Stress Tests for Wall Street -- What About the Billions in off-the-Books Toxic Assets?

This report was produced in collaboration with American News Project.

At the center of President Obama's overhaul strategy for Wall Street are the "stress tests" which will be applied to all financial institutions. But how accurate will the test results be? That will depend on whether the treasury takes off-balance-sheet assets into account, experts say. Back in February, in the House Financial Service Committee, when asked a question about the value of Citigroup's assets, CEO Vikram Pandit provided a less-than-clear response: "It's an extraordinarily difficult question."

Click the video below to WATCH the exchange between Rep. Louis Gutierrez (D-IL) and Vikram Pandit.

Rob Weissman, director of the corporate watchdog group, Essential Action, and author of a new report called Sold Out: How Wall Street and Washington Betrayed America, said that, in addition to what Pandit said, there's an additional factor that could fog the test results: off-the-book assets.

"If you don't include the off-balance sheet assets in the stress test, then it's not a legitimate stress test," Weissman said. "It's pretty plain that the off-balance-sheet operations are a central part of the story of why we don't know what the banks own." The Treasury Department declined to comment on whether they would take off-book-assets into account when running the stress tests.

Weissman says that recipients of bailout money, like Citigroup, Bank of America and JP Morgan, have been engaging in "fanciful accounting" of what they owe and what they own by relocating of their less-than-healthy assets off the books, in shadow corporations. Rep. Brad Sherman has described the process as, "apples on one balance sheet and oranges on another."

According to RGE Monitor, off-balance-sheet operations have skyrocketed over the last 15 years. From 1992 to 2007, on-balance-sheet assets grew by 200 percent, while off-balance-sheet assets grew by 1,518 percent. In 2007, it was estimated that there was 15.9 times more money parked in off-balance-sheet operations than in on-the-book operations. Not all off-book assets are toxic. Some financial institutions might park assets off their books if they are planning, for instance, to sell them. However, in rough economic times, off-balance sheet accounting allows banks to veil their losses from investors, regulators, and even insiders.

"This turns out to be a really important benefit [for a bank] if it happens to be insolvent," Weissman added. "And many believe that if you total Citigroup's assets and liabilities, it is insolvent."

As of July, Citigroup appeared to have the most off-book assets -- an estimated $1.1 trillion. But they aren't alone. As of July 2009, JP Morgan Chase & Co. had more than $400 billion off their books. Bank of America had $48.2 billion off the books before it bought Merrill Lynch. "If you start adding up all the potential exposures, it's a huge number," Sam Golden, former ombudsman for the U.S. Office of the Comptroller of the Currency, told Bloomberg. "The banks will say that it was disclosed. Investors are saying, 'Yeah, but it was cryptic.'"

Disclosure rules for off-balance sheet operations are notably less strict than those for assets on the books. Neri Bukspan, chief accountant for Standard & Poor's told Bloomberg, "A lot of information tends to disappear."

The use of the off-balance-sheet assets was a core part of the Enron scandal, where they were able to wrap debt inside of debt, using obscure corporations, so no one could track what they owed and what they owned. After the Sarbanes-Oxley Act of 2002 was set in place, there were efforts to address the problems with off-book assets. But after heavy lobbying by two main trade groups, the Securities Industry and Financial Markets Association and the American Securitization Forum, banks were given special exemptions.

In September of 2008 as the financial crisis was coming into full view, the Senate Baking, Housing, and Urban Affairs Committee held a hearing, discussing off-balance sheet operations. Senator Jack Reed recalled Enron: "This phenomenon of moving assets off the balance sheets is eerily familiar. We recall back in the days of Enron that its schemes to manufacture false profits included special purpose entities that conducted transactions off-balance sheet. The goal was to avoid financial reporting. While no one is necessarily suggesting scandals of the Enron kind, we cannot fail to admit the irony. We are dealing with a similar problem yet again, only six years later."

George P. Miller, Executive Director of the American Securitization Forum, said that moving assets off-book back on to the books would cause dangerous swelling of balance sheets. He added, "There are many other steps that the industry can and should undertake to promote broader and better transparency about risk exposures in these vehicles, whether they are on or off-balance sheet."

But Donald Young, former member of the Financial Accounting Standards Board countered, "We just had an investment bank [Lehman Brothers] go bankrupt with a fair value balance sheet that showed it had plenty of assets and liabilities. And it almost seems like financial reporting is out of control and not trusted and not believed in. And I think what we do here has got to establish transparency. If the transparency is such that we're going to bring out some bad news that wasn't there before, that's a risk. But I think the benefits of reestablishing confidence in the markets will overwhelm that."

The Financial Accounting Standards Board (FASB) are revising the rules so some off-book assets will have to be reported on the books. However, the changes won't be effective until January 2010 at the earliest. In March at a House Financial Services Subcommittee hearing, Rep. Sherman complained about this lag. He told the chairman of the FASB, Bob Herz, "If you guys can't act quickly and logically, perhaps the regulatory accountants need to act and depart from what is a somewhat illogical and certainly slow process that you've got."

In the meantime, in a recent letter to his employees, Pandit has said Citigroup is having its best quarter since 2007 and the bank had conducted its own internal stress tests with positive results. But Weissman says something doesn't add up. "Either they've done a lot of due diligence in a short amount of time that they hadn't done before, or the stories are incompatible."

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