From the Wall Street Journal:
Subprime Detectives Search
In Dark for Next Victim
Wall Street Can Bury
Mistakes in Fine Print
By DAVID REILLY and KAREN RICHARDSON
August 2, 2007; Page C1
Shoot first. That is what investors have been doing to financial stocks lately.
And they have some good reasons. The crisis in the subprime-mortgage market, for instance, has led to the collapse of several hedge funds, including some run by Bear Stearns Cos. At the same time, stalled corporate-bond deals and the collapse of hedge-fund Sowood Capital Management show cracks widening fast in the credit markets.
But investors in banks and brokerage houses also have been spooked by what they can’t see. Namely, potential losses that many fear have been hidden in the books of financial firms, or stuffed in off-balance-sheet vehicles.
That has made it difficult for investors to gauge exactly who has lost money on subprime wagers and how much has gone up in smoke.
The uncertainty has hit stocks of financial houses that so far have said they don’t have any major subprime problems. Deutsche Bank AG was one of yesterday’s casualties. The German bank reported upbeat profit and said it wasn’t exposed to the subprime crisis, but investors drove its stock down more than 2% on the Frankfurt stock exchange. Merrill Lynch & Co. has fallen about 22% since the start of the year, Citigroup Inc. is off 16% since January, and Lehman Brothers Holdings Inc. is down about 22%.
The mystery of “where are the losses?” has confounded hedge funds searching for opportunities to bet against banks whose day of reckoning has yet to come.
“We’ve been looking for financials that show losses from these securities on their books, and they’ve been very difficult to find,”‘ says Keith Long, president of Otter Creek Management, a hedge fund in Palm Beach, Fla., with $150 million in assets. “It’s very opaque.”
Investors have long complained about the lack of transparency when it comes to huge financial firms, whose balance sheets are so big that they can easily mask multimillion-dollar gains or losses. Analysts and investors currently cite several potential factors that could help hide subprime wounds.
Corporate executives and fund managers may still be relying on inflated values for mortgage-related securities. The widespread use of off-balance-sheet vehicles by banks and other financial institutions may also enable them to shift losses elsewhere. And a menu of choices offered to companies by accounting rules allows management to decide whether to recognize certain losses or push bad news into the future.
Some coming accounting-rule changes may help investors get a clearer picture. But those likely won’t offer help for another year. In the meantime, markets are going to have to keep guessing about where losses are and how bad they could be.
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Another way companies and banks might hide losses on securities backed by risky mortgages is to classify them for accounting purposes as being “held to maturity.” This effectively precludes a company or bank from selling the security, but also means that it doesn’t have to mark the security to market on its books.Instead, the security stays on the books at its historical cost. Investors won’t know if companies tried this maneuver until they file annual results for 2007, in which case they would have to disclose the amount of securities classified this way during the year, Prof. Ketz says.