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Fred Feldkamp: The End of Off Balance Sheet Liabilities

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Below is a comment by my friend and mentor Fred Feldkamp on the end of off-balance sheet liabilities ("OBSLs"), a key element in ending the problem of "too big to fail" with respect to the zombie banks.  Fred is an attorney at Foley & Lardner in Detroit and arguably one of the fathers of "true sales" as used in the world of residential mortgage backed securities ("RMBS").  

With the changes to accounting rules for OBSLs at the end of 2009, much of the legal structure for RMBS has been changed significantly, but few in the media or on Wall Street have paid attention.  Indeed, with the end of the safe harbor by the FDIC for true sales, it is questionable whether banks will be able to do RMBS transactions as true sales in the future.  As with auto and credit card securitizations, going forward RMBS may in fact be secured borrowings and not true sales at all.  Read my ISU paper on fixing the shadow banking sector for further bankground. -- Chris

 

The End of Off Balance Sheet Liabilities (“OBSLs”)

Frederick L. Feldkamp

June 10, 2013

 

Last week, US markets affirmed that the pending and necessary end of OBSLs will produce enormous benefits for the world’s economy. The rally on Friday ended nearly a month of uncertainty (see, the attached charts). The rally coincided with steps that will put an end to OBSLs, practices that hide taxpayer-backed liabilities and are, therefore, a primary cause of financial crises.

Considering the benefits, how could it be otherwise?

Ending OBSLs terminates a fraud which dates to at least the 17th Century (and, perhaps, to ancient Greece and Rome). The numerous crises created by this fraud have destroyed far more than $100 trillion of worldwide investor wealth (up to $67 trillion in the last crisis alone). Consider the role of OBSLs in four of the most familiar financial crises in world history:

1. The South Seas Bubble. This crisis destroyed Scots banks backed by contemporaries of Adam Smith. In 1776, it led Smith to support “reserve” banking (over the flawed OBSLs of the British “central” bank model) in The Wealth of Nations. The crisis arose because Parliament allowed the Hanover kings of England to use a central bank to hide the cost of war with France. As in the US after 2001, hiding British government debt in OBSLs of government-backed banks hid the need for Parliament to raise taxes. The South Seas Bubble burst when war proved (as war almost always does) a losing economic proposition. As need for revenue to pay central bank debt became clear and Parliament still refused to accept its duty, investors demanded payment of the government’s OBSLs. Rates and credit spreads skyrocketed as Parliament dithered. That drove sound Scots banks to insolvency, making it still harder to raise taxes. The king sought to shift losses to American colonies. As that failed, the US was born. The solution, of course, was to eliminate OBSLs and insist on taxation in the first place.

2. The Great Depression. The “roar” of the Roaring Twenties was funded by OBSLs. Financial accountants and lawyers convinced governments there was no fraud if debts of subsidiaries were not reflected on financial statements of parent firms (holding companies and various business trusts that sold stock to the public).  By the mid 1920s, financial giants like Alfred Sloan recognized the problem and ended pyramid schemes of a few firms which then survived the Great Depression almost entirely unscathed (Sloan’s GM went on to produce about 10% of all goods used in WWII). In 1929, other investors awoke. There was NO value in the stock of a parent firm or trust if its assets (stock of subsidiaries) were subject to OBSLs that the subs could not pay when business slowed. US securities laws were enacted to require (a) auditors to opine that a firm’s financial condition was “fairly stated” without regard to details of GAAP and (b) financial consolidation of operating affiliates. It was not until the 1990s, however, that the US finally insisted on consolidation of the liabilities of financial affiliates of industrial firms (e.g., GECC and GMAC).

3. The “S&L Crisis.” Speculative OBSL funding for the Vietnam War and Pres. Johnson’s war on poverty generated an inflationary bubble that government brought to an end as the 1980s began. The result, however, decimated the government-controlled banking model implemented to unwind the Great Depression. S&Ls, the funding source for US housing, ceased to function as short term deposit costs skyrocketed while long-term mortgage assets stopped prepaying. In 1982, government decided to “free” the S&Ls by letting them speculate on whatever loans they desired to make while retaining the government’s OBSL guarantee of their deposits.

William Seidman, Pres. Reagan’s FDIC Chair, labeled this OBSL process “the worst mistake in the history of government.” The crisis ended when Congress accepted a process for indirect taxation to cover the losses. As confidence was restored in the 1990s, Pres. Clinton became the beneficiary of the first “Goldilocks Economy.” The 1991 automatic process for resolution of OBSLs by taxation, if needed to resolve a bank crisis, restored investor confidence and economic growth converted government deficits into apparently infinite surpluses.

4. The 2008 Crisis. Both the Clinton and subsequent Bush administration missed the process by which financial accountants and lawyers successfully converted the “Goldilocks Economy” of the 1990s into what became the largest OBSL debacle in world history. By 2006, national accounts showed that the world’s investment assets were about $200 trillion, funded by roughly $100 trillion of reported debt and $100 trillion of market equity.

What the accounts did NOT reveal, however, was $67 trillion of OBSLs, hidden in what is now referred to as “the shadow banking system.” Similar to 1929, investors soon began to recognize that equity has no value when debt cannot be paid. When US investment assets began to shrink in value due to bursting of a housing bubble, investors panicked. As with all prior OBSL crises, until government stepped in to fill the “gap” (by expansion of direct liabilities and bank reserve investments), credit spreads skyrocketed (i.e., the 2007-8 spikes on the enclosed charts). Before the process reversed following the US election of 2008, panic destroyed about 30% of the value of all private debt and equity investments in the world.

In all of these cases, OBSLs were a primary driver of the investment “bubbles” and inevitable crises that followed. By law, the US now imposes automatic funding processes (indirect forms of taxation) to cover OBSLs that must be recognized on elimination of “systemically significant” financial firms. By law, moreover, it is criminal to defraud taxpayers by failing to fairly report firms’ financial condition.  As the recent crisis unfolded, steps were taken to mandate that ANY otherwise unreported entity that relies on a US financial institution for asset/liability management and ultimate credit support be consolidated with that entity. Thus, OBSLs generated by bank sponsored “conduits” should all now be reported by that sponsor.

By 2011 actions of the FDIC, the last step in ending OBSLs is now locked into a solution. The former ability of banks and other entities to circumvent law by reporting potentially fraudulent transfers of financial assets as OBSLs has now ended. All that is left is a sufficient education of lawyers and accountants to bring total acceptance of this conclusion. 

The grand OBSL error of the Clinton/Bush administrations ended in September 2011 when the FDIC eliminated a rule that had absolved those responsible for the honesty of US banks from liability for OBSL frauds committed by transferring assets for the purpose of eliminating need for bank capital. From April Fools’ day 2001 until November 2011, a “safe harbor” rule made it unnecessary for bank counsel to opine that such trades were free from challenge under fraudulent transfer laws dating to at least the 16th Century.  

Moneys received by any transfer that fails to fully comply with fraudulent transfer law (and any transfer made for the purpose of reducing capital needs rather clearly violates that law), is (by law) a secured borrowing by the transferor from the transferee. Failure to report the transfer as a secured borrowing, therefore, is fraud. If the reporting institution is unable to pay its debts and the government must pay resulting OBSLs, it would now seem that anyone responsible for improper reporting (in the case of US banks, that includes management, as well as bank accountants, attorneys and appraisers) can be held liable, and perhaps criminally so.

For many years, senior managers of major financial institutions have recognized the eventual need to eliminate OBSLs. The hurdle, however, has been to generate a means for mandating instant uniformity—to assure all similarly situated reporting firms that the result will be a move with which all must comply at once.

The FDIC’s 2011 actions are the key. By eliminating the only “safe harbor” that avoided longstanding accounting requirements which mandate “secured borrowing” reporting for transfers that violate fraudulent transfer laws, FDIC ended this debate. It is now up to the lawyers and accountants of America to recognize and accept reality—OBSLs are “history.”

Investors have voted their approval.

 

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Tue, 06/11/2013 - 14:15 | 3646864 Rick64
Rick64's picture

  December 4, 2012: 4:06 PM ET

Financial firms have made a mint this year offloading home loans on the giant government-backed mortgage insurers. In the third quarter, bank profits from that business hit an all-time high.

http://finance.fortune.cnn.com/2012/12/04/bank-profits-fannie-freddie/

The GSEs can only handle so much. You didn't think they weren't going to profit from their fiscal mess. End of OBSL ? Maybe , but get ready for some new way of ignoring or off loading them while making a profit off their own liabilities. Remember the banks and corporations write the legislation. Thats why they are always one step ahead. Throw us a bone once and a while. Like Bush giving everyone $600 dollars back at tax time. Sure I'll give you $600, but your going to pay for two goddamn wars. 

Tue, 06/11/2013 - 14:16 | 3646962 disabledvet
disabledvet's picture

the Federal Government has been doing this on a MASSIVE scale since the 1980's. are you arguing something new? ironically it is these Agencies that have minted the money not the Banks as "they gave up on lending altogether" and took everything in house. Which really makes we wonder about "all those other debt markets out there" actually. If Agency MBS has had such stellar performance going back 30 years now...what about all those "other debt holders"?

Tue, 06/11/2013 - 23:03 | 3649017 Rick64
Rick64's picture

 I am aware that they have been doing it, but that they still did it right through 2012 is ridiculous, after they were exposed as having the toxic debt they were allowed to offload them on to the GSEs at the taxpayers expense, thats whats amazing. Not really amazing because as we all know the political system is run by puppets for the banks and corporations. 

 The banks were packaging their loans and selling them by the bulk, which was probably more profitable short term than 10 to 30 yr. mortgages. 

ironically it is these Agencies that have minted the money not the Banks

Not sure what you mean.

Tue, 06/11/2013 - 13:45 | 3646803 IamtheREALmario
IamtheREALmario's picture

Two great errors creted by traitors to this country:

1. Gramm-Leach-Bliley (repealed Glass-Steagall)

2. The Commodity Futures Modernization Act of 2000 (also a Phil Gramm treasonous act)

Both signed by Bill, the live action figure of a president, Clinton.

Of course these pale in comparison the the traitorous Woodrow Wilson and the Federal Reserve Act of 1913.

Tue, 06/11/2013 - 12:38 | 3646496 RaceToTheBottom
RaceToTheBottom's picture

Is it April 1st ?

Tue, 06/11/2013 - 12:12 | 3646414 Whiner
Whiner's picture

The curious problem of balance sheet liabilities has not been resolved, Inspector Clouso. The hundreds of trillions in western derivatives do not "net out" and are not reflected on the balance sheets of mega-financial institutions for what they are, according to Warren Buffoon: "instruments of mass destruction". When the collateral grab starts, these contingent liabilities will start the cascade to the Lehman bottom.

Tue, 06/11/2013 - 13:01 | 3646594 Bear
Bear's picture

Right, Mark-to-Whatever still lives

Tue, 06/11/2013 - 12:05 | 3646385 moneybots
moneybots's picture

"The End of Off Balance Sheet Liabilities"

How much in the way of off balance sheet liabilities does the government have?

Tue, 06/11/2013 - 11:58 | 3646346 GMadScientist
GMadScientist's picture

OPOSL

Tue, 06/11/2013 - 11:50 | 3646306 Fishhawk
Fishhawk's picture

His first paragraph shows observer's bias: the markets did not react to a change in accounting rules; the market reacts to however the cartel is painting the tape.  Beyond that, any pretense that the banks can be controlled, and their frauds limited by rules of law is foolishness squared.  The banks have shown utter contempt for law; they are a bandit gang who knows that they have the means to hold society hostage, and besides they have compromised the elected government into perfect lackeys.  Expect this accounting change to have no effect on future bank frauds.   

Tue, 06/11/2013 - 14:20 | 3646994 disabledvet
disabledvet's picture

actually markets have sold off (both debt and equity) on this "good news." in other words "your job as a banker is not to create a pristine balance sheet" but to "lend money profitably." i still find this one of the Worst Wall Street's ever because "all that money was for something other than New York." So now New York State is sucking just as all those "fancy foreign bets go sour." What is there to fall back upon again? "A big tall building"? Wow...like there's a shortage of those. more like 2% economic growth in the USA "forever." Great job!

Tue, 06/11/2013 - 12:57 | 3646291 OneTinSoldier66
OneTinSoldier66's picture

"...it would now seem that anyone responsible for improper reporting (in the case of US banks, that includes management, as well as bank accountants, attorneys and appraisers) can be held liable, and perhaps criminally so."

 

HOW MANY TIMES DO I NEED TO ASK....

 

WHERE IS JON CORZINE!?!?!?

 

When was the last time that a Banker/Broker was prosecuted and held accountable for fraudulent activity!?!

 

I'm now supposed to believe that there is suddenly going to be accountability where there was previously almost none?

 

oh wait... after spending the first half of my life seeing all this happen, I have to now wait the second half of my life for the LAWYERS, ACCOUNTANTS, REGULATORS, AND BANKERS.. to become "educated"... for something REAL to actually happen. Got it. MY BAD!

Tue, 06/11/2013 - 11:32 | 3646219 fijisailor
fijisailor's picture

 The End of Off Balance Sheet Liabilities ?  Sure, future liabilities could be a problem.  This is just a distraction.  The problem is existing OBSLs.  Probably in the hundreds of trillions

Tue, 06/11/2013 - 11:16 | 3646157 DeadFred
DeadFred's picture

The real safe harbor that still allows businesses to get away with fraud is Eric Holder. Rule changes mean very little if you can use cash or influence to ignore them.

Tue, 06/11/2013 - 10:51 | 3646056 Rainman
Rainman's picture

Accountants and rating agencies package this numerical baloney and sell it as USDA choice ...... and that is the real outrage !

Tue, 06/11/2013 - 10:51 | 3646055 Fuh Querada
Fuh Querada's picture

Tidings from a retired partner of a Detroit -???- firm, who is evidently still resident in that pulsating city.

Great. Now what? What has happened since 2011?

Tue, 06/11/2013 - 10:40 | 3646005 New American Re...
New American Revolution's picture

Bully, this solves EVERYTHING...or should I say Bullshit!  Nothing is going to change as long as this government remains in power.  www.electanewcongress.com

Tue, 06/11/2013 - 14:09 | 3646923 NotApplicable
NotApplicable's picture

Keep voting for more government, and watch as it only grows worse.

But hey, I guess it can't be your fault now, can it?

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