Chapter 16
IN THIS CHAPTER
Understanding how companies can manipulate accounting numbers
Seeing how investment bankers can identify accounting problems
Identifying potential accounting red flags
Understanding the importance of accounting assumptions
Developing a skeptical nature
The lifeblood of investment banking is the analysis of financial statements like the ones we introduce in Chapter 7 (for example, the income statement, balance sheet, statement of cash flows, and proxy statement). Even though each of these statements is prepared using the same rules — generally accepted accounting principles (GAAP) — and the financial statements are audited by independent accounting firms, like Alice in Wonderland, things aren’t always as they seem. A successful investment banker is part financial analyst and part detective. An inquisitive and skeptical nature is essential.
One of the fastest-growing fields related to the accounting profession is forensic accounting, which uses accounting, auditing, and investigative skills to essentially get behind a company’s financial statements and explain what’s really going on — what’s behind the numbers. Investment bankers need to draw on the principles of forensic accounting when counseling companies, preparing them to go public, and advising them on mergers-and-acquisitions (M&A) activity.
This chapter shows you some of the most common creative accounting methods that some companies employ to fool both investment bankers and investors into believing they’re performing better than they actually are. Of course, the primary motivation to mislead the markets is that executive compensation is tied to firm performance. Relatively minor improvements in earnings per share and stock price can mean added millions of dollars for executives of large, publicly held corporations.
There are tremendous temptations to represent a firm’s results in the most favorable light. Investment banking analysts and investors alike should do as Deep Throat advised Woodward and Bernstein to do: “Follow the money.” In this chapter, we provide examples from well-known and highly visible firms to illustrate the various methods that executives can use to mislead people. The financial improprieties commonly used by firms generally fall into one of the following categories:
In the pages that follow, we provide real-world examples of each of these accounting games. In several cases, the featured firm wasn’t simply engaged in one of these misleading practices, but was involved in multiple scams. Astute investment bankers need to be vigilant in order to identify these behaviors before they or their clients incur losses from investing in these firms.
It would seem pretty straightforward to identify when a sale has been made. When you have a yard sale and get rid of an old box of baseball cards or the fondue set your crazy uncle gave you as a wedding present, you likely consider the sale consummated when the buyer hands you the cash and walks off with your unwanted items.
In the corporate world, however, things aren’t as simple as transactions in yard sales. What if someone comes to your yard sale and promises to pay you tomorrow for your items? What if you send your items to someone who has simply expressed an interest in buying them? What if you send your items to someone who says he’ll try to sell them for you? Have the items truly been sold? Some corporate executives have stretched the limits of credulity in booking sales.
Dunlap earned the colorful nickname “Chainsaw Al” while at Scott Paper by firing thousands of employees, closing plants, and cutting costs to the bone. After downsizing Scott Paper and making it more attractive to suitors, he engineered the 1995 sale of the firm to Kimberly-Clark and personally parachuted off with a lucrative cash payout of over $100 million.
Sunbeam — maker of grills, blenders, bread makers, coffee makers, microwave ovens, and many other consumer products — hired Dunlap shortly after he left Scott Paper, and it appeared that his methods were very successful in turning Sunbeam around. Shortly after Dunlap assumed control, Sunbeam went on a buying spree, acquiring several well-known brands; the stock price soared. In 1996, when he took the company over, it had reported negative net income and in 1997 it reported large positive net income — an impressive turn of events. Dunlap’s reputation was burnished, and he was lauded as a hero. Or was he?
Typically, businesses produce inventories, sell them to firms on credit (resulting in an account receivable), and finally collect on that account receivable by getting the cash. If a firm is growing, all those accounting line items should be growing by approximately the same rate. If inventories and accounts receivables are growing faster than revenue, then either customers are paying awfully slowly or inventory is piling up — both developments that signal problems.
Sunbeam overstated revenue by aggressively booking sales. Reported net income did increase in 1997, but cash flow was decidedly negative — the grills were sitting in Sunbeam’s warehouse and not generating cash. An examination of Sunbeam’s statement of cash flow revealed that Sunbeam had positive net income in 1997, yet actually had negative cash flow. This was exactly the opposite situation as occurred in 1996, when the firm had negative net income but positive cash flow. This turn of events was alarming. As any businessman knows, you can’t pay bills with inventory — you can only pay bills with cash.
Dunlap was fired in 1998, and the Securities and Exchange Commission (SEC) investigated and determined that, for 1997, at least $60 million of Sunbeam’s reported $189 million in earnings from continuing operations before income taxes came from accounting fraud. The SEC issued a consent judgment against Dunlap, and he was permanently barred from serving as an officer or director of a public company. Sunbeam declared bankruptcy in 2001 and emerged from bankruptcy in 2002 as American Household, Inc., a privately held company. In 2009, Condé Nast Portfolio named Dunlap the sixth worst CEO of all time. Just imagine: There are five CEOs worse than he was!
Satyam was founded by Ramalinga Raju with a handful of employees in 1987. As outsourcing to India became popular, Satyam rode the wave and grew to be one of the largest and most celebrated firms in India. It employed more than 50,000 people and was listed on both the New York Stock Exchange and Bombay Stock Exchange. At its peak, the market capitalization of Satyam was over $9 billion, and the firm, as well as Raju, enjoyed a sterling reputation as one of India’s business titans.
The high-flying firm came crashing down when it was found to have allegedly falsified revenue, income, and the level of interest-bearing deposits over an extended six-year period from 2003 to 2008. Skeptical investment banking analysts could’ve examined the reported numbers and clearly seen that something was rotten in the state of Denmark — or in this case, in the city of Hyderabad, India.
Just like the case of Sunbeam (see the preceding section), Satyam’s revenues were growing rapidly — in this case, despite the slowing of the world economy due to the financial crisis that began in 2007. Specifically, revenues in 2008 were reported to have risen by an astonishing 46 percent. That would certainly be a good thing if the growth were real. The problem is that accompanying this shocking revenue growth, three accounts receivable items on the balance sheet — short-term trade receivables, long-term trade receivables, and unbilled revenue — were all growing at a pace much higher than revenue.
The rapid growth of the receivables and unbilled revenue accounts certainly indicated a problem. At best, it said that Satyam was doing a poor job of collecting its receivables; at worst, fraud was highly likely. However, the most unusual item on the balance sheet was an amount that was reported separate from cash — investments in bank deposits. It’s quite unusual that this would be broken out from cash, and it’s an indication that perhaps the auditors were provided with different documentation for these accounts than they normally see for cash. Suffice it to say, there certainly must have been a reason this amount was treated separately. The increase in the receivables accounts plus the odd cash-like account amounted to nearly $375 million. According to the SEC lawsuit on this matter, Satyam allegedly overstated revenue by over $430 million in 2008. This overstatement of revenue resulted in an overstatement of assets and provided the warning signs that “the truth” was far from it.
U.S. President James Garfield (or maybe it was Mark Twain) once said, “The truth will set you free, but first it will make you miserable.” This is an accurate depiction of the unraveling of the Satyam scandal. In a letter to the board of directors of Satyam in early 2009, Raju confessed to this elaborate accounting scam and admitted that he falsified accounts and dramatically inflated the financial position of Satyam. The firm was eventually sold via a public auction process, and Raju was disgraced.
One of the most basic principles of accounting is the matching principle. GAAP are based on the premise that a company should match expenses incurred to produce revenues with revenues in order to accurately report a company’s profitability during a specific time period.
At the most basic level, garbage disposal is a fairly simple business, one that doesn’t appear on the surface to be particularly ripe for abuse. Firms in this business collect and dispose of rubbish. Among other assets, Waste Management owns garbage trucks and landfills. However, in the late 1990s, profits were allegedly inflated to the tune of $1.7 billion by some fairly unsophisticated accounting machinations that went undetected by corporate auditors who were asleep at the switch. So how did the executives at Waste Management pull off a multi-billion-dollar fraud?
Garbage trucks are assets the value of which is used up, or depreciated, over time. Companies must estimate the useful lives of their depreciable assets and take annual charges to recognize that those values have declined. If a garbage truck costs $100,000 and can be expected to be used for ten years and have no residual or salvage value, then the firm is required to take a depreciation charge of $10,000 per year to account for the decline in value of the truck. This isn’t a cash expense and doesn’t require any outlay of funds, but the charge will reduce net income before taxes by $10,000. If a company wanted to make net income appear better in the current year, it could depreciate the truck over a longer period — say, 20 years — and the reduction in net income before taxes would be only $5,000. This is exactly what Waste Management did. It simply extended the assumed useful lives of certain assets to an unsupported age.
As if that weren’t enough, Waste Management also failed to account for some other expenses that are common in the waste-disposal business. A landfill is an asset of a waste-disposal company. But, as the landfill gets increasingly filled with garbage, the value of the landfill declines. In addition to overstating the useful lives of its garbage trucks, Waste Management also failed to account for the fact that its landfills were filling up. It should’ve been taking charges against the value of the landfills. Those charges would’ve reduced net income and made the firm appear less profitable.
The SEC investigated Waste Management, and the firm principals agreed to a settlement that involved multiple millions of dollars in payments and banned the executives from serving as officers or directors of any public company. The firm’s auditing firm, Arthur Andersen, was also fined by the SEC for being complicit in the fraud.
Things changed dramatically in just a few years. By 1989, the firm was in bankruptcy, and Antar fled the country. He was later caught and sentenced to eight years in prison. So what happened and what were the clues that analysts could’ve used to determine that Eddie was not only crazy but also perpetrating a fraud?
The accounting game that Antar was playing involved understating the cost of goods sold — the cost of the stereos and eight-track players (do you remember eight-tracks?) that the firm was selling — thus, overstating his profits. In fact, Crazy Eddie overstated inventory by $65 million — more than the cumulative profits since the company went public — in order to report higher profits, please his shareholders, and line his own pockets. The overstatement of earnings resulted in an overstatement of owners’ equity. The accounting equation balanced because inventory was also overstated, and no one was the wiser.
The two previous accounting tricks — overstating revenue and understating expenses — are both involved primarily with the income statement providing a misleading representation of net income. Firms also have been known to do things to overstate the value of their assets or understate the value of their liabilities, making their balance sheets appear stronger than they actually are.
One of the biggest crises facing many city and state governments is the future pension and health benefit obligations of workers. Quite simply, these governmental entities have promised more future benefits than they likely will be able to deliver. And these benefits to retired (and soon to be retired) schoolteachers, firemen, policemen, and other government employees are staggering in relation to the budgets of these government entities. While the pay of government workers is typically lower than their corporate counterparts, many people agree to work for these entities because the benefit packages are so attractive.
Simply put, in a defined benefit plan the employer bears the risk that the investments set aside in the plan will be enough to cover the obligation. Any shortfall must be made up by the corporation. On the other hand, in a defined contribution plan, the employee bears the risk of underperformance and may find she doesn’t have enough money to fund her retirement and may face the prospect of subsisting on macaroni and cheese and Ramen noodles into her golden years.
Accounting for both the pension assets and pension liabilities require several assumptions to be made. These estimates require the work of actuaries (business professionals who deal with the financial impacts of risk and uncertainty). (There is no truth to the rumor that actuaries are people who really wanted to be accountants but didn’t have the personality for it.) Total employer contributions to a defined benefit plan are very complex to determine because they depend upon a myriad of factors, including the length of time retirees will, on average, live. The assets of a defined benefit plan are held in a pool, rather than in individual accounts for each employee. Once established, employers must continue to fund the plans, even if the company has no profits or loses money in a given year. Because the employer makes a specific promise to pay a certain sum in the future, the employer assumes the risk of fluctuations in the value of the investment pool.
The expected (or assumed) rate of return on defined benefit pension plans is found in the notes to financial statements in the annual reports and 10-Ks companies distribute to investors. Table 16-1 provides a sample of the expected rate of return on defined benefit pension plans for four large publicly traded companies. You can see how dramatically different the assumptions are. And keep in mind that a difference in the assumed rate by just a few basis points can mean a difference of many millions of dollars. Note that Johnson & Johnson uses much more aggressive return assumptions than Intel and Walt Disney. Is there any reason to believe that Johnson & Johnson will earn a much higher return on investments than Intel or Walt Disney will?
TABLE 16-1 Assumed Rates of Return on Pension Plan Assets
Year |
Coca-Cola |
Walt Disney Company |
Intel |
Johnson & Johnson |
2018 |
8.00% |
7.50% |
4.70% |
8.46% |
2017 |
8.00% |
7.50% |
4.60% |
8.43% |
2016 |
8.25% |
7.50% |
5.50% |
8.55% |
The assumed rates of return on pension assets give you a clue about how conservative or aggressive the firm is being in the current year, because this assumption affects current period earnings and the income statement. Another assumption that must be made with respect to defined benefit pension plans is the discount rate used to determine the total pension liability.
The net pension liability (total pension liability less accumulated plan assets) appears as a liability on the balance sheet. The higher the discount rate being assumed to discount future pension liabilities, the lower the value of pension liabilities will appear on the balance sheet. So, if a firm wants to make its financial position appear stronger, it will assume a higher discount rate to apply to pension liabilities. Firms cannot simply pull these assumptions out of thin air. The discount rate should reflect economic realities — specifically, if interest rates in the government bond market are low and expected to remain low, it’s difficult to justify a high discount rate.
In Table 16-2, you can see how the four firms we profile in Table 16-1 differ with respect to the discount rates they apply to pension liabilities. While Intel made, by far, the most conservative assumptions regarding assumed rates of return, the firm made the most aggressive assumptions of our small sample group regarding discount rates. Still, the spread in 2018 between the assumed rate of return and the discount rate for Intel was only 1.7 percent (that is, 4.70 percent minus 3.00 percent). The largest spread between assumed rates of return and the discount rate was Johnson and Johnson’s 4.70 percent. When compared to other very large corporations, Intel appears to be toward the more conservative end of valuing pension assets and determining long-term pension liabilities. There’s a reason for Intel’s conservatism. Of the 200 biggest defined benefit pension plans in 2017, Intel’s plan was the most underfunded. Intel is adopting relatively conservative assumptions because it needs to close the funding gap. Apparently in the past, the firm didn’t take such a conservative stance.
On the other hand, Johnson & Johnson had the most aggressive assumptions with respect to the combined impact of assumed rates of return on pension assets and discount rates used to determine pension liabilities. Given that Johnson and Johnson’s pension funding ratio (that is, plan assets as a percentage of projected benefit obligations) is slightly below the average for S&P 500 companies, a closer look by skeptical analysts may be warranted. And it is certainly something to closely monitor moving forward.
TABLE 16-2 Discount Rates Used to Determine Pension Liabilities
Year |
Coca-Cola |
Walt Disney Company |
Intel |
Johnson & Johnson |
2018 |
3.50% |
4.31% |
3.00% |
3.76% |
2017 |
4.00% |
3.88% |
3.20% |
3.30% |
2016 |
4.25% |
3.73% |
3.30% |
3.78% |
How extensive is the problem of underfunded pension plans largely due to unrealistic return assumptions? According to the actuarial firm Milliman, in mid-2019, total pension deficits in the 100 largest corporate defined benefit pension plans was around $219 billion, and the average plan was considered 88 percent funded. Further evidence from Bloomberg reported that of the 200 biggest defined benefit pension plans in the S&P 500 based on assets, only 14 are fully funded. It isn’t only states and municipalities that have a pension problem.
WorldCom had a number of accounting improprieties (too numerous to describe, including making personal loans to Ebbers to fund his margin calls on WorldCom stock), but the fraud that was the ultimate undoing of the firm was largely based upon a very simple notion: Expenditures were classified as long-term investments and capitalized instead of simply being charged to the current period as the routine expenses that they were. Specifically, the firm took normal expenses (in this case, line costs, the fees paid to other telecommunications companies for the use of their lines and satellites) and recorded them as increases in assets (property, plant, and equipment) rather than expenses. To unsuspecting investors and analysts, it appeared that the company was growing its asset base by investing in long-term assets that would be productively used for many years to produce revenue. Instead, WorldCom was simply paying “rent” for the use of the lines and satellites of other firms. The analogy to personal finance was that WorldCom was renting an apartment but booking the rent payments as equity in the apartment.
A common size analysis of WorldCom’s income statements across time shows that line costs as a percentage of revenue was steadily declining over time — falling from around 55 percent in 1996 to around 40 percent in 2001. At the same time, property, plant, and equipment as a percentage of assets had risen from roughly 20 percent in 1996 to over 45 percent in 2001. Couple that with the fact that WorldCom’s chief competitors had line costs as a percentage of revenues that were fairly constant throughout the same period, at around 50 percent and, in retrospect, it’s easy to see the game that the company was playing.
The message of the WorldCom debacle is that simple tools and a skeptical nature can lead the investment banker to the heart of the matter. Yet the scam wasn’t uncovered until many investors had lost a great deal of money, investment banks had lost some reputational capital, and auditors had come under fire.
You would think that by looking at a company’s balance sheet, you would get an accurate picture of all the firm’s assets and liabilities and, as a result, you’d have a good idea of how financially strong the company is. Unfortunately, that isn’t always the case. Firms often use accounting machinations to remove some liability items from the balance sheet — by using off–balance sheet financing or creating off–balance sheet entities — in order to make the firm appear stronger. (It’s ironic that these transactions are called “off–balance sheet,” because often both the intent and the result is to keep investors off balance. We’ll be here all night!)
What’s an example of off–balance sheet financing? Companies often choose to rent rather than buy capital assets such as equipment or trucks. This is done through an operating lease, and the company is allowed to record only the rental payments, and not the whole cost of the asset on its financial statements as a liability. By keeping both this asset and debt off the balance sheet, the company looks more attractive — it seemingly has more debt capacity — and serves to understate the true indebtedness of the firm.
The following case studies present examples of the use of off–balance sheet items and describe some clues to alert investment banking analysts to potential problems.
Enron was a Houston-based energy and commodities corporation that, like WorldCom, was a Wall Street favorite and appeared on many investment firms’ buy lists. Enron began as a relatively simple natural gas company and evolved into an extremely complex firm that had holdings in, among other assets, pipelines and power plants, and placed huge bets in energy markets. The firm was lauded as being innovative right up until the time that the fraud was uncovered. In fact, Fortune magazine named Enron the most innovative company for six consecutive years. Unfortunately, it was the accountants and financial managers at Enron who were really innovative.
An operating lease is a relatively simple example of off–balance sheet financing, but the creation of special-purpose entities (also known as special-purpose vehicles) is a more complex version of off–balance sheet financing and one that played a role in many high-profile accounting scandals. A special-purpose entity (SPE) is most often a subsidiary company that, from a legal standpoint, has its own assets and liabilities. It’s created by the firm by transferring assets to the special-purpose vehicle to carry out a defined purpose, activity, or series of transactions. The usual purpose is to finance certain assets or services. For example, an oil drilling company may set up an SPE to finance specific oil exploration projects. In effect, the SPEs have no purpose other than the transactions for which they are created. The legal form for these entities may be a limited partnership, a limited liability company, a trust, or a corporation.
Enron grew at a remarkable pace — from 1996 to 2000, revenues increased by more than 750 percent — and much of the growth centered around and was fueled by the creation and use of SPEs in a complex and dizzying array of transactions. In Enron’s case, the typical SPE was created to fund a specific project, like a pipeline, and keep the debt off the balance sheet. When the pipeline was transferred to the SPE, Enron would book the projected profits from the pipeline on its books, even if the pipeline wasn’t yet operational. Enron was engaged in hundreds of these types of partnerships.
But the real clue is in the note about related-party transactions. A related-party transaction is simply a business deal between two parties that are joined by a special relationship prior to the deal. There are many related-party transactions common to businesses that are wholly appropriate and innocent enough — for example, a company may hire the CEO’s brother-in-law to cater a corporate event. But the notes to the financial statements show that Enron was gorging on related-party transactions, and the related parties were the senior executives at Enron. In essence, Enron was partnering with itself. If this doesn’t scream conflict of interest, we don’t know what does. These arrangements allowed the firm to conceal and perpetuate the massive fraud. The following paragraph appears in the 2000 Enron Annual Report:
In 2000 and 1999, Enron entered into transactions with limited partnerships (the Related Party) whose general partner’s managing member is a senior officer of Enron. The limited partners of the Related Party are unrelated to Enron. Management believes that the terms of the transactions with the Related Party were reasonable compared to those which could have been negotiated with unrelated third parties.
Another explanation is that many analysts didn’t want to admit that they didn’t really understand Enron’s business model. The description that Enron itself provided in the 2000 Annual Report is several pages long and virtually unintelligible. If you can’t describe what a firm does in a paragraph or two, warning lights should flash. One credit-rating agency analyst, in reference to Enron’s business model, was quoted as saying, “If you figure it out, let me know.” When professional analysts admit they can’t understand a company, it’s time to abandon ship — especially when those analysts are charged with rating the creditworthiness of those firms.
The Olympus Corporation is a Japanese-based manufacturer of precision machinery and optical equipment — most notably cameras — and has a long and distinguished history. Founded in 1919, shares of Olympus traded on the Tokyo Stock Exchange, and American depository receipts (ADRs) of Olympus traded on the New York Stock Exchange. An ADR is a certificate issued by a U.S. bank that entitles the holder to a certain number of shares of a foreign stock. It makes it easy for U.S. investors to invest in foreign-based companies. So the Olympus scandal affected investors in both Japan and the United States.
In late 2011, it was discovered that Olympus had engaged in a series of complex maneuvers to allegedly keep a significant loss and, hence, a major liability off its financial statements since about 1990, making its financial position look better than it was for many years. It’s estimated that the loss was slightly less than 100 billion Japanese yen in 1990. For many years, Olympus kept the loss off its own books by transferring financial assets that had declined in value to a series of companies that were not consolidated into Olympus’s balance sheet. Like Enron, Olympus made use of SPEs. The loss was transferred by having these SPEs purchase the financial assets from Olympus at their accounting-book value rather than their lower fair-market value. The funds used by these other entities came from bank borrowing conveniently arranged by Olympus. What this meant was that Olympus didn’t report any gain or loss on the sale.
This may have continued without being uncovered, but in the late 1990s the accounting rules changed — largely as a result of other Japanese accounting scandals — such that Olympus now had to consolidate these outside entities on the corporate balance sheet. To keep the ruse going, Olympus had to allegedly devise a scheme to avoid recognizing the losses. Olympus management engineered a plan to purchase these entities back at a price much greater than their true value and recorded the excess of the purchase price over the fair value as goodwill. At the same time, Olympus overpaid for other acquisitions, apparently paying high “fees” that could be used to further obscure the losses. As an example, Olympus acquired the Cyrus Group in a $2.2 billion deal in 2008. In conjunction with this deal, Olympus paid the highest M&A fee ever — a staggering $687 million.
So effectively Olympus kept liabilities and losses off its books for many years (understating liabilities and overstating owner’s equity) and booked assets as goodwill to make the books balance. The jig was up when Olympus had to finally recognize a loss. But it didn’t give up without one last-gasp effort — it tried to label the loss as simply an impairment loss related to the numerous acquisitions.
The unique aspect of the Olympus case is that it went on for such an extended period of time. In the interim, there were many warning signs at Olympus that investment bankers chose to ignore. Certainly, the large amounts of goodwill on the balance sheet and the staggering M&A payment fee should’ve given even casual observers pause.
Everyone understands the concept of a trade or a swap. Youngsters trade baseball cards on the playground, and many economies are based on barter transactions in which goods or services or traded. In principle, credit default swaps are fairly simple transactions that are a type of insurance policy. The purchaser of a credit default swap pays a premium for protection against an adverse outcome — the default of a particular financial instrument. So, if that’s all they are, how did credit default swaps contribute so much to the financial crisis, and why has Warren Buffett referred to these derivative instruments as “weapons of mass destruction”?
Derivatives are simply securities whose value depend or are derived by the value of another asset. A call option on a share of stock is dependent upon the value of the share of stock.
When you think of an insurance policy, you think of being compensated for the potential destruction or loss of value of an asset that you own. For instance, when you purchase insurance on your car, you’re protecting yourself financially in case something happens to your car — like it’s stolen and destroyed or is damaged in an accident. Credit default swaps work like insurance policies. Let’s say you own some bonds issued by the government of France. You can purchase a credit default swap and, in return for premium payments, you’ll be paid off if the government of France defaults on those bonds.
However, there is one big difference: In the car and homeowner insurance markets you can only buy insurance on your own car or your own house. You can’t buy insurance on your neighbor’s car or your brother-in-law’s house. The purchase of insurance is a means to hedge your exposure to adverse events — to reduce your risk. Credit default swaps, on the other hand, can be purchased (and sold) by any entity, whether it has a position in the underlying asset or not. In this way, credit default swaps can be used to speculate on events. For instance, if you think that the government of France may default on its bonds, you can purchase a credit default swap that pays you if that indeed happens.
Investment bankers are a very creative lot and have developed credit default swaps on just about any asset you can imagine, including sovereign debt, mortgage-backed securities, and corporate debt. Investors can take either bullish or bearish positions on the creditworthiness of entities by selling or buying credit default swaps. By the way, this is how renowned hedge-fund manager John Paulson made billions during the mortgage crisis — he bought credit default swaps on mortgage-backed securities, betting that a significant number of mortgage holders would default on their obligations. When that happened, his insurance paid off handsomely.
Now, the interesting thing about derivative markets is that they are a zero-sum game. The party that was on the correct side of the contract wins, and the party on the other side of the contract loses an equal amount. If I buy a credit default swap and the underlying asset doesn’t default, I lose an amount equal to the premiums that I agreed to pay. The seller of the credit default swap pockets those premiums. If I buy a credit default swap and the asset defaults, I’m paid the difference of the expected value of the asset and what its liquidation value is. The potential losses of buyers of credit default swaps are limited to the premiums they pay, while the potential losses of sellers of credit default swaps can be virtually unlimited.
In the financial crisis that began in 2007, the big winners were those individuals and firms who bet against the mortgage market by purchasing credit default swaps on mortgage-backed securities. The big losers were those firms such as Deutsche Bank, Lehman, and American International Group (AIG) and clients of those firms who sold those same credit default swaps.
Selling credit default swaps is tremendously alluring for companies. The premiums they receive are immediately booked as revenue and increase the firm’s earnings in the short run, while the potential negative ramifications are generally far out in the future. Plus, many people at these firms that sold credit default swaps thought there was no way these securities would ever default. Some individuals at AIG thought of this as “free money” — they collected the premiums and never thought they’d have to pay out on defaults.
As an interesting aside, Buffett sold some credit default swaps on municipal bonds before the beginning of the financial crisis. They may be weapons of mass destruction, but if the Oracle of Omaha sees a profit opportunity, he has shown that he will act upon it.
The case studies in this chapter should serve as cautionary tales to encourage investment bankers to perform due diligence on the companies they’re working with. There are often time pressures to complete analyses and make decisions, and mistakes are most often made under duress. In addition to looking for the specific accounting manipulations presented in these case studies, investment bankers should heed a few timeworn axioms:
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