Bean Counters: PwC DOUBLE STANDARDS

Extracted from:

Bean Counters: The Triumph of the Accountants and How They Broke Capitalism

 Pag. 122

DOUBLE STANDARDS

Within a day of Lehman’s downfall, insurance giant American International Group (AIG) received the first taxpayer-funded bailout. Its AIG-FP financial products unit had badly misjudged the market by taking on huge exposures to the subprime market. Through the boom years it had been writing credit default swaps, insuring banks against losses on their holdings of subprime-laden collateralized debt obligations. When the CDOs began to falter and AIG’s own credit rating was marked down, it was forced to hand over increasing amounts of collateral, or upfront cash on account of any final payouts, to the banks on the other end of the credit default swaps.

After another rating downgrade on the day of Lehman’s collapse, AIG’s collateral needs rose to the point where it could no longer raise the cash demanded of it. To avoid another Lehman – with far-reaching consequences for all AIG-FP’s other counterparties – the Federal Reserve stepped in with an $85bn bailout.

How had a once solid insurance company come to this? Hadn’t the whole
point of AIG and its financial products arm been that it could shoulder and
manage risk? The US government’s later Financial Crisis Inquiry Commission would pin the blame on ‘its enormous sales of credit default swaps [which] were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure’. 43

In other words, AIG-FP had drastically underestimated its potential losses.

Details that would later emerge of its dealings with its largest credit default swap counterparty, Goldman Sachs, revealed the helpful role of its auditor, PwC, in the under-reporting.

When the events of 2007 hit the value of Goldman’s CDO portfolio, the bank
had reckoned that the credit default swaps it had entered into with AIG-FP as
insurance against such losses were going to have to pay out. It had therefore
demanded that AIG-FP hand over more than $1bn of collateral on account of the eventual outcome. AIG-FP had taken a different view, insisting the contracts wouldn’t have to pay out.

As the dispute rumbled on, in several quarterly and annual reports to the markets AIG and Goldman gave widely divergent values to the swaps – which could really only have one value – and thus the collateral that ought to be handed over. Goldman was using a model that marked the contracts down by as much as 40% of their full value as it now expected to receive payments to offset the premiums it was paying. Which was fine with its auditors from PwC. AIG-FP, on the other hand, had no model at all with which to value the contracts and gave them full value with no discount. Its auditors, who also happened to be from PwC and were led by the firm’s US financial services boss Tim Ryan, were fine with that, too. The world’s largest accountancy firm thus sat back as two of its biggest and most systemically important clients, with its full knowledge, valued the same assets wildly differently.

If this could happen with the same auditor on both ends of one deal, the mind
boggled at what contradictory accounting involving different auditors might be
out there. Warren Buffett’s long-standing vice chairman at Berkshire Hathaway,
Charlie Munger, voiced his exasperation in a 2009 interview: ‘Two firms make a big derivative trade. The accountants on both sides show a large profit from the same trade [when the profit on one side must equal the loss on the other] . . . and nobody’s even bothered by the fact that this is happening.’ By way of explanation for a scenario that ‘violates the most elemental principles of common sense’, he offered: ‘There’s a demand for it from the financial promoters.’ And they generally got what they wanted from the bean counters. The accounting profession, concluded Munger, ‘is a sewer’. 44

PwC did eventually prompt AIG to try to value the relevant swaps properly.
But when the model it used to do so produced an unhelpful $5.1bn loss at the
end of 2007, the company arbitrarily slashed the figure to $1.5bn. PwC nodded
its approval. More flattering results duly appeased the none-the-wiser stock
market analysts. Four months later, in February 2008, PwC told AIG that the move had been ‘improper and unsupported’, and that ‘this deficiency was a
material weakness’. The books had to be rewritten. ‘Why the auditors waited so long to make this pronouncement is unclear,’ the Financial Crisis Inquiry Commission would comment three years later, ‘particularly given that PwC had known about the adjustment in November.’ 45

Why the auditors played along with false accounting at key moments was in
fact becoming obvious. Inflated profits and hidden losses were now the life support system for the financial system, from which the bean counters were profiting just like the bankers they were serving. In 2007, PwC worldwide
earned $7bn of its $25bn revenues from financial services. 46
Hanging onto the major payers of these fees like AIG and Goldman Sachs was worth a little duplicity.

Notes:

43. Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, January 2011, p.273

44. Interview with Stanford University professor Joseph A. Grundfest, 2009. Available on the website of Ian Fraser, http://www.ianfraser.org/charlie-munger-getting-accounting-integrity-right-has-enormous-implications-for-future-of-mankind/

45. Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, January 2011, p.273.

46. PwC worldwide annual report, 2007. Income includes banking and capital markets, investment management and insurance.
https://www.pwc.co.uk/assets/pdf/annual-report07.pdf