We have a scapegoat (yay~!)

The Global Financial Crisis (Gee Fee Cee as the media calls it, or O F*** as the economy calls it), has been characterised by one thing. There’s been no one to blame for it. Oh yes, the politicians and the media are having a right riot blaming the investment banks (or the financial sector generally) for the GFC, but as I’ve previously argued, the investment banks are not at fault. Stepping away from the issue of investment banks, why drag the entire financial sector into this? For example, one of the major sticking points in the financial reforms last year were credit card companies. Yes, those reforms were critical, but linking credit card companies to a real estate financial crisis is a bit of a long bow (though they obviously contributed to high consumer debt generally). The radical right is trying to blame the US Government – in particular, the Federal Reserve for keeping interest rates low or for using Fannie Mac as a social justice tool rather than a financial services tool. But the Federal Reserve had a tough challenge back in 2001 when it decided to keep interest rates low – cause a recession now, or possibly cause a recession later. It didn’t have the tools to deflate the asset bubble in housing and in stocks without deflating the economy generally.

So what I’m saying is, though each and every one of these people is somewhat to blame, no one is actually to blame. There’s been no smoking gun.* Until now.

*Actually, not true: it’s been quite easy to tell which banks had very low lending standards that caused the subprime bubble to collapse. The problem is that none of the major banks did it because they have their own sources of finance. The ones that did it, are the ones who collapsed and can’t easily be blamed. Plus, the ones that did it are community banks… the exact banks which Congress now wants to preference over the major big banks like Bank of America, or the investment banks like Merrill Lynch.

The court-appointed examiner for Lehman Brothers has just put out a 2,200 page report which details many of the dodgy accounting practices employed by Lehman. These were signed off on by both Lehman executives… and partners at the accounting firm, Ernst & Young. The NY Times is quite careful not to make substantive allegations in its article (I generally regard NYT articles as top notch stuff for this exact reason – not overstepping the evidence before it). But my reading of the article is that the Lehman executives are less aware of the accounting malpractices than the accountants themselves.

Can I just say, Arthur Anderson II? During the Enron and Worldcom sagas, some of America’s biggest companies failed spectacularly and the market was unable to respond because of dodgy accounting practices, signed off on by Arthur Anderson partners. As a small time banker, I can say that a large part of the work in understanding how a company works is trying to figure out what those damned accountants have done to the balance sheets. And I don’t just mean dodgy practices, when a company has 20 different lines of business and has just states revenues in one line, how am I meant to tell how large line 1 has been compared to line 2? How can I track the growth of line 1 across time? For Arthur Anderson’s trangressions, the entire worldwide firm was abolished. And as a result, US accounting laws became ever more complex and time-wasting. Sarbanes-Oxley is a ridiculously over-tight regulation. Half of the stuff it regulates is never going to be a problem, but it doesn’t cover every aspect of accounting so there are gaping holes elsewhere. That’s the problem with US Congress- it takes a punitive approach to law-making, rather than a practical approach. It’s like welding  titanium alloy sheet metal to the hull of the Black Pearl and missing the rotting wood on the other side of the ship.

Will something similar happen to Ernst & Young? I’ve honestly no idea, and I somewhat doubt it. The investment banks are a much more fun pinata. You can whack them all you like and they just have to sit there and take it. But this isn’t just a rabbit I’m pulling out of the hat. Accounting practices (and other failures in transparency) are at the heart of what went wrong in the financial crisis. Special Purpose Vehicles are another accounting tool to hide stuff off-balance sheet. Subprime mortgage derivatives only failed because there wasn’t a clear chain of information between the thing you bought, and all the mortgages that went into that derivative instrument. If clear accounting had been there, we would not be in this mess. (On the other hand, I’m sure lawyers may be to blame too – I’m just not as across the details on that).

Markets don’t have magical properties. Market forces are just another force of nature to be manipulated and moved, like a raging torrent. You can capture its power with a well-designed hydro-electric dam, or you can redirect it to flood an entire city. Allowing accountants to hide important information from the market hinders the ability of the market to forecast how well a company is doing and to take steps accordingly.

Death to accountants!