Or, at least, if it did, the Reuters-reported loss did not take into account “many of the firm’s market-making and client facilitation strategies” which “utilize financial instruments across various product types,” and therefore is “not representative of the way in which the firm manages its business activities.” Read more »
As Luck Would Have It, Goldman Sachs Didn’t Actually Lose $1 Billion On Currency Bets Last Month: Goldman SachsBy Jon Shazar
A criticism of the SEC that you’ll sometimes hear is that it’s mostly a bunch of lawyers, and two things that are broadly true of lawyers as a class is that they are good at close readings of dense texts and terrified of math. This means, some might say, that the agency is ill-equipped to regulate the high-tech quantitative world of modern finance. So it’s obscurely pleasing to read that the SEC’s office of quantitative research is rolling out a new program that applies high-tech quantitative methods to, basically, close reading of dense texts:
An initial step in the SEC’s new effort [to crack down on accounting fraud] is software that analyzes the “management’s discussion and analysis” section of annual reports where executives detail a company’s performance and prospects.
Officials say certain word choices appear to reveal warning signs of earnings manipulation, and tests to determine if the analysis would have detected previous accounting frauds “look very promising,” said Harvey Westbrook, head of the SEC’s office of quantitative research.
Companies that bend or break accounting rules tend to play a “word shell game,” said Craig Lewis, the SEC’s chief economist and head of the division developing the model. Such companies try to “deflect attention from a core problem by talking a lot more about a benign” issue than their competitors, while “underreporting important risks.”
It’s also pleasing to hear that a CFO’s guilty conscience over his earnings manipulation seeps directly into his prose. Though the article is a little light on the details of the SEC’s earnings-manipulation model, which I guess makes sense, since “companies and their lawyers are expected to respond to the crackdown by trying to outsmart the agency’s computers,” which I would really like to see.1 That could be a mixed bag; the Journal hints that it might result in easier-to-read but more grandiose filings:2 Read more »
Here’s a good Sonic Charmer post about how JPMorgan could have prevented the London Whale loss by imposing a liquidity provision on the Whale’s desk:
Liquidity provision means: ‘the more illiquid the stuff you’re trading, the more rainy-day buffer we’re going to withhold from your P&L’. And since one way a thing becomes illiquid is ‘you’re dominating the market already’, you inevitably make it nonlinear, like a progressive income tax: No (extra) liquidity provision on the first (say) 100mm you own, half a point on the next (say) 400mm, a point on the next 500mm, 2 points on the next 1000mm, etc etc. (specific #s depend on the product). Problem solved. In fact, it’s genuinely weird and dumb if they didn’t have such a thing.
The London Whale’s problem (one of them) was that he traded so much of a particular thing that he basically became the market in it. That means among other things that even if on paper “The Price” of what he owned was X there would have been no way for him to sell the position for X. A liquidity provision is a rough and dirty way of acknowledging this fact.
This suggestion isn’t a matter of GAAP accounting: JPMorgan wouldn’t report its asset values, or its revenues, net of this liquidity provision. It’s just an internal bookkeeping mechanism: his bosses informing the Whale that, for purposes of calculating his P&L and, thus, his comp, they would take the GAAP value of the things he had and subtract a semi-arbitrary number for their own protection.
It is weird and dumb that they didn’t do this although you can sort of guess why: the Whale portfolio started very small, and by the time it got big the Whale was both profitable and a (mostly imaginary) tail risk hedge, so it would have been hard for a risk manager to take a semi-punitive step to rein in his risk-taking. “Just tell the Whale to take less risk” does in hindsight seem like a sensible suggestion, but I suppose if he’d made $6 billion it wouldn’t.
This Bloomberg article about accounting differences between the US and Europe for derivative-y things comes down pretty squarely on the side of Europe, which is to be expected: European (well, IFRS) standards tend to gross up the size of bank balance sheets, compared to US GAAP standards. Grossing up bank balance sheets makes for bigger numbers and scarier banks, and “US banks are scarier than they seem” is more newsworthy than “European banks are less scary than they seem.” Also intuitively truer. As Bloomberg puts it:
U.S. accounting rules allow banks to record a smaller portion of their derivatives than European peers and keep most mortgage-linked bonds off their books. That can underestimate the risks firms face and affect how much capital they need.
Or it can overestimate the risk European firms face. Or any estimating of risks based on any measure of balance-sheet size is necessarily indeterminate. Risk happens tomorrow, not yesterday.
Anyway though some of these accounting differences are puzzling insofar as they are not accounting differences. Here is the mortgage bond one: Read more »
I’m generally fond of companies that find creative ways to access the public equity markets while not giving away all the “rights” that traditionally go to “owners” of “companies.” I mean, you want money, you ask people for money, you give them the terms that you need to give them to get the money: what is so sacred about shareholder voting rights?
At the same time though I’m a little skeptical of some of the reasons that private companies give for not wanting to go public. These seem to me to be basically two:
- High-frequency-trading computers robots algorithms crash scary scary.
- “If we go public our shareholders will force us to focus on quarterly earnings rather than the long-term good of the company.”
The first one, as you might notice from its grammar, seems ill-defined, though the fact that like every high-profile IPO this year has suffered from a computer glitch makes me think that it’s on to something. Something vague though. The second one: I mean, just don’t do that. What’s gonna happen to you if you manage for the long-term good of the company? Your stock will go down this quarter? Who cares? I thought you were in this for the long haul?
But they’ve got a point. Today in “shareholders are assholes,” here’s a delightful recent paper by three business professors about how stronger shareholder rights make companies more likely to manage earnings.1 As they point out, you could have two models of how strong public-shareholder rights (i.e. things like robust shareholder voting rights, weak anti-takeover provisions, etc.) affect corporate behavior:
- Shareholders are good and will make companies do good things if they’re empowered,2 or
- Shareholders are self-interested jerks and will make companies do bad things if it makes them more money.
There’s no particular reason to believe the first one but, y’know, it’s a hypothesis; it is also wrong: Read more »
Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.
One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1
Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.
So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:
- You have a pool of reference assets,
- You pay some spread to a protection writer,
- If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
- So for instance if there are 40% losses you get paid 25%.
- The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.
So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:
- The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
- The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
- If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3
Oh man, what is going on in this FT article? Here is the bottom line:
In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses.
“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants.
The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!
Here’s a synopsis of what seems to have been going on:
- Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
- The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
- A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
- Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades: