naked capitalism

By Ian Fraser, a financial journalist who blogs at his web site and at qfinance. His Twitter is @ian_fraser

Call me naïve but, back in 2002, I genuinely believed that Enron-esque accounting would become a thing of the past. Having turned “aggressive” accounting and (off-) balance-sheet manipulation into an art form, the Texas-based energy giant got caught with its pants down — and was forced into bankruptcy. The auditors who cooked its books may have evaded justice, but their firm did implode.

Sadly, however, lessons were not learnt. As we saw with Lehman Brothers’ rampant abuse of Repo 105 to minimize apparent debt levels, a ruse signed off by auditors Ernst & Young, accounting dodges bearing an uncanny resemblance to those favoured by the Enron CFO Andrew Fastow became de rigueur in the financial sector during the “age of moderation” — and remain so today.  Sarbox, the monumental rules-based doorstop intended to put a stop to this sort of thing, was widely ignored, and if anything seems to have made it eaiser for the creative accountant or the would-be manipulator of financial reporting to work their “magic”.

In the City of London Enron-style accounting remains prevalent. It might be a legacy of the “race-to-the-bottom” pursuit of “lighter touch” regulation of the former government (as Tim Geithner recently highlighted in a much quoted interview with the BBC).

Take Lloyds Banking Group, 41.3%-owned by the UK government.

I first highlighted concerns about the Enron-esque tendencies of this deeply flawed bank in a blog post back in October 2009, just as it was tapping investors for a further £22.5 billion, in a capital raising without which the bank would have had to be fully nationalized.

The bank released its financial results for the year to December 31 last Friday. Its US-born chief executive, Eric Daniels, who steps down today (March 1) spent his third last day at the helm touring the television and radio studios, bragging about how Lloyds had turned the corner, and was back in profit after several shockingly loss-making years.

Daniels, who some have described as being about as detached from financial and economic realities as your average North African dictator is from political realities, seemed to be telling us that, having generated profits “on a combined business basis” of £2.2 billion last year, everything Lloyds’ garden was blooming rosy.

And when compared with the bank’s £6.3bn loss in 2009 and truly mind-numbing provisions for bad debts of £24bn (which are largely a consequence of Daniel’s near-insane decision to buy rival UK rival HBOS at the peak of the crisis) there’s a degree of truth in this.

However if you scratched the surface, not everything was quite as it seemed. Indeed there seems to have been a fair degree of subterfuge going on in the Lloyds finance department, which since 2008 has been overseen by former KPMG accountant and CFO Tim Tookey. The Economist, in its Newsbook blog, highlighted some instances of accounting sleight-of-hand.

Page 1 of the results release herald’s the firm’s “return to profitability” during 2010. Page 2 says the firm made a statutory loss to attributable to equity shareholders of £320m in that year.

Of course, there are different definitions of profit. A further one is “comprehensive income attributable to equity holders”, which also includes movements on the balance-sheet that are not booked directly in the profit-and-loss account. On that basis the firm lost £37m. The firm itself prefers, like many companies, an underlying measure that excludes one-off or non-cash items and attempts to capture the recurring earnings of the business. That showed a pre-tax profit of £2.2 billion, but the definition looks rosy. It excludes cash restructuring costs of some £1.7 billion that are arguably part of the firm’s core cost of doing business, and includes a £3.2 billion, non-cash, “fair value” boost related to the HBOS acquisition that is fairly clearly not part of core earnings.

Reasonable people can disagree about one number. But Lloyds also said that it had made “excellent progress” in sorting out its funding, arguably its biggest strategic problem. It did manage to improve the maturity profile of its borrowings, making them more long-term. But it still has £298 billion of overall wholesale debt, down by only 8% over the year, a position which means it is probably still the bank with the single largest shortfall between loans and deposits in the world. At the end of the year it owed some £100 billion (down from £157 billion) to central banks and governments, again probably still making it more dependent on public funds in absolute terms than any other bank in the world. It also said that this year its lending margin would not expand as the firm’s medium-term targets suggest, partly due to the additional cost of refinancing all that wholesale funding and the difficulty of passing this on to customers.

Analyst Ian Gordon, a banks analyst at Exane BNP Paribas, accused Daniels, Tookey and Lloyds of trying to peddle “an illusion”. He said the results and outlook were “a bit of a horror show,” and counseled caution over the pretax profit figures provided by the bank, since charges including £1.65bn cost of integrating HBOS, £500 million to reimburse ripped off mortgage customers, and a £365m loss on the sale of two oil-rig subsidiaries had been stripped out. He also pointed out that higher valuations on HBOS assets and business lines since the January 2009 HBOS deal had added £3.12 billion to Lloyds’ headline pretax figure, in a “fair value unwind” gain (see Margot Patrick’s story for more on this theme).

In his research note, Gordon added:-

The true horrors of the HBOS acquisition can never be unwound, and, after an 1106% increase in sharecount over three years, a large element of the associated value destruction is seemingly permanent

Over at FT Alphaville, Tracy Alloway spotted further accounting anomalies at Lloyds.  Having studied the balance sheet more thoroughly than any MSM journalist, she noticed that the bank had stuffed some £7.9bn of largely unidentified ‘available for sale’ assets into a newly-created accounting basket of ’held to maturity’ assets (apparently this is part of the “fair value unwind” mentioned by Gordon, but to me it does seem malodorous).

All the bank said about this apparent ruse was that £3.6bn of the £7.9bn was accounted for by government bonds, which for some reason the bank has decided it now wishes to retain, not sell. Maybe they’re from PIIGS countries? But of course, the state-owned bank provides zero disclosure of this sort of thing. Alloway pointed out why such a manoeuvre might benefit the bank:-

As an accounting reminder, HTM assets aren’t marked-to-market — that is, they don’t necessarily have to be marked down as market values fall. AFS assets held in banks’ trading books, however, usually are impacted by market movements.

The asset switch and general accounting obfuscation raises a number of key issues. First, why did the bank’s auditors, PWC — who are heavily conflicted given the range of other services they provide the bank — deem such chicanery appropriate? Could it have had anything to with the fact that PWC earned £25.2m in audit fees from Lloyds in 2009 and £15.5m in non-audit fees (source Financial Director magazine)

A second question is whether Daniels indulged in such deceitfulness in the hope the mainstream papers would fall for his decription of 2010 as a “very, very good year”? In the hope of salvaging what little is left of his tattered reputation? Of somehow making his parting bonus of £1.45m more palatable to a furious British electorate?

Whatever the Montana born chief executive would have us believe, the truth of the matter is that Lloyds is, in fact, in a truly horrible position.  Despite the confident spiel one hears from Daniels HBOS, acquired for £8bn in September 2008, remains one of the most toxic banks in Europe, plagued with ‘Scooby’ loans made in Ireland and in UK under the leadership of ex-directors Andy Hornby and Peter Cummings. The situation in Ireland where HBOS was particularly cavalier in its business approach, would make a Captain Mainwaring-type bank manager weep. Lloyds has already written off £7.2bn of the loans it and HBOS made to Irish customers in the past two years. It has already owned up to 54% of its £26.7bn Irish loan book being impaired.

Austerity programs in Ireland and the UK are almost certainly going to make things worse and require the bank to make further mark downs. A recent WSJ article suggested that fire-sales loom in the UK and Irish commercial real estate markets, as the banks’ previous favoured methods of dealing with poor quality loans — “delay and pray” and “extend and pretend” — become increasingly impossible to pull off in a much tighter regulatory and capital environment.

The elephants in Lloyds’s room, of course, are the bank’s £298bn of wholesale debt (aka its ‘funding gap’), mentioned in the Newsroom article, and the risk that the UK’s Independent Banking Commission will recognise Lloyds has become an oligopolistic presence in the financial services market, and force a break up.

No wonder incoming chief executive António Horta-Osório, who formerly ran Santander’s UK operation, is embarking on a full strategic review which he expects to complete by the end of June. But I suspect even he is incapable of putting Daniels’ dysfunctional legacy back on an even keel.