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Posted by on June 2, 2008, 3:38 pm
no wonder their ratings are being cut. i wonder if people who think
they know economics, understand what the world really faces.
its always cool to see something the free market wrote themselves,
then watch it implode, then hear the libertarians whine about
government involvement.
http://www.bloomberg.com/apps/news?pid=20601109&sid=a2ppBYA0ELaU&refer=home
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 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'
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.
``No one's going out in the market and actually retiring this 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.
To contact the reporter on this story: Bradley Keoun in New York at
bkeoun@bloomberg.net.
Last Updated: June 1, 2008 19:01 EDT
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