Magic!

by hilzoy

From the NYT:

"The rest of the nation may be getting back to basics, but on Wall Street, paychecks still come with a golden promise.

Workers at the largest financial institutions are on track to earn as much money this year as they did before the financial crisis began, because of the strong start of the year for bank profits.

Even as the industry's compensation has been put in the spotlight for being so high at a time when many banks have received taxpayer help, six of the biggest banks set aside over $36 billion in the first quarter to pay their employees, according to a review of financial statements."

The fact that the very banks who just caused the world's economy to collapse are helping themselves to the same pay they made when they were earning record profits has occasioned a certain amount of snark from the class warriors of the hard left. But I think they're wrong. The banks' profits in the first quarter absolutely justify enormous paychecks, since they had to be made to appear where the uninitiated might see no profits at all. 

Consider Citi: it made a profit of $1.6 billion, of which $2.7 billion was gains booked because -- get this -- its creditworthiness went down. To those of us outside the financial services industry, this might sound fishy: how can the fact that people think you're getting more likely to default mean that you are doing better? Here's the answer:

"When the debt declines in value, the banks have to assume at the end of the quarter that they bought the debt back and retired it. The banks would “buy it back” at a lower price, so they get to make a profit. Here’s an example: Imagine that a bank has a bond that was once worth 100 cents on the dollar and is now trading at 60 cents on the dollar. At the end of the quarter, the bank has to assume it would buy that debt back at 60 cents — which is essentially a profit of 40 cents.

That’s what happened to Citigroup in the first quarter. Citigroup had a rough quarter in which investors showed little faith in the bank’s future by widening the spreads on the bank’s credit-default swaps. As those spreads widened, they sent the message that investors believed Citigroup would be less profitable. In a nice twist, the widening spreads also triggered an accounting rule that allowed Citigroup to record a profit."

Citi would have booked over a billion in losses without this -- and that's without getting into the other fascinating ways in which they made their earnings look more impressive than they otherwise have seemed. Bank of America did the same thing. Wells Fargo also deserves credit for using other accounting rules to make profits appear where none had been before.

But all of these feats of accounting pale before the astonishing achievement of Goldman Sachs, which is on track to pay employees almost as much, on average, as it did in 2007. That might seem excessive -- until you realize that in order to book a profit, Goldman Sachs had (among other things) to make an entire month disappear -- a month with a pretax loss of $1.3 billion. That's not easy to do -- but the intrepid Goldman employees made it happen. I'd say that deserves a raise.

If it weren't for the magicians on Wall Street, Goldman Sachs might have had to make do with twelve months like everyone else. Citi and Bank of America would not have been able to transform their deteriorating credit into big profits. Their actual loans disintegrate before our eyes, along with the rest of the economy; there seems to be no relief in sight; and lo! they make profits appear out of thin air. If Penn and Teller deserve their millions, why not Wall Street? 

Comments

[russell]

Maybe we could just pay all of these guys $100M a year each to go the hell away. Tax free if necessary. They could pack their bags, leave the country, and stay the hell away. Buy a condo in the Caymans, spend the winter skiing in Austria, whatever floats their boat. Just get the hell out.

The way things are going, it would be short money.

[matth]

Isn't writing down corporate liabilities just the mark-to-market principle at work?

Still, I do wonder how this coordinates with the asset valuation rules. You would obviously want to avoid a situation where troubled firms did not mark their assets down, claiming that no liquid market existed, but did mark their liabilities down.

And even I can't keep a straight face while talking about Goldman's missing month, so I won't even try.

[Warren Terra]

Isn't writing down corporate liabilities just the mark-to-market principle at work?

I have to say I'm pretty confused by this maneuver, and this question. As I understand it, mark-to-market is supposed to be a call for honesty in bookkeeping, so that a drop in your assets' values gets reflected in your books as your having less assets. But this maneuver just puzzles me, and it's all about the scare quotes in the passage from the WSJ blog:

When the debt declines in value, the banks have to assume at the end of the quarter that they bought the debt back and retired it. The banks would “buy it back” at a lower price, so they get to make a profit.

Now, if they had outstanding bonds and they managed to genuinely buy them back cheaply because their bonds were seen as being bad bets, couldn't that be a genuinely good thing for their bottom line? I mean, the bonds were already on the market, they were obligated to pay at face value at some point, but if the bond issuer got to buy the bonds back discounted because the bondholders got nervous then the bond issuer's balance sheet would, it seems to me, actually benefit from the reduced future obligations that had been cheaply canceled (although I'd have no notion whether those gains should be booked within that year or spread across the terms of the bonds being repurchased at a discount).

But then there's the scare quotes, suggesting that the bonds aren't actually being repurchased (and if I were a bondholder and the issuer offered my cash money for me to sell it back to them at a discount, I'd be rather miffed). If this really is just all fancy bookkeeping, then it's one more example that the people who affect to report on business for our media deserve to be driven through the streets chased (non-injuriously, I hasten to qualify) by the jeering contempt of those they ought to inform. Or maybe just to replace their sharp business attire on camera with the clown suits they deserve.

And, as with matth, I am totally left awestruck by Goldman's audacity, but I do have one suggestion: the executives should get their bonuses in some form at least as imaginary as they seem to feel December was.

[matth]

Warren, I thought it was analogous because, applying mark-to-market rules, a firm must write down assets' value even if it doesn't actually sell them.

On the face of it, the same reasoning might apply to the firm's liabilities: when the cost of retiring the liabilities decreases, it should make the firm's balance sheet look better.

Of course, the firm hasn't actually bought up the liabilities. But I don't know why you think that's "fancy book-keeping." Mark to market requires the firm to adjust assets' values on its balance sheet even though it hasn't actually sold them. Why not the same principle for liabilities that it hasn't actually bought?

[Warren Terra]

Now, I'm certainly not especially well informed, but my understanding was that a bond issue is, in its simplest form, a promise that the issuer will redeem the bond for its face value at some future date (more complicated ones might give regular fixed payments for a period of time, etcetera). So unless the issuer has actually bought back their bonds at the discounted price - which seems implausible, as their ability to do so would pretty much prevent the discounting in the first place - the fact that the bonds now trade for a lower price has absolutely no effect on the bond issuer's obligation to the bondholder; it just means that the bondholder is factoring in an increased chance of the issuer defaulting.

So if they really are deliberately confusing the bondholders' reduced asset values with their own unchanged obligations, I don't think it's unreasonable to call that fancy book-keeping.

[paulh]

Under mark-to-market accounting rules, banks are obliged to mark their debt at market prices.

You might well think that this is misleading nonsense. And that banks shouldn't be paying bonuses out of the resulting accounting profits. But the mark itself is not a trick by the banks.

[matth]

For limited liability firms, like corporations, the owners can just walk away; so, the corporation's obligations are worth less and less as its default risk rises. To see this in practice, one can look at how firms on the brink of bankruptcy can sometimes successfully re-negotiate contracts.

If you were a potential investor, it's the true economic outcomes you'd care about, not the face value of the firm's obligations. That's why you might want firms to mark down liabilities on the firm's balance sheet.

(Imagine a corporation with $10 in assets that made a 50/50 bet for $100. Ordinarily, the expected value of the firm would still be $10. But if the owner's not liable for the firm's debts, its value is really $55, since the owner walks away and leaves the firm's creditor with just $10 if he loses the bet. Obviously, in the real world, you wouldn't want to be quite this blatant, but that's the basic idea.)

[Matthew Ernest]

Warren Terra has it right, except "buy back at reduced price" is really "retired at reduced price" which also includes actual default and bankruptcy.

The market value of the debt has gone down, because the market prices in the risk of default. The obligations of the debt issuer do not go down unless they actually default. To take credit for that on your balance sheet is to say that you are more likely to default.

Marking down the value of an asset that depends on the actions of others that you cannot control is prudence. Marking down the obligations on debt you issued because of the risk of default that you control is moral hazard.

In addition, you've done yourself no favors if you expect to issue new debt in the future since the market will now price that risk into the initial yield you have to offer.

[Point]

Somehow, I'm not so outraged at the simple idea of bank exec's writing themselves multi-million dollar checks -- granted their only using their own money, and not the taxpayers.

So Citigroup -- pretty much straightforward defrauding the public. Ditto for Bank of America.

Wells Fargo's a little trickier -- from what I gather I read about their role in the bailout, I hear they were "forced" to take the money, but I'm a little unclear how Paulson twisted their arm. And couldn't they just give the money back if they don't like the strings?

And as to Goldman Sachs -- to my knowledge they never got a direct bailout (though they profited from the AIG rescue). That doesn't mean there's nothing wrong with making a month of the financial year disappear -- just that moral umbridge doesn't seem relevant.

[russell]

Somehow, I'm not so outraged at the simple idea of bank exec's writing themselves multi-million dollar checks -- granted their only using their own money, and not the taxpayers.

For "taxpayers" read "taxpayers and/or shareholders" and see if it still feels OK to you.

It's not their money. Every dollar they award themselves comes out of someone else's pocket.

[brendan]

If bonuses at banks at the end of this year are the same as in 2007, Obama will only be serving one term.

[BrianA]

From one of hilzoy's links, it seems clear that the debt-buyback stuff isn't mark-to-market at all, just another accounting shenanigan:

http://dearjohnthain.wordpress.com/2009/04/20/citis-earnings-even-cittier-than-you-think/>http://dearjohnthain.wordpress.com/2009/04/20/citis-earnings-even-cittier-than-you-think/
And, while we’re here, I want to dispel a myth. This accounting trick has nothing to do with reality. The claim has always been that a firm could purchase it’s debt securities at a discount and profit from that under the accounting rules, so this was a form of mark-to-market. Well, unfortunately, rating agencies view that as a technical default–S&P even has a credit rating (”SD” for selective default) for this situation. This raises your cost of borrowing (what’s to say I’ll get paid in full on future debt?) and has large credit implications. I’m very, very sure that lots of legal documents refer to collateral posting, and other negative effects if Citi is deemed in “default” by a rating agency, and this would be a form of default. This is a trick, plain and simple–in reality, distressed tender offers would cost a firm money.

[gg in st louis place]

Hmmm. I am one of those "workers at the largest financial institutions", a database worker, specifically. We just completed the very, very large live database merge/r between AGE and Wachovia Securities. Without taking a breath, we are merging again with Wells Fargo data. For this, we have had massive layoffs and salary cuts, and swapped out many, many 20 year veterans for the class of 2008. This week, I hit 40 hours midday on Tuesday, while making 12% less this year than last year. They literally offered us a free pre-frozen muffin of choice (1 per employee, please!) in the lobby after the 120 hour week merger was completed. They know we are not going to bolt into the arms of a global recession. I know where those larger paychecks and quarterly profits are coming from -- my paycheck, my back, my health and my family life. There will be a massive defection of the IT community away from the banks just as soon as we possibly can. Everyone on my floor wants to get into health care database work ASAP.