Wall Street Accounting Shenanigans

Pretty much everyone who reads the financial press knows that investment banks are stuck with large LBO fundings and commitments that are under water. That means that. properly accounted for, the reduction in value of these positions is a loss. Yet there are increasingly indications that the soon-to-be released third quarter earnings may not be fully haircutting these holdings.

As Serena Ng in the Wall Street Journal’s Deal Blogs tells us:

In July and August, banks were forced to loan money directly to such companies as Chrysler, U.S. Foodservice, ServiceMaster and Thomson Learning after failing to sell much of the debt financing buyouts to investors. The banks weren’t the only ones on the hook, as some hedge funds invested in small portions of the temporary “bridge” loans that the banks extended to finance the deals. The banks are, of course, planning to try again to sell the debt when market conditions improve.

A veteran hedge-fund manager who last month invested in one of these bridge loans says he recently asked a Wall Street bank to provide him with a value for that loan so that his fund could accurately value its assets, or “mark them to market.” The bank refused to provide a “mark” on the loan, he says.

The incident made him wonder if Wall Street firms are marking the value of bridge loans on their own books at 100 cents on the dollar, as opposed to the 90-95 cents on the dollars that many recently sold leveraged loans are trading at in the secondary market. “It seems they don’t want to mark these loans down, but it’s intellectually dishonest to record them at full value,” he says.

There also is chatter in the market that some banks are asking rivals not to sell off pieces of bridge loans at discounted prices because that would force all the banks who hold the same loans to mark down their values and recognize losses on them. Given the state of the credit markets, that could be like trying to stop the sun from rising.

The losses in aggregate are not trivial. From Barrons:

Over the past three or four months, bankers have committed to lending LBO targets about $300 billion to fund buyouts. Their plan was to sell the loans to institutional investors. But demand for leveraged debt has evaporated in the recent market turmoil, even as yields on existing leveraged loans have risen.

So bankers now have two choices: sell the debt to investors at losses that could approach 10% to 12%, or hold onto it and hope the market improves. Most market players think the banks, when possible, will opt to take their lumps sooner, rather than later.

$30 billion in losses is enough to focus the mind.

We had noted a few days ago that Goldman was peddling a retail distressed debt fund and was touting LBO debt as one of the planned targets. It looked like the typical use of retail investor as stuffee: get them to take whatever Wall Street is keenest to unload.

But there may be yet another angle for targeting retail investors. If this paper really isn’t trading much, another use of the retail chump could be to establish a sales price for inventory valuation purposes. Now you wouldn’t sell a lot of paper to the fund, that’s asking for liability problems. But small transactions often legitimately go for higher prices than large ones, and a bank could conceivably sell a small participation in a few deals at a not-egregious-if-you-are-retail level above where the market really was (say 95 when the market would probably be 92). Now it would probably be pushing it to stuff your own paper into your own fund, but there are enough banks in the same boat that mutual backscratching isn’t out of the question.

Of course, Wall Street may not need to do anything so convoluted. It turns out that the Financial Accounting Standards Board now permits companies to engage in fraudulent, um, creative accounting, and it’s perfectly kosher. A recent Bloomberg story reported on how Wells Fargo made use of this innovation called Level 3 gains:

So what are Level 3 gains? Pretty much whatever companies want them to be.

You can thank the Financial Accounting Standards Board for this. The board last September approved a new, three-level hierarchy for measuring “fair values” of assets and liabilities, under a pronouncement called FASB Statement No. 157, which Wells Fargo adopted in January.

Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to- market.

Level 2 values are measured using “observable inputs,” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.

Then there’s Level 3. Under Statement 157, this means fair value is measured using “unobservable inputs.” While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

“If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer research service in Baltimore. “It’s akin to voodoo.”

And who is the most active practitioner of this black art? According to MarketWatch, it’s Goldman:

Percentage of Level 3 trading inventory valued using mark-to-model techniques
Goldman Sachs 15%
Morgan Stanley 13%
Lehman Brothers 8%
Bear Stearns 7%
Merrill Lynch 2%

Source: Bernstein Research

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  1. Anonymous

    I agree that “If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up,”. However I don’t quite understand your suggestion that Level 3 gains are necessarily “creative” or “fraudulent”.

    There are some derivatives that need inputs that may not be market-observable. For example the cost of an employee share option scheme must include some factor for the number of employees likely to leave during the vesting period.

    A CDS on a custom basket of reference entities can only be valued by looking at the default correlation of the underlying entities. If it is a custom basket there may be no 3rd party value available – for this basket. People may be quite happy to extrapolate from apparently similar baskets that have market quotes, but that doesn’t make it any less “mark-to-make-believe”.

    I agree that there is always a threat that such inputs may not be reliable, but without them the valuation obtained would be irrelevant. What would you suggest? Stick the derivatives at cost? Ignore significant inputs and come up with a completely useless number?

  2. Anonymous

    It’s not always sinister motives that level 3 model derived prices are used. Many of these assets’ fundamental values are much greater than what they would fetch in this panicky environment. In practice, a mark to “market” would require infusion of capital simply because the mark to market must be accounted for through earnings. In such a climte firms see this as an inefficient use of capital.

  3. Lune

    In such a climte firms see this as an inefficient use of capital.

    It’s only inefficient if you believe the risks of your level 3 valuation being off are low. If you invest in a highly volatile market, you necessarily need higher capital reserves to ride out the inevitable peaks/troughs. That’s not “inefficient” use of capital. It just means investing in volatile markets has a higher capital cost, which should be figured into risk/return calculations.

    Similarly, investing in assets that can only be valued by opaque and hard to quantify inputs means that the intrinsic value of those investments is more uncertain, which means you *should* have higher reserves of capital to keep you solvent in case your models are wrong.

    The only time this is inefficient is if you believe that some external source of capital *cough* Fed *cough* will rescue you if your models are wrong.

    Sort of like buying insurance: buying insurance is good use of capital if you believe your risk of losses are high. But if you know someone else will eat your losses for you, then you’re absolutely correct that buying insurance is inefficient use of your capital.

    We’ll soon see if the Fed rides to the rescue or whether the IBs should have been a little less “efficient” with their capital.

  4. Anonymous

    Surely the point is not that level 3 valuation should not exist, but that in the current situation it’s very hard to trust that banks will be entirely honest in their valuations. If high percentages of level 3 valuation end up costly some banks big time, because investors don’t trust these valuations — well, that’s all part of the natural market response to the facts, isn’t it?

  5. Lune

    If high percentages of level 3 valuation end up costly some banks big time, because investors don’t trust these valuations — well, that’s all part of the natural market response to the facts, isn’t it?

    That’s very true. But there is a role for regulation to ensure that banks make reasonable estimations. That’s why entities like the FASB and SEC exist, to ensure that companies put out accurate and standardized information that investors can use. If that information is costly to banks (i.e. if level 1 valuations would cause a hit to earnings), then so be it. The FASB doesn’t exist to protect the earnings reports of companies, it exists to ensure that earnings reports are calculated to a reasonable set of broadly applicable assumptions and rules thereby ensuring that investors can compare earnings between companies and with historical data. The whole point of accounting standards is to prevent each company from having its own set of financial assumptions and rules (that they can also change year to year as they see fit), because that makes the job of investors much more difficult. To the extent that Level 3 valuations essentially allow a bank to make up its own assumptions and rules, it violates the very principle of having accounting standards in the first place.

    You’re correct that an investor could plow through all the data and decide if the valuation is accurate or not, but then why have the FASB in the first place? It’s sort of like saying the FDA should allow each company to decide on its own whether its drug is beneficial or dangerous, with its own definitions of health, sickness, statistical significance, etc., and then let the public decide if they want to take it or not.

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