Friday, September 28, 2007

Ben Graham, You Magnificent Bastard! I Read Your Book!!!! 
Usually the news laugh line of the day comes from the New York Times. But today it comes from the Wall Street Journal. Specifically, the Journal reports that America's ratf**k bankers, having mismanaged credit underwriting with disastrous results, are now moving to claim their heavily marked down debt - debt marked down as a result of their own mismanagement - as a credit on the earnings statement.

While the bond market mess made the earnings reports for the big investment banks feel like a game of roulette, there was one area where they were almost guaranteed to win: the falling value of their own debt.

This allowed the firms to book hundreds of millions of dollars in profit, helping to offset multi-billion-dollar charges they had to take on commitments to fund leveraged buyouts.

The Wall Street Journal, of course, knows where their bread is buttered: By the den of thieves known as Wall Street and their big ticket financial industry advertisers, such as CitiGroup, Bank of America Corp., and J.P. Morgan Chase - named in the article as among those banks claiming the collapse of their own bank-issued debt as earnings. And so the Journal takes their side:

"The brokers and banks are doing nothing wrong or improper in booking such gains. The accounting rules as they stand allow the practice."

Only then do they report that some investors are crying foul.

Count me among them.

To illustrate the absurdity of this practice, suppose I took out a credit line for 500,000 at the bank. I then proceeded to miss payments, load up on other debt, and drive my income prospects into the ground, so that my credit score plummeted, and the bank thereby considered me a seriously impaired risk.

So impaired, as a matter of fact, that when I called them up to settle for twenty cents on the dollar, they heaved a sigh of relief to take me up on the dollar.

Suppose further that I then filled out a mortgage application, and claimed that $400,000 that they lost in capital losses as income. Would these very same banks loan me money against that income?

Hell no. 1.) Because it's not income, and 2.) Because it's not sustainable anyway.

These bastards know that full well. This is a gross abuse of accounting rules.

Let's look at it another way: If this fall in the value of their crap debt is income, then let every company issue a special dividend reflecting the per share allocation of this gain. Now sit back and watch these shysters raid their surplus accounts and loss reserves to make the dividend.

Here's a hint: If you have to raid loss reserves to pay the dividend, it ain't earnings.

Let's look at it another way:

Suppose I aquired control of a publicly traded corporation. Suppose further that I was a total incompetent who blew my reputation with customers and vendors such that future sales prospects were almost nil, and earnings from operations were zero.

Suppose further that I leveraged the company to the hilt - it doesn't matter what I did with the bond proceeds. Let's suppose I turned it all into cash and then set the pile of bills on fire.

If I leverage the company enough, my earnings actually go UP!!!! Why? Because the credit markets would figure out what was going on and mark down my debt to Enron levels, worth just pennies on the dollar.

But if the debt level were large enough, I could claim the difference between issue value and market value as earnings. And the dumber I was, and the more money I literally burned, the more debt would be marked down, and the more earnings I could claim.

This is another reason why we should be hanging bankers from lampposts all up and down Wall Street.

Benjamin Graham, author of Security Analysis, the classic work on business and stock analysis first published in 1934, anticipated this ridiculous practice. From page 360:

At times a substantial profit is realized by corporations through the repurchases of their own senior securities [bonds or preferred stocks] at less than par value. The inclusion of such gains in current income is certainly a misleading practice, first, because they are obviously nonrecurring and, secondly, because they are at best a questionable sort of profit, since they are made at the expense of the company's own security holders.


To add insult to injury, by claiming the reduction in debt values as income, shareholders will almost certainly be, indirectly, forced to pay the corporate income tax rate (35%) on these nonexistent earnings.

Worse, unless the bonds are actually repurchased, the company's shareholders actually gain nothing: They are still required to make coupon payments and interest payments on time.

Now, most retail investors wouldn't think to dig that deep into income statements. And these cretins are hoping you don't. The insider, then, is given an unfair trading advantage.

What kills me is these green eyeshade types know full well what they are doing. Most of them probably had to read Graham's book in college.

There is simply no reason to allow banks, or any other publicly traded company, to claim the results of their own lousy underwriting as earnings. If the securities are retired early, to the companies advantage, earnings statements will eventually reflect higher earnings, in the form of interest payments no longer paid.

The balance sheet will also reflect the difference, in that the balance sheet will no longer list that bond as a liability. Both cases are true if, and ONLY if, these bonds are actually repurchased and retired.

What these banks want to do is claim the benefit of future earnings unencumbered by debt service payments, AND simultaneously and perversely claim an undeserved profit in the current earnings statement arising from their own crappy underwriting and lousy risk management.

The same dollars are therefore accounted for twice - and if the debt is actually retired, they'll claim the same dollars a third time on the balance sheet.


Splash, out






I'm a Kudlow guy. Let the market sort it out. Winners and Losers.

Thanks for the post!
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