Plus ça change, plus c’est la même chose


They say that history repeats itself, first as tragedy, then as farce. The recent debacle at the 2008 Equity Derivatives House of the Year, where a junior traded used fraudulent hedges on vanilla index futures to create the largest trading loss in history, seems to sum up in an especially ironic way all of the recent trouble we have seen in the financial sector.

Investors in banks and brokerage houses have recently been burned repeatedly by opaque holdings and complex trading strategies, and it feels at times that there is no end in sight to the losses and writedowns. Even legendary investors like Bill Miller have suffered from the toxic mess that has bubbled up at large financial institutions. As it turns out, the humblest neighborhood thrift may be a harder business to value than bleeding-edge tech or biotech firms.

But should anyone feel that any of these problems are new, or only a feature of modern financial markets, Fred Schwed, writing Where are the Customers’ Yachts? in 1940, reminds us otherwise:

A large [Wall Street] firm has many partners, many seats, great earning capacity, great capital outlay, amazing overhead, and all sorts of securities. Each evening the workers in the “cage” are not allowed to go home until the books “balance.” But it is frequently most difficult to ascertain whether the firm is making or losing money.

I know of a banking institution whose local rule is that the bookkeepers may not go home if there is a “difference” of more than six cents. Nevertheless it is quite impossible for anyone to state, at any time, what they are really worth within a couple of million dollars.

Accounting, some say, is not a science but an art… Since 1938 a not implausible argument could be presented to show that accounting is not even an art, but just a state of mind. In that year occurred those two fantastic accounting cases – McKesson and Robbins, and Interstate Hosiery Mills. For some time both corporations had flourished like the green bay tree, chiefly on assets that simply weren’t there, but which everyone thought were there. Everyone, that is, save one man in each case, who had created the assets all by himself, using only a pen, some ink, and a lot of skillful dishonesty. Presumably these corporations’ securities would never have taken those two dives if only the noexistent assets had not been destroyed by having their nonexistence discovered.

While some valuation-sensitive investors have begun to shy away from the financial sector for good, forensic accounting research, as performed by firms like Starmine, Jefferson Research, Assay, RiskMetrics CFRA, and Behind the Numbers, may be able to shed some light on what financial institutions are really worth. Another interesting source is the Analyst’s Accounting Observer, which provides “remedial accounting lessons” for institutional investors (and also publishes a blog). These written reports present discussion and analysis of current financial accounting topics in a way that makes sense to financial analysts.


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