By Ignacio de la Torre, professor at IE Business School

Investment banking has once again shown us the way to address the world’s enormous and recurring debt problem. It is, of course, by cheating.Although it may not have been noticed, investment banking has shown us the way solve the world’s enormous and recurring debt problem. What did the last entry in Lehman Brothers profit and loss statement show? Enormous profit. Let’s see why. The results of the third quarter of 2011 for Lehman Brothers produced “profits” as a consequence of the fall in value of the debt market of the banks themselves. In other words, if the risk of bankruptcy of, for instance, Morgan Stanley, increases, the price of its bonds falls, which means its “profits” will rise. Intuitive? That’s why the last entry in Lehman’s books was actually an enormous profit. The five main investment banks have posted “profits” totaling 15,000 million dollars obtained this way in the third quarter, which means that the position of the bank’s “own” funds is skewed by an equivalent amount, as is its solvency, measured in relative terms (value at risk) or absolute terms (leverage). In short, over 80% of the profits posted by investment banks in the third quarter of 2011 is a result of this fantasy.

Thus the profits of 6,200 million dollars posted by Bank of America contain a bonus dividend of 3,600 and a “profit” due to a fall of 1,700 million dollars in the amount of debt. Citigroup’s profits have risen by 74% to 3,800 million dollars thanks to the recognition of a “profit” derived from the drop of 1,900 million in its debt level. Morgan Stanley posted a profit of 2,150 million dollars, of which 3,400 were the result of a fall in the value of its debt, and JP Morgan posted a profit of 1,900 million dollars using the same system, beating the market with a profit of 1.02 dollars instead of the expected 91 cents (its shares fell by 4.8% – the market is not quite as simple as it looks). Unfortunately, this practice is also being employed in Europe, where UBS has posted a profit of 1,800 million Francs as a result of the fall in value of its debts. Its total profit was 1,000 million Francs, which means that if it hadn’t used the trick it would have posted losses, not profits, as a result of its trading scandal (2,300 million dollar loss).

The “logic” of posting a profit when the risk of bankruptcy rises lowering the value of liabilities is that the bank will then have the capacity to repurchase that debt, i.e., it is assumed that it will be capable of finding the cash required to repurchase said debt and to amortize it, which is a highly questionable hypothesis. This way of treating debt was obtained from the banking lobby (despite honorable opposition from Goldman Sachs, which nevertheless didn’t think twice about benefitting from the system when it came to posting results) when the regulator applied the mark to market system to its assets. The banking system said: if the accounting system forces us to apply market value to assets, we should also be able to apply it to liabilities. And that’s how the prudence principle was breached.

As the Financial Times pointed out on October 24, if you are a Visa customer and you realize that there is a considerable risk that you will not be paying what you have spent on your card, all you have to do is amortize the part of the loan that you will not be paying by posting it as a “profit” on your household accounts.
Governing authorities, entrepreneurs and citizens should learn from such a clever accounting system. Greece would gain instant solvency, given that its bonds are being sold at 40% of their face value. It could post an enormous revenue by multiplying 60% by the notional value of its debt, and that would mean that would be no deficit but rather an gigantic “profit”, much to the relief of the German taxpayer. Berlusconi would be saved, given that Italy could achieve a similar effect by posting a profit equal to the current 8% discount on their bonds (the third largest sovereign bond market in the world), or Spain with 3%.

The deficits would be eliminated with the stroke of a pen and there would be no need for painful social cutbacks. Nor would it be necessary to intervene in the CAM savings bank or the Caja Castilla la Mancha savings bank. In fact, the savings banks would be more profitable (and therefore more solvent) than the banks. Nueva Rumasa would also have avoided being put out to tender, and the more problems Banco Santander pointed out when restructuring its debt, the more “profits” it could have chalked up, thereby instantly improving its balance sheet. Real estate developers would all be saved, and subprime mortgages would post the greatest profits ever achieved in the history of economy.
I don’t want to delve too deeply into the realms of absurdity, but it is disgraceful that this is a reality. I am going to quote three universal truths to illustrate the moral of this story:

a) With reference to their bank balances Anglo Saxon accountants say “on the left side there is nothing right, on the right side there is nothing left”.

b) An investor will say about a firms accounts that “profits are a matter of opinion, the cash flow is a fact”.

c) In finance classes we say: “TCFIMITYM”.

TCFIMITYM stands for “The Cash Flow Is More Important Than Your Mother”.

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