Bob Jensens overviews of accounting for derivative financial instruments, including cases and case solutions, can be found at the following two links: trinity.edu/rjensen/caseans/000index.htm cs.trinity.edu/~rjensen/ How the professions of financial analysis and investment banking became Congress to the core is elaborated upon at trinity.edu/rjensen/fraud.htm#Cleland Tricks with Derivatives to Hide Rather Than Manage Risk: What is a tranche? DEBT TRICKS: Covering Their Assets, Fortune Magazine, March 4, 2002, by Julie Creswell --- fortune/indexw.jhtml?channel=artcol.jhtml&doc_id=206542 So you think you escaped Global Crossing and Enron? Surprise! Bankings dastardly debt trick may leave you vulnerable. For all the talk of what banks have done wrong lately (huge write-downs! swelling bad debt!), theyve also done something right: passed the buck. Turns out its not just lenders like J.P. Morgan Chase and Citigroup that are on the line for billions in loans to now-bankrupt entities such as Enron and Global Crossing; its a host of hedge funds, insurance companies, and even retirement plans that bought slickly repackaged debt from them. While these complicated credit derivatives helped banks sidestep even bigger losses and possibly prevented systemic stress on the banking system by diffusing liabilities, unwitting investors may soon be in for a rude awakening. One way or the other, somebody is sitting on a huge amount of risk, says Doug Noland, financial market strategist at David W. Tice & Associates. Indeed, federal banking regulators are increasing scrutiny of moves that push risky transactions off bank balance sheets, while the SEC is looking into PNC Financial for its debt-repackaging dealings. Though only the first repercussions of the credit-derivative fallout have been felt, theres going to be a huge problem, predicts Noland. Somethings going to blow up. Heres why: One of the more common hedges banks used is called a collateralized-debt obligation, or CDO, a bundle of around 50 corporate loans that is sliced and diced into pieces called tranches. In theory, the resulting product is akin to a mutual fund--one or two defaults dont taint the whole batch. Each tranche carries a degree of risk, from investment grade to--in traders parlance--toxic waste. Thats why safety-conscious insurance companies and pension funds snapped up the higher-rated, lower-yielding tranches, while hedge funds and investors seeking higher returns bought the riskier tiers. Banks love transforming loans into these derivatives because they dont have to reserve as much capital on their balance sheets, which frees up more money for new loans. CDOs are fairly new, but theyre the fastest-growing fixed-income sector. In the past five years the market has swelled from a few billion dollars to more than $500 billion. When all goes as planned, investors love CDOs too--they get a steady stream of interest payments. But this time around everything didnt go as planned. Banks started ramping up CDO sales in the late 1990s when default and bankruptcy rates were at historic lows; that persuaded less experienced investors to bite. Banks became very good at using financial engineering to make credit risk more palatable to the end buyer, says Charles Peabody, a banking analyst at brokerage firm Ventana Capital. But that risk just doesnt disappear. The sharp increase in defaults--from telecom startups to Kmart--caught buyers off guard, thus throwing CDOs into downgrades and losses. American Express financial advisors group learned that lesson the hard way: It bought a batch of CDOs in 1997 to juice returns and last summer was forced to take an $860 million charge related to that ill-fated purchase. Furthermore, there is a certain lack of transparency in some types of CDOs, explains Mitchell Lench, senior director of European CDOs for Fitch Ratings. Investors know the ratings, the industries, and the amount of exposure they have to the industries, but after that, its kind of a guessing game. As the aftermath of the credit-derivatives game unfolds, expect to see some angry players. I added the definition of tranches to trinity.edu/rjensen/acct5341/speakers/133glosf.htm In particular, it has raised awareness of “hollow swaps”, where two telecoms companies exchange identical amounts of network capacity, then book the purchase cost as capital expense and the sale as revenue. Although C&W says it does not use hollow swaps, it has recently admitted to using another controversial accounting method to book the sale of “indefeasible right of use” (IRU) contracts. C&W booked the contracts, which give access to its telecoms network, as upfront revenue even though they were spread over periods of up to 15 years. Such deals — which were outlawed in 1999 by regulators in America — boosted C&W’s revenues by £373 million in 2001. Chris Ayres and Clive Mathieson, London Times Online, March 1, 2002 --- thetimes.co.uk/article/0,,5-222235,00.html Hi Ceil, I dont recall a table on derivatives fraud alone, and I would think that this would be extremely difficult to compile since derivatives fraud interacts in such complicated ways with other types of fraud. For example, in the Enron scandal, derivatives are playing a huge role, but these interact with insider dealings (especially those of Andy Fastow) and SPEs hidden everywhere. Also, you cannot attribute all derivatives fraud to bad accounting. Nor can you assert that bad accounting for derivatives is intentional fraud. While at the SEC, Lynn Turner (see Forbes, 1/7/2002, Page 89) estimated that investors lost more than an average of $20 billion per year due to financial fraud and the accompanying earnings restatements (but these were not all derivatives related by any means). This does not include frauds related to bad accounting that was not detected and restated (which is probably much greater). Derivatives fraud is on the rise since it is so easy to write derivatives contracts that befuddle the experts. For example, take a look at my Sixty Minutes video clip and try to make any sense out of a typical derivatives contract entered into by Orange County --- cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Introduction You might take a look at The Devils Derivatives Dictionary at margrabe/Devil/DevilF_J.html
Posted on: Mon, 10 Mar 2014 07:04:59 +0000