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TMFAleph1 (94.87)

Bank Accounting and the Risk/ Return Trade-Off

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September 28, 2007 – Comments (5)

9:54 AM

Because I love confirmation bias, I’m going to pat myself on the back for a comment I wrote in follow-up to my recent post on quantitative hedge funds. In the comment, I wrote that these funds were unlikely to be coming up with original return factors/ strategies because they were staffed with people that share the same training at the same institutions. This morning, I read a post on Richard Bookstaber’s blog in which he says the same thing. Bookstaber, the author of A Demon of Our Own Design, is a former risk manager at Salomon Smith Barney and a deep thinker on risk. He currently manages a long-short hedge fund on behalf of FrontPoint Partners. Okay, that’s my bit of self-congratulation for the day.

There’s an interesting article in this morning’s journal (The Gold at Crunch’s End, page C1), that highlights a new accounting rule that allows brokers and banks to mark their own liabilities to market. As a result, when their bonds lose value (possibly indicating a higher risk of distress), the decline in value actually flows through the income statement as positive earnings (lower liabilities means higher shareholder’s equity, after all). In a report, Moody’s indicated that bondholders should consider that these earnings aren’t “core earnings” and that they aren’t sustainable. No kidding! This is just another earnings quality issue to look out for when you are examining financial institutions’ financial statements. For those of you who don’t have access to the Wall Street Journal Online, this topic was covered in an earlier piece on the Journal’s blog.

Have a great weekend!

 
Total: 261 words

Time: 10 minutes (w/o spellcheck)

*** The above text was written (and spell-checked) in ten minutes. As a result, some of it may not stand up to rational scrutiny. I apologize preemptively for any errors, omissions and misrepresentations. ***

5 Comments – Post Your Own

#1) On September 28, 2007 at 11:30 AM, retailsails (96.63) wrote:

There are many interesting ways in which the I-Banks are able to use creative accounting to offset their massive writedowns - see here for my post on how they short their own crappy deals using "structured notes"...

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#2) On September 28, 2007 at 11:57 AM, TMFAleph1 (94.87) wrote:

JR10022,

Thanks for your comment. In fact, the broker conference call excerpts you quote refer directly to the practice of marking liabilities to market and recognizing earnings on a decrease in liability values. Structured notes are classified as debt for accounting purposes, but they are hybrid instruments with returns that may be linked to equity prices (or even commodity prices). I'm not sure what you mean by "shorting their own crappy deals", but I don't think it's an accurate characterization of these transactions.

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#3) On September 28, 2007 at 12:39 PM, retailsails (96.63) wrote:

What I mean is they effectively shorted the Asset Backed Securites & CDO's they structured & sold by issuing structured notes tied to the same indices as the bonds - they bet spreads were going to widen and credit quality would deteriorate, and both of those things happened - investors lost on both ends, and the only reason the banks lost was because they were stuck holding the inventory they couldn't offload onto unsuspecting investors...

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#4) On September 28, 2007 at 1:55 PM, TMFAleph1 (94.87) wrote:

What I mean is they effectively shorted the Asset Backed Securites & CDO's they structured & sold by issuing structured notes tied to the same indices as the bonds

There are two things going on here, as described by the Lehman speaker on the conference call excerpt you quote:

1. The investment banks have a structured notes activity. These notes are tied to a wide variety of underlying and the bank acts as a market-maker. As such, it's quite normal for the banks to hedge the various exposures that selling these notes creates. These are the "economic hedges" the Lehman speaker refers to.

2. The investment banks may issue debt or structured notes in which they are the reference credit. 

and the only reason the banks lost was because they were stuck holding the inventory they couldn't offload onto unsuspecting investors...

This refers to a different activity altogether -- leveraged finance -- in which the broker-dealers underwrite high-yield debt in order to finance LBOs.

I don't consider the banks' actions to be unethical in these instances. Keep in mind that they sell different products to different investors who wish to bear different risks.

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#5) On September 28, 2007 at 2:06 PM, retailsails (96.63) wrote:

Regarding point 2, I wasn't talking about the LBO loans they were stuck with (although that's where a large part of the writedowns came from ), but rather mostly "super-senior" tranches off of their own CDO's which they were either forced to hold on to or chose to hold on to for various reasons...

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