Why You Should Still Avoid Banks Like the Plague

Submitted by Quest-News-Serv... on Fri, 03/19/2010 - 00:59.

In mid-2008, hedge fund manager David Einhorn took notice after Lehman Brothers made either an egregious typo or lied through its teeth. Lehman's "Level 3 assets" presented in its conference call were different from those disclosed in its SEC filings. Einhorn confronted Lehman management, who essentially told him to shut up and mind his own business. Lehman went bankrupt four months later.

By Morgan Housel
March 17, 2010 | Comments (19)

Why You Should Still Avoid Banks Like the Plague

In mid-2008, hedge fund manager David Einhorn took notice after Lehman Brothers made either an egregious typo or lied through its teeth. Lehman's "Level 3 assets" presented in its conference call were different from those disclosed in its SEC filings. Einhorn confronted Lehman management, who essentially told him to shut up and mind his own business. Lehman went bankrupt four months later.

And that's just one example of Wall Street's quest to blast a hole between truth and reality. It gets better.

Operation repo
Just before its death, Lehman used something called "repo 105" transactions to make chunks of its balance sheet disappear during the days it reported to shareholders, only to reappear days later.

In a repo loan, a bank borrows money from an investor. The bank backs that loan by lending the investor assets and promising to repurchase them at a set time at a slightly higher price (hence "repo"). The bank doesn't really sell these assets; it just posts them as temporary collateral, so for reporting purposes they're still part of its balance sheet.

But accounting rules say this is only the case if the collateral is worth between 98% and 102% of the repo loan's value. So all Lehman had to do was overcollateralize the loan by 105% (hence "repo 105"), and voila, the assets could be classified as "sold," even though by definition it was obligated to repurchase them in the future. As long as that future was after Lehman reported results, management could spew some cock-and-bull story about getting rid of toxic assets and reducing leverage. None of which was true. 

Surprised? I wouldn't be. These accounting pranks happen more often than you might think. Here are other games banks play to mess with reality.

1. The quarterly pump 'n' dump
The balance sheet doesn't show results over a given period. It just shows what a company looks like at a specific point in time. Investors only get four of these snapshots per year -- on the last day of each quarter. That leaves 361 days for management to go nuts behind closed doors.

Remember the ridiculous 30-to-1 leverage ratio stories we heard about? Forget those. Former investment banker William Cohan explains in The House of Cards how it really works:

Before the [leverage] ratio was published at the end of each quarter, investment banks would take the necessary steps to sell enough of the assets to get the leverage down to a more "acceptable" ratio.

In the meantime, leverage "often approached 50:1 during the middle of the quarter," Cohan writes. Yeehaw!

2. Rewriting history
In late 2008, Goldman Sachs (NYSE: GS) switched from a fiscal year ending in November to one ending Dec. 31. In doing so, December 2008 was literally eliminated from its Q1 2009 results. It became an orphan month. Not surprisingly, Goldman stuffed as much crap into this orphaned month as it possibly could. In Q1 2009, Goldman reported net income of $1.81 billion ... kind of. The orphaned December generated a $780 million loss. This completely important fact was buried on page 10 of its press release without a single mention in the much-trumpeted headline.

Goldman's CEO later bragged that "Our results reflect the strength and diversity of our client franchise, the resilience of our business model and the dedication and focus of our people."

That, and awesome amounts of arrogance.                                     

3. Heads, I win. Tails, go fly a kite.
Wells Fargo (NYSE: WFC) posted a $4 billion pre-tax profit in Q4 2009, nearly half of which came from writing up the value of its mortgage-servicing rights (MSRs).

There's nothing wrong with writing up MSRs. But Wells Fargo marked up both its MSRs and the corresponding hedges that are designed to (and historically did) move in the opposite direction -- by $1.1 billion and $830 million, respectively.

How'd that happen? Well, the hedges are typically Level 1 or Level 2, meaning their value is based on market prices, or something close. The MSRs, however, are Level 3, meaning management can value them based on whatever twisted logic it sees fit.

If both the MSRs and the hedges increased in value at the same time, then management's valuation estimate directly contradicts the view given by the rest of the market. Someone's probably wrong. Guess who.

4. The bankruptcy bonanza
A group of clever accounting regulators once got together and decided that being flung toward bankruptcy was to henceforth be known as "record profits."

This whack-job rule goes like this: When the market thinks a bank is about to fail, it sells its debt. The bank can then theoretically repurchase that debt on the cheap, discharging a liability at less than par value. Ergo, huge profits! Best of all, it can do this even if it doesn't actually repurchase the debt. Just theorize it and call it good.

On Sept. 16, 2008, Morgan Stanley (NYSE: MS) was in the midst of a bank run that nearly cost it its life. In an attempt to quell the fear, it released earnings showing a $1.4 billion profit. But every penny of that came from "the widening of Morgan Stanley's credit spreads on certain long-term debt" In other words, investors betting it was about to fail.

Citigroup (NYSE: C) and Bank of America (NYSE: BAC) pulled similar stunts. In April 2009, Citigroup reported a $1.6 billion profit only after booking $2.5 billion in gains from its own debt getting blown to shreds amid insolvency fears. B of A then followed with a $4.2 billion profit, $2.2 billion of which came from the erosion of its own bonds. Management accepted praise for a job well done.

Your move, dear investor
These accounting tricks aren't the scariest part. What's scary is that absolutely nothing has changed since all this occurred. The rules are the same. The laws are untouched. And management is still incentivized to tweak short-term results at any cost. Until there's a dramatic regulatory overhaul, it's crazy to assume this stuff won't happen again -- or isn't happening right now.

That's why I'm still avoiding banks like the plague.

Be sure to check back every Tuesday and Friday for Morgan Housel's columns.

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Fool contributor mhousel [at] gmail [dot] com doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 17, 2010, at 12:02 PM, ron153 wrote:

    Right, let's ignore the best investors in the world, Buffett, Watsa, Soros, Berkowitz, Paulson, and the list goes on - who have loaded up on these banks, and listen to Housel. Really good idea. Let's further ignore Buffett's assessment of the strength of Wells Fargo's balance sheet, I'm sure this guy is much more capable than Buffett, and has better access to information.

    What a ridiculous article.

  • Report this Comment On March 17, 2010, at 12:07 PM, ron153 wrote:

    Doesn't seem like a very good idea to ignore the best investors in the world, people like Buffett, Watsa, Soros, Paulson, Berkowitz, etc. who have been loading up on these banks and take the advice in this article.

  • Report this Comment On March 17, 2010, at 12:11 PM, TMFHousel wrote:

    Ron153,

    I think the notion that investors should disregard what they see and don't understand only because famous investor owns shares is dangerous. Other than the fact that many investors own bank shares, what parts of the article do you disagree with?

  • Report this Comment On March 17, 2010, at 1:09 PM, ZZyzxZZ wrote:

    So who R U going to believe? Names based on their reputations (and what they own) or will you choose to examine the evidence?

    Morgan Housel presents some interesting evidence and I'm impressed.

  • Report this Comment On March 17, 2010, at 1:11 PM, ZZyzxZZ wrote:

    So who R U going to believe? Names based on their reputations (and what they own) or will you choose to examine the evidence?

    Morgan Housel presents some interesting evidence and I'm impressed.

  • Report this Comment On March 17, 2010, at 1:37 PM, killtheump wrote:

    If I'm not mistaken Bernie Madoff was a pretty famous investor too that people blindly had manage their money.

  • Report this Comment On March 17, 2010, at 1:42 PM, TMFHousel wrote:

     

  • Report this Comment On March 18, 2010, at 12:27 AM, fsx101 wrote:

    To quote (paraphrase) Citi's Vikram Pandit:

    "We have already taken $100 Billion in write-downs/losses, have $100 Billion in TCE, have $40 Billion in Loan Loss Reserves, and expect to be profitable shortly".

    Both Citi and BOA were "written" off as dead, 1 Yr ago. Thats when I started buying them. Citi at $1.23, and BOA at $2.87.

    Look where they are now. Thanks to the Fed Spread, and no more "market to market" of Level 3 Assets.

    Everyone else can wait till banks return to "normalized earnings", if they want. All the nice returns will be gone by then.

    I normally like reading TMFH, but in this case, it is he who is the FOOL.

  • Report this Comment On March 18, 2010, at 12:48 AM, TMFHousel wrote:

    Just to be clear, fsx101, I'm not waiting for banks to return to "normalized earnings." I'm waiting for a regulatory overhaul that prevents them from creating their own definition of reality.

  • Report this Comment On March 18, 2010, at 12:59 AM, JibJabs wrote:

    "What's scary is that absolutely nothing has changed since all this occurred."

    This is not true. Owners lost their shirts, managements have been removed, banks have failed, winners and losers have emerged. Sure, it's unfortunate that some of the winners were the same CEOs that strayed into the mess but they have been socially disgraced if not financially, at least. I'll also concede that too much is the same still, but that may not persist, and even if it does it will be some time before the same type of excessive risk emerges again. The tide has rolled out- we now know who in the sector was not swimming naked.

  • Report this Comment On March 18, 2010, at 1:02 AM, JibJabs wrote:

    "What's scary is that absolutely nothing has changed since all this occurred."

    This is not true. Owners lost their shirts, managements have been removed, banks have failed, winners and losers have emerged. Sure, it's unfortunate that some of the winners were the same CEOs that strayed into the mess but they have been socially disgraced if not financially, at least. I'll also concede that too much is the same still, but that may not persist, and even if it does it will be some time before the same type of excessive risk emerges again. The tide has rolled out- we now know who in the sector was not swimming naked.

  • Report this Comment On March 18, 2010, at 1:11 AM, TMFHousel wrote:

    Jibjabs,

    Nothing on the regulatory or accounting front has changed, except for last March's M2M relaxation, which some might say wasn't a move in the right direction.

  • Report this Comment On March 18, 2010, at 2:14 AM, carolina1954 wrote:

    Mr. Housel is correct to lambast Lehman for the Repo 105 trick. Fuld's claim that he didn't know about it is unbelievable. He wasn't the naive piano player in the cathouse who didn't know what was happening upstairs, he was the Madam. With any luck, civil litigation will inflict the same financial ruin on Fuld and other LEH management and Ernst and Young that they inflicted on LEH debt and equity investors.

    But it is wrong to equate the commercial banks' accounting integrity with Lehman's. CBs are much more heavily regulated and less leveraged than the pre-crisis IBs. Mr. Housel refers to BAC's booking of $2.2 B of positive debt-related revenue marks in Q1 2009, but fails to mention that BAC more than reversed that sum with negative marks in subsequent quarters. GAAP requires banks to book revenue marks (positive or negative) to reflect fluctuations in the value of their debt: it is the flip side to mark to market accounting for assets. These marks cannot be equated to Lehman's deliberately deceptive balance sheet manipulations.

    Investors shouldn't let accounting fog obscure the outlines of what is emerging in the banking sector. The financial panic and recession are over; the long, relentless build-up of credit costs has peaked and will plummet over the next few quarters, sending bank earnings and stock prices sharply upward. Investors who avoid the large bank stocks now will be sorry they did.

    C. David Kirby

  • Report this Comment On March 18, 2010, at 3:06 AM, carolina1954 wrote:

    Mr. Housel is correct to lambast Lehman for the repo 105 trick. Fuld’s claim that he didn’t know about it is unbelievable. Fuld wasn’t the naïve piano player in the cathouse who didn’t know what was going on upstairs, he was the Madam. With any luck, civil litigation will inflict the same financial ruin on Fuld and other LEH management and Ernst and Young that they inflicted on LEH debt and equity investors.

    But Mr. Housel is off-base in equating the accounting integrity of the commercial banks to LEH’s. CB’s are much more heavily regulated and have a far more conservative risk culture than the pre-crisis IB’s. He refers to BAC’s booking of $2.2 B in positive debt-related revenue marks in Q1 2009 as a “stunt” without mentioning that BAC more than reversed that sum with negative debt-related marks in subsequent quarters. GAAP requires banks to record revenue marks (positive or negative) to its debt liabilities as a flip side to mark to market accounting for assets, which Mr. Housel seems to favor. To equate these revenue marks to LEH’s deliberate balance sheet manipulations is misleading.

    More generally, investors shouldn’t let accounting fog obscure the outlines of what is emerging in the banking sector. The financial panic and recession are over; the long, relentless build up of credit costs has peaked and will plummet over the next few quarters, sending bank earnings and stock prices sharply upward. Investors who avoid bank stocks now will be sorry they did.

    C. David Kirby

  • Report this Comment On March 18, 2010, at 3:15 AM, TMFKopp wrote:

    @ron153

    The key question is _why_ are those investors buying? Do you know?

    An investment thesis built around "so-and-so is buying" is a pretty weak one. Could Morgan be wrong? Sure, but I think he's raised some really damning points here and individual investors that want to jump in on the big banks better be comfortable with those shenanigans.

    @fsx101

    There are plenty of speculative profits to be made out there. The question is whether you can intelligently invest in banks like Citi -- that is, invest based on the fundamentals and an understanding of how the business works.

    Matt

  • Report this Comment On March 18, 2010, at 3:19 AM, TMFKopp wrote:

    @carolina1954

    Sure, but I think Morgan's point is that it's rather convenient that the banks were able to puff up their earnings with debt marks when they were in the most dire state. Investors need a clear picture of the state of the bank at the time, and booking billions in debt marks doesn't exactly give them that. And to be fair, reversing those debt marks doesn't give them that either.

    Matt

  • Report this Comment On March 18, 2010, at 8:23 AM, fsx101 wrote:

    TMKF:

    "The question is whether you can intelligently invest in banks like Citi -- that is, invest based on the fundamentals and an understanding of how the business works."

    The answer I got early last year was YES, with BOA and Citi. How, in the fog of "war" and panic?

    a) The "previous" owners (stockholders) had already taken the hit for the mistakes that management had made.

    b) In Q1 '09, much of the selling was "panic driven" on "expectations" that Obama would socialize the banking system.

    INSTEAD (and this is key)...

    c) I had THE best shareholder/partner in the world (at that time of need) in the form of the USG come in and share the risk/reward with me.

    This to the tune of close to $100 Billion ($90B, $45B to Citi, and $45B to BOA).

    And this "partner" could do things like no one else, like lower my cost of borrowing to 0.5% from them, and then could turn around and loan that money BACK TO THEM, at a higher rate.

    Basically,by that point, the USG wasnt going to let ANY more Large Money Center Banks Fail, and was pretty much committed to doing whatever it had to, to get them "healthy" again.

    I wanted to be on the side of that "bet" at that point, not holding my cash in a CD at 2% (which is where 90% of it was from 2007-09).

    "Be fearful, when everyone else is greedy. Be greedy, when everyone else is fearful"

  • Report this Comment On March 18, 2010, at 8:28 AM, carolina1954 wrote:

    Matt:

    I agree that revenue marks, positive or negative, distort the run-rate of earnings, but it is illogical to support ("procyclical") asset-related revenue marks under M2M accounting while objecting to ("anticyclical") debt-related revenue marks. And since both are mandatory under GAAP, they are not at all similar to LEH's discretionary sham asset sales that were designed to fool everyone into thinking LEH was reducing its high-risk assets and leverage, as claimed by LEH management in 2008.

    I also agree that following big name investors isn't necessarily wise. Soros and Maurice Greenburg both invested millions in LEH shortly before the collapse. And even Buffet blunders occasionally, as in his Conoco investment.

    C. David Kirby

  • Report this Comment On March 18, 2010, at 8:31 AM, carolina1954 wrote:

    Matt:

    I agree that revenue marks, positive or negative, distort the run-rate of earnings, but it is illogical to support ("procyclical") asset-related revenue marks under M2M accounting while objecting to ("anticyclical") debt-related revenue marks. And since both are mandatory under GAAP, they are not at all similar to LEH's discretionary sham asset sales that were designed to fool everyone into thinking LEH was reducing its high-risk assets and leverage, as claimed by LEH management in 2008.

    I also agree that following big name investors isn't necessarily wise. Soros and Maurice Greenburg both invested millions in LEH shortly before the collapse. And even Buffet blunders occasionally, as in his Conoco investment.

    C. David Kirby

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