Were Subprime Mortgage Risks Hidden?

Yesterday's news included a story that a German bank called SachsenLB was forced by subprime mortgage losses to sell itself to another German bank. This marks the second time in the subprime mortgage mess that a German bank has needed a bailout because of mortgage losses. In both instances, it appears that the banks' losses came from affiliated hedge funds or other affiliated entities that invested in subprime mortgages.

The German banks have hardly been alone in having subprime problems emanate from an affiliate. Bear Stearns and Goldman Sachs had similar problems. So, too, did a major French bank, BNP Paribas. An Australian bank, Macquarie, also fell victim to losses in an affiliated fund. A French insurance company, AXA, encountered problems with an affiliated hedge fund.

The Fed and other central banks have been quietly bailing out the major players in the financial system. See our previous blog, http://blogger.uncleleosden.com/2007/08/federal-reserves-quiet-bailout-of.html. Since significant amounts of the losses evidently came from affiliates of regulated financial institutions, it may be a good idea to a look at how financial institutions use affiliates.

First, let's review how financial regulation works. The regulators of the banking system provide benefits--deposit insurance and funding when the banks have trouble finding other financing. In turn, the regulators control and limit the risks that the banks take, so that the government's facilities and resources are not exploited by the banks to profit from every loony and harebrained risk out there. Otherwise, the banks might take extreme risks in the hope of gaining extreme profits (called "heads, we win"). And if the extreme risks blow things up, the government steps in and provides a bailout (called "tails, the government and taxpayers lose"). The key to effective financial regulation--the maintenance of stability of the financial system--is to control and limit the risks that can clobber regulated financial institutions.

It appears that at least some of the affiliated hedge funds were "off-balance sheet vehicles." This is an accounting term for entities that a sponsoring corporation (i.e., the financial institution in this case) is associated with, but whose assets, liabilities, earnings and losses are not included in the sponsoring corporation's financial statements. Depending on context, their structure and where they are established, these entities might be known as special purpose entities, special purpose vehicles, structured investment vehicles, variable interest entities, or special purpose companies. In general, they are created to serve a narrow purpose that benefits the sponsoring corporation that creates them. The narrow purpose could be investment in high risk assets that the sponsoring corporation could not or does not want to directly invest in. The sponsoring corporation may hold some sort of equity interest in the off-balance sheet entity (not common stock, but perhaps preferred stock), so that it can profit if its little brother does well. It is likely to provide the affiliate with asset management and other services, which provide fee income to the sponsoring financial institution. And it will often provide financing, since leverage is the key to making big bucks investing. Until recently. But that's another story.

Thus, the affiliates become a way for the sponsoring financial institution to derive income and profit, without formally recognizing the risks and losses that the affiliate incurs. At least that's the theory. But things seem to be turning out differently. The two German banks needed government bailouts. The other financial institutions have closed their funds, in some cases with losses to themselves as well as to investors. We'll know more as they start to announce third quarter results in the next month or two. See http://blogger.uncleleosden.com/2007/08/when-credit-crunch-losses-will-become.html. In reality, the financial institutions haven't been insulated from the risks of the off-balance sheet vehicles.

Because they've created losses for the regulated financial institutions, these vehicles and their use raise questions for regulators. To what extent were the regulated financial institutions truly insulated from losses and liabilities of these entities? If the financial institutions in reality had exposure, did they disclose it clearly and completely to regulators and investors? Did they maintain adequate reserves and capital against the possibility of loss? Did they properly account for their exposures on their financial statements? Did they suitably manage their risks? (Apparently not, in some cases, so hard questions should be asked.)

The use of off-balance sheet entities extends well beyond hedge funds and similar investment vehicles. Essentially all of the CDOs, CMOs, CLOs and the like that have proven so risky are off-balance sheet vehicles created by banks that packaged debt obligations into them. Because the banks packaged these deals, it's possible that they could have contractual liability for some of the losses, either because of obligations to buy back defaulting mortgages or failures to make appropriate disclosures in offering documents they prepared as underwriters of the securities. There are trillions of dollars of asset-backed securities drifting around the financial netherworld, and the potential liabilities from the off-balance sheet entities that issued these securities could dwarf the losses to banks from affiliated hedge funds. If it turns out that the banks have liabilities emanating from their creation and underwriting of asset-backed securities, the same questions about disclosure, capital adequacy, accounting, and risk management should be asked.

Off-balance sheet vehicles have largely stayed hidden in the shadows of the financial world, of interest only to the cognoscenti. They made a brief appearance under the klieg lights during the Enron scandal, where we learned that Enron executives used off-balance sheet entities they controlled to play accounting shell games that applied an impermissibly large amount of makeup to Enron's financial statements.

Now, it turns out that a shipload of risk and losses to the world financial system were lurking in off-balance sheet vehicles used in the world of hedge funds and asset-backed securities. And its unclear that these risks and losses were known to regulators or investors. These losses have necessitated government bailouts around the globe. Understanding and limiting the exposure of regulated financial institutions to such losses is essential to effective regulation. Granted, the issues here are highly technical (take a look at the Financial Accounting Standards Board's FIN 46R, if you're in the mood for brain death). Nevertheless, it would do taxpayers, depositors and investors a good turn indeed if regulators were to focus their magnifying glasses on the use of off-balance sheet vehicles.

Crime News: robbery in moderation. http://www.wtop.com/?nid=456&sid=1233897.