Northern Country

Accounting statements in accordance with the actual business are more and more becoming complex and bloated fixtures of financial institutions. At the end of third quarter 2008 Goldman Sachs listed six recent accounting developments on its consolidated financial statement 10-Q.

This changed dramatically for the most recent quarter and Goldman’s 17 accounting changes opened a new frontier for wild west style accounting. Though these days reading a financial statement and understanding it is almost impossible, tenacity can pay off and hopefully reveal some insight into the health of Wall Street’s former behemoths.

Under cash flow from operating activities there is a fixture called trading assets at fair value. There is nothing peculiar about this other than the fact that its value jumped beginning with the fourth quarter of 2008. Inquisitive minds might remember that a significant accounting change took place during this quarter.

The Financial Accounting Standards Board (FASB) introduced FAS 157-3 in October 2008. Staff Position 157-3 acknowledged the use of management estimates or assumptions in “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. In April 2009 this accounting rule was amended to FAS 157-4 to accept this kind of fair value estimates also to not orderly transactions with significantly decreased trading activity.

Goldman’s worst quarter ever was the third quarter ending August 29, 2008. This was the quarter before the accounting changes were implemented. During nine months ending August 2008 (GS fiscal year used to start in December before the firm changed its status to a bank holding company), cash flow item trading assets at fair value registered a meager inflow of $37.9 billion. A year earlier the company had even outflows of $92.7 billion on the same position.

From January to June 2009, in the first two quarters of the new bank holding company, inflows into this category of cash flow from operating activities had already taken off at $172.39 billion. A year earlier in the six months to May 2008 inflows came in at only $28.8 billion. The firm of course does not further specify trading assets at fair value and which assets create its cash flow. 

Since assets are designated fair value therefore not easily convertible to cash it is reasonable to assume that cash flow generated is associated with non-current assets. Associated cash flows are added back or subtracted from the income statement depending on inflows or outflows respectively. In that sense $172.39 billion of fair value inflows might have substantially contributed to positive earnings during the first two quarters of 2009.

I think is is fair to say that accounting change FAS 157-3 threw a lifeline to even our most venerable institutions on Wall Street. In the Huffington Post Nathan Lewis asked the question: Do We Need Goldman Sachs? Without FAS 157-3 this question would be redundant. Most likely GS would have already drowned in the stormy sea of mortgage backed securities and credit derivatives.

Could it be that recent celebrations on Wall Street are nothing but a smoke screen blowing hot air into the face of investors? In its August monthly report a congressional oversight panel (COP) evaluating troubled assets on the books of large and smaller BHCs came to the conclusion that a substantial portion of toxic assets from mortgage backed securities and real estate whole loans still remains on bank balance sheets.

Goldman Sachs and Bank of America are two examples of masterful deceit sanctioned by the appropriate agencies. I am beginning to think that former New York AG Spitzer is right and democratization of capital markets is no more.

In September 2008 after bankruptcy of Lehman the financial industry as a whole nearly collapsed. Subsequent contraction of international trade was tangible proof for the serious threat Lehman posed to the stability of the system. Ben Bernanke putting the proverbial gun to Ken Lewis head while trying to rescue another Wall Street titan, Merrill Lynch,  broke the law but might as well have saved international commerce and the world from the brink of disaster.

A government report from the congressional oversight panel (COP) on troubled assets from financial institutions concludes that banks’ balance sheets are still clogged with possible future losses from hundreds of billions of impaired assets (also….). In the report’s data something else is being revealed too, with respect to Bank of America’s acquisition of former investment bank Merrill Lynch.

After the merger with Merril BofA’s most toxic level 3 assets jumped 127 percent to $126.9 billion in the first quarter of 2009. Loan quality in the form of 90+ day past due loans ballooned from $5 billion at the end of 2007 to $141.7 billion as of March 31, 2009. BofA’s credit derivative exposure to sub-investment grade assets experienced a significant uptick from little more than $500 billion to about $1.65 trillion over the last 15 months.

Under these conditions Lewis’s reluctance to close the deal is understandable, so is Bernanke’s assertiveness on this issue. The following diagrams reveal survival of the financial system and the well being of international commerce might have been at stake in those crucial days of late 2008. It seems that BofA will chew on this piece of financial crap from Merrill’s almost bankruptcy for years to come.

All the while executives at the firm and elsewhere are starting to rejoice again on better than feared earnings for the most recent quarter and reward themselves with another round of lavish bonuses. Wall Street star analyst Richard Bove in a note to investors cut short any hopes for a sustainable recovery in financials claiming bank earnings won’t improve in the third or even the fourth quarter.