Thursday, October 4, 2007

Hocus Poke-us (Bank Accounting)

In a recent (very well written, in my opinion) article in The WSJ online Edition, which can be found here , author David Reilly describes how banks are taking advantage of new accounting rules that allow them to mark-to-market their liabilities. For those lucky enough to not know what that means, here is how it works. Assume a bank has a really bad quarter, even has a loss. That makes the bonds issued by that bank more risky because the bank is more likely to default on the payment of those bonds. All else being equal, buyers of bonds will demand less of those bonds at the given price, and, based on the laws of supply and demand, the price of the bonds will fall. The bank can now say that its liability has gone down, and record that decline as profit. So, poor performance = profit. Eureka, there is a free lunch!

But wait, here’s the rub. The bank still owes the face amount of the bond. The only way to owe less is to go into the market and repurchase the bonds. News flash from Economics 101: banks are profit-maximizing entities. If they could repurchase their liabilities below cost (all in) they would. So if they don’t, they can’t. If they can’t, they should not record the decline as a profit because it is not really there. Any gain should be recorded when they actually achieve it (the way it has been done). Anyone surprised this change is occurring at this point in our history? Not me.

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