What would you think if a coach went bet against his own team? Do you believe he should be vilified, or should he be applauded for capitalizing on an opportunity to make some extra money? Well history has taught us that this is the ultimate sin in sports, but what if it was a company, instead of a coach, who was betting against itself? Should they be applauded for capitalizing this opportunity in the wonderful world of financial instruments? If not, then why should they be allowed to report “gains” if they don’t represent anything of true economic substance?
Recently, many of the major banks reported “earnings” exceeding most analyst expectations. However
the market responded negatively to the news. For example, Citi’s stock opened at 28.40 on Oct 17th and
closed at 27.93, a 1.65% drop, on THE SAME DAY it beat analyst’ EPS expectations by $0.51. The driving force behind the decrease was that investors thought those earnings lacked “true substance”, since net income was inflated by gains pertaining to their credit default swaps AGAINST THEIR OWN DEBT!
the market responded negatively to the news. For example, Citi’s stock opened at 28.40 on Oct 17th and
closed at 27.93, a 1.65% drop, on THE SAME DAY it beat analyst’ EPS expectations by $0.51. The driving force behind the decrease was that investors thought those earnings lacked “true substance”, since net income was inflated by gains pertaining to their credit default swaps AGAINST THEIR OWN DEBT!
Yes, you did not misread that. Citi, like most banks, bet AGAINST themselves and since they ended up being right, they were able to record a “gain” when they adjusted this bet to fair value. No, this is not financial reporting fraud, or a malicious attempt to mislead investors. Banks were forced to report this gain if they wanted to be in accordance with GAAP thanks to FAS 157.
The purpose of this post is not to discuss the mechanics of fair value accounting, or to discuss the exact reasons why banks were allowed to benefit from CVA's (credit valuation adjustments). Instead the purpose is to question the value of accounting in the role of financial reporting.
Accounting is supposed to provide useful information to the users of the financial statements, not mislead them. When the market reacts negatively to a company’s reported “earnings” that were in no way in violation of GAAP, this objective is not being met. Why do investors have to “unwrap” financial gains to arrive at a company’s true economic gain?
Just like many people argue regarding Barry Bonds, the only thing missing next to the banks earnings report was an “asterisk."
But this is just my unqualified opinion….*
