Tuesday, February 16, 2016

"Window Dressing".....

Isn't "Window Dressing" a nice, fun, cute term?  In the good old days it used to mean that financial managers would sell off their mistakes just prior to quarter/year end, keeping the details of their folly off the financial statements, burying the minutiae in "other income/expense" and perhaps include a cryptic footnote or two describing, in no great detail, the relatively immaterial events comprising the need for the aforementioned "Window Dressing" in the first place.  Investors and shareholders wouldn't see (or apparently care) how misguided some of their decisions had been during the accounting period.  After all, that's what the footnotes buried deep in the financial statements were for. The footnote disclosure would meet the bare minimum financial reporting standards and nobody, unless they were forensic accountants, would be the wiser.  In any case, in the good old days, the transactions were closed, finalized, completed and relatively small.  All would be right with the universe.

As most of you know, my game plan for successful, long term investing is as follows:

1.) Look for huge, unexpected events.
2.) Investigate and try to understand these events as best as possible.
3.) Adjust holdings/strategy accordingly.

Given the above, I ran across this curious schedule from the NY Fed in a Yahoo! Finance post from Jared Bilkre which I would consider a "huge unexpected event".  Apparently, on 12/31/15 the FED sold $475 Billion worth of collateral (Treasury Repos) to the banking system "overnight" to be "returned" the next day.  This figure was $306 Billion more than 12/31/14 and roughly $375 Billion more than the historical average daily supply required by the US financial system.



The question that immediately came to mind was "Why does the demand for Treasuries accelerate so much at quarter and year end?"  The US financial system apparently requires $475 Billion, nearly the equivalent of the market-cap/value of Apple, in Treasuries, overnight on 12/31/15?  Hmmmmmm.....

If you'd like to learn about the Repo Market I've attached a number of links which describe accounting and process.  For the purpose of this post, let's just say Repos are the life blood of the banking system, providing cash in exchange for collateral as needed. The banking system can't function efficiently without it.  It's fascinating and extremely complex, but a full  understanding isn't necessary for what we're talking about here

That said, here's a top level diagram from the NY FED that describes the market structure.


Again, there's no need to fully understand the above for the purposes of this post.  There are two "clearing banks" (JPM and Bank of NY Mellon), 163 firms with direct access to the FED Repo Facility and thousands of Financial Institutions, Funds and Investors providing/receiving Cash/Collateral within the system.   All of these "counter-parties" can exchange cash for collateral or visa versa as their needs/desires dictate.  There are, of course, transaction costs and "haircuts" which generally increase based on the perceived riskiness of the collateral. I've included the diagram only to illustrate how collateral is exchanged for cash, at lightning speed, throughout the financial system

Now, let's have a little fun with Repos and see how they might apply to "Window Dressing" today.

Hypothetical Phone Conversation - Early December 2015

The following hypothetical phone conversation may have taken place between a Money Manager (aka Mike) and a Banker (aka Dave) sometime in December of 2015.  I've included the translation output from my the Dick Fuld-Banker-Speak Translator (BST) in italics below the actual dialogue:

Banker (Dave) "Hey Mike, Happy Holidays, how's it going, hope all is well!"
BST "This guy is a mess.....I'm surprised he's not out of business by now..I half-figured that his phones would be shut off."

Money Manager (Mike) "Thanks for calling Dave, what can I do for you?"
BST "Dave is a pain, but he knows his stuff, I wonder what he's up to now?..."

Banker (Dave) "I just wanted to let you know that I've been working with a number of money managers to help them clean up their financials as we approach year end.  Our Program is getting rave reviews and we'd like to open the program up to you if you need it."
BST "Mike would be a moron to turn this offer down.  I know he's got a balance sheet full of il-liquid junk.  If he discloses it, his investors will bail and he'll be the next Third Avenue."

Money Manager (Mike) "Well Dave we really don't need to clean anything up, we're rock solid, but just for my education, how would your program work?"
BST "Geeeezzz .....I hope this isn't BS.....I've been looking for a way out of this mess for a while now.  I've got $100 million of absolute crap I can't get rid of on the books and my Investors are going to blow a gasket if they figure it out.  I don't want to end up like Third Avenue."

Banker (Dave) "It's pretty simple, it's a Repo and a reverse Repo, we buy some of your less liquid assets and exchange them for Treasuries.  Instead of reporting the value of the troubled assets on your financial statements, you report the same value as a loan payable to us and Treasuries.  No gain or loss is recognized as of 12/31/15 and the transactions and ownership of the securities reverse the next day.  Everything goes back to the way it was.  Your fees and financing costs are minimized since it's just an overnight deal. You just need to provide some footnotes per FASB 140 and ASC 860. In other words you are "renting" a tiny chunk of our fortress-like balance sheet for a day. We've got unlimited access to the FED Reverse Repo facility, $2 Trillion dollars.  I can send you our summary and opinion from our lawyers if you'd like.  Everybody is doing it.  I'm just trying to help.....What could possibly go wrong?."
BST  "I'm going to get this knucklehead to pay me some significant fees for a virtually risk free overnight loan.  He's screwed.  It's either pay me or liquidate.  We paid big bucks to find some obscure dink-water lawyers and accounts to come up with a favorable opinion on this thing....but hey, I'm just selling it.  Nobody ever goes to jail for this stuff.  Easy money baby...."

Money Manager (Mike) "Really?....I don't think we need it but it sounds interesting, yes please send me the documents & I'll have my lawyers and accountants look them over...this isn't one of those Lehman "Repo 105" scams is it?  It's legit? Right?
BST "I don't trust this guy as far as I can throw him....but he seems to have an answer for everything.  I hope this jerk doesn't screw me over somehow."

Banker (Dave) "Of course it's legitimate.  As I said, this program absolutely conforms to the post Lehman FASB rules for Repo Accounting and satisfies the "control" requirements of ASC 860."
BST  "It's actually the same as Repo 105, but we're changing the contract to meet the risk and control requirements of ASC 860, but that shouldn't matter to you.    Besides the FED has our back, we've got virtually unlimited overnight credit."

Money Manager (Mike)  "So we do the Repo on 12/31/15 and everything goes back to the way it was the next day? Having all of those il-liquid assets on your balance sheet at year end doesn't hurt your Capital Ratio?  And we can do it again on March 31st? June 30th?"
BST  "Are you kidding me?  I never have to disclose all of the crap on my NQ and in my Financials?  I've got some time to dig out of this mess?  You are the Man!"

Banker (Dave) "Yes, for you Mike, it's an open facility.  I'm not making this offer to everyone, just our best clients.  Our Balance Sheet is your Balance Sheet.  We're so big and fortress-like that these Repos are a rounding error on our balance sheet.  They don't even need to be disclosed in detail.  We just report a Lump Sum "Level 3 Assets".  Access to the FED does indeed have it's benefits  I'll send you the documents"
BST "I'll make this offer to any desperate dufus who'll pay my gigantic fees and accept my huge margin/haircut requirements.  Our accountants and lawyers will find a way to bury this.  They always do exactly what we tell them to do. Otherwise we'd find different accountants and lawyers."

Money Manager (Mike)  "Sounds great....Looking forward to working with you...talk to you soon."
BST  "You better not be screwing with me...." 
Click....

Banker (Dave)  - Dialing Phone "Hey Mark.....how are things going at the XYZ Fund....do you have a minute?"

Repeat the above call thousands of times at dozens of Banks/Dealers .......

So here's a diagram of how the above described transaction might work as well as what the Balance Sheet and NQ might look like for Mike's Fund after Dave the Banker gets a hold of it:






Of course, in "real life" the descriptions above won't be as obvious as "Il-Liquid Junk" and the haircuts, interest rates and fees would be applied to the transaction as market conditions dictate.  The above simply gives us an idea how Dave and Mike might hypothetically "Window Dress" their year end numbers.  Lehman brothers did the same thing, until, of course, they couldn't.  Isn't Window Dressing fun?  

In "real life", the terminology would look like cryptic codes that only industry experts would know (or should know) are "il-liquid Junk". Below are a few footnotes from the Third Avenue filing.  Note how the words "restricted" and "pledged" are used in the footnotes.  These may or may not be buzzwords for "It's on our balance sheet but we don't own it".  The point is, it's getting more difficult to tell.


(k)A portion is segregated for future fund commitment.
(l)Includes restricted cash pledged to counterparty as collateral management for forward foreign currency contracts.

(e)
Security subject to restrictions on resale.  At July 31, 2015, these restricted securities had a total market value of $92,323,647 or 4.40% of net assets of the Fund.

For reference, I've also posted (below) links to FED docs showing the securities that qualify as FED collateral and the corresponding average haircut each security generally requires. Note that there is an active, liquid market for each of these security classes.  The higher the perceived risk of a change in value, the greater the haircut. (margin).  There are, of course, no "Level 3" assets on the FED's list.  Level 3 Assets  (Which. in my opinion, usually should have been written off to zero ($0.00) are trapped, albeit for a day, on the Balance Sheet of the Big Reliable Bank (BRB).  But in most cases, this is dismissed as a rounding error because it's only a small fraction of the BRB assets.  Everyone makes mistakes...right?

So what?..... 

So there might be some mutual funds that are monkeying around with their financial statements.  So what? Window Dressing has been going on for years.  The FED put the Repo/Reverse Repo facility in place to provide liquidity and ostensibly make the financial system safer.  In fact, they just increased the facility limit from $300 Billion to $2 Trillion.   So what's the problem?  As always, everything works just fine until it doesn't.

Now, to illustrate, let's go back to the Lehman Brothers case study and their infamous "Repo 105/108's".  The quick description of these securities, in Steve Carell's words, is that they are overnight loans of "dog-shit wrapped in cat-shit" disguised as sales (with an associated profit) of 105% or 108% of the (probably) inflated book value of the DsWICs.  These Window Dressing transactions would be reversed in later accounting periods. The chart below describes what happened to Lehman's liquidity once nobody on Wall Street wanted to let them play in their sandbox.  An astonishing thing happens once counter-parties begin to suspect that they might not get their money/collateral back.  In Lehman's case, once the other kids decided that they didn't want to play anymore, Lehman lost its' ability to keep its' window-dressing going.  As you can see, the end was swift, but far from painless.  



Moreover, the FED's Examiner's Report described that more than $50 Billion of this type of window dressing was taking place on the LEH balance sheet, the equivalent of about 2x stockholder equity at he time.  After the fact, the Wall Street Journal reported that many banks had been quietly admitting that, like Lehman Brothers, they too had been using a Repo 105/108-like strategy to lower their leverage at quarter end. Citigroup, Bank of America and Bank of New York Mellon all used short term loans to temporarily reduce their holdings, while classifying the transaction as sales.

If you've ever been in a closed door management meeting where the discussion topic morphs into a round table investigation of what sort of financial engineering might be deployed to properly goose earnings and meet the quarterly numbers, you know exactly what I'm talking about.

Obviously, given the $475 Billion demand for Treasuries on 12/31/15 we can ask the question "so what the heck is going on?"  The obvious concern here it that the FED may believe that it has created a wonderful device to provide short term liquidity to the financial system, when in reality, it has provided a terrific tool for troubled mutual funds and banks to Window Dress their il-liquidity and hide all of their mistakes from their investors.


Goldman Sachs

Now....Given all of the above.....let's take a look at two very interesting, recently filed, Goldman Sachs documents.  In January, Goldman filed its' 2015 8-k Financial Summary reporting $71B Tangible Shareholder's Equity and $24B in Level Three Assets.  If we use my rule of thumb, that, in all probability, Level Three Assets should be written off, that puts Goldman's Tangible Shareholder's Equity at $47 Billion with a corresponding debt/equity ration of 18:1.  In other words, an accounting entry/write-down, impairment or devaluation of only 5.2% on its balance sheet assets would mathematically wipe out all of Goldman's Tangible Shareholder's Equity (Book Value).  Of course, history (2009, 2000, 1997, 1987, etc.) has shown that these banks somehow magically "link" their asset values with associated liabilities and are able to shed liabilities almost as quickly as the asset values decline, so the relationship isn't 1:1.  It's impossible to tell what the ratio is, but the destruction of book value doesn't track the reduction in asset values on a dollar for dollar basis.  That said, I don't think I have to mention (but I will) that volatility has been a bit spikey lately.  Japanese, Hong Kong, Chinese and other EM markets are routinely moving more than 5% on any given day, in any given direction right now, so whatever positions GS has in those assets, let's all hope, for the sake of the banking system that they are safe/hedged and at least relatively insulated from the fray.

The second document referenced above is the "Settlement in Principal with the RMBS Workgroup". This document describes the $5.1 Billion settlement for wrong-doing related to the 2009 Financial crisis.  The Banker Speak-Translator (BST) would simply describe this fine as a "cost of doing business".  So we might conclude, at least from past indiscretions, that Goldman doesn't exactly stake a claim to the summit of moral ground when it comes to making a quick buck.

That said, I've heard people say lots of things about Goldman Sachs over the years, but I've never heard anyone say anything like:

"Wow....those guys at Goldman are really a bunch of dopes....we really took those clowns to the cleaners on that deal."

Goldman Sachs, no matter what your opinion of their business practices, is always on the leading edge of everything and anything that happens in the financial markets. Whether it's "Portfolio Insurance", dot.com IPO's, Mortgage Backed Securities or the China Dream, Goldman Sachs, more often than not, is usually the first one to the party on most of these scams....um...uh....I mean "investment opportunities".


Today's Question

Is it more likely that Goldman somehow made a series of mistakes and got stuck with $24 Billion in Level Three Assets?;  or is it more likely that these assets are actually misguided window dressing for other mutual funds or money managers, and are sitting on Goldman's balance sheet for a few days until the coast is clear?  Moreover, could they be leading the charge on an unprecedented level of financial subterfuge that will only become apparent once the dust clears.  After all, there are plenty of potential Window Dressing customers out there.  Nobody wants to be the next Third Avenue, although it's becoming more likely by the day that these liquidity/redemption problems will be rearing their ugly little heads.

Finally, I'm not specifically picking on Goldman Sachs or accusing them of anything.  I'm working on a post which should provide more empirical evidence as to where this window dressing phenomenon is most likely be concentrated and how relatively widespread it might be.  Of course, this one is tough to prove. Obviously, nobody is talking about it....that would be counterproductive. Like Lehman's Repo 105's, the entire scheme depends on its secrecy.  Anyway.......Stay tuned.



Other light reading.....

2015 8K (Financial Summary) - $71B Tangible Shareholder's Equity and $24B in "Level Three" Assets
http://www.sec.gov/Archives/edgar/data/886982/000119312516433035/d84817dex991.htm

Settlement in Principal with the RMBS Workgroup
http://www.sec.gov/Archives/edgar/data/886982/000119312516430087/d119173dex991.htm

2014 8K (Financial Summary) - $69B Tangible Shareholder's Equity and $36B in "Level Three" Assets
http://www.sec.gov/Archives/edgar/data/886982/000119312515012516/d846191dex991.htm

FASB Repo Accounting
http://www.fasb.org/cs/ContentServer?pagename=FASB%2FFASBContent_C%2FNewsPage&cid=1176164127256

PWC ASC 860 - Executive Summary
http://www.pwc.com/us/en/cfodirect/assets/pdf/accounting-guides/pwc_transfer_2013.pdf

FASB ASC 860 - Grant Thornton Analysis
http://www.grantthornton.com/staticfiles/GTCom/Audit/Assurancepublications/New%20Development%20Summaries/NDS%202010/NDS%202010-32.pdf

More on Leh repo 105
http://blogs.wsj.com/deals/2010/05/27/the-repos-of-citigroup-and-bofa-honest-mistakes-or-window-dressing/

Epstein - Lehman Repo 105
http://www.ifrsaccountant.com/articles/repo-105-lehman-accounting.html

Yahoo! Finance post from Jared Bilkre
http://finance.yahoo.com/news/-475-billion-year-end-fed-auction-suggests-more-problems-in-credit--mutual-funds-023901085.html

NY FED - RRP Markets
https://www.newyorkfed.org/markets/rrp_faq.html

Counter parties - Primary dealers
https://www.newyorkfed.org/markets/pridealers_current.html


Expanded counter parties
https://www.newyorkfed.org/markets/expanded_counterparties.html

http://www.pragcap.com/window-dressing-with-feds-reverse-repo-program/

Zero hedge
http://www.pragcap.com/window-dressing-with-feds-reverse-repo-program/

Yahoo finance
http://finance.yahoo.com/news/-475-billion-year-end-fed-auction-suggests-more-problems-in-credit--mutual-funds-023901085.html

Tri party repo NYC
https://www.newyorkfed.org/banking/tpr_infr_reform.html

Ny fed presentation
http://www.bis.org/events/cpss_wspsmi/fahymartin_pres.pdf

NASDAQ/NYSE - Company/Symbol List
http://www.nasdaq.com/screening/company-list.aspx

http://people.stern.nyu.edu/jcarpen0/courses/b403333/08repo.pdf

http://www.bis.org/events/cpss_wspsmi/fahymartin_pres.pdf

https://www.blackrock.com/cash/literature/whitepaper/understanding-repurchase-agreements.pdf

Fed reserve rept 2013
https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr529.pdf

http://www.federalreserve.gov/monetarypolicy/files/pdcf_margins.xls

Third ave - footnotes on window dressing in the fine print
http://www.sec.gov/Archives/edgar/data/1031661/000134100415000918/form40-app.htm

Third Ave Language
(k)A portion is segregated for future fund commitment.
(l)Includes restricted cash pledged to counterparty as collateral management for forward foreign currency contracts.
(e)Security subject to restrictions on resale.  At July 31, 2015, these restricted securities had a total market value of $92,323,647 or 4.40% of net assets of the Fund.

http://www.reuters.com/article/us-usa-fed-reverserepos-idUSKBN0UE18Q20151231


FED Temporary Open Market Ops by day
https://apps.newyorkfed.org/markets/autorates/tomo-results-display?SHOWMORE=TRUE

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