Commentary: Masking debt mars earnings season — and analysts don't help
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Fairy tale season is about to begin.
Wall Street banks and brokerages are readying second-quarter numbers for mass digestion. They'll show healthy balance sheets, tolerable risk levels and have all the trappings of well-run companies.
Don't believe a word of it.
If the second quarter is anything like quarters of the past couple years, risk is up and capital is down. And what you'll see on earnings day bears little resemblance to the business being conducted between the bookends of the start and end of the latest quarter. After all, Wall Street is an industry built on prevaricating for clients — Enron Corp., Greece and Parmalat Spa (PLATF.PK - News) to name a few — why would it come clean with its own financials?
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Late last week, Bank of America Corp. (NYSE: BAC - News) became the latest big financial firm to cop to manipulating end-of-the-quarter earnings. In a letter to the Securities and Exchange Commission, B. of A. said it masked debt levels between 2007 and 2009 by making six trades designed to shine up the numbers on earnings day.
You can bet that the Charlotte, N.C.-based bank isn't the only one using the David Blaine accounting method. In April, the The Wall Street Journal examined data from the Federal Reserve bank of New York and found 18 banks including Goldman Sachs Group Inc. (NYSE: GS - News), Morgan Stanley (NYSE: MS - News) and J.P. Morgan Chase & Co. (NYSE: JPM - News) masked debt levels in the five quarters ending in March.
The Journal found the banks "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, the data showed. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters."
Of course, like many Wall Street practices in the era of deregulation, all of the trades were perfectly legal, just as the "repo" accounting used by Lehman Brothers to hide its leverage exposure was legal — at least in the opinion of the U.K. attorneys they could get to approve the deals.
Lehman was hardly alone. Before, during and after the financial crisis, banks used countless accounting tricks, including off-balance sheet entities called special purpose vehicles, short-term repurchase agreements, securities that banks label "available for sale," and all varieties of "intent-based accounting."
You would think this kind of window dressing would raise the ire of analysts whose rosy analysis of Wall Street firms including American International Group Inc. (NYSE: AIG - News) Bear Stearns, Lehman Brothers and Merrill Lynch were made to look foolish by opaque and misleading balance sheets.
Think again. Most analysts still read the suspect financial data they're handed every three months and take it as gospel.
Take a look at the usual suspects. Since the start of the year, analysts have issued six ratings upgrades to Citigroup (NYSE: C - News), six to Goldman, four to Morgan Stanley and nine to Bank of America, according to FactSet. Combined, analysts have only issued five downgrades.
Even some of the best analysts, including Brad Hintz at Bernstein Research, Meredith Whitney, who runs her own research company and Glenn Schorr at Deutsche Bank AG seem reluctant to mention the fact that banks are tweaking the numbers. And why should they? Admitting that a bank has cut risk for earnings day undermines their "analysis."
Denials and lies
Less than a decade ago, a crusading attorney general upended Wall Street with a series of investigations and settlements concerning practices that the industry and public took for granted: late trading of mutual funds, bid-rigging in the insurance market and research conflicts.
Regardless of Eliot Spitzer's personal failings and his lasting impact as a reformer, at least he had the gumption to challenge practices on the grounds of common sense and evenhandedness. Unfortunately, no one seems to have taken up the mantle of championing fairness in the markets.
Even after the financial crisis, financial firms still take short cuts behind the scenes, the analysts keep playing it straight, investors continue to follow the analysts and credit ratings agencies. Not only does the emperor have no clothes, no one in the kingdom cares.
Maybe it's the obfuscation: like the way a chief financial officer authoritatively patronizes investors on the earnings call. Or perhaps it's the way banks such as Goldman and Morgan Stanley vehemently deny they use "repo" transactions to make the books look better at the end of the quarter but are hazy when asked about other transactions.
Maybe it doesn't matter anyway. All of this stuff, we're told, is legal. And if the SEC does make a move, it's only going to require more disclosure of mid-quarter activities.
Maybe lie is too strong a word for the game big finance plays at the end of the quarter. It is, after all, trickery played inside the lines.
But here's something you should refuse to call it: the truth.
David Weidner covers Wall Street for MarketWatch.