Wall Street Whispers - Banks' Dirty Windows

Investors still don't have access to basic information from banks.
Publish date:



) -- "Window dressing" is a cute term for something with the intention to deceive investors and regulators, but such is the way of financial firms' accounting practices.

When I first got tipped off to the whole

"off-balance sheet" issue

in early 2009, it was difficult to tell what exactly was going on off the books: There were QSPEs, VIEs and the CDOs, SIVs and other less-exotic items that resided within them. There were notional values and much smaller values "at risk," none of which was explained in a coherent fashion to the investors buying bank stocks, or highlighted by regulators or the mainstream press as a valid concern.

But it was clear that there were a ton of assets and liabilities hiding out there that banks hadn't necessarily been reserving capital against or informing investors about appropriately.

After the

Lehman Brothers report

came out in March, everyone was all aflutter about the "Repo 105" tactic involving off-balance sheet items. In Repo 105, banks "sell" assets through QSPEs with the intention of buying them back soon after. But instead of being classified as a loan, the transaction is considered a sale. Therefore, banks don't have to hold reserves against the possibility of default on the underlying assets, or on the loan of those assets to another entity.

Repo 105 is a "window-dressing" tactic, usually performed near the end of a quarter so that bank balance sheets can appear stronger than they actually are. Lehman had used Repo 105 to move $50 billion in assets off balance sheet, according to the examiner's report. Over the weekend, word surfaced that

Bank of America

(BAC) - Get Report

improperly considered up to $10.7 billion worth of ... let's call it "stuff" as assets rather than loans.

For investors, this is not really a big deal. Bank of America has $2.3 trillion in assets and said that the accounting issues -- which related to six trades involving mortgage-backed securities in its capital markets business from 2007 to 2009 -- were "immaterial" to reported results over that time.

What's more important for investors to find out is why did Bank of America and other firms even bother with Repo 105 if it was so immaterial, and what happened to all the other

off-balance sheet assets

that banks had sitting around up until the beginning of this year?

Before 2010, banks had all kinds of QSPEs and VIEs held off the books.

Wells Fargo

(WFC) - Get Report

was the most exposed, and mostly held mortgage-backed securities and interest-rate hedging vehicles off balance sheet.

The top six banks -- Wells, Bank of America,

JPMorgan Chase

(JPM) - Get Report



(C) - Get Report


Goldman Sachs

(GS) - Get Report


Morgan Stanley

(MS) - Get Report

-- had nearly $4 trillion in assets held off the books as of March 31, 2009.

Fannie Mae



Freddie Mac


together still held over $5 trillion as of Sept. 30, nearly as much off the books as on.

Starting Jan. 1, financial firms were supposed to be required to move most of their off-balance sheet assets onto their books -- or get rid of them -- and hold capital against them. But federal regulators extended that rule by six months to allow banks adequate time to adapt. Somehow,

Wells Fargo

was able to whittle down its $1.9 trillion in notional exposure to a balance-sheet addition of just $55 billion. Bank of America -- whose off-balance sheet credit card trusts stoked much concern -- was able to take a

minimal charge

on its $150 billion worth of assets that moved onto the books.

But one has to ask: What happened to all the other exposure, and what else is still able to be stored off the books? Are there loopholes that persist? And, perhaps more importantly, why did oxymoronic off-the-books accounting exist in the first place?

As I pointed out in September taking a look at one

collateralized debt obligation

-- structured by


in 2006 -- tells a lot about the standards or lack thereof.

The $1.3 billion off-balance sheet vehicle was backed by over seven million square feet of commercial real estate in the Sun Belt: California, Florida and other states that have suffered terribly from the real estate bust. The entity was housed in the Cayman Islands and assets could be transferred into and out, as long as they met certain vague criteria.

Yet, years after it was structured, it still wasn't clear who owned the vehicle, what assets it was backed by, how loans have performed, or whether it has lost or earned money. It is also unclear how much exposure Wachovia -- née Wells Fargo -- had to the SIV any longer, if any at all.

Instead of looking at dirty windows in the rear-view mirror, investors would be better served knowing what problems lie ahead.

The government and the industry have been doing a lot of window cleaning to make it seem as though quarterly and annual reports are much more "transparent." Yet bank accounting is plagued by many issues and investors still don't have access to basic information -- not least of which is how to value

illiquid assets

or how much

capital regulators will require

to hold against them. Furthermore, there's no assurance that all the factors an investor ought to pay attention to are considered on the balance sheet at all.

As James Dailey, portfolio manager of the TEAM Asset Strategy Fund, recently put it: "Their earnings reports are all a mess anyway, because it's all fictional accounting at this point. It's all about how the market reacts to it rather than the numbers."

That sentiment crops up more frequently when the market loses confidence in what banks are telling them and whether regulators have a handle on the task at hand. Rules need to be established and followed in order for bank stocks to be seen as a long-term investment rather than a short-term play.

-- Written by Lauren Tara LaCapra in New York


Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.