Apr 23rd 2010

Respecting the Uncertainty Principle in Financial Accounting

by David Eichler

The author is a professor of physics at Ben Gurion University in Israel. He received his Ph.D. in 1976 from the Massachusetts Institute of Technology. Further biographical information can be obtained at http://www.bgu.ac.il/~eichler/.

The debate goes on over how to do proper accounting for financial institutions. After each major debacle, there is a stampede to some other accounting method, as if the previous method were the problem. Perhaps the chronic problem is the ongoing assumption of modern accounting that every security has an instantaneous value, based on its expected revenue and its risk, and that the rights to something in the distant future can therefore be considered a present asset.

Risk is by its nature uncertain. Making the quantification of risk a prerequisite to a law invites trouble. Laws that constrain how much banks may lend should not presuppose any relation between current value and promised future value, which is properly the subject of speculation. The debate over how to place a value on mortgage derivatives - e.g. "mark to market" accounting versus "mark to model" accounting, each of which makes such a presupposition - misses this point. While the hinging of legal matters on speculation is in itself a problem, the deeper problem is that treating anticipated future wealth as a well defined quantity in the present can create a wormhole in time that exposes the future wealth to present greed. Next year's crop gets eaten by this year's worms.

Take, as an example, a simple toy model: Two mortgage banks make $300,000 loans to respective home buyers, each in return for $700,000 - the $300K principal and $400K in interest - in monthly payments over the next 30 years. The banks can each make $400K profit over that rather long time scale. How much is the right to collect the $400K in the future worth at the present time?

No law should exist whose enforcement requires guessing an answer to this question.

For even if you could make a totally reliable guess (and you can't), the following problem would still exist: Suppose each bank sells the other an identical MBS (mortgage-backed "security") for $500K, backed by the anticipated mortgage payments. The exchange of identical securities is obviously an empty exercise in terms of meaningful wealth, yet, on paper, each bank has lent out $300K and received $500K shortly thereafter. Seems like a $200K profit, right? True, they each spent $500K buying the other's MBS, but in return they each got an MBS said to be worth (for the time being) $500K, so they broke even on that; you can hardly consider it a loss.

Where, then, did the $200K profit that appears on the books come from? Answer: It came from the future, and was declared a profit in the present. With that profit, the banks can immediately bloat their "operating costs" by paying bigger bonuses and larger salaries, and hiring more employees. Meanwhile, the cash to pay these expenses, raised by each bank's sale of an MBS, flows from the deposits in the bank that purchased it. Armed with MBSs or similar mechanisms, the banks can in this way each catalyze the embezzlement of the other's deposits.

In actual fact, bloated "operating costs" (hundreds of thousands of Wall St. employees each consuming hundreds of thousands of dollars per year on average - in salary, bonuses, office space etc.) consume far more wealth than the shortfall from delinquent mortgage payments (about a million delinquent mortgages on a bad year, with perhaps an average of five or ten thousand outstanding dollars per year per delinquent mortgage). The Wall St. cash shortages in 2008 resulted largely from the huge appetites that were developed in 2007, when financial institutions were living it up on earnings from the future. All of the TARP money used to bail them out could have easily been saved had they cut the salaries and bonuses of their employees down to size.

Now the paper trail in the mortgage industry is, of course, far more complicated than in the above toy model, but I bet that underneath all the complicated mortgage derivative paper, the same principle has been at work: anticipated future wealth is somehow cashed in and distributed in the present. For example, the obligation in a credit default swap or insurance policy on a mortgage may be activated as soon as the default is declared, even though the default is on a future debt repayment. Creditors that collect their insurance on a defaulted debt thus enjoy a payment in the present on a debt that should have properly been collected in the future.

Debating how much anticipated future revenues are worth at present does not change a basic fact of life: A promise is worth less than what is promised. The risks that the promise might not be kept are a form of negative wealth. Mortgage-backed securities simultaneously create mutually canceling positive wealth (short term profits) and negative wealth (future risk) out of thin air, the way positive and negative charge are created by a spark. In this manner, they allow present wealth to flow, like electric current through a short circuit, from the deposits to the bank's administration, while the risk flows in the opposite direction. In the above example, the promise of $400K in future interest payments is worth only $200K at present. The wait for future mortgage payment and risk that it might not be paid are negative wealth worth, say, minus $200K, i.e. the difference between the market value ($500K) of the right to collect $700K and the $700K. There is only one acceptable limit to the amount of negative wealth that a government-insured mortgage bank should be allowed to slip to its depositors or to taxpayers without their consent: zero. (Would you debate how many short circuits should be acceptable in a car battery?)

To be perfectly clear, freedom is always good, freedom of enterprise is always good, and freedom to speculate is good. (Even speculation itself often yields favorable results.) These freedoms help private citizens protect themselves from inflation when the government prints out more paper money, which happens to be most of the time. On the face of it, one might therefore defend the freedom of any corporation to sell the rights to its future profits to speculators. The risk that these future profits might not come to fruition, after all, is knowingly and consentingly taken by the speculators off the hands of the corporation's shareholders and bondholders. What would stink, however, would be corporate management underselling what those future profits are worth, recording it as a present profit, and distributing the cash among themselves and their employees, leaving their own investors with a glowing annual report and a dismal future. Similarly, accepting risk on behalf of a corporation in exchange for money, and then recording the payment as a current profit to be distributed among employees (while the risk is distributed to the shareholders), creates the moral hazard that the risk will be underestimated by those who take home the money, who stand to gain from the underestimate. This sort of moral hazard exists in any corporation; there have always been the occasional corporate raiders that take over some corporation and plunder it before the stockholders get wind of it, and their reputations have, in the past, generally had very short shelf lives. But the problem is greatly aggravated by Federal protection of potential plunderers, and any recipient of such protection should pay for it by agreeing to be tightly regulated.

Bank regulation takes on the difficult task of drawing a line between instruments of investment and instruments of embezzlement. It should therefore insulate the future from the present to the full extent possible. This means counting the chickens only after they hatch. A proper evaluation of a bank's solvency should respect the dimension of time; it should keep track of the bank's books and regulate its activities accordingly on a year-by-year basis well into the future. The amount of obligation that banks are permitted to assume at a given time should be tied to their reserves in hand at that time, not to revenues that are anticipated to arrive in subsequent years. Confusing future receivables with present assets is asking for trouble, no matter what mathematical modeling procedure one may use to evaluate the present worth of the receivables. No matter how reliably risk can or cannot be quantified, the fact remains that it is easily planted on the unsuspecting.

Uncertainty in the present worth of anticipated future interest payments should remain the risk of speculators, not depositors, taxpayers, or lawmakers. Depositors whose money was loaned via a bank to home buyers already assume a fair share of the risk merely by parting with cash in exchange for the collateral, whose value may yet go down. Anyone's rights to a share in future interest payments should be predicated on their waiting patiently for them, unless they pay (with their own money that is, not someone else's) a consenting party to do the waiting for them in clearly spelled out terms. Depositors and taxpayers are not necessarily consenting parties, and the law should fully protect their right to not consent.

Short term gain and long term consequences go together like booze and hangovers. The plundered future has arrived, and there is plenty more of it.

Copyright: David Eichler, 2009

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