The Delicate Art of Misleading Your Shareholders

Two weeks ago, I gave four reasons why you should avoid banks. All of them. Anywhere. Simply, accounting gimmicks and industrywide disclosure shenanigans often mask banks' true health. What you as an individual shareholder see is just a fraction of reality.

Lehman Brothers' use of so-called repo-105 transactions to reduce its balance sheet during the days it reported to shareholders is a prime example -- but hardly unique. In the article, I quoted a former senior investment banker as saying:

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."

According to the Wall Street Journal, data from the Federal Reserve Bank of New York proves the prevalence of this practice. A study found that 18 banks, including Goldman Sachs (NYSE: GS  ) , Morgan Stanley (NYSE: MS  ) , JPMorgan Chase (NYSE: JPM  ) , Bank of America (NYSE: BAC  ) , and Citigroup (NYSE: C  ) , "understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods."

They intentionally (albeit legally) misled shareholders, in other words.

To explain this further, the balance sheet -- far and away the most important piece of data when analyzing a bank -- is only reported to shareholders on four days each year -- the last day of each quarter. During the other 361 days, investors have no idea what's going on inside the company. Banks (now probably) utilize that blackout to leverage up to juice returns. That makes a bank's return on assets look higher than it really is, because net income is compared with the reported balance sheet figure.

Here's a simple example. Say a bank is levered 20-to-1 during most of the quarter, and earns $100 million on $4 billion of assets. That's a return on assets of 2.5%. But if that bank then sells assets just before reporting to shareholders, bringing leverage down to 10-to-1 and total assets down to $2 billion, then suddenly it achieves a 5% return on assets. Managers look like geniuses (and pay themselves accordingly), but in reality, the reported results were far riskier and unimpressive than shareholders perceived them to be.

None of this surprises me, and shouldn't surprise you, either. More than any other industry, banks have proved that what you see isn't always what you get.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


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  • Report this Comment On April 09, 2010, at 4:41 PM, questioner5000 wrote:

    So you mean they're doing Quarter-end "window dressing", just like every mutual fund out there?

    Or like every retailer that has a fiscal year ending on January 31st, so that they can include Christmas sales as well as pumped-up activity using post-Christmas sales, to dress up their year-end numbers?

    Or like the TV networks do during sweeps week, to boost their audience figures?

    Or like the newspapers that have special promotions just before their circulation numbers are calculated for advertisers?

    Oh, I get it! Naughty banks!

  • Report this Comment On April 09, 2010, at 10:38 PM, srorer wrote:

    Conceptually, what they are doing is the same as an investor who buys on margin and calculates his profits on his unmargined holdings.

    If all the banks do it, then who cares? It's just that if you're sailing along believing the numbers, when things to south for the banks, you're going to lose a lot of money.

  • Report this Comment On April 10, 2010, at 9:22 AM, aj485 wrote:

    Morgan,

    You say "Lehman Brothers' use of so-called repo-105 transactions to reduce its balance sheet during the days it reported to shareholders is a prime example -- but hardly unique."

    According to the part of the Bankruptcy Examiner's report about the Repo 105 transactions http://lehmanreport.jenner.com/VOLUME%203.pdf , the issue with the Repo 105 transactions wasn't that Lehman was using "repo" transactions to decrease their balance sheet - it was that Lehman was improperly accounting for these transactions as sales, rather than borrowing. In fact, if the Repo 105 transactions had been properly accounted for as "repo" transactions, there would have been an increase in Lehman's borrowings at quarter-end, not a decrease.

    The only reason that Lehman's borrowings appeared to decrease at quarter end was due to fraudulent accounting, not due to decreasing repo borrowing. So to try to say that what the other banks are doing by decreasing their repo borrowing is similar to what Lehman did is incorrect - they are doing the exact opposite of what Lehman did, and properly accounting for it, in accordance with GAAP.

    "What gets measured is what gets done" - so the banks, just like anyone else being measured, is going to try to put their best foot forward. The fact that they have the ability to make themselves look better on paper points more to measuring them incorrectly, rather than their intent to commit fraud.

  • Report this Comment On April 10, 2010, at 10:43 AM, TMFHousel wrote:

    aj485,

    Repo105s are perfectly legal, a point the examiner's report and Lehman's auditor makes dozens of time. The legal issue LEH faces regarding repo 105 is that it didn't report material changes the transactions imposed on its balance sheet to shareholders.

    By definition, repo-ing assets with 105% collateral (hence repo 105) *could not* be classified as repurchase agreements. That's the loophole LEH exploited -- legally.

  • Report this Comment On April 11, 2010, at 9:59 AM, aj485 wrote:

    Morgan,

    You say "By definition, repo-ing assets with 105% collateral (hence repo 105) *could not* be classified as repurchase agreements. That's the loophole LEH exploited -- legally."

    Actually - the Examiner questions the legality of the way that Lehman exploited the loophole - as the Examiner points out, Lehman had to use a letter stating that these repos were "true sales" from the UK and run the transactions through their UK subsidiary, to meet the US accounting rules. From page 740 of the Examiner's report "Unable

    to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo 105 program under the aegis of an opinion letter the Linklaters law firm in London wrote for LBIE, Lehman’s European broker‐dealer in London, under English law."

    Even Lehman's policy acknowledges that they are not able to operate legally under US law. A quote from Lehman's policy on Repo 105 on page 776 of the Examiner's report states “Repo 105 and Repo 108 contracts typically are executed by Lehman Brothers International (Europe) (‘LBIE’) because true sale opinions can be obtained under English law. We generally cannot obtain a true sale opinion under U.S. law.”

    So, Lehman was committing accounting fraud under US law and GAAP principles.

    The banks that are reducing their repo borrowing are legally doing so under GAAP in order to dress up their balance sheets - which leads me to the conclusion not that these banks are committing fraud, but that the system that they are being measured by is a bad system, if you are concerned about net borrowing as a critical measurement.

    If the system that they were to measure 'peak net borrowing' or 'average net borrowing' during the quarter - you might get a more conservative measurement, but the banks would then operate in a way that would make those measurements look good, too. As I said before "What gets measured is what gets done" - there isn't any way you are going to get away from that with any company, not just banks. It's human nature to make yourself look as good as you can vs. the measurement systems that are in place.

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