How Wall Street Uses Repo Deals to Fluff Earnings

Last Updated May 26, 2010 6:45 PM EDT

When Bank of America (BAC) CEO Brian Moynihan in April attributed the financial giant's strong quarter to the healthier credit environment and a rebound in the U.S. economy, he left out a key profit-driver for the company: Creative accounting.

Citing data from the Federal Reserve, the WSJ noted today that B of A, along with Citigroup (C) and Deutsche Bank (DB), has a nasty habit of temporarily paring back debt shortly before reporting its financial performance. The firms do this by reducing their short-term borrowing and leverage. And it's dangerous:

The practice, known as end-of-quarter "window dressing" on Wall Street, suggests that the banks are carrying more risk most of the time than their investors or customers can easily see. This activity has accelerated since 2008, when the financial crisis brought actions like these under greater scrutiny, according to the analysis....

The data suggest "conscious balance-sheet management," said Robert Willens, an accounting specialist who heads Robert Willens LLC. If there are big gaps between average quarterly and quarter-end data, he said, the quarter-end numbers "are at best meaningless and at worst misleading and disingenuous."

Earnings management is an old story in the corporate world. Roughly a decade ago, the SEC launched a campaign to stop companies from improperly gussying up their financial results. "Managing may be giving way to manipulation," said Arthur Levitt, chairman of the agency at the time, in decrying the practice. "Integrity may be losing out to illusion." That turned out to be a prescient prediction, as Enron, WorldCom and a string of other companies subsequently vaporized in a cloud of bogus numbers.

For obvious reasons, the problem is especially troubling for financial firms. Misrepresenting a bank's financial performance affects its value, potentially harming borrowers and investors. It can reduce trading in a company's stock and increase its costs for raising capital, which in turn affects the terms on which the bank makes loans. Disguising earnings also makes it hard for regulators to do their job. In short, everyone suffers.

Banks, too. In a new study, German researchers found that banks that manage earnings saw their cost of equity rise by up to 17.5 percent and trading volumes fall up to 5 percent. "The results... show that investors punish banks for manipulating their earnings," they concluded.

Banks can groom earnings by fiddling with their so-called loan-loss provisions, the money set aside to cover bad loans. They can also "smooth" their income to reduce major earnings fluctuations, masking a company's real performance. Then, of course, there are the kind of "repurchase agreements" Lehman Brothers allegedly used to hide its debt shortly before going bust.

B of A contends that any mistakes it made in accounting for its repo deals were minor. That's besides the point, says Boston University visiting law professor Elizabeth Nowicki, a former lawyer with both the SEC and on Wall Street.

"Despite Bank of America's position that their repo 'errors' had no material impact on their financial statements, the argument can be made that the practice itself of hiding debt -- even 'erroneously' -- by way of repo transactions is itself a practice that is material and should have been disclosed over the years," she said by email. "Phrased differently, isn't it material to one poker player to know that all the other poker players at the table regularly cheat in other games, even if none of the players actually cheats in the game then being played?"

Not surprisingly, other Wall Street firms also appear to be using repo transactions to primp their earnings. The SEC has been investigating the practice and looks likely to come out with new rules to stop such blatant manipulation. That won't be easy. Bookkeeping standards are notoriously squishy, and accounting watchdogs are in perpetual pursuit of companies that bend the rules.

Still, it's worth doing. Clamping down on earnings management would do more good for financial reform than zapping every synthetic derivative in sight.

Image from Flickr user Sonyadee, CC 2.0

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    Alain Sherter covers business and economic affairs for