Tuesday, September 23, 2008

Accounting arbitrage

Why is it so urgent that Goldman Sachs and Morgan Stanley become banks that even the normal five-day waiting period was waived? They were already well enough capitalized to meet the bank holding company requirements, so what's the added benefit? It might have something to do with a rushed bailout coming soon.

Sept. 22 (Bloomberg) -- Goldman Sachs Group Inc. and Morgan Stanley may be among the biggest beneficiaries of the $700 billion U.S. plan to buy assets from financial companies while many banks see limited aid, according to Bank of America Corp.

"Its benefits, in its current form, will be largely limited to investment banks and other banks that have aggressively written down the value of their holdings and have already recognized the attendant capital impairment," Jeffrey Rosenberg, Bank of America's head of credit strategy research, wrote in a report dated yesterday, without identifying particular banks.

Many banks may not participate in the Troubled Asset Relief Program because they haven't had to write down as much assets under accounting rules, meaning decisions to sell into the program would cause them to lose capital, Rosenberg wrote. Investment banks operate "under a mark-to-market accounting model while commercial banks hold assets at cost until realizing a loss (or until they reasonably expect one)," he wrote.

Essentially, because of the differences in accounting standards for commercial banks and investment banks, the investment banks have been forced to write down the value of their holdings aggressively, where the commercial banks have held on to the assets without taking the paper losses and the attendant capital impairment.

Since BofA and the rest of the commercial banks are carrying these securities at higher prices on their books, in order for them to exchange their assets at the same prices as Goldman or Morgan they would have to take another series of massive writedowns.

What's the bottom line? If Goldman and Morgan can participate in the TARP, then they may be able to exchange these under-performing illiquid assets for the US Treasury's cash at the same prices at which they are already valuing these securities.

Bloomberg points out the difficulties Japan had in trying to force viable banks to sell off their illiquid assets in the 1990s:

In the 1990s, a Japanese government effort to buy troubled assets from banks to free up lending failed because sellers weren't willing to accept the prices offered, said L. William Seidman, a former chairman of the Federal Deposit Insurance Corp. He said that wasn't a problem he had as chairman of the Resolution Trust Corp. in the U.S., which sold off failed lenders' assets after the savings-and-loan crisis of the 1980s.

"If you're talking about institutions that haven't failed, then you have the question of whether they want to sell at a low price, particularly if that price depletes their capital," Seidman said in a telephone interview today.

"In Japan, we did all kinds of things, trying to have a mediator who would set a price and other kinds of methods to get around that," he added. "It never really got done, so it was not successful, but here we probably have a more urgent need for more institutions to do something."

As BHCs, Morgan and Goldman will be able to raise money more easily while selling their illiquid paper to the Fed at no further discount. It's an accounting arbitrage.

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