Saturday, June 29, 2013
Law of Set-off Makes No Sense to New York Times Business Columnist
In a column on the front page of Friday's Business Day section in the Times, provocatively titled, "Wielding Derivatives as a Tool for Deceit", Floyd Norris writes that derivatives
"are often weapons of mass deception.
"For some derivatives, a desire for deception is the only reason they exist. That deception can allow those who own derivatives to evade taxes or accounting rules. It can allow activity that might otherwise be illegal, were it not called a derivative, or that would face regulation if it were labeled what it truly is.
"Sometimes, banks use derivatives they create to help their clients deceive the public. Other times, they enable the banks to deceive those clients."
He tells an interesting story of how, during the 1990s, Italy used derivatives, in which it got upfront payments, to make its budget deficit look smaller, thereby easing its admission to the Euro Zone. At the time, Mario Draghi, now head of the ECB, was the director general of Italy's Treasury department. Norris believes the transactions should have been treated as loans, such that the cash received by Italy at the start of the transaction would not have run through the report of receipts and disbursements for the year, and thus would not have reduced the deficit. (To be fair, he credits the FT and La Repubblica for the story).
The anecdote leads him to his general claim that banks use derivatives to create misleading depictions of their financial condition and further that accounting rules condone the practice. This is where the law of setoff comes up. Norris writes (my emphasis added),
"The current accounting rules in the United States go so far as to say that banks can hide obligations that are classified as derivatives. They do that by “netting” derivative positions that are currently profitable against positions that have losses, and show only the net value. That reduces the amount of assets on their balance sheets and thus makes them appear less leveraged than they are.
They can do that even if the two positions have nothing in common — save the identity of the counterparty on the other side of the transactions. It makes no sense at all to be able to hide a bet on, say, the Canadian dollar, by offsetting it against a bet on German stock prices. But that is legal now in the United States."
Now I have no idea whether combining a bet on the Canadian dollar with a bet on German stock prices is a good trade. But I do know that setoff between two parties who are obligated to each other is a pretty clear legal principle that has been around for centuries, and the ISDA's master agreement provides for cross-termination, mark to-market and netting, and the safe harbors in the Bankruptcy Code permit financial institutions to do all that even after one of them goes bankrupt. So it's pretty likely that, if Bank A owes Bank B money on the "Canadian dollar bet" and Bank B owes Bank A money on the "German stock prices bet", that they can net, under the ISDA master agreement, or the law of setoff, and neither of them is mis-representing its financial condition or leverage by reflecting that prospect on their financial statements. ( I suppose I should be lawyer-like and note that I only am familiar with the US law and have no idea if the same is true if one of the banks is from a non-US jurisdiction. And, yes, I know that banks don't file under the Bankruptcy Code, but (a) the practice in bank liquidations is not meaningfully different and (b) I think Norris is using "banks" as a shorthand for all large complex financial institutions including many which could file under the Bankruptcy Code.)
I feel for journalists who have to distill complex subjects and come up with something interesting to say under deadline pressure. Mistakes are inevitable. Financial journalism has always seemed to be a particularly mistake-prone field. And generally I find many of Norris's columns quite well thought out. On the other hand, it would be nice if journalists, being in a profession that purports to be interested in fact, would actually pose questions to people with knowledge in a field before they upload their mistakes to the reading public. So:.
Dear Mr. Norris,
Setoffs have generally been permitted for centuries, and taking setoff principles into account is not something that can be accurately labeled "deceptive"..