Remedial Accounting and Bankruptcy Law

Over at Angrybear and (thanks John Quiggin) crooked timber, I have gotten some flak for dubious claims about accounting standards.

My claim was that a firm can write a credit default swap on its own debt without telling anyone. 2 commenters correct me.

Fred at angrybear writes

no. can't be. these would be contingent liabilities and have to be on balance sheet at their expected loss. that matters because under bk law any transfers w/in 2 years of relief date are voidable if made to hinder creditors or if as a result there was balance sheet insolvency, and if insufficient consideration was received. bonuses that are discretionary and not the result of contract rights would be such. failure to mark to market the contingent liabilities in this context would be a serious bk matter.
fred

at Crooked Timber Royt writes, among other things,

ROYT 09.28.08 at 9:45 am

The central assumption in “AngryBear’s” speculation is this: “Lehman could have made their senior debt worth 12 cents on a dollar in case of default by selling CD insurance on their own debt—lots of it. This would not require any false accounting as they are not required to report this fact.”

The AngryBear couldn’t be more wrong. Reporting of such a CDS would indeed be required.

and in more detail

ROYT 09.29.08 at 7:41 pm

[snip]

I asked above, Why would CDS positions such as have been theorized by Waldmann (and further speculated upon here) be required to be disclosed? One answer is, Materiality. Another is Concentration.

Lehman did not, in a recent reported quarter-end have any such position. We know this because we can read their May 31 10-Q. We can peruse their footnotes for extraordinary transactions (which E&Y would surely have regarded these as being), we can search the MD&A, examine disclosures on liquidity and concentration… in vain.

I reply

Robert Waldmann 09.30.08 at 4:18 pm

[snip]

Thanks Royt. I admit I am fairly ignorant about accounting standards and don’t know what is in the Lehman May 31 10-Q. Could you provide a link ?

This seems relevant
“SEC Info – Lehman Brothers Holdings Inc – 10-Q – For 5/31/08 – E”…
is
http://www.secinfo.com/d11MXs.t1C1k.c.htm seems relevant

I search for concentration
I get “Concentrations of Credit Risk
[snip] The Company’s exposure to credit risk associated with the non-performance of these clients and counterparties”

Not relevant. That is risk related to Lehman assets not liabilities.

something in a section on valuing securities which is not relevant

“geographic concentrations” (not relevant)

more on concentration of assets (not relevant)

something on risk management thinking about concentration (not relevant)

Concentration appears to be a word related to assets and counter party risk. It has nothing to do with Lehman liabilities which require payment only if Lehman defaults on its debt (the topic of my post).

The word “materiality” does not appear in the 10-q report entitled “Lehman Brothers Holdings Inc · 10-Q · For 5/31/08”

I’ll keep looking
26 Robert Waldmann 09.30.08 at 4:30 pm

I’m searching for “credit default” a relevant entry just shows the current market value. This is not the issue. The issue is the value of liabilities if Lehman is in liquidation

I quote

“Fair Value of Derivatives and Other Contractual Agreements”
this includes credit default swaps as liabilities. They are booked at current market value. This is not relevant.

It also appears in a section entitled

“LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements
(Unaudited)”

There is another entry about credit default swaps with SPE’s again in (Unaudited). Again just amounts at fair value. Nothing about the correlation with bankruptcy of Lehman brothers and typically in unaudited notes.

I don’t see how I can tell if Lehman wrote CD swaps on its own debt from this document (but I repeat I am ignorant).

Now maybe a competent accountant, which I am not, can tell that Lehman didn't write any CDSs on its own debt from the May 31 10-Q but I sure can't.

Finally John Quiggin himself notes

John Quiggin 09.30.08 at 7:54 pm

ROYT, it appears from your explanation that any requirement to disclose is very limited, and that the disclosure is far from continuous.

Indeed. It isn't May 31 2008 anymore.

I might add that Quiggin explains how to do it without being too obvious in his post

For a start, it seems obvious that allowing firms to sell CD swaps on themselves is a terrible idea, but Waldmann says it’s not illegal and has happened in the past. But even if you could stop the most obvious version, there are plenty of ways around it. Suppose for example that Bank A and Bank B sell lots of CD swaps on each other. Then if one gets into trouble so does the other, and both default, so the CDS are reduced to their bankruptcy value. As long as both banks survive, it’s money for jam.

My bottom line view is that booking CD swaps at fair market value and telling bond holders and rating agencies the total value is no where near enough to protect bond holders from the scam I imagine. What matters to bond holders is not the expected value of liabilities, but the value of liabilities if the firm is bankrupt. If Lehman had written CD insurance on its own debt, the fair market value would be low (few imagined that Lehman would go bankrupt and most are not attracted by a claim on a bankrupt firm even if it has positive value).

On accounting I think the one thing I don't know about is whether the accounting firm which certifies the books would add a specific warning.

Now Fred also makes an important claim about bankruptcy law, another aspect of my almost infinite ignorance. It seems to me clear that a self CDS can't cause insolvency (it costs the firm nothing until it is already insolvent for some other reason). It also seems hard to argue that the compensation for the liability was inadequate as disinterested people have claimed that the just price is zero. I think a judge could just decide that the contract is illegitimate, because it was designed to hinder creditors. That is, in common law countries, you can lose by being too clever as judges have great leeway to interpret and apply vague principles in a way that punish people who followed the letter of the law (to the extent that it was explicit) while violating its spirit.

I'd say the chance that a bankruptcy judge would void a contract, because Robert Waldmann can think of a sneaky reason to write it is less than 100% and so the value of the contract is still positive and the deal benefits shareholders at the expense of bond holders.