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.
Bloomberg

The mother of all short squeezes (3)

Broc Romanek's TheCorporateCounsel.net blog was the first to point out the importance of companies' Standard Industrial Classification (SIC) codes in determining which stocks were and were not subject to the SEC's emergency order. His post is well worth reading for a sense of the contingencies involved in this kind of emergency, ad hoc action.

I received a number of emails from panicky members whose financial service companies were not part on the SEC's list. Some of these companies have SIC codes covered by the SEC's emergency order, but they were not listed by name in the SEC's order. For example, this situation applies to AllianceBernstein Holding, Invesco and Legg Mason. They've all filed Form 8-Ks stating that they believe they should be on the list since they were covered by the SIC code used by the SEC...

Others believe their companies are financial services companies and should be on the list, but their companies don't have SIC codes - at least, as they show up in the SEC's database (however, EDGAR shows their SIC code) - that correspond to the range of SIC codes covered by the SEC's "No Short List." To illustrate, CNBC reported that several companies - like General Electric - may be added to the list because their financial services businesses are substantial. GE's SIC code in the EDGAR database shows up as "SIC: 3600 - Electronic & Other Electrical Equipment (No Computer Equip)."

The SEC has since formally recognized the inadequacy of its first "best efforts" and has assigned responsibility for preparing an appropriate list to the exchanges. From yesterday's revised order:

In light of the familiarity of the exchanges listing financial institutions with the nature of their respective businesses, the Commission has determined to amend this Order to provide that the listing markets shall select the individual financial institutions with securities covered by the Order. The Commission expects each national securities exchange listing financial institutions to immediately publish a list, on its internet Web site, of individual listed companies with common equity that will be covered by the Order’s prohibition on short sales. The Commission expects these lists to cover banks, savings associations, broker-dealers, investment advisers, and insurance companies, whether domestic or foreign, and the owners of any of these entities.

To the extent an issuer chooses not to be covered by the Order’s prohibition on short sales, we have authorized the applicable national securities exchange to exclude that issuer from its list of covered financial firms.

Will this voluntary opt-out position separate the wheat from the chaff? If enough companies opt out of the SEC's protection, the ones left will be the obvious targets for speculative attacks.