Here’s one way to do it. You own a small business which in turns owns a building you partially use. You go to the bank for a loan and bank says you are already over extended with your building mortgage payments. What do you do?
You say no problem. You sell off the building, pay off the mortgage and ask for the loan again.
What you do not tell the bank is that you have signed a 20 year lease with the person to whom you have sold the building. In all likelihood you have incurred the same amount (or more) liability leasing as when you owned. In fact accounting rules require businesses to “capitalize” leases which have long term obligations.
So what’s this about?
Big banks like Bank of America, JP Morgan Chase, and Citibank would never let someone get away with a slight of hand like this. Yet when it comes to their own books, they have been quite creative and equally as misleading.
The game big banks play is to “net” their assets. Let’s say BoA has a trillion dollars in assets surrounding collateralized debt obligations (like with subprime mortgages). They decide that if they could lover this amount, they could lend more and therefore make more earnings. No one seems ready to buy these CDOs.
How to do this?
Magic. Let’s buy some credit default swaps which insure against these CDO’s defaulting. BoA will pay the CDS issuer some amount of money each year in return for the CDS issuer agreeing to make BoA whole in case the CDO defaults. In the minds of the big banks, they have reduced the liability of these CDOs to practically zero and therefore they record zero on their liabilities side of the balance sheet.
In a perfect world, this practice might make prudent sense. In our actual world, CDOs are of unknown value and the ability of CDS issuers to pay up is very questionable. The practice of using CDS is not risk free.
So as a user of one of these banks, you should know just how much they are exposed to the unknown. Today you can’t, but hopefully tomorrow government pressure will force banks to reveal all their assets and liabilities and not allow the practice of netting.