Are Derivatives Accounting Rules Helping the Big Banks Overstate Their Earnings?

Posted on November 21, 2011

Profits do not mean the same thing for the major banks as they do for ordinary businesses.  If you manufacture or distribute widgets, calculating your profit on a sale is pretty straightforward.  What did it cost to acquire or make the widget? What did you sell it for?  The difference is profit.  For a broker/dealer it works pretty much the same way.  What did the bond cost me?  What commissions did I pay?  The difference is profit.

Now consider the case of the major money center banks.  Thanks to the repeal of Glass Steagall they are in the position to act not only as a broker dealer, but also as a principal, holding the financial instruments they create in their long-term investment book.  During the heyday of the mortgage securitization boom, this permitted the banks to package bundles of mortgages into mortgage-backed securities (MBS), booking a hefty spread in the process.  The MBSs could then be repackaged as collateralized debt obligations (CDO) and the CDOs could then be re-repackaged an infinite number of times as synthetic CDOs thanks to the magic of credit default swaps.

At each step of the process the bank earned a hefty origination spread, the investment bankers, brokers, lawyers and a myriad of consultants and rating agencies made their commissions and fees and everyone was happy, at least as long as the securities could be pawned off to some Norwegian village north of the Artic Circle.  At some point the music stopped and the Norwegians went back to hunting reindeer, but not so the bankers.

Thanks to the repeal of Glass Steagall the banks were able to find new customers for the convoluted structures their well-oiled machines were churning out by the hundreds: they held them on their own books.  By booking the securities at “retail” this process enabled the … read the rest

Proposed Changes to Estate and Gift Tax – A Wakup Call for Business Owners

Posted on July 29, 2009

Congress and the President appear dead set on creating lasting damage to independent business through ill conceived tax policies. The latest reports show that Congress is planning to solve our health care crisis at the expense of the “rich” with family incomes over $350,000 by imposing a new surtax of as much as 8-9% in addition to other tax increases already in the Obama budget. According to a 2007 Treasury study reported by the Wall St. Journal, fifty percent (50%) of the incomes affected by the new taxes will be generated by the sole proprietorships and Sub-S corporations which are responsible for creating 70+% of the new jobs in the United States.

If anything like the proposed new taxes comes to pass, it may be time for business owners to shift some wealth back to their tax planners and to dust off C-Corporations and tax shelters as areas of strong interest. When considering their options, business owners should take into account the negative (double taxation) impact of tying up their wealth in taxable C-Corps. In our M&A practice, we find that structuring private businesses as C corporations is one of the major impediments to successful exit transactions. Planned increases in the capital gains taxes are certain to make things even worse. For many business owners the best answer may well be to sell now before these overreaching tax law changes make it infinitely harder to realize fair value from their many years of hard work.

Less well publicized are various tax proposals aimed at “reforming” the estate tax laws. In addition to the planned return of the wealth transfer tax following the expiration of the Bush tax cuts, the administration has several surprises in store which could have a major detrimental impact on the ability of business owners to pass ownership … read the rest

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The Worst of Times – the Not So Worst of Times

Posted on June 26, 2009

The recently released Brookings Institution Metro Monitor confirms something I have thought for some time; the recession’s impact has been very different in the Central U. S., including Memphis, where I live.  Certainly unemployment is up, but there is no feeling of impending doom or of pervasive despair.

Fourteen of the strongest twenty metros in the report are in Texas, New Mexico, Oklahoma, Arkansas, Iowa or Kansas.  Memphis and its neighbor to the south, Jackson, MS, are in the second quintile.  Housing prices in Memphis were flat from Q1 2008 to Q1 2009 and they were actually up in many of the Texas markets.  “What’s going on here?” you might ask.  Certainly the regional focus on agriculture and energy, which remain relatively strong, doesn’t hurt, but I don’t think that’s the primary issue.  The mid-continent never enjoyed the full force of the Bubble to the extent experienced on the coasts, so we just didn’t have as far to fall.

This recession is proving to be a great leveler.  My guess it that this applies not just to states and regions, but to economic strata as well.  All that data which Robert Reich and others use to deplore a growing concentration of wealth at the top, has likely turned dramatically down over the past year as portfolio values have collapsed and outsized bonuses have become the bête noir of the American economy.  For the first time in my thirty-six year career, fear stalks the halls of the major law firms as hundreds, perhaps thousands of six figure associates and more than a few seven figure partners have been laid off by some of the largest and most prestigious law firms in America and similar impacts are being felt throughout the higher end of the economy.

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Categories: Business Survival, Economics, Uncategorized

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Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted on April 23, 2009

Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.

The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.

From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.


Source Churchill Financial – On the Left; S&P LCD Index

At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in … read the rest

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We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted on April 14, 2009

Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG.  These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008.  But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.

Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s.  For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence.  We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer.  Another “green shoot” is the middle market M&A market, where I spend much of my time.  The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.

So what is the economic scorecard to date and what can we expect to see going forward?

1)    The World economy is in the midst of the first major global recession of the postwar era.  Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.


While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern.  … read the rest