Misunderstanding data on economic growth

According to Paul Krugman, we know that the growth estimates of the naughties are close to accurate because:

On the financial side, the point is that we measure growth by output of final goods and services, and fancy finance is an intermediate good; so if you think Wall Street was wasting resources, that just says that more of the actual growth was created by manufacturers etc., and less by Goldman Sachs, than previously estimated.

This just shows how little economists have tried to understand the nature of recent financial innovations.  Wall Street can now create synthetic assets.  That’s what a synthetic CDO is — it goes on someone’s balance sheet as an asset and there’s no requirement in accounting conventions that it go on somebody else’s balance sheet as a countervailing liability.  AIG is just an illustration of how the accounting for such CDOs takes place.

In an environment where Wall Street can fabricate assets that enter into financial accounts in this way, it’s not realistic to claim that “fancy finance is just an intermediate good”.  That used to be true in the good old days, when there was no reason to believe that the CDS contracts underlying synthetic CDOs would be enforceable contracts, but after the CFMA of 2000 (and other changes in the law), that isn’t true anymore.

For this reason, the economic assumptions underlying analyses like Krugman’s and Steindel’s do not reflect reality — and in fact they function as a blinder that prevents these economists from seeing and understanding what’s actually going on.  By assuming that financial institutions can’t do what they did do, economists hobble their understanding of the nature of the current economic malaise.

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9 comments so far

  1. Sonic Charmer on

    Wall Street can now create synthetic assets. That’s what a synthetic CDO is — it goes on someone’s balance sheet as an asset and there’s no requirement in accounting conventions that it go on somebody else’s balance sheet as a countervailing liability.

    Is this true? Could you expand on it a little? To me, any sell of protection that’s in the money looks and feels like a liability; it will be on the books as a negative PV, may require margining, etc etc.

    In a (funded) synthetic CDO, the arranger (i.e. bank) has ‘bought protection’ from a vehicle. If that protection is in the money (as is the case in the vast majority of synthetic CDO deals at this point), the bank will see a positive PV, i.e. an asset, but the vehicle has a corresponding liability (which it has pre-funded by selling notes to investors, and parking the proceeds in some eligible assets).

    In an unfunded synthetic CDO, i.e. purely a swap b/t two counterparties, the situation is the same with the counterparty in place of a vehicle: buyer of protection has an asset, seller has a liability.

    So where do you see the ‘missing liability’ – is there something esoteric/advanced about the accounting treatments here that I am missing? (probably :) Thanks,

    • csissoko on

      I wouldn’t make the claim if the accountants hadn’t made it first. If you follow the AIG link to re: The Auditors, Francine McKenna, an accounting professional, roasts PwC for auditing both Goldman’s and AIG’s books — and clearly signing off on very different valuations of identical assets.

      In the normal course of affairs, different auditors are likely to be reviewing valuations, and there’s nothing in our system of accounting to force these valuations to be consistent with each other. Obviously this is more of a problem where assets are priced by model (like synthetic CDOs), than where a clear market price can be established.

      • Sonic Charmer on

        Ah I see – you’re talking about counterparty valuations and whether they tie out with each other. Yes, in that sense one side could see an asset where the other side sees no liability, depending on where the two sides are marked. I think this is widely understood to be, er, a ‘problem’ if/when it happens, and will almost certainly lead to a lot f inquiries/discussion. I would think that almost anywhere this would be flagged and provisioned. But maybe you’re right that no accounting convention prevents it per se. Thanks,

      • csissoko on

        will almost certainly lead to a lot f inquiries/discussion. I would think that almost anywhere this would be flagged and provisioned.

        Hmm. Aren’t the underlying problems that (i) most of the time mismatched valuations won’t be caught, because there’s no point in the regular course of business at which the two counterparties’ valuations for financial reporting purposes are compared and the auditors don’t consider it their job to check up on this and (ii) accounting conventions sometimes promote mismatched valuations — and are exploited for this very purpose. The ancient example of the latter is lease accounting, but it’s also my impression that for example European banks are able to account for the sale of CDS in a way that is unlikely to match up with the valuation of a US counterparty. (I may be wrong about the latter.)

        Synthetic assets make the weakness of accounting conventions much more dangerous than they were in the past, because the degree to which such arbitrage opportunities can be exploited is not limited by, for example, the number of airplanes available for lease.

        I’d be interested in what you know about the “flagging and provisioning” for these problems.

      • Sonic Charmer on

        Aren’t the underlying problems that (i) most of the time mismatched valuations won’t be caught, because there’s no point in the regular course of business at which the two counterparties’ valuations for financial reporting purposes are compared

        I disagree; best I can tell, counterparty valuations are matched and checked, mismatches greater than such-and-such threshold are queried, adjustments to marks and/or provisions are taken where deemed appropriate, breaches of various flags/limits will be escalated and have to be explained, etc. etc. This is, after all, about collateral/margining – real cash being handed back and forth – and so of course both counterparties have an interest in surveilling valuations and investigating mismatches, regardless of what accounting conventions might dictate. (And I don’t know that they dictate otherwise). Maybe this is all done worse at some places than at others but I don’t think it’s correct to say it’s not done at all.

        The Goldman/AIG article you link to, although I only skimmed it briefly, appears to refer to a genuine collateral dispute, in which (I presume) AIG was understating their liability in Goldman’s eyes, PwC was accused of having had a conflict of interest, etc. Certainly it shows that a large mismatch can persist for an extended period and this buttresses your point, nevertheless the very existence of a dispute implies that the valuations are, in fact, being compared.

        The speed/efficiency with with such valuation mismatches are able to be rectified is another story, of course. And the opaque/’black box’ nature of valuation of e.g. level 3 assets can obviously contribute. As can conflicts of interest (if indeed it turned out there was one in the PwC case – I don’t quite remember how that played out).

        accounting conventions sometimes promote mismatched valuations — and are exploited for this very purpose. [...] it’s also my impression that for example European banks are able to account for the sale of CDS in a way that is unlikely to match up with the valuation of a US counterparty. (I may be wrong about the latter.)

        I’m not familiar with the Euro-CDS example you give here, but I don’t doubt that accounting-convention arbs exist and are exploited. Good luck getting every last one closed… ;-)

        Anyway I want to be clear that although I have disputed a couple of the side assertions, the basic point you make (now that I understand it better) rings true to me: assets that can only be valued by model make accounting mismatches more likely and more difficult to clear up. Yeah, that about sums it up.

        best

      • csissoko on

        I apologize for the delayed reply, but I’ve been buried in work lately.

        This is, after all, about collateral/margining – real cash being handed back and forth

        I agree that there’s less to worry about with those derivatives on which collateral is currently being posted. Unfortunately I’m concerned (i) that far too many derivative contracts aren’t subject to margining (According to the ISDA only 70% of OTC derivatives have collateral agreements and many of these are either unilateral or have collateral thresholds. Thus a large fraction of OTC derivatives will not involve regular comparisons of value, and even a small fraction can cause problems) and (ii) other assets (often with derivatives built into them) can escape this kind of treatment.

        assets that can only be valued by model make accounting mismatches more likely and more difficult to clear up

        We obviously differ more on the degree to which this is a problem than on its theoretic possibility. The issue is that we are both discussing an issue on which very little data is available, so a variety of interpretations of clear cases like the AIG/Goldman example are all possible.

        The point of my post was to indicate that, because our financial structure is such that the accounting mismatch problem may be very large indeed, theorists like Krugman need to take that possibility into account rather than simply assuming it away.

      • Sonic Charmer on

        I see & understand your point here. I think where I come down is that I simply doubt that mismatched-valuation is a large factor to anything in the grand scheme of things. I could be wrong, but it sounds as if neither of us have hard data either way.

        best

  2. Francine McKenna on

    Thanks for highlighting my discussion of the AIG/Goldman Sachs disputs. One small correction. My blog is re: The Auditors.com. Footnoted.org is written by my dear friend Michelle Leder, is now a part of Morningstar.com and focuses on SEC disclosures.

    fm

    • csissoko on

      Arrgh! My apologies for that mistake. I’ve gone ahead and edited the comment, so it is now correct.


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