Analytical Wealth

As if we didn't already have enough financial chicanery in the banking world, there comes this story from the Financial Times around how an accounting rule allows banks to record negative sentiment against them as a paper gain.

(From the Financial Times) "Banks are set to cushion the blow of more credit-related losses by using an accounting rule that enables them to record exceptional gains when their financial health deteriorates. The method, which has allowed US and European banks to add more than $8bn in paper profits, faces increasing opposition from investors, analysts and credit rating agencies.

Under the rule, introduced in February 2007 after lobbying from banks, financial companies are allowed to use “mark to market” accounting on their own debt. As a result, if the price of their bonds and notes falls, banks can record a gain equal to the difference between the original value of the debt and its market price.

In past months, the rule has helped banks including Lehman Brothers , Citigroup , Goldman Sachs , Morgan Stanley and Merrill Lynch to boost profits.

Analysts forecast that Merrill and Citi, which report second-quarter results next week, will offset part of their expected multibillion-dollar writedowns with these gains. The impact of the accounting rule could be muted by a brief rally in debt markets in April.

Critics, such as David Einhorn, the hedge fund manager who has been shorting Lehman shares, say the rule lets banks record accounting gains when sentiment towards the companies worsens.

Mark LaMonte, a senior vice-president at Moody’s, said the credit rating agency had advised investors to strip out these gains from their analyses. “We are not big fans of the fair-value option when it is applied to a company’s own debt because the results are very counterproductive. It creates very poor quality earnings."

In other words: the poster children for more greater transparency so investors can make more informed decisions, are going to use an oft  hidden (if not spurious) accounting trick to offset the losses from their often byzantine mortgage investment activities. The problem is even worse when you consider that the banks are desperate for cash and are inflating the appearance of their financial health with paper gains;  I.e. record all the paper gains you want, it's still not going to solve your cash and capitalization problems , or improve your intrinsic financial health.  

I don't know about you but this doesn't exactly encourage me to put my money into financial stocks right now, sure there are definitely going to be some winners out there but it's hard to know what exactly you're investing in. Especially when it seems like certain companies are telling you everything is fine one day, and desperately raising cash the next.

You can read the entire Financial Times article in full here

Sources:

The Financial Times: "Banks find way to cushion losses" -- Francesco Guerrera and Ben White, July 8, 2008.