off-balace sheet items

[bestmarcus]

Hi David
i would like to ask u about off-balace sheet items

Why are the off-balance sheet items so important?

Explain why off-balance items are viewed as contingent
commitments.

What contingencies affect them?

Marcus

 

[David Harper CFA FRM]

Hi Marcus,

Huge topics, I am not sure i can give them pithy justice. Although contingency (contingent liabilities) and off-balance-sheet classification may often coincide, I do not think one implies the other; i.e., contingency per se does not earn off b/s treatment. Conversely, off balance sheet does not necessarily imply contingency in the accounting sense (I *think*, sorry i don't have time to check); e.g., the classic off example of off b/s is an operating lease, I don't think that is a contingent liability. So, my first reaction is to parse these two ideas..but of course, they are very much related at the heart of the securitization debate

Why are the off-balance sheet items so important? To a trained finance professional, they are not supposed to be special or important! For example, the CFA curriculum reflects an traditional view of financial statements: we are not supposed to think that financial reports reflect economic reality (the accounting principles that inform financial reports are deliberately, understandably, necessarily in tension with economic reality). The equity analyst is *supposed* to recapitalize off balance sheet assets/liabilities as part of a broader analytical exercise that reverse-engineers the "obviously distorted" financial reports into "true economics" (this is arguably the foundation of EVA, e.g.). Similarly, the aim of Basel II is to not be fooled by "mere" off balance sheet treatment. (Basel I notoriously allowed for "regulatory arbitrage" that includes capital charge benefits of securitization). The classic answer used to be: companies can distort solvency (eg, debt to capital] or return ratios (ROA; immediate boost) with off-balance sheet treatment, but i think we are beyond that now: I don't think any serious firms *really* depend only on reported (book-based) metrics.

Explain why off-balance items are viewed as contingent commitments? As above, I don't understand this (or i don't agree with it)?

It may be slightly different, but i think a hot-button issue is the challenge of certain contingent liabilities that may have historically been off balance sheet. For example, when AIG wrote credit protection, they incurred a contingent liability (ie., no payoff unless credit default; although in this example, i think AIG CDS were on balance sheet). Now, the issue here (IMO) is not really on/off balance sheet, rather the issue is the inherent difficulty of valuing the liability. Derivatives tend to have zero value at inception, but often time massive potential exposure. You can put the CDS contingent liability on balance sheet, but you can still dramatically underestimate the liability. And if you do a weighted average, you will: e.g., 99% of no liability, 1% probability of paying [1-recovery]. It's non-trivial to figure the current liability of such an instrument ?! hope that at least sheds a bit of light on a big topic

David