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The Great Sewer of the Financial System

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On Sept. 16, 2008, Morgan Stanley (NYSE: MS  ) was in serious trouble. By most hindsight accounts, the bank was feet away from collapse and ruin.

Yet something remarkable happened: Morgan Stanley reported a $1.4 billion quarterly profit. Excluding the peak of the credit bubble, it was one of its best quarters in more than a decade.

How, in the middle of the worst financial crises in 80 years, was the bank able to book a solid profit? Thank one of the most inane accounting rules even invented.

The rule, totally legitimate and used by every major bank, goes like this: When the market thinks you're about to go bankrupt, the value of your debt declines. When the value of your debt declines, you could theoretically buy it back for less than par value. If you did, you would have less debt. And getting rid of debt is the same as profit. So connect the dots: When banks found themselves in grave trouble and the value of their debt plunged, they booked the difference as net income. The worse shape they were in, the more profit they could book.

We're four years past the financial crisis, and nearly every participant has been flogged. Bankers, consumers, and politicians have all been blamed -- rightly or not.

Yet one group has squeaked by without much notice: the accountants.

I recently came across a December 2008 interview with outspoken Berkshire Hathaway (NYSE: BRK-B  ) Vice Chairman Charlie Munger. In it, he tackles how the accounting profession's indiscretions fueled the financial crisis, and what we can do about it. You can watch the whole thing here, but here are the important excerpts (emphasis mine).

I would argue that a majority of the horrors we face would not have happened if the accounting profession were organized properly. In other words, they have a position from which, if they behaved intelligently and correctly, they could prevent a huge amount of all that's wrong with the system. And they have failed utterly, time after time after time. They are way too liberal in providing the kind of accounting the financial promoters want. They've sold out. And they do not even realize that they've sold out, which is, of course, a common human psychological phenomenon. ... [C]ompared to what it could reasonably be, with intelligence and honor, the accounting profession is a sewer.

Take derivatives trading with mark-to-market accounting, which degenerates into mark-to-model. Two firms make a big derivatives trade, and the accountants on both sides show a large profit from the same trade. They can't both be right, and nobody is even bothered by the fact that this is happening. It violates the most elemental principles of common sense. And the reason they [the accountants] do it is there's a demand for it from the financial promoters.

It didn't used to be this way, Munger says:

I remember when interest rate swap accounting was done on a different and more conservative basis. The Morgan bank [I'm pretty sure he means JPMorgan Chase (NYSE: JPM  ) ] was the last holdout. And finally they couldn't hold their traders and report the same kind of income other people reported, so they threw out the sound accounting and went to the phony accounting. It was kind of funny at the time -- this was many decades ago -- and some of the people were kind of reluctant, but they said "We'll go with the flow." It was a huge mistake.

He's then asked whether the system can be fixed:

I think you're talking about a problem rooted so deeply in human nature that I don't think you'll live long enough to see [a big change]. If it gets 20% fixed in the direction it should go in your remaining lifetime, you'll be a fortunate man.

I don't know how to transform all human life ... there are huge forces in play. The entire momentum of existing thinking and existing custom is in a direction which allows these terrible follies that have happened.

Either way, it's ugly:

The terrible follies have terrible consequences. What we're in now is, in its triggering circumstances, worse than anything that has ever happened. ... The economy hasn't contracted as much as the Great Depression, but the malfeasance and silliness that [has been] the triggering event was way greater and more widespread. In the 1920s, a tiny little class of people were our financial promoters, and a tiny little class of people were the people who bought securities. This now is deep into the whole culture and way more extreme. If sin and folly get punished, we're in for [severe] punishment.

Getting your financial integrity and the financial accounting right has enormous implications for the future of mankind, and yet very few people realize how much we screwed up. Very few people realize, even in leading law schools and business schools, how Enron never could have happened if they hadn't changed the accounting rules. And what we have now is just a bigger, widespread Enron.

No one should be happy about this:

Idiot bubbles blessed by accountants are terrible for the whole civilization. It would be much better if we didn't have these idiot bubbles, or at least if they were dampened very considerably. But people use the idiom "No one ever wants to take the punchbowl away when everyone is having a good time at the party." The people who do it tend to be despised and hated, and not a lot of people are willing to be despised and hated.

The main thing you have to realize is Ben Franklin's basic idea that an ounce of prevention is worth a pound of cure. That's understated -- an ounce of prevention is sometimes worth a ton of cure. And your only real chance was to not allow it to happen.

When they put in the options exchanges, there was like one letter saying we shouldn't do this, and Warren Buffett wrote it. He said: "This is not doing any good for the wider civilization. We don't need this." He was all alone! And he was totally right.

What did we used to do right? He explains:

When we separated banking from investment banking on the theory that investment banking had a natural proclivity to get a fair amount of knavery and folly into it and we wanted to protect our banks from contagion, that was a good idea.

When we created margin rules that discouraged heavy borrowing against securities just to make more money when the securities went up in value, that was a good idea.

When they wanted to make the market system a better gambling casino as a side function of unnecessary capital markets with vast profits for the people who were helpers -- the traders and the market-makers and the brokers -- that created a big constituency in favor of a dumb change. There was little Warren Buffett saying "this is a dumb idea."

And so, just one after another we made these insane departures from the corrective devices we had put in the last time we had big trouble. It really worked quite well. The investment banks of yore, when the Mellons were running First Boston and Morgan Stanley was a very conservative place chastened by the 1930s, the investment banks were partnerships, they were totally private ... the places were much more responsible and honorable ... they cared terribly about the consequences to their clients long term from the securities they sold. That ethos, by the time the year 2006 came along, had pretty well disappeared.

On a final, pessimistic, note:

Some of the most eminent and most admired people in finance, including [Alan] Greenspan, argued that derivatives trading, in the [modern] form of the old bucket shop, was a great contribution to modern economic civilization. There is one word for this: It is insane.

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Read/Post Comments (4) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 11, 2012, at 12:39 PM, Classof1964 wrote:

    The banks and financial industry all complain loudly that we have too much regulation. Given that the Glass-Steagall Act was about 34 pages compared to Dodd-Frank 's thousands of pages, there is probably a point there. But at the root of accounting and financial regulations is the corruption of our political system by campaign contributions and the influence every special interest gets as a result. Instead of the kind of straightforward principles to which Munger refers, e.g., separation of federally insured savings banks from investment banks, every special interest now gets a paragraph or subsection to try to avoid having its conduct restricted.

  • Report this Comment On December 11, 2012, at 2:04 PM, oldman144 wrote:

    Thanks for an excellent article. Sounds like Alice in wonderland- up is down, down is up and nothing is as it seems. Off with their heads.

  • Report this Comment On December 13, 2012, at 11:39 AM, actuary99 wrote:

    This guy and Buffett amaze me over and over again with their wisdom. If the majority of voters were financially literate AND close followers of what these guys say and do, we might not have such a stinking pile of excrement in Washington right now.

    I wish they could make financial decisions on behalf of our country, but I'm not sure they're not crooked enough to get elected.

  • Report this Comment On December 18, 2012, at 1:51 PM, barteln wrote:

    It's easy to bash something you don't understand and count on the fact that your readers don't either.

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