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Destructive Accounting

The economic recovery from the 1980 recession was slow, so Congress they decided to jump-start it by invigorating the banking system. They authorized bankers to make equity investments. Instead of lending money to build a shopping center, for example, they could buy it. Later, they were allowed to buy companies. Indeed, bankers were strongly encouraged to be more than mere bankers.

The accounting was simple enough. The asset was put on the bank’s balance sheet at the lower of cost or market value. However, adjusting the value on the balance sheet requires the adjustment be reflected on the income statement. For example, suppose you have a million dollar investment on your balance sheet and realize the value has decreased by 10%. You must show a loss of $100 thousand on your income statement. Nobody wants to report losses.

To avoid reporting a loss on the income statement, you might set up another company, which would buy the asset from you at full price, avoiding any loss to report. To make it easier, the bank can make a new loan to the new company to buy the asset, allowing the bank to charge loan fees to the new company. This is not creative accounting. It is destructive accounting.

In 2001, Enron was a Houston-based energy company that was heavily invested in energy-futures, which is too exotic and too volatile for most investors. To protect the value of their publicly-traded stock, they had to avoid even little losses. To do so, they created many other entities to self-deal with. Not surprisingly, many executives went to prison for self-dealing.

In 2022, FTX was a Bahamas-based exchange for crypto-currencies. It also did business with a number of related entities.

What do shady bank “loans”, energy futures, and crypto-currencies have in common? NOTHING, except most all assets can be used for self-dealing. There is nothing inherently evil about owning bank loans, energy futures or crypto-currencies. Defrauding others by self-dealing is both evil and illegal.