Disclosure? I Call B.S.
Disclosure and financial filings seem to be topical today with the S.E.C. announcing the Investment Banking Analyst Mercy Initiative. So, I’ll play ball. I have read a bunch of things recently making claims about the ability of a diligent investor to know what they are “getting into” and what the risks are for investing in a public company that has disclosure requirements. Actually, I haven’t been doing this for decades, so let’s quote someone that has… Tom Brown:
No one, inside or outside the company, could accurately predict what … ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general–is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.
I emailed Tom to clarify a few thing, but never heard back. So, as I am prone to do, I’ll assume I’m correct in my interpretation and move on. I’m assuming that this was also the case in the past–how else would people be able to buy into a financial institution in the past if Tom didn’t think his words were just as true two to three years ago? (Nothing has really changed in disclosure requirements, right?) Surely, in the past, the issue would have been taking a view on the performance of the various financial institutions’ assets as well.
I looked at three firms’ disclosure, from 2006, related to C.D.O.’s … what I could find. Now, in the interest of full disclosure, I’m not trained to do this. I’m just a person, with some financial experience, looking at some S.E.C. filings. I knew i was looking for C.D.O. exposure, especially in the context of figuring out what banks would need to be responsible for if the market had a severe dislocation. Let me explain what I mean by this. Remember all the liquidity put chatter? While mostly related to S.I.V.’s, this is still a relevant concept for C.D.O.’s. As in any syndicated deal, most common for selling bond or stock offerings related to corporations but also relevant for securitized products, when an investment bank agrees to do a securitization they have most likely (call it 80+% of the time) agreed to “take down” or purchase the securities they are unable to sell to investors. Easy enough, right? Those assets are what has generated a huge amount of writedowns. It’s very easy to see the relationship between market share in the C.D.O. and securitized products space and magnitude of writedowns.
These relationships, however, are very complex. Multiple investment banks could be selling an individual deal and each could be responsible for purchasing different parts or different percentages of leftover securitizations. These are individually negotiated for each transaction. As a firm is building up assets (for example, sub-prime mortgage-backed securities), before they have enough to actually securitize and create a C.D.O., the bank/investment bank could have all the risk of those assets losing value or defaulting–if the C.D.O. doesn’t get done then it becomes a big problem. It’s also a big difference what types of assets or structures make up the C.D.O. securities. One sees the problem growing. There is a lot of information that needs to be processed to come up with a reasonable estimation of losses. I would claim that it is completely insufficient for a bank, as they have been, to disclose exposures once they start to become a problem.
So, what did I find? Terrible disclosure. I was able to find almost no information. Certainly no information that would have helped come up with an estimate for losses from these firms based in any sort of logic or fact. Now, I’m not saying one should be suspect of current disclosure–I don’t know what is next to blow up or cause big problems and none of these firms are run by the same regime that decided the previous level of disclosure. What I am saying is that I wouldn’t have been able, even if I had known exactly what was going to happen, to know the magnitude of the losses.
First, I looked at Citi. Citi had a notion of participating or structuring. Those numbers were combined and reported together. This helps to determine market share, perhaps. This does nothing to disclose the risk on the balance sheet. This number ($110 billion) could be made up entirely of bonds were Citi is at risk. It could also be entirely made up of bonds where Citi has no risk and is taking fees. There is nothing I found in the 10-K’s to say anything more helpful. So we know losses, if these C.D.O.’s (named V.I.E. or Variable Interest Entities in the disclosure) were sold at 22 cents on the dollar, as Merrill reportedly did, the losses would have been between zero and $86 billion. Whew! Nailed it down… Now, knowing that, do you buy or sell Citi’s stock?
Second, I looked at Merrill. They state some numbers and then footnote saying they might, potentially, hold a financial interest in some of the securitizations. Same situation as Citi. No disclosure as to what kinds of bonds these are. How much was retained? How much in financing obligations exist related to these? What percentage would have had to be retained by Merrill if unsold?
Last I looked at Bear’s filing. Bear was a slight improvement. They actually stated some of what they retained and have some exposure numbers which one could back out some other information from. Still, if I was modeling the losses I would be asking for a lot more information–while an improvement, in my opinion, it wasn’t enough.
Below are the tables from the various filings. Also, if one was looking for C.D.O.’s, I put the number of instances the term of interest appeared.
Now, since the S.E.C. is mandating and revamping filings and disclosure, perhaps they can do something about this. Maybe financial firms should be forced to disclose risk numbers and sensitivities. I certainly don’t have all the answers, but I think it’s pretty clear that no one had the answers, nor did they have the specific questions, before this crisis occurred.
From the Citi 10-K (2006):
Mentions of the word C.D.O. : Thirteen (lucky!)
From Merrill’s 10-K (2006):
Mentions of the word C.D.O. : Zero
From Bear’s 10-K (2006):
Mentions of the word C.D.O. : Eight