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Welcome to 'Amazing Grace' Accounting

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What once was lost from government balance sheets is being found.

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MINYANVILLE ORIGINAL

I promise this won't be as boring as you think.

In June 2009, with the stroke of a pen, the Financial Accounting Standards Board moved more than $600 billion in off-balance sheet liabilities onto financial services firms' balance sheets as it "change[d] the way entities account for securitizations and special-purpose entities." In its accompanying press release, Robert Herz, chairman of the FASB, said:

These changes were proposed and considered to improve existing standards and to address concerns about companies who were stretching the use of off-balance sheet entities to the detriment of investors. The new standards eliminate existing exceptions, strengthen the standards relating to securitizations and special-purpose entities, and enhance disclosure requirements. They'll provide better transparency for investors about a company's activities and risks in these areas.

Three weeks ago, the Governmental Accounting Standards Board (GASB) voted to approve two new standards "that will substantially improve the accounting and financial reporting of public employee pensions by state and local governments." In its accompanying press release, GASB Chairman Robert H. Attmore stated, "The new standards will improve the way state and local governments report their pension liabilities and expenses, resulting in a more faithful representation of the full impact of these obligations," and noted, "Among other improvements, net pension liabilities will be reported on the balance sheet, providing citizens and other users of these financial reports with a clearer picture of the size and nature of the financial obligations to current and former employees for past services rendered."

That the FASB and the GASB acted in the way they did was hardly a surprise to me. At their core, accounting policies are nothing more than regulations, and as history repeatedly shows, we deregulate during periods of rising mood and we re-regulate during and in the aftermath of periods of falling mood. And I suspect that securitization and pension accounting are only the first of what will be a long list of what I call "Amazing Grace" accounting reforms in which liabilities which once were lost are found so that those who once were blind can see them clearly in company and government financial statements.

But what brought all of this to mind this morning was this statement in today's Wall Street Journal (Hat tip to FTAlphaville) from German finance minister Wolfgang Schauble with regards to the Spanish banking recapitalization plan approved by EU finance ministers in the early hours of this morning:

"We expect that the final liability of the state will remain" even once the banking supervisor is up and running, he told journalists. He added that what mattered was that the bank support wouldn't add to a country's debt-something that he said would be possible even under a scenario where the government retained liability for potential losses.

Assuming that I understand Mr. Schauble and the proposed plan correctly, what EU finance ministers are counting on to solve Spain's bank capital problem is the distinction between a "contingent liability" for Spain and "debt" with the former being off-balance sheet (and therefore of no concern to Spain sovereign debtholders) and the latter being on-balance sheet. Spain won't be directly on the hook for EFSF/ESM borrowings, but only responsible for the "potential losses" which the EFSF/ESM might take in the future should things not turn out as everyone clearly hopes.

From my perspective, there are three flaws with this plan.

First, the problem the EFSF/ESM are trying to solve is Spanish bank solvency. The funds being discussed will be used as equity capital in troubled Spanish banks to protect those banks' depositors and creditors. As equity capital is considered to be the "first loss" should a bank fail, what the plan is suggesting is that Spain will liable for the first loss of a first loss financial instrument. What Spain is being asked to backstop is a very leveraged investment in which "first loss" could quickly become "all loss."

Maybe it is just me, but it feels like the "potential losses" Spain "might" be on the hook for are hardly remote. What is being portrayed by policymakers as contingent feels very real to me.

Second, yet again European leaders have failed to appreciate the social mood correlation between banks and sovereigns. If things are good for banks, most often they are also good for sovereigns. But unfortunately the reverse is also true. My guess is that the economic environment in which Spain will be called upon to honor its "retained liability for potential losses" is the same environment in which it will be least able financially to do so.

Finally, from my perspective European policymakers are clearly fighting the social mood-driven "Amazing Grace" accounting trend that is clearly underway. As long time Minyanville readers know, I have been worried about the proliferation of public sector financial guarantees and other contingent liabilities for some time.

Back in March 2010 I offered:

But much like the marketplace demanded that private sector banks "reveal" their off-balance sheet SIVs and other footnote "commitments," I suspect that it won't be long before the marketplace begins to undertake a full accounting of public sector guarantees and commitments, and all "off-budget" and off-balance sheet obligations are consolidated -- at least in the market's mind.

By proposing the solution that they did last night, Mr. Schauble and his fellow finance ministers clearly believe that investors will continue to permit contingent liabilities to remain off-balance sheet.

Should social mood improve from here, that may be the case, but investors would be wise to consider the opposite scenario in which social mood declines further (along with equity markets and economic strength) and investors/accounting regulators demand more conservative accounting and greater transparency in government financial reporting.

At that point, I am afraid that those who once were blind may not like what they see.

Peter Atwater's groundbreaking book "Moods and Markets" is now available for pre-order on Amazon and Barnes & Noble.

"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world." -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation


Twitter: @Peter_Atwater
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Position in SH and JPM
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