Home > bailout, financial crisis > There’s Just No Accounting For Federal Bailouts

There’s Just No Accounting For Federal Bailouts

October 27, 2008

In the last few months, the federal government has intervened in financial markets to an extent unparalleled in U.S. history. A partial tally includes the $29 billion, no-recourse loan from the Fed to rescue Bear Stearns; the federal takeover of Fannie Mae and Freddie Mac and their exposure to the credit risk on $5 trillion of residential mortgages; loans in excess of $100 billion to insurance giant AIG, and of course, open-ended Congressional authority for U.S. Treasury Secretary Henry Paulson to purchase up to $700 billion in troubled assets from financial institutions, part of which has already financed the purchase of over $250 billion of preferred bank stock.

Whatever you think about the wisdom of these interventions, one fact is indisputable: The government is not saying how much it expects all of this to cost us. The dearth of official estimates has, on one hand, led to Pollyannaish claims like “taxpayers could actually make money on this.”. On the other hand, it has stoked fears that taxpayers may be on the hook for trillions of dollars in losses.

More worrisome: Without hard numbers, not only is the initial cost of these interventions obscured, but it will be nearly impossible to assess the government’s performance as it manages these huge new commitments going forward.

Producing credible cost estimates is not easy, but it is necessary. Private-sector entities have to comply with strict and often frustrating accounting standards so that investors can make informed decisions. Taxpayers and policymakers need just as good data if they are to be equally well equipped.

What is insufficiently appreciated is that the government holds itself to a much less stringent accounting standard that what it imposes on the private sector. Importantly, the principles of fair value accounting are largely absent from federal budgeting for risk.  I would single out two accounting rules that create serious distortions in accounting for federal ownership of financial securities.

The first is in the treatment of the market price of credit risk, which is omitted from the pricing of federal credit obligations. By law, projected net cash flows must be discounted at maturity-matched Treasury rates.  This causes the value to the government of a loan to risky borrowers like Ford Motor Co., AIG or Morgan Stanley to be systematically overstated.  Thankfully, this byzantine rule was waived temporarily for the $700 billion bailout bill, but it remains a problem for most security purchases.

The second is that the value of equity investments, like the recent purchases of preferred bank stock, are systematically understated initially because these are accounted for on a cash basis, which means the full purchase price of stock is counted as an outlay, with no offset for the value of the claim received. In later years any positive cash flows from dividends and principal repayments reduce the reported budget deficit, even if the recoveries fall far short, in present value terms, of the initial value expended.

Some might argue that in the middle of a crisis the last thing we have to worry about is bean counting. But we should remember that lax government accounting rules—such as those that kept Fannie and Freddie off the federal budget despite their longstanding federal ties—are among the culprits responsible for getting us into the current mess, and failing to strengthen them will make it harder to get out of it.  Just imagine how difficult it will be in a few years for the government to re-privatize banks if, because of accounting distortions, it looks like they are making money for taxpayers instead of losing it.

Note: This is an expanded version of my editorial that appeared last week in Crain’s Chicago Business.

Categories: bailout, financial crisis
  1. RJ Dragon
    November 5, 2008 at 2:07 pm

    Clear government accounting? Next thing you will be asking for is that the government actually actuarially fund Social Security pensions with more than a promise! If we were to use GAAP accounting for the US government, the Chinese would wake up and stop purchasing our debt. Then the whole overspending carousel would grind to a halt.

    Seriously, I think the more interesting accounting question to come out of this bank crisis is whether market to market fair value accounting is appropriate for institutions with long-lived assets and liabilities. One could argue that the whole purpose of a bank is to manage the swings of the market though the diversity of its portfolio and the skills of its workout department for impaired assets. Fair value accounting forces such institutions to price assets as if they were 100% liquidatable on a daily basis. That is in direct contradition to the stated purposes of the long -term loans. If fair value’s correctness is the assumption, then one should dispense with the financial intermediaries and directly match up borrowers with sources of funds in the capital markets.

  2. Stephen Carlson
    December 20, 2008 at 6:10 am

    However much this all WOULD HAVE cost us, the price tag just got a lot higher today with the automotive bailout. I’m scratching my head as to how a conservative president can justify “abandoning free market principles in order to save the free market system.” When the dust settles on this mess, historians will not judge today’s decision kindly, in my view.

    Bush missed his one chance today to put the industry on the right path and make these guys file bankruptcy with government guaranteed warranties, tax incentives for new car purchases, and a government-sponsored DIP. Bush pretty much had the power to dictate terms, and he will never again run for re-election; why he didn’t make the language tougher and more binding is beyond me.

    I suppose he’s intimidated by threats that he won’t get the second tranche of TARP if he lets GM go bankrupt, plus he didn’t want to be the president that pushed GM into bankruptcy. He’s paranoid about his legacy and he went soft.

    Does he really believe that adding a positive NPV test will hold GM’s feet to the fire? Come on. Every forecast GM has ever built shows them having positive NPV. They’ll just keep saying that it will be better two or three years out, even though they know those numbers will prove elusive at the end of the day. It’s the same song and dance they’ve been up to for years, and Bush didn’t have the guts to finally put that behavior to an end.

    Now that the wheels have been put in motion by a conservative president, it’s difficult to see how a Democratic president and Congress will ever let the automakers fail…maybe Chrysler, but not GM or Ford…they are too symbolic. If Bush couldn’t do it, how will Obama and Pelosi?

    Barney Frank issued a statement today that he’s drafting a bill to release the second tranche of TARP funds, but use of those funds must include a plan for the automakers. GM’s management today dodged questions today about how much money they’ll need in total to get through 2009 and he put a lot of lingo in his speech about cooperation with the UAW. Meanwhile, the UAW president, instead of expressing his gratitude to the president, criticized the bailout language for being too harsh on labor. He’ll take his case to Obama, he says.

    To top it all off, Obama also came out with a pro-labor statement today. A lot of powerful people are protecting labor. It’s also true that the gap between the rich and the poor is widening, and the UAW is the symbolic protector of the middle class even if the UAW is unpopular with most of America. At the end of the day I doubt the UAW will give the necessary concessions to make the US guys competitive. After all, what’s the point of having a union if your wages are the same as non-union wages? It would be a nail in the UAW’s coffin. Unions will fight for self preservation, and they will probably win. Will Obama be the president who finally breaks the union? Obama…who was one of the most liberal Senators and just appointed a Labor Secretary who’s father is a former union officer?

    Which leads us to the same problem…if GM’s wages are higher than Toyota’s, and an identical car with a Toyota sticker on it commands a premium of several thousand dollars (and even Toyota isn’t making money), how in the world will GM ever make money?

    Also, so much for protecting the taxpayer by giving them senior status. In their infinite wisdom, the govt must have missed the section on permitted liens in the credit agreement that enables governments to take pari-passu positions on existing collateral. It seems that instead they’re accepting a second lien on collateral that’s already encumbered. With all the lawyers on Capital Hill, you’d think they could have found one capable of reading the credit agreement.

    Today was just a down payment. Even the smarteest private equity investors make the mistake of throwing good money after bad when it comes to protecting their portfolio companies. Since the government will never let GM fail, Americans are now on the hook for perpetuating a broken industry and funding a company that burns well over a billion dollars of cash every month. Good luck accounting for that.

  3. GM Stock Twit
    March 27, 2009 at 11:49 am

    Not to draw criticism from the room, but while the bail turns my stomach I feel it was a necessary evil. GM for example was simply too big of a domino to let fall. Today 03.27.09 GM up +10.56% GM Stock News and 75% of other blue chip Fortune 500 stocks in the black as well. Without question there was abuse with the stimulus funds but we are seeing more good than bad, only the media rarely reports the good.

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