It's an open secret on Wall Street that many big banks routinely, and legally, fudge their quarterly books.
But now Washington is taking a hard look at a range of maneuvers that help banks dress up their financial statements, and raising some uncomfortable questions about banks’ bookkeeping.
The techniques in question, which are normally relegated to the shadows of finance, are expected to be thrust into a public spotlight on Wednesday by the federal committee that is investigating the causes of the financial crisis. The Financial Crisis Inquiry Commission is expected to focus most sharply on the way banks slim down their balance sheets before reporting their results and loans they receive from entities like special purpose vehicles and hedge funds, which are allowed to operate with little public disclosure.
Financial engineering: James Cayne, former chief of Bear Stearns, will testify before the Financial Crisis Inquiry Commission. NYT
What is perhaps surprising is that many of the practices that enabled investment banks such as Lehman Brothers to mask their deteriorating finances during the crisis are still wide open—and still being employed by other banks.
Before it collapsed, Lehman crossed the line with a stratagem that enabled it to hide $50 billion, according to a report on the bankruptcy released earlier this year by a court-appointed examiner.
The big question is the extent to which other major banks used, and still use, creative financing techniques, and whether they, like Lehman, broke any rules.
The Securities and Exchange Commission (SEC) is examining the borrowing practices of nearly two dozen financial companies. It is unclear if SEC will turn up any wrongdoing.
But industry analysts say that, even now, many financial companies routinely obscure their assets and risks in their quarterly financial statements through a variety of practices.
“Do financial institutions window-dress? Yes,” said Brad Hintz, an analyst with Sanford C. Bernstein and Co., who was Lehman's chief financial officer in the 1990s. “You have close client relationships that you deal with to bring your balance sheet up and down. Absolutely. That's part of the process.” This wizardry is typically carried out in a variety of ways on a bank’s trading floor.
In what is known as netting, for instance, banks that swap similar shares with each other, or their clients, can avoid recording those assets on their financial statements.
Banks also lend out routinely lend out shares that they own in return for cash, thus temporarily removing those shares from their books. Total return swaps—part of a family of financial derivatives that played a role in fomenting the crisis—are used to achieve similar results.
The Jefferies Group, a midsize investment bank, has gone so far as to shift the timing of its own financial reports this year so that, for a price, it can open its balance sheet to other banks looking to massage their numbers, industry analysts said. A Jefferies spokesman declined to comment.
It’s all perfectly legal. But accounting experts say such transactions, which are kept off the books and thus rarely disclosed publicly, can carry risks that shareholders should know about. Financial trades are different from such deals that are struck between, say, manufacturers.
“The basic convention of offsetting made a lot more sense when it came to the exchange of goods and services," said Tom Selling, publisher of The Accounting Onion, a website about accounting. "When you get to the future exchange of financial instruments, it's a whole different story."
The dangers—real and potential—of trying to keep certain assets off the books were made painfully clear during the mortgage meltdown. Many bankers thought they had carefully hedged against the risks posed by mortgage investments with other, offsetting trades. Many of those hedges didn't work.
According to his prepared testimony, James Cayne, Bear's former chief, plans to say that the firm collapsed because Bear's clients withdrew assets and its lending partners cancelled those loans, which were known as repurchase agreements. "The market's loss of confidence, even though it was unjustified and irrational, became a self-fulfilling prophecy," Cayne plans to say in prepared testimony. Before they ran into trouble, both Bear Stearns and Lehman Brothers created so-called shadow financial vehicles.
For SEC, the financial inquiry commission and, ultimately, investors, the question is whether such deals are transparent.
©2010/THE NEW YORK TIMES