The article Wielding Derivatives as a Tool for Deceit by Floyd Norris, a writer for the New York Times, talks about how derivatives can be used as “weapons of mass deception”. Enron is a classic example of this. They used phony accounting methods, including derivatives, to make their financial statements seem stronger and less risky than they actually were. The banks, that were essentially giving them loans, were also involved in this scheme. The latest news of large-scale use of derivatives to deceive is the case of Italy and Greece entering into the Euro. The government received money, which was essentially a loan, but was able to keep it off the balance sheet because of its title. This made the financial statements look better so that the country could join the Euro. The article compared this to a student cheating on entrance exams to be accepted into a better college. This article brings into question the moral and ethical decisions businesses must make regarding their financial actions. Just because something is technically legal to do, does not mean it is ethical. Key individuals, who are in charge of what a business does, need to be involved and knowledgeable enough to understand when something like this is happening. If the business is doing something to deceive others, it is probably something they shouldn’t be doing.

June 27, 2013
Wielding Derivatives as a Tool for Deceit
By FLOYD NORRIS
Derivatives are not always “financial weapons of mass destruction,” as Warren Buffett famously called them.
But they are often weapons of mass deception.
For some derivatives, a desire for deception is the only reason they exist. That deception can allow those who own derivatives to evade taxes or accounting rules. It can allow activity that might otherwise be illegal, were it not called a derivative, or that would face regulation if it were labeled what it truly is.
Sometimes, banks use derivatives they create to help their clients deceive the public. Other times, they enable the banks to deceive those clients.
The latest revelation of deception by derivative came in Italian government documents leaked this week to two European newspapers, La Repubblica and The Financial Times. The Financial Times said it appeared that Italy had used derivatives in the 1990s to allow it to make its budget deficit seem smaller, thus enabling it to qualify for admission to the euro zone. The report said it appeared those derivatives, now restructured, might be exposing Italy to a loss of 8 billion euros ($10.4 billion).
La Repubblica noted that the director general of the Italian Treasury Department at the time, Mario Draghi, is now running the European Central Bank.
Italy’s economy minister, Fabrizio Saccomanni, said it was “absolutely baseless” to say that the country used derivatives to lie its way into the euro zone. It was simply hedging against market risks. As for the current situation, he said, “There’s been no material damage to our public finances.” He drew a distinction between realized losses and those based on market values that could change.
What seems to have happened in Italy is similar to something that we already know Greece did. Rather than borrow money — which would increase the reported budget deficit — the country entered into a derivatives contract that called for the banks to make large upfront payments in return for larger payments later from the government.
And how did that differ from a loan? Functionally, not very much, in all probability. But if you call something a derivative you can often get away with keeping it off your balance sheet — or putting it on the balance sheet in a misleading way. If The Financial Times report is right, the deal made Italy’s reported budget deficit smaller just when the country needed that to join the euro zone.
There is some evidence that Europe knew what was going on and chose to ignore it. Joining the euro was seen as more of a political event than an economic one, a symbol of European unity.
The effect of the funny accounting was similar to that of a student cheating on college entrance exams. The student may get into a university where he or she cannot compete, just as Italy and Greece find themselves in a currency bloc where their economies are at a significant disadvantage.
But while uncompetitive students can drop out, or be expelled, the euro zone rules provide that no country can leave. That fact, perhaps more than anything else, accounts for the persistence of the euro zone crisis.
Such deception by derivative is hardly new. Enron was a pioneer. It used derivatives called “prepaid forward” contracts to hide debt in a way that made corporate cash flow appear better, something the company thought was necessary to impress the bond rating agencies.
Responding to claims that his bank and Citibank had made “disguised loans” to Enron, a JPMorgan Chase executive told a Senate hearing in 2002 that “the prepaid forwards were undoubtedly financing, as all contracts are that involve prepayment features, but every financing is not a loan.” He said the bank had properly accounted for them, but “the manner in which Enron accounted for them” was of no concern to the bank. It was, instead, “a matter for Enron and its management and auditors.”
That was not the way the banks saw it when they were seeking the business. “The evidence,” said Senator Susan Collins, Republican of Maine, “revealed them to be nothing more than sham transactions designed to obtain, as one of the banks continued to tout on its Web site, ‘financial statement friendly financing.’ Like so many of the other deals at Enron, the apparent motive was to portray a false image of the company’s financial health.”
That “friendly financing” came at an extra cost, of course. In reality, the banks charged Enron a fee for enabling it to deceive. Those same banks ended up losing a lot of money when Enron collapsed. How could the banks have guessed that a customer that would pay them to aid in lying would be less than honest in dealing with them?
Calling something a derivative can help a company get around inconvenient laws and regulations. Intrade pioneered Internet gambling on everything from election results to whether an executive in trouble would be forced to resign. Gambling? Perish the thought. Those were “futures contracts.” That worked until this year, when the United States government forced Intrade out of business.
Then there are “credit default swaps,” which offer a payoff if a company or a country defaults on its obligations. If you called that insurance, a company issuing them would face requirements that it maintain reserves to pay future claims. But call it a derivative, and the rules do not apply. The American International Group was able to collect billions in premiums for such swaps without taking any reserves. When the credit crisis arrived, A.I.G. would have collapsed without a government bailout.
The current accounting rules in the United States go so far as to say that banks can hide obligations that are classified as derivatives. They do that by “netting” derivative positions that are currently profitable against positions that have losses, and show only the net value. That reduces the amount of assets on their balance sheets and thus makes them appear less leveraged than they are.
They can do that even if the two positions have nothing in common — save the identity of the counterparty on the other side of the transactions. It makes no sense at all to be able to hide a bet on, say, the Canadian dollar, by offsetting it against a bet on German stock prices. But that is legal now in the United States.
The banks have done an excellent job of persuading the Financial Accounting Standards Board, which sets the rules, not to mess with them. Rather than force the banks to put the assets and liabilities on their balance sheets, as is required in most other countries, the board has proposed additional disclosures that might make it easier to discern the reality.
And this week the board proposed new accounting standards for insurance that would force many contracts not called insurance — but being basically the same thing — to be accounted for in the same way as insurance. But credit default swaps were exempted. Why? The logic, such as it is, is that insurance is sold to people who are seeking to be reimbursed for possible losses, like an automobile accident. Because credit default swaps are sold to people who are simply speculating, they can continue to be accounted for as derivatives.
None of this is to argue that some things called derivatives cannot be useful in the right circumstances. But in many cases those things deserve to be called what they really are. Often, they are simply ways to place wagers.
A risk for banks is that calling these things gambling could prejudice courts deciding whether to enforce them. Many municipalities entered into what were called interest-rate swaps with large banks before the credit crisis arrived. “The cities,” says William J. Quirk, a law professor at the University of South Carolina who formerly worked as a lawyer for the New York City, “lost every bet.”
That may be an overstatement. But those contracts have certainly produced large profits for Wall Street, and many will continue to do so for years to come. “The funny part of the story,” Mr. Quirk wrote in the July issue of Chronicles Magazine, “is that the cities keep paying despite the fact they have a good legal defense: The bets are not enforceable because cities are not authorized to place bets with taxpayers’ money.”