Tuesday, April 20, 2010

How Accounting Changes Created Wall Street's Good Earnings

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.


If you can't win under the existing rules of the game, simply change the rules. Wall Street firms were losing big money during the Credit Crisis, but not only did the federal government come to their rescue with truckloads of taxpayer money, but accounting rule changes were also instituted to make their financial position look much stronger. The much improved earnings for the banks and investment houses showing up today are the result of both and not an improved economy.

After a record earnings year in 2007, built on a highly leveraged sub-prime mortgage pyramid, things started to go terribly wrong on Wall Street in 2008. Mark to market accounting was forcing firms to value their sub-prime paper at fire sale prices. This was causing massive losses. Wall Street's friends in the federal government launched a massive counteroffensive, including TARP - the welfare for Wall Street banker's bill, approximately half a dozen new Fed policies that supported the market for Wall Street's junk paper, legislation to hold up the housing market to give underlying value to that paper, and a change in accounting rules that would allow the big banks to look like they were making money even if they weren't.

Citigroup's first quarter 2010 earnings report provides a good example of the better earnings through accounting chemistry approach. Many market observers maintained that Citi was insolvent during the Credit Crisis. The U.S. Treasury wound up buying 27% of Citigroup's shares to help keep the company afloat. In reaction to the Credit Crisis debacle, Citi set up a company, Citi Holdings, to isolate its questionable assets. That entity had losses of $5.49 billion in the first quarter of 2009. It only lost $876 million in the first quarter of this year. The difference improved Citigroup's earnings in Q1 2010 by $4.61 billion. Total earnings reported for Citi in the quarter were $4.43 billion, so it would have lost money without the boost from Citi Holdings. Nevertheless, mainstream media reports were aglow with Citi's great earning's recovery.

The change in accounting rules took place between September 2008 and April 2009. On September 30, 2008 the SEC and FASB, the Financial Accounting Standards Board, issued a joint announcement that stated that forced liquidations of securities, meaning subprime junk debt, were not indicative of fair value. The Emergency Economic Stabilization Act of 2008, which was passed a few days later on October 3rd, codified this into law by allowing the SEC to suspend existing accounting rules if doing so was thought to be in the best interests of the public. In actuality, the 'best interests' being protected were the Wall Street's. Goldman Sachs and Morgan Stanley stock price's hit bottom and began rallying the next month. On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting and this eased balance-sheet pressures on the big banks by letting them cross out the old bad numbers and start replacing them with much better looking new numbers. The overall stock market bottomed right around this date.

The accounting changes came too late to save Bear Stearns and Lehman Brothers of course. Bear went under in March 2008 and the events surrounding its demise indicate that existing Wall Street accounting numbers already had a large fantasy component before the gutting of mark-to-market for subprime junk. Bear Stearns was trying to expedite a good first quarter earnings report before it collapsed. When the feds arranged for it to be bought by JP Morgan, they valued it at $2 a share. The book value for Bear Stearns was around $90. If people at the Federal Reserve and Treasury Department think that $90 really means $2 for a Wall Street company, the individual investor might want to take the hint. These people have a lot more information about what is really going on than you do. If they don't believe the numbers, why should you?

Disclosure: None applicable.

Daryl Montgomery
Organizer, New York Investing meetup
http://investing.meetup.com/21

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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