Accounting according to Barclays: declining creditworthiness as a source of profits

Either accountancy rules in the UK are generically nuts, or Barclays PLC’s accounting conventions are idiosyncratically nuts, or both are (nuts, that is).

In its report today on Barclays’ Annual results for 2008, the Financial Times writes:

“The bank confirmed it had written down its exposures to complex debt instruments by £8bn in 2008, though the impact was reduced by a £1.66bn gain it booked from the reduced value of its own debt.”

My immediate thought was: surely that report cannot be true.  When your market-traded debt becomes worth less because the market considers you less creditworthy than before, and prices your debt to reflect that perception of increased default risk, this does not add to your profits – it simply makes you a worse credit risk.

This is mark-to-market gone mad.  It ignores the fact that, if there really were any higher current or future profits from the decline in the valuation of the debt because of higher default risk premia, these profits would have to be paid out as debt service: holders of Barclays’ debt have a claim on its resources that is senior to that of its profit claimants (see also the last section of this post).

As I understand it, should a debtor try to repurchase his own debt at the discounted market price, this would constitute an act of default.  I ran into this problem all the time during the years I worked regularly on emerging markets and developing countries.  Dodgy sovereigns would issue debt or borrow from banks.  If and when the sovereign turned out to be non-creditworthy, the debtor government frequently tried to sneak behind the backs of the IMF and the other multilateral organizations to buy back its own bonds (or the by then often securitized bank loans) at a discount.  This was not permitted under the rules of the sovereign borrowing game, although it did happen.  It was a good boondoggle for the borrower.  First you borrow and spend the proceeds.  Then you convince the world (your creditors in particular) that you are a terrible credit risk.  Your creditors run for the exit and agree to sell your debt back to you at a discount, all without any formal default or bankruptcy procedures.

Clearly, reducing the face value, notional value or contractual value of your outstanding debt by paying off part or all of it in accordance with the normal terms of the debt contract, does reduce your outstanding liabilities.

Surely, neither the accounting rules in the UK nor Barclays would be silly enough to mark to market capital gains or losses on contractual obligations like notes and then count the losses (gains) as contributions to profits (losses)?

So I delved into the Barclays PLC Results Announcement Figures 2008, and there it was.  The FT’s report was correct: Barclays had gone well beyond making a silk purse out of a sow’s ear, and had transmogrified an adverse market judgment on the development of its creditworthiness into a contribution to profits.

“Group profit before tax was £6,077m, down 14% on 2007. Profit included:

- Gains on acquisitions of £2,406m, including £2,262m relating to Lehman Brothers North American business

- Profit on disposal of the closed life assurance book of £326m

- Gains on Visa IPO and sales of shares in MasterCard of £291m

- Gross credit market losses and impairment of £8,053m

- Gains on own credit of £1,663m”

The ‘surely they could not be quite that stupid’ inner voice kept me going deeper into the entrails of the Results.  And yes, they could be, because on page 7 of its results announcement, it reads:“Barclays Capital was affected by very challenging market conditions in 2008, with income falling by £1,888m (27%) on 2007, reflecting gross losses of £6,290m relating to credit market assets, partially offset by gains of £1,663m on the fair valuation of notes issued by Barclays Capital due to widening of credit spreads and £1,433m in related income and hedges.” (underlining added by me (WHB)).

At that point I checked whether I had taken the tablets this morning, and yes, I had.

What this means is that Barclays PLC results for 2008 contain a contribution to profits of £1.66 bn that is completely spurious from an economic, financial, commercial and common sense perspective.

What else could be wrong?

If the market’s declining valuation of Barclay’s creditworthiness is recorded in the accounts as a contribution to profits, it makes you wonder what else in these accounts makes no sense.  In the year since 31-12-2007, the size of the balance sheet has increased from £ 1,227 bn to £ 2,053 bn. Much of this massive increase is accounted for by almost matching increases in derivative financial instruments of over £ 700 bn on both the asset and liability side of the balance sheet.  There were just under £45 bn of derivative financial assets whose valuations were based on unobservable inputs (internal models etc.).  Just over £14 bn of derivative financial liabilities had their valuations based on unobservable inputs.

Following the crisis, I have adopted the rule: if it is unobservable, it is not believable.

Despite the massive increase in the size of the balance sheet, the value of the assets held in the most transparently valued asset categories has declined: trading portfolio assets by £ 8bn and financial assets held at fair value by £35 bn. More assets are held in the ‘available for sale financial investments category’.  These are held at fair value on the balance sheet, but changes in fair value are not reflected in the profit and loss accounts.

With very few exceptions, banks now use every means at their disposal to hide financial embarrassments on of off the balance sheet for as long as possible.  Rigorous mark-to-market valuation without managerial discretion as to whether to shift assets from one valuation bucket to another is a partial solution.  Unfortunately, the IASB lost first its nerve and then the plot in response to pressure from those exposed to toxic and dodgy assets.  Banks can now drive a coach and horses through fair value principles and release what information they want when they want it.

Declining market valuation of creditworthiness as a source of profits, again

Assume I have a debt of £1000 at face value with a ten year maturity.  Against the law, it is secured against my future labour income.  I have no financial assets, nor do I acquire any over the rest of my life.  The risk-free nominal interest rate is zero.  My creditors have complete confidence in my ability to pay (until they find out that I cannot).  My debt contract requires me to pay a coupon of £100 at the end of each of the ten years.  I have a wage income of £150 per year and a subsistence level of consumption of £50 per year.  First assume the debt is a loan from the bank.  It is not traded or priced.

No sooner have I signed the loan agreement, taken and consumed the money (at the very beginning of year 1), when the unexpected news arrives that I will die for sure at the end of year five of the loan.  I pay my first five £100 annual instalments and join my ancestors.  The loan goes into default.  In present discounted value terms the bank loses £500.  According to Barclays’ accounting standards, I make a £500 profit when the news of my untimely demise arrives.  It does not feel like it.  Where are the additional income, the additional resource flows and the additional consumption permitted by the increased profit corresponding to the reduced present discounted value of my loan?

Now assume that instead of a bank loan held to maturity by the issuing bank, my debt is a tradable note with the same cash-flow profile.  Before the news of my untimely demise, the note trades at £ 1000.  When the news hits, the value of the note falls to £500.  Since the contractual debt service on the note has priority over my profits, the capitalised value of the shortfall of the actual debt service from the contractual debt service is not available as profits or income to me.  If there were any surplus income over the £150 I earn for the five years I have to live (£50 of which goes for subsistence and £100 to debt service), it would go to make up the debt service shortfall, up to the point where the contractual terms are met in full.

In Barclays’ accounting universe, a bank can walk away from its (traded) debt and distribute the resulting debt service savings as profits.  That is insane.  These ‘profits’ do not exist.  The only interesting question remaining is whether it is just Barclays’ accounting standards or UK accounting conventions for banks in general that are off the wall.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website