Wednesday, August 1, 2012
Once again, the 2010 video clip of the Federal Reserve Auditor General is making the rounds over on the right and among the easily alarmed - the clip which supposedly says there is $9 trillion missing” from the Federal Reserve. (See, e.g., http://www.youtube.com/watch?v=GYNVNhB-m0o - I picked this one because the uploader amuses us with is paranoia about her lapel pin, inter alia.)
At one point in the clip, Rep. Alan Grayson asks about the “$9 trillion in Off-balance sheet transactions” - see, e.g., at 3min 45sec.)
A lot of people freak when they hear that exchange and seem to think Grayson is referring to “missing money” or sneaky accounting tricks. (A few seconds later, he does ask about some supposedly missing money, but he is no longer referring to the off-balance sheet accounts. That the Inspector General bobbles the question adds to the impression some people have that there is something sneaky going on. Nope, just a missed opportunity.*)
"Off-balance sheet" accounts are transactions which simply do not fit on a balance sheet. The term does not mean "missing money" or “losses.” And it does not mean those accounts aren't being tracked and reported.**
An example of an “off-balance sheet" transaction:
Suppose that today, Dollars are trading 1:1 against Doubloons. I think Dollars are going to go up against Doubloons in the next month, you think they are going to go down. We place our bets by agreeing that in one month, I'll deliver 1,000 Doubloons to you and you'll deliver 1,000 Dollars to me. (Most foreign exchange contracts are simply to deal with potential exchange rate shifts when one is dealing internationally and aren't simply bets.)
If I'm right, and dollars go up, in a month I can perform by buying those 1,000 Doubloons with less than the $1,000 I'm going to receive from you. Say the exchange rate has shifted so that I can buy those 1,000 Doubloons for $950 I've made $50, you've lost $50.
But how should that transaction be recorded on our balance sheets as of Day 1?
A balance sheet is a financial statement that summarizes a company's assets, liabilities and shareholders' equity at a specific point in time.
So what is the value of that foreign exchange contract?
Is the value $1,000? Nope. even if you fail and go out of business before then, I won't lose a thing.
Is the value zero since today they have the same value?
Is it $50? (Remember, until the settlement date, neither of us knows what the rate will be on the delivery date.)
It simply makes no sense to put that sort of transaction on a balance sheet. That DOES NOT mean the transaction is not accounted for in our books and records - it just means it isn't in the balance sheet, it is being kept track of in other ways. (Actually, such transactions are “on the balance sheet" in footnotes, but not included in the balance calculation because there is no exact figure which can be given.)
Furthermore, one of the features of an off-balance sheet transaction is that in the real world, the amount at risk (one way of measuring value) is nowhere near the face amount of the transaction. That adds to the rationale for keeping such transactions “Off-balance sheet” since including them would mislead people. (Just as the fact that people are mislead when they think “Off-balance sheet” means “lost” or sneaky.
And that is why off-balance sheet accounts are typically such large numbers - the real risk is a minuscule fraction of the face amount.
= = = =
* Just before that exchange, the Inspector General explains that her only jurisdiction is over the Board of Governors of the Federal Reserve, not over the Federal Reserve Banks. Despite that, Grayson persists in asking her about reviews of the Federal Reserve Banks. I think she is still trying to figure out how to got him to understand that he is asking the wrong person when asked about the off-balance sheet accounts.
** FWIW, I learned this stuff when I was legal counsel to several areas of a major bank which dealt with "off-balance sheet accounts" (including the foreign exchange trading desk). I too originally though "off-balance sheet" meant or at least implied something tricky and I didn’t understand that it refers to transactions that are being accounted for in other ways. It doesn't mean anything tricky.