Bloomberg: Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math
Posted by: Davies Town in Bloomberg, Fundamental Analysis, NewsAfter reading this story, a few thoughts come to mind:
WHOOPS, the guys at FASB didn’t really think things through
or maybe they were persuaded by the big investment banks a little too much from their lobbying efforts…
This is gonna make financial companies less transparent when looking just at their books…|
This will give the edge to hardcore investors but will give the regular investor yet ANOTHER barrier
—–Here’s the story—–
Wire: BLOOMBERG News (BN) Date: 2008-06-01 23:01:00
Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math
By Bradley Keoun
June 2 (Bloomberg) — Leave it to Wall Street to profit from
its own distress.
Merrill Lynch & Co., Citigroup Inc. and four other U.S.
financial companies have used an accounting rule adopted last year
to book almost $12 billion of revenue after a decline in prices of
their own bonds. The rule, intended to expand the “mark-to-
market” accounting that banks use to record profits or losses on
trading assets, allows them to report gains when market prices for
their liabilities fall.
The new math, while legal, defies common sense. Merrill, the
third-biggest U.S. securities firm, added $4 billion of revenue
during the past three quarters as the market value of its debt
fell. That was the result of higher yields demanded by investors
spooked by the New York-based company’s $37 billion of writedowns
from assets hurt by the collapse of the subprime mortgage market.
“They can post substantial gains as a result of a decline in
their own creditworthiness,” said James Cataldo, a former
director of treasury risk management for the Federal Home Loan
Bank of Boston and now an assistant professor of accounting at
Suffolk University in Boston. “It’s completely legitimate, but it
doesn’t make sense by any way we currently have of thinking of net
income.”
The paper profits have helped offset more than $160 billion
of writedowns taken by U.S. financial-services companies during
the past year. Now some investors and analysts say the winnings
are illusory and may have to be reversed.
“The piper will have to be paid eventually,” said Robert
Willens, a former Lehman Brothers Holdings Inc. accounting analyst
who left the New York-based firm earlier this year to become an
independent consultant.
Statement 159
The debate over what is known as Statement 159 adds to the
number of accounting techniques called into question as the U.S.
debt market unravels. Investors have criticized banks for booking
some writedowns in an accounting category called “other
comprehensive income” that bypasses their income statements.
Accounting rulemakers are now proposing changes to standards that
let banks use off-balance-sheet vehicles to juice earnings without
tying up precious capital.
Statement 159, formally known as the “Fair Value Option for
Financial Assets and Financial Liabilities,” was issued in
February 2007 by the Financial Accounting Standards Board, or
FASB, which sets U.S. accounting rules. It was adopted by most
large Wall Street firms in the first quarter of last year and
becomes mandatory for all U.S. companies this year, although they
have wide latitude in how to apply it, if at all.
Lobbying Effort
The rule was enacted after lobbying by New York-based
companies, led by Merrill, Morgan Stanley, Goldman Sachs Group
Inc. and Citigroup, which wrote letters to FASB arguing that it
wasn’t fair to make them mark their assets to market value if they
couldn’t also mark their liabilities.
“We do not believe it would be appropriate” to let
investors consider creditworthiness when valuing bonds if the
issuing company couldn’t do the same, wrote Matthew Schroeder,
managing director of accounting policy at Goldman, the largest
U.S. securities firm by market value, in an April 2006 letter.
Companies are allowed to decide for themselves which of their
outstanding bonds, loans and other liabilities will get mark-to-
market treatment. That’s an unprecedented degree of leeway, said
Willens, who is also an adjunct professor at Columbia University
in New York.
“It’s kind of a dumb rule,” Willens said. “In the entire
panoply of accounting, this is the most flexible and elective and
optional rule that we have.”
The Fed Objects
Here’s how it works, according to Richard Bove, an analyst at
New York-based Ladenburg Thalmann & Co. A company decides to
designate $100 million of its subordinated bonds as subject to
mark-to-market accounting. The price of the bonds drops to 80
cents on the dollar from 100 cents. So the firm books $20 million
on the “presumed savings that you have on your liabilities,”
Bove said.
“In the real world you didn’t save a dime,” he said. “You
still owe the $100 million. It’s another one of these accounting
rules that basically takes you further and further away from
reality.”
The Federal Reserve, Federal Deposit Insurance Corp., Office
of the Comptroller of the Currency and Office of Thrift
Supervision objected to the rule before its passage, saying in a
joint 2006 letter to the FASB that it would “have the contrary
effect” of increasing a bank’s net worth at the same time its
“financial condition is deteriorating.”
Split at FASB
The regulators remain so skeptical that they refuse to let
banks apply the phantom revenue toward minimum capital
requirements, according to reporting rules posted on the Web site
of the Federal Financial Institutions Examination Council. Deborah
Lagomarsino, a Washington-based spokeswoman for the Federal
Reserve, declined to comment.
Not even the FASB was united on the new standard. Two of its
seven board members — Thomas Linsmeier and Donald Young — voted
against it, according to the February 2007 statement. Linsmeier
said the rule “will provide an opportunity for entities to report
significantly less earnings volatility than they are exposed to,”
according to the statement.
The FASB tried to limit abuses by forcing companies to
designate their “fair value” liabilities when they adopt the new
standard. Subsequently, they can’t change their minds. Liabilities
added after adoption can only be designated at inception.
“The statement was thoroughly discussed with users and
preparers” in advance of its publication, said Neal McGarity, a
spokesman for Norwalk, Connecticut-based FASB. A March survey by
the CFA Institute, a Charlottesville, Virginia-based group that
administers a financial-analyst designation program, showed that
74 percent of investors believe the standard “has improved market
integrity,” he said.
Merrill’s Liabilities
Merrill designated about $166 billion of liabilities, or 17
percent of its total, as fair-value instruments subject to mark-
to-market accounting at the end of 2007, according to its annual
report. Included in the amount were $76.3 billion of long-term
borrowings and $89.7 billion of payables under securities-
financing transactions.
Prices for the firm’s bonds tumbled over the past year: Its
floating-rate notes due in January 2015 are trading at about 87
cents on the dollar, compared with about 100 cents last June.
Merrill has said its gains from the liabilities don’t add to
true earnings power. In a spreadsheet posted on its Web site,
Merrill says that investors who want a “more meaningful period-
to-period comparison” should exclude the $2.1 billion of revenue
recorded in the first quarter.
Merrill spokeswoman Jessica Oppenheim declined to comment.
The company owns a passive 20 percent stake in Bloomberg LP, the
parent of Bloomberg News.
Lehman to Goldman
Lehman, the fourth-biggest securities firm, has reported $1.9
billion of gains related to a widening of its own bond spreads.
Citigroup, the largest U.S. bank by assets, has booked $1.7
billion; Morgan Stanley $1.7 billion; JPMorgan Chase & Co., the
third-biggest bank, $1.7 billion; and Goldman Sachs $550 million.
There may be more to come, JPMorgan analyst Kenneth
Worthington wrote in a May 28 report. Lehman may book $325 million
for the second fiscal quarter ended in May, and Morgan Stanley,
the second-biggest U.S. securities firm, may report $470 million,
Worthington estimates.
Spokesmen for Lehman, Morgan Stanley, Goldman, Citigroup and
JPMorgan in New York declined to comment.
`Shell Game’
“No one’s going out in the market and actually retiring this So far, most banks’ writedowns are “unrealized,” meaning
they’ve been unwilling or unable to liquidate distressed assets.
If prices reversed, the banks would record mark-to-market profits.
The same is true for the liabilities. Companies can’t
“realize” the mark-to-market gains on their debt unless they buy
it back at the discounted price. They’re unlikely to do so,
because the deterioration in creditworthiness means they’d have to
replace the debt with higher-cost borrowings, Willens said.
debt,” Willens said. “It’s a shell game.”
David Moser, Merrill’s managing director for accounting
policy, acknowledged that concern in an April 10, 2006, letter to
the FASB.
“It seems counterintuitive that when a company’s credit
spreads are widening, it would recognize a gain in earnings,”
Moser wrote. “The amounts are typically not realizable and
therefore less relevant.”
He nevertheless supported the new accounting standard because
it “mitigates some of the uneconomic volatility in earnings”
that results from marking assets to market without doing the same
for liabilities.
Market Reversal
Bear Stearns Cos., which adopted the new standard this year,
reported a $305 million windfall in the fiscal first quarter,
which ended in February, as bond spreads widened on concerns the
company might face a funding shortage. Then in March, after the
New York-based securities firm was forced to sell itself to
JPMorgan, Bear Stearns’s bond spreads tightened, resulting in a
$372 million loss, according to a regulatory filing in April.
Worthington estimates that similar tightening of bond spreads
at Merrill, Morgan Stanley, Lehman and Goldman Sachs may cause
them to reverse $5.96 billion of revenue by the end of the year.
“It could very well hurt earnings,” said Jeffery Harte, an
analyst at Sandler O’Neill & Partners LP in Chicago, in an
interview. On the flip side, a recovery may result in asset write-
ups, he said.
Standard & Poor’s, which relies on banks’ financial
statements to issue credit ratings, said in April 2006 that the
new rule might lead to “diminished analytical transparency.”
“Equity may be overstated as a result of these illusory
gains that may never be realized, hindering the analysis of the
equity cushion to absorb losses,” S&P Chief Accountant Neri
Bukspan wrote in a letter to the FASB.
If and when the “illusory” revenue is reversed as losses,
the banks and brokers may have to work harder to convince
investors to ignore them, Willens said.
For related news:
Merrill earnings: MER US <Equity> TCNI ERN <GO>
Top finance: FTOP <GO>
Credit Market in Turmoil: EXTRA <GO>
–Editors: Robert Friedman, Tim Quinson.
To contact the reporter on this story:
Bradley Keoun in New York at +1-212-617-2310 or
bkeoun@bloomberg.net.
To contact the editor responsible for this story:
Otis Bilodeau at +1-212-617-3921 or
obilodeau@bloomberg.net.
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Copyright (c) 2008, Bloomberg, L. P.
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