The Dodd Wall Street Charade

The senator's financial reform proposal is missing one key paragraph—and without it, the idea that banks will be kept honest is just a charade.

Harry Hamburg / AP Photo

Senator Dodd unveiled his financial reform bill today that has satisfied neither Democrats or Republicans. Below, Frank Partnoy on the key paragraph Dodd’s proposal is missing and why, without it, the idea that banks will be kept honest is just a charade.

The new financial reform bill proposed today by Senator Christopher Dodd, the Chairman of the Senate Banking Committee, is missing one crucial paragraph. The gaping hole in the bill involves a concept known as off-balance sheet accounting. The dirty secret of the markets is that financial statements of major Wall Street banks were, and still are, a fiction. Until bank balance sheets reflect reality, financial reform will not work.

If the balance sheets of Citigroup or AIG or Lehman or Bear Stearns had been accurate, they would have shown massive exposure to complex financial instruments.

The Lehman Brothers report from last week scratched the surface of this problem, with news about how that bank used scandalous “Repo 105” deals to hide tens of billions of dollars of debt. But Lehman was not alone. Consider the balance sheet below. It is a real balance sheet, of an actual company. (Assets are the good stuff, liabilities are the bad stuff, and equity is what’s left.) Think about the financial roller coaster ride of 2006-09. Now answer this question: who is it?

2006 2007 2008 2009 Assets $1,884 $2,188 $1,938 $1,889 Liabilities $1,765 $2,074 $1,797 $1,746 Equity $120 $114 $142 $142

You might think these rock solid numbers are from a conservative steady company that weathered the recent financial storm. Perhaps McDonalds? Or Wal-Mart?

In fact, this balance sheet belongs to Citigroup. There is not even a hint in these numbers that the value of Citigroup’s business went from a quarter of a trillion dollars to nearly zero. There is no indication that Citigroup suffered massive losses in 2007 and 2008, and then a major post-rescue recovery in 2009. Instead, the balance sheet suggests that Citigroup’s was steadily and consistently healthy for all four years. This balance sheet is, in a word, fiction.

Citigroup is not alone. The balance sheets of every major Wall Street bank are equally fictitious. They do not reflect trillions of dollars of swaps. They do not include so-called “Variable Interest Entities,” the subsidiaries banks use to avoid recording risks. Instead, the banks’ exposure is off-balance sheet. Their financial statements do not show many of their actual liabilities.

The balance sheet is not a trivial document. It is the basis for much regulation, including Tier 1 and Tier 2 capital requirements. Investors and regulators look to balance sheet numbers for a range of purposes. And yet balance sheets are not even close to accurate.

Wall Street lobbyists say fixing off-balance sheet transactions is too complicated. Instead, they argue that if Senator Dodd and his colleagues want to adopt reforms related to this area, they should focus on other issues, such as centralized clearing of derivatives. But banks already have been moving to implement centralized clearing on their own. They want that anyway, and will do it even if Congress does not act.

The truth is that the supposedly novel and intractable problems associated with off-balance sheet transactions are neither new nor even particularly complex. The problem is simple, and it has a simple solution: bank balance sheets should reflect reality. Indeed, Congress confronted this same problem in 1933, when it investigated the off-balance sheet transactions of that era. Then, the straightforward solution was to require disclosure, and to provide for enforcement when companies failed to disclose their risks. That approach worked then, and it will work today.

The 1930s securities laws deterred excessive off-balance sheet transactions for many decades. These deals resurfaced during the 1980s, after the Financial Accounting Standards Board backed down from a proposal to record swaps as assets and liabilities. In response, the swaps and derivatives industry skyrocketed. Today, there are $600 trillion of derivatives, ten times the size of the entire world’s gross domestic product. Yet those derivatives do not appear on balance sheets.

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Lynn Turner, the former chief accountant at the Securities and Exchange Commission, and I recently published a white paper for The Roosevelt Institute, and we proposed a straightforward fix to the off-balance sheet problem: require that balance sheets reflect reality. We even included proposed language for Congress to adopt. It is just one paragraph, with a second paragraph anticipating some of the objections Wall Street might raise.

It wouldn’t take long for Senator Dodd to add this language. Nor would it be difficult to explain to the public why financial statements should show reality, not fiction. (Here’s an 8-minute video of me explaining the whole thing at The Roosevelt Institute’s financial reform conference last week.)

If the balance sheets of Citigroup or AIG or Lehman or Bear Stearns had been accurate, they would have shown massive exposure to complex financial instruments and subprime mortgages. But they did not, and now people want to know why. It only takes a few simple questions for the average person to understand how much trouble off-balance sheet accounting can cause. What if the next time you wanted to borrow money you didn’t have to list most of your debts? What if Congress let you keep your credit card bills and mortgage liabilities hidden from view? If you could hide your debts, how much would you borrow? What would you do with that borrowed money? How much risk would you take? The answers do not require knowledge of rocket science. Common sense tells us that if we let people hide their debts, they will borrow more than they should, at the wrong times, for the wrong reasons.

Simply put, our biggest banks have been hiding their debts. Even after the recent crisis, they continue to hide them, now more than ever. Most people and business include all of their liabilities on their financial statements. Banks should, too.

Senator Dodd told reporters last week that, “The moment has arrived to put down a proposal.” He has done so—almost. The test of whether any reform proposal will work is whether it includes a paragraph requiring that financial statements of major banks reflect reality.

Frank Partnoy is a law professor at the University of San Diego and has written several books about financial markets, including The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals (just out from PublicAffairs).