Rescue Plan Relies on Accounting Finesse

Green Eyeshade.jpg Treasury’s latest plan to address the credit crisis by direct investment of $250 billion in US banks has politicians telling Americans one thing and firms telling investors another. Politicians tell Americans the investments are temporary, no threat to private market capitalism in a democracy; thanks to deals brokered by Treasury and the Securities and Exchange Commission this weekend, firms will tell investors the investments are permanent, necessary to account for them as increasing firms’ permanent capital and minimizing dilution of common stockholders.

The tension is finessed by imaginative design and classification of the two components of the government’s investment: preferred stock and warrants to buy common stock. As to the preferred stock, the solution is designing terms to exploit a gray area in accounting dividing debt from equity. Borrowed funds a firm must repay are debt (liability); permanent funds a firm need not repay are equity (capital). Preferred stock is a liability if the firm must repay it and equity otherwise.

Critical to the Treasury’s plan is boosting firms’ equity capital, which means making the securities look as permanent as possible. But if they look too permanent, that would impeach the political story. The result is a term sheet negotiated this weekend calling the preferred perpetual while incentivizing firms to repay it within five years, without an explicit obligation to do so. Examples include a spike in the dividend rate at year five from 5% to 9%, forbidding firms to pay dividends on common stock unless dividends are first paid on preferred and limiting firms’ right to repurchase common stock while the preferred is outstanding.


The warrants pose an additional problem as wsj.online reports. To treat them as permanent equity capital, ordinarily a firm must prepare financial statements as if the warrants had been converted into common stock. But doing so would increase reported common shares outstanding, diluting earnings per share and book value per share. To avoid that, Treasury seems to have gotten the SEC to say it would not object to treating warrants as equity capital now so long as the bank has, or within one quarter obtains, shareholder authority to issue the required number of new common shares.

Must finessing accounting standards play so central a role in Treasury’s plan and balancing political need to sell deals as temporary with regulatory need to say banks have enough permanent capital? If Treasury thinks government’s investments give banks adequate permanent capital, why not simply modify existing capital adequacy rules to support this conclusion instead of manipulating design and classification to get desired accounting treatment?

Finessing accounting treatments tend to exacerbate problems, not cure them. This lesson is frequently re-taught. Examples include 1980s US thrift crisis, 1990s Japanese banking crisis, Enron’s early 2000s fraud, and even this 2008 credit crisis Treasury is trying to fix.

Hat tip: Lynn Turner, Former SEC Chief Accountant

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3 Responses

  1. A.J. Sutter says:

    Thanks for your post. I’m a little confused by something in the WSJ report; maybe you can set me straight. WSJ says, “However, the $700 billion rescue legislation passed by Congress requires that the warrants be treated as a liability on their balance sheets.” I did a word search on ‘warrant’ and ‘liability’ in the enrolled version of the Act, and couldn’t find any such express requirement. Is it buried away somewhere subtle?

    If so, then how could SEC unilaterally decide to ignore something that Congress has passed?

    As for finessing accounting rules, isn’t that generally what asset-backed securities, and derivatives generally, are all about? To do off the balance sheet what would look bad were it on?

  2. Lawrence Cunningham says:

    AJ,

    Thanks for the comments.

    Nor can I find where the statute requires government investee banks to treat warrants as liabilities on their balance sheet. In fact, Section 113 suggests the opposite: it uses the phrase “warrant or other equity security” and repeatedly juxtaposes warrants against debt instruments.

    But GAAP may require treating warrants as debt. Usually, GAAP treats freestanding warrants as equity. But when terms unconditionally require settling them by transferring assets, GAAP (in SFAS 150), and SEC interpretations, treat them as debt, at least in part.

    The SEC has plenary statutory authority to set accounting standards. Its letter to Treasury, in the style of a no action letter, probably is within its power.

    But suppose the statute really directs that warrants be treated as debt, or that the statute could plausibly be so read. An interesting question of agency interpretation of statutes appears. Expert colleagues tell me this subject has received surprisingly limited scholarly (or judicial) attention.

    One approach, courtesy of my colleague Jon Siegel, would give deference to agency interpretations consistent with the “field specific principles” the agency applies in its regulatory activities. Alternatively, given exigencies of this statute and Treasury’s policy switch after enactment (from buying assets to making investments), perhaps the SEC’s functional no action letter deserves no rebuke.

    I’m not sure that asset backed securities and derivatives are all about finessing accounting rules. For ABS, there are substantive economic reasons to transfer assets for immediate cash that costs less than other financing sources and for derivatives there are substantive economic gains from hedging. It is true that deal and instrument design must contend with accounting constraints (and other constraints) and the result can be accounting finesse.

    And, to be sure, accounting finesse rarely is good practice; it is hard to see how it could be good policy.

  3. A.J. Sutter says:

    Thanks for your reply. BTW, from a business perspective, the off-balance sheet nature of these instruments is a *big* part of their appeal, not just an incidental feature.