Tag: accounting

The Repo 18: It’s Not the Collateral, It’s the Cover-Up

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here).  Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

Since reading portions of the report issued by Anton Valukas, the examiner in the Lehman bankruptcy and writing about the firm’s accounting tricks in “A Whiff of Repo 105,” I’ve been thinking about footnote 69.

Perhaps ‘obsessing’ is a better description of my state of mind. Consider that I possess a printed copy of the nine-volume, 2,200 page report. However, that obsession seemed justified, very early this morning, when the Wall Street Journal broke the story, Big Banks Mask Risk Levels, revealing the early results of the SEC’s probe of repurchase agreement accounting practices at major firms.

According to the WSJ, based on data from the Federal Reserve Bank of New York, eighteen banks “understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods.” These banks include Goldman Sachs, Morgan Stanley, JP Morgan Chase, Bank of America and Citigroup.

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Regulatory Capital Arbitrage for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Arnold Kling helpfully pointed out a 2000 paper on regulatory capital arbitrage by David Jones, an economist at the Fed. In his post, Kling said, “In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.” Having finally read the paper, I have little to add in the way of analysis. But I thought it provided a useful basis for a discussion of what regulatory capital arbitrage (RCA) is and why it is a helpful way of thinking about the financial crisis.

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More Accounting Games

The New York Times is reporting that the administration is thinking of stretching its TARP funds further by converting its preferred shareholdings to common stock.

The change to common stock would not require the government to contribute any additional cash, but it could increase the capital of big banks by more than $100 billion.

I hope this is one of those trial balloons they float and later think better of. Most importantly, it makes no sense. That is, there’s nothing fundamentally wrong with converting preferred for common, but it doesn’t create anything of value out of thin air. I wrote a long article about preferred and common stock a while back, but here are some of the highlights.

  • If you don’t give a bank any more money, it doesn’t have any more money. By converting preferred into common, you haven’t changed the chances of the bank going bankrupt, because its assets haven’t changed, and its liabilities haven’t changed. If it had enough money to cover its liabilities, but it couldn’t buy back its preferred shares from Treasury, it’s not like the government would have forced it into bankruptcy anyway.
  • If you accept the idea that converting preferred into common creates new capital, then you are implying that those preferred shares weren’t capital in the first place. From a capital perspective, then, the initial TARP “recapitalizations” did nothing, and nothing happens until the conversion. You can’t say that JPMorgan got $25 billion of capital last fall and it’s going to get another $25 billion now just by virtue of the conversion.
  • Tangible common equity and Tier 1 capital are just two ways of measuring the health of a bank. Taking money that wasn’t TCE and calling it TCE doesn’t serve any economic purpose. There is a minor benefit to the bank because now it doesn’t have to pay dividends on the preferred. But otherwise you’ve just shuffled together the claims of the last two groups of claimants – the preferred and the common shareholders. You’ve made things look better from the perspective of the common shareholders as a group, because they no longer have preferred shareholders standing in front of them, but the total amount available to all shareholders hasn’t changed.

Is there another way to explain this even more simply?

Update: I made a mistake in interpretation last night. They aren’t floating a possible strategy here; this is already what is going to happen. I forgot that the Capital Assistance Program already announced by Treasury – the mechanism for giving more capital to banks that need it after the stress tests – specifies the use of convertible preferred shares. So imagine you are a bank with $5 billion in TARP capital already. You issue $5 billion of convertible preferred under the CAP, use the proceeds to redeem the initial TARP, and then – if and when you choose – convert the convertible preferred into common. So the mechanism to do it is there already. I guess they are floating the spin to see if anyone believes this would actually make healthier banks.

Update 2: In case it wasn’t clear from the above, I don’t have any problem with converting preferred for common. I am probably mildly in favor of it, even, for roughly the same reasons as Matt Yglesias: as a taxpayer, I’d rather have the upside and control that come with common shares.

By James Kwak

The Mark-to-Market Myth

Today the Financial Accounting Standards Board voted – by one vote – to relax accounting standards for certain types of securities, giving banks greater discretion in determining what price to carry them at on their balance sheets. The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets.

This makes no sense, for three reasons.

1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to “fire-sale” prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. It’s a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.

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The Importance of Accounting

Or, as I thought of titling this post, SEC does something useful!

Accounting can seem a dreadfully boring subject to some, but it gets its moment in the sun whenever there is a financial crisis . . . remember Enron? This time around is no exception. During the panic of September, some people were calling for a suspension of mark-to-market accounting, and while they did not get what they wanted, they succeeded in inserting a provision in the first big bailout bill to study the relationship between mark-to-market accounting and the financial crisis.

A brief, high-level explanation of the dispute: Under mark-to-market accounting, assets on your balance sheet have to be valued at their current market values. So if you have $10 million worth of stock in Microsoft, but that stock falls to $5 million, you have to write it down on your balance sheet and take a $5 million loss on your income statement. The criticism was that mark-to-market was forcing financial institutions to take severe writedowns on assets whose market values had fallen precipitously, not because of their inherent value, but because nobody was buying these assets – think CDOs – and that banks were becoming insolvent because of an accounting technicality. Under this view, banks should be able to keep these assets at their “true” long-term values, instead of having to take writedowns due to short-term market fluctuations.

I am instinctively skeptical of this view, and in favor of mark-to-market accounting, because I believe that while market valuations may not be perfect, they are generally better than the alternative, which is allowing companies to estimate the values themselves, subject only to their auditors and regulators. But the issue is considerably  more complicated than either the simple criticism or my simple defense would imply.

Earlier this week, the SEC released its study of mark-to-market accounting as required by the bailout bill. Their conclusions are simple:

fair value [mark-to-market, as will be explained] accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence.

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