Equilibrating Corporate Financial Engineering and Reporting

1
Equilibrating Corporate Financial Engineering and
Reporting

• Shyam Sunder
• Yale University
• 20th Anniversary Conference on Financial
  Economics and Accounting, Rutgers University
• November 14, 2009

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An Overview

• Let us look at accounting and finance from a
  social science perspective
• Objective in corporate financial engineering to
  design transactions to optimize from the point of
  view of the organization, e.g., increase assessed
  creditworthiness and lower risk based on facts
  and appearances of its financial reports
• Objective of financial reporting to provide
  information useful for investment and other
  decisions by various agents in the economy
• Does the interplay of these two objectives lead
  to a stable equilibrium?
• If yes, what is the equilibrium?
• If not, what are the consequences and what, if
  anything should be done about it?

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Accounting and Finance as Aspect of Social
Sciences

• These disciplines have been seen from several
  points of view
• One of them is to think of their topics of
  substantive interest (e.g., corporate finance and
  reporting, investments, and auditing) as social
  phenomena
• Social phenomena are characterized by multiple
  levels of analysis, e.g., macroeconomic,
  organizational, and individual
• At each level, and across the levels, social
  phenomena exhibit interaction among agents
  (individuals, organizations, and government),
  learning by them, feedback effects, and
  consequently, pervasive endogeneity
• These features of a social science make it more
  difficult to identify laws or relationships which
  are stable relative to their discovery and
  characterization (e.g., small firm effect)
• In these few minutes, I would like to discuss one
  aspect of such interactions between financial
  reporting and engineering, and share some
  preliminary thoughts about their consequences

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Objectives in Financial Engineering

• The Financial Engineering Concentration
  encompasses the design, analysis, and
  construction of financial contracts to meet the
  needs of enterprises. (Cornells ORIE M.S.
  concentration in financial engineering)
• What are these needs? In at least some cases,
  these needs consist of finding ways of
• Reducing indebtedness on the balance sheet, or
• Reducing expense on income statement, or
• Increasing revenue on income statement, or
• Increasing deductions on tax returns

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Securitization according to International Finance
Corporation

• A form of off-balance sheet financing which
  involves the pooling of financial assets
• Risk transfer mechanism that allows loan
  originators to optimize balance sheet management
• Allows highly rated securities to be created
  from less credit worthy assets
• Can be in local or foreign currency, depending
  on client needs
• A rapidly growing asset class with proven
  benefit for emerging market borrowers
• For summaries of prior deals, please visit
  www.ifc.org/structuredfinance

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Financial Reporting Standards as Constraints on
Financial Optimization

• In such optimization, standards of financial
  reporting are treated as constraints
• Most optimization problems have hard
  constraintstheir violation brings well-specified
  penalties (dual prices)
• With optimization confined by the production
  possibilities set and other such physical
  limitations, external constraints make a real
  difference to the final actions
• What kind of constraints do accounting standards
  offer?
• I am going to argue that these standards offer
  softer constraints because the forms of
  contracts, transactions, as well as
  organizational forms that businessmen can devise
  and use are beyond the scope of accounting
  standards

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Redesigning Contracts

• A manufacturer needs to buy a machine for the
  factory
• Borrowing is an option, but the manufacturer does
  not want more debt on its balance sheet
• The leasing subsidiary of a bank buys the machine
  and gives it to the manufacturer on a long term
  leasemachine is in the factory but no debt on
  balance sheet!
• FASB writes Standard 13 leases gt90V and gt75T
  must be treated as capital leases (debt is back
  on BS)
• The bank revises the lease to levels below the
  thresholds specified in the standard (debt is off
  the BS)
• FASB goes back to work, and so on until the
  rulebook grows to over a 1,000 pages

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Redesigning Transactions

• Depending on the current standards of financial
  reporting, transactions can be redesigned to
  achieve the desired consequences for revenues,
  expenses and taxes

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Redesigning the Organization

• When design of contracts and transactions is not
  sufficient, organizations themselves can be
  redesigned, or new ones created in order to have
  the desired consequences for balance sheets,
  income statements and tax returns
• Special purpose entities (SPEs and SPVs) are
  examples of organizations created for this
  purpose (see Klee and Butler 2002 and Gorton and
  Souleles 2005)
• Hundreds of respected U.S. companies are
  ferreting away trillions of dollars in debt in
  off-balance sheet subsidiaries, partnerships, and
  assorted obligations (Henry et al. 2002)

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Asymmetric Game

• Note that financial reporting standards neither
  have, nor can have, any say in any of these
  business decisions of the management
• The role of the accountant and auditor is limited
  to preparing financial reports given all these
  decisions
• While these decisions clearly consider what the
  accounting standards are, accountants have little
  freedom to take into account how and why these
  decisions were taken in the first place
• There is great asymmetry between the freedom
  available to the business decision makers and
  constraints on the accountant who must abide by
  relatively rigid written standards

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The Net Effect

• The decision to write an accounting standard is a
  matter of social policy that calls for a
  deliberative due process it typically takes
  years to determine which rules might best serve
  investors and others. Inevitably, these standards
  are written on the assumption that the current
  forms of contracts, transactions, and
  organizations will continue to be used in the
  future when these standards are applied
• The decision to change contracts, transactions
  and organization is an individual decision that
  may be taken within days if not hours. Further,
  the scope of these decisions is virtually
  unbounded (except by the imagination of the
  businessmen). Soon after the standards are
  issued, the environment to which they are applied
  changes relative to the what the standards were
  written for
• The net effect Financial reporting standards
  serve as relatively weak constraints (if at all)
  on what businesses can do

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Three Major Classes of Derivatives

• Futures/Forwards are contracts to buy or sell an
  asset on or before a future date at a price
  specified today.
• Options are contracts that give the owner the
  right, but not the obligation, to buy (in the
  case of a call option) or sell (in the case of a
  put option) an asset. The price at which the sale
  takes place is known as the strike price, and is
  specified at the time the parties enter into the
  option ( European vs. American options)
• Swaps are contracts to exchange cash (flows) on
  or before a specified future date based on the
  underlying value of currencies/exchange rates,
  bonds/interest rates, commodities, stocks or
  other assets.

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Six Types of Underlying Assets

• Interest rate derivatives (the largest)
• Foreign Exchange derivatives
• Credit Derivatives
• Equity derivatives
• Commodity derivatives
• Weather derivatives

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Over-the-Counter Derivatives

• Traded (and privately negotiated) directly
  between two parties, without going through an
  exchange or other intermediary (e.g., swaps,
  forward rate agreements, and exotic options)
• This largest of the derivatives market is largely
  unregulated with respect to disclosure of
  information between the parties (banks and hedge
  funds etc.)
• Reporting of OTC amounts are difficult because
  trades can occur in private, without activity
  being visible on any exchange.
• According to the Bank for International
  Settlements
• The total outstanding notional amount is 684
  trillion (as of June 2008)4.
• 67 are interest rate contracts,
• 8 are credit default swaps (CDS),
• 9 are foreign exchange contracts,
• 2 are commodity contracts,
• 1 are equity contracts, and
• 12 are others

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Exchange-traded derivatives

• A derivatives exchange acts as an intermediary to
  all related transactions, and takes Initial
  margin from both sides of the trade to act as a
  guarantee.
• The world's largest derivatives exchanges (by
  number of transactions) Korea Exchange, Eurex,
  and CME Group (made up of the Chicago Mercantile
  Exchange, the Chicago Board of Trade and the New
  York Mercantile Exchange.
• According to BIS, the combined turnover in the
  world's derivatives exchanges totaled USD 344
  trillion during Q4 2005.
• Some types of derivative instruments also may
  trade on traditional exchanges (convertible bonds
  and/or convertible preferred, warrants,
  Performance Rights, Cash xPRTs and various other
  instruments that essentially consist of a complex
  set of options bundled into a simple package)

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Why Is It So Difficult to Write Standards for
Derivatives Accounting?

• Some derivatives are designed to get around the
  intent (provision of information) of the extant
  financial reporting standards
• How does one write standards for these
  instruments?
• Is it possible to have an equilibrium between
  design of such instruments and standards for
  reporting them?
• The problem seems to have gone largely unnoticed
  in the flurry of proposals on financial reforms
  now on the table
• The question is Are the optimization in
  financial engineering (relative to prevailing
  reporting standards), and search for standards
  that provide useful information to investors
  mutually consistent goals?

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Social Norms of Accounting and Finance

• I personally doubt that a non-cooperative game
  between financial engineers and accountants has
  led us to a socially efficient outcome
• Accountants have, over the past eight decades,
  increasingly come to rely on written rules as
  opposed to their judgment and social norms of
  their profession
• Financial engineers, on the other hand consider
  it their own professional duty to design whatever
  instruments/transactions/organizations will best
  serve the immediate interests of their clients
  under the prevailing written standards of
  financial reporting
• Social norms play a diminishing, if any, role on
  either side
• Is it possible that some part of the blame for
  the systemic failures of the recent years may be
  linked to this diminishing role?

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Ethics and Moral Code in Business Programs

• Shiller Many schools now offer a course in
  business ethics, and some even try to integrate
  business ethics into their other courses. But
  nowhere is ethics seen as the centerpiece or even
  integral part of the curriculum. And even when
  business students do take an ethics course, the
  theoretical framework of the core courses tends
  to be so devoid of any moral content that the
  discussion of ethics must seem like some side
  order of overcooked vegetable.
• If the role of ethics in curriculum is minimal,
  what is the role of ethics (i.e., social
  consequences of our work) in choosing the
  substantive topics of our research
• Identifying mispricing of securities, for
  example, may help move prices to more efficient
  levels
• What about identifying a way of redesigning a
  transaction so a financial obligation will not
  show up on the balance sheet under the prevailing
  reporting standards?

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Ethics and Moral Code in Research Programs

• In some recent theoretical and experimental work,
  we find that the constraints imposed by financial
  and social institutions (e.g., bankruptcy laws,
  commercial code, accounting) can help resolve
  otherwise mathematically intractable problem of
  multiplicity of equilibria in economy. Could this
  also apply to interaction between financial
  engineering and reporting?
• Which one of us would refuse to work on either an
  optimal transaction design or accounting
  standardization problem on ethical (social
  consequences) grounds?
• If I were a locksmith, and published the locking
  codes for the university doors, I might bear some
  moral culpability
• Is, or should, there be any moral culpability
  associated with devising a way around a standard
  of financial reporting intended to provide better
  information?
• When, and where, should we raise such issues?

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Some Fundamental Issues

• Role of social ethical norms in accounting and
  financial institutions
• Reflexivity of markets and of financial reporting
  (Keynes, Sunder)
• Rationality can serve as an anchor, not a
  description irrationality offers no explanation
• Fractal structure of knowledge (try for yourself,
  e.g., http//www.coolmath.com/fractals/fractalgene
  rators/generator1/index.html)

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Roles of Accounting and Finance Research

• Progressive micronization of research
• Progressive shift in research attention to better
  explanatory power through additional variables
• This process is understandable, but does not
  create a micro-macro issues balance
• Discarding of details, standing back, to allow a
  big picture to emerge is just as important
• What is the big picture of corporate financial
  reporting and engineering today?

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In Summary

• Accounting and finance originated as a single
  discipline have increasingly diverged in the
  recent decades
• Interaction of financial reporting standards on
  one hand and financial engineering on the other
  has created a newer kind of interaction between
  them with its own special consequences
• What, if any thing, should we, and can we do
  about this?
• Are there some alternatives to bringing in a
  sense of social responsibility for the
  consequences of our research agendas? If so, let
  us explore them.

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References

• Hans J. Blommestein, The Financial Crisis as a
  symbol of failure of academic finance (a
  methodological digression), The Journal of
  Financial Transformation, Fall 2009.
• G. Gorton and N. Souleles, Special Purpose
  Vehicles and Securitization, FRB Philadelphia
  Working Paper, 2005.
• Henry, David, Heather Timmons, Steve Rosenbush,
  and Michael Arndt (2002), Who else is hiding
  debt?, Business Week (January 28), 36-37.
• J. Huber, M. Shubik, and S. Sunder, Default
  penalty as disciplinary and selection mechanism
  in presence of multiple equilibria, Cowles
  Foundation Working Paper 1730, October 2009.
• K. Klee and B. Butler, Asset-Backed
  Securitization, Special Purpose Vehicles
• and Other Securitization Issues, Uniform
  Commercial Code Law Journal 35 (2002), 23-67.
• J. Mason, E. Higgins and A. Mordel, Asset Sales,
  Recourse, and Investor Reactions to Initial
  Securitizations Evidence Why Off-balance Sheet
  Accounting Treatment Does not Remove On-balance
  Sheet Financial Risk LSU Working Paper, 2009.
• Robert J. Shiller, How Wall Street learns to
  look the other way, The New York Times, Feb. 8,
  2005.
• Shyam Sunder. Theory of Accounting and Control.
  Southwestern Publishing, 1997.
• Shyam Sunder, Determinants of Economic
  Interaction Behavior or Structure. Journal of
  Economic Interaction and Coordination 1, no. 1
  (May 2006) 21-32.
• Shyam Sunder, True and Fair as the Moral
  Compass of Financial Reporting, in Cynthia
  Jeffrey, ed., Research in Professional
  Responsibility and Ethics in Accounting
  (Forthcoming 2009).

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Thank You.

• Shyam.sunder_at_yale.edu
• www.som.yale.edu/faculty/sunder