Posts Tagged ‘accounting’

barclays’ creative accounting

February 10, 2009

Barclays announced that they made a profit to the market’s delight. It is interesting to see where this money comes from, and which part is actually real.

The announcement document hides a few real gems.

On page 7, fourth bullet point, one reads that Barclays books “gains on own credit £1663m”. And this amount is clarified on page 29, naked in all its glory, as “[…] gains of £1663m (2007: £658m) from the general widening of credit spreads on issued notes by Barclays Capital”

What does that mean? Well Barclays have issued bonds that other market participants bought. These bonds are promises, made by Barclays, to deliver a fixed amount in the future.

Say that the amount is GBP100. This GBP100 are clearly a liability for Barclays, but now they are making the following claim:

Well we might default in the near future, in which case the debt is forgiven and bondholders take zip. The credit spread quotes put a price on this default probability, say that they imply a probability of 5%. Then, according to the current accounting standards, we don’t really have a liability of GBP100 but a liability of GBP95 only. So compared to last year when our default probability was negligible we have made a gain of GBP5.

What is the bottom line? the higher our probability of default => higher probability that our debt is forgiven => lower current value of our debt => higher gain we book. Nice!

This blog is doing a good job in explaining the rationale behind the standards that allow such acrobatics.

There I found the quote: “If your own credit spread widening counts as revenue, and you pay compensation as a percent of revenue, the most profitable and lucrative day in the history of your firm will be… THE DAY YOU GO BANKRUPT!

W Buiter, on the other hand, goes berserk about that. He calls it “mark-to-market gone mad”.

A similar construct appears in counterparty risk management a’la Basel II, where capital can be released as one becomes a worse counterparty.