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The Great Sewer of the Financial System

Monday - 12/10/2012, 2:00am  ET

On Sept. 16, 2008, Morgan Stanley 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 as squeaked by without much notice: the accountants.

I recently came across a December 2008 interview with outspoken Berkshire Hathaway 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 use 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 ] 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.

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