Wall Street's banking titans have a history of being slow to acknowledge bad news. Don't count on them to come completely clean in their quarterly earnings reports next week about how the credit crisis is rocking their businesses.
That's because bank leaders have a crafty tool on their side: accounting rules. They give Goldman Sachs, Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers wiggle room in sizing up – and potentially downplaying – the losses they are facing on illiquid assets they hold that have been battered by imploding credit markets.
That may make it hard for investors to judge the impact of the credit crisis on markets and the economy.
The market turmoil, which intensified in August, has inhibited bond underwriting and the unloading of loans used to finance leveraged buyouts. Distressed subprime mortgage debt also remains a significant worry.
Wall Street research analysts have been cutting the investment banks' profit projections in recent weeks in anticipation of weak earnings reports.
Goldman Sachs Group Inc. may take as much as a $3.1 billion haircut as it writes down the value of assets tied to subprime mortgages and leveraged loans, cutting earnings by 24 percent, according to credit research firm CreditSights. Lehman Brothers Holdings Inc. could see its earnings sliced in half due to an estimated $2.8 billion write-down, while Bear Stearns Cos. could see a $696 million write-down, which could knock down earnings by 23 percent.
Although those estimates are eye-popping, no one really knows for sure what will happen when the quarterly reports start coming in Sept. 18.
“These are not people who will just say 'We blew it,' “ said Lynn Turner, former chief accountant of the Securities and Exchange Commission and now an independent consultant. “They don't like putting out bad news unless they have a good reason or an excuse.”
Turner says accounting rules could enable the banks to report better results than anyone is expecting. That's because they have the discretion to determine the market value of certain parts of their credit portfolios.
Put simply, the banks can adjust the value of their assets each quarter by assigning a price to them based on what the marketplace commands for similar assets. The process is known as mark-to-market, and it's not complicated as long as there is something that can be used as a benchmark.
That's not what's happening now, however. There is no market for many of the mortgage-backed and other securities hit hardest by the credit crunch. That means the bank leaders have to rely on financial models or their best guesswork to determine what such values might be.
It's like shooting ducks in a barrel, but with a blindfold on: Sometimes, with luck, you'll hit one; most times you won't.
“Mark-to-market works just fine as long as you have an active and reliable market,” said Alex Pollack, a resident fellow at the American Enterprise Institute, a Washington-based think tank. “But when you have no market, then what does mark-to-market really mean?”
The effect on earnings comes when companies then create reserves, or financial provisions, to cover potential loan losses.
For instance, before writing down a loan, the banks must determine whether the decline in value is “other than temporary” – meaning it has little chance to recover but is not permanently impaired. “That's absolutely a judgment call,” said Lehman Brothers accounting analyst Robert Willens.
Given the complicated financial instruments involved, it might be difficult for the companies' auditors to know what there is a market for and what there is not.
The banks have plenty of incentive to delay the bad news for as long as they can – and try to ride out the current financial storm with as little damage disclosed to investors as possible.
Should the Federal Reserve begin to cut interest rates next week, that could breathe some life back into credit and mortgage markets. Over time, that could pump up the value of some of the banks' troubled assets.
The good news is that some in the banking industry – including Deutsche Bank CEO Josef Ackermann – are reminding their peers why giving the news straight up is the way to go. They say proper valuations and more comprehensive disclosure about credit exposure could be key to reviving investor confidence in the market.
It's in the banks best long-term interest, too. If investors fear that there is more trouble lurking in the banks' portfolios, they could steer away from buying those already battered stocks. Most of the investment banks have seen much sharper share-price declines than the broader market since the turmoil began in mid-July.
Shares of Bear Stearns and Lehman, for instance, are down more than 20 percent since July 19, while the Standard & Poor's 500 index is off 5 percent.
Of course, that could be an incentive for them to hide the bad news.
There have also been calls on banks to adopt a common methodology to adjust their assets to current market values, which could make it easier for investors to compare on bank to the next.
It's probably too late for any industry-wide fix this time. U.S. investment banks will begin to report in a matter of days. Be warned: What you see may be a sugarcoated version of earnings.