Fred Feldkamp: The End of Off Balance Sheet Liabilities

rcwhalen's picture

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.