Here is a must-read essay: The Bear’s Lair: The dangerous games managements play
- Then there was Enron. The sentences handed out to Enron’s top management made it appear that its collapse was due to thieving but in fact the thieving was minimal in the context of Enron’s overall size. The collapse resulted from sheer incompetence. Enron was running a huge energy trading operation from a company whose debt rating never exceeded BBB. Consequently, when the market turned against it, Enron’s counterparties quickly required additional collateral to be posted and the house of cards collapsed. Enron’s energy trading operation was perfectly viable, as has been demonstrated by its subsequent success within UBS, but was far too big for anyone but a major international bank.
Unlike earlier derivatives catastrophes, Ford’s and Fannie Mae’s losses don’t relate to poor trading, but from the difficulty in valuing a large portfolio of derivatives in financial statements. Financial Accounting Standard 133, which deals with derivatives valuation, allows companies to divide derivatives positions between trading, in which positions are marked to market and profits and losses taken and hedging, in which they are held for the long term against the asset being hedged. Naturally, you’re supposed to decide immediately you buy the derivative which category it will go into. In the case of Fannie Mae, management had been holding new derivatives positions for several weeks to see which way the market went, and then recording them so as to book the profits and leave the losses as hedges, to accrue over the life of the instruments concerned.
Needless to say, when this trick was discovered much later, after Fannie Mae management had collected several years of record bonuses, it was more or less impossible to determine what the correct position should have been – thus the accounting uncertainty and the two years of cleanup work.
Derivatives are sold by investment banks to corporations seeking to hedge risks in interest rates, currencies, equities or commodities. To the banks selling them, who make trading profits through their knowledge of the deal flow, they’re a wonderful business. To corporate management, which can use them to create artificial profits in a quarter in which earnings are falling short of forecasts, they may also be attractive – any accounting restatements occur several years later, and pass almost unnoticed by the market. For example Sears, now owned by ex-trader Ed Lampert, announced Thursday that it made more money -- $101 million – from trading in credit derivatives in the third quarter of 2006 than it did from its core retailing business --$95 million.
I’m sure Lampert feels very proud of himself, and will be given some suitably munificent reward. However Sears shareholders – and customers, and employees – will wonder what the hell is going on. Trading credit derivatives is a huge distraction from management’s primary purpose of running a retailing operation. Indeed, the market reflected this view, with Sears’ share price dropping 5.5% on the day
And for the shareholder or the investor, the following paragraph says it all.
- To corporate shareholders derivatives are all risk and no reward. In addition to the risk of a rogue trader, the risk of a hedging system that proves flawed and the risk of overtrading, shareholders also suffer the risk of corporate management dressing up earnings. Further, whereas before the derivatives era shareholders in a company selling products in Germany knew they would have an exposure to the deutschemark/euro, and could judge the investment merits of that position, these days a company doing business in Germany may turned out to have exchanged that cash flow for floating rate Thai baht. At the end of the year, shareholders who read annual report footnotes carefully will discover their new baht exposure, but not before. Options make the position even more opaque. Given the agency problems between shareholders and management, and between management and traders, allowing companies to play the derivatives markets is a mug’s game for shareholders.
Remember the most important issue...
If the bet works out great, the management like in Fannie Mae's case, the maangement will take all the credit and most important, the BIG-FAT-OUT-THE-WORLD-BONUSES!!!
And what does the shareholder get?
And oh... if it fails.... what does the shareholder get?
Posts
