of the cash flows and the accurate writedown scenario- their losses didn't come in year 0, they lost 20 dollars a year in years 1 and 2. Making today the allegory, last year was year 0 and this year is year 1, so it looks like they have a 15 dollar profit when they don't.
 
 
If, instead, the banks had underestimated the size of the crisis and didn't write down enough assets, and didn't :
yr 0:
Net Income (profits): -20 in writedowns
Balance Sheet value (assets): 80
 
yr 1:
Revenue: 30
Depreciation: -40 (to account for the fact that my asset has paid out some of its value and thus isn't worth what it used to be)
Net Income (profits): -10
Balance Sheet value (assets): 40
 
yr 2:
Revenue: 30
Depreciation: -30 (to account for the fact that my asset has paid out some of its value and thus isn't worth what it used to be)
Net Income (profits): -10
Balance Sheet value (assets): 30
 
Total profits: -40 + 0 + 0 = -40
 
And we'd be complaining about how the banks have been bleeding money for three years.
 
There are some financial assets that are treated differently than the regular GAAP assets (some of them do get written back up - in banks, insurance companies and other financial entities only, which is called "mark to market", which are gains booked immediately), but this would likely result in profits being shifted from year 2 to year 1, so year 1 looks like even more of a bonanza than it really is. The point stands even more strongly.
 
Anyway, all of these reflect the exact same cash flow patterns. Accounting can get complicated, and there is guesswork involved to maintain a reasonable balance between relevance (the accounting system reflects some semblance of economic reality, which isn't reflected by a -100 profit in year 0 in the cashflow scenario when they're getting that money back) and reliability (the accounting system portrays things as they actually are, which isn't reflected by a -40 dollar writedown in year 0, cuz you didn't lose any money then). The idea that you can rail on the banks for "big profits" this year is absolutely absurd and uneducated in how these numbers are calculated.
 
An appropriate response would be "Then why are they getting bonuses?"  The short answer is that you can't give no bonus for two years and expect to keep your talented employees, because the longer they go without bonuses, the less in terms of stock options they have keeping them attached to the firm. Finance is all about positional externalities - there are fewer people capable of doing a good job than there is demand for services (a major reason why this crisis happened in the first place), so holding onto your superstars, or anyone who could become a superstar, is really, really important if you want your firm to survive. It's an operating cost, no different than Ferrari having to buy expensive paint. Could they sell awesome Ferraris with cheap paint? Of course, the paint isn't that important in and of itself. But if Ferrari cares about competing with Lamborghini, and Lamborghini is using nice paint, then Ferraris had better use nice paint, even if the paint itself is useless. Not every financial firm has been bailed out - most haven't, actually - and the bailed-out banks don't want to go belly up by losing all their talented people. As the article notes, the only inputs in finance are initial capital (money) and smarts, and there's usually much more capital than there is smarts in this world.
 

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