Bank of America comes clean – well sort of …

Bank of America has finally admitted that it understated the quarter end assets and liabilities for the years 2007 to 2009.  It does not (yet) admit that similar transactions took place in many other years and it does not spell out the effect of these transactions on BofA’s need to carry capital.  To quote BofA’s local paper:

Bank of America Corp. has told securities regulators that it made six quarter-end transactions from 2007 to 2009 that were not in "strict compliance" with accounting rules.

In correspondence with the Securities and Exchange Commission, the Charlotte bank said the so-called "dollar roll" transactions were designed to meet internal balance sheet limits. The bank said it does not believe the transactions had a material impact on its financial statements, according to a May 13 letter posted by the SEC late Friday.

I wrote a post stating that BofA had long been reducing its quarter-end balances in March this year so this should not surprise regular readers.  Nor will not surprise regular readers of the Huffington Post and many other places where my article was reprinted.  I think the WSJ also had a poke at the story after my blog post.  Alas the story died down as BofA issued denials only to retreat from those denials in a (then private) letter to the SEC. 

BofA note that the transactions did not change reported profit.  I agree.  The transactions were however designed to shrink reported quarter-end balance sheet and hence reduce the apparent need to hold capital.  One of the reasons why BofA was short capital when the crisis came was that they did things like this to reduce the stated need for capital and they ran capital close to the “apparent” minimums. 

Anyway there are things that bug me about BofA’s admission.  Firstly at senior management it appears that they did not even know they were doing this.  The company denied the bleatingly obvious in the aftermath of my original blog post.  I do not think they were directly lying – the better explanation is that they simply did not know.  Moreover they now state that the transactions “were designed to meet internal balance sheet limits”.  In other words some internal part of the bank was using more balance sheet – hence more capital – than it was permitted under internal risk controls and entered into quarter end transactions to hide it. 

Lets put this more directly.  BofA imposes internal risk controls (usually called limits).  BofA staff enter convoluted transactions to avoid having to meet those limits.  Head office does not know – and only in response to an SEC subpoena (following a blog post a nondescript fund manager in Australia) do they conduct a review and find these transactions.  This is – it seems – worse than the transactions itself.  What it demonstrates is that BofA does not police its own risk control rules until forced to by SEC subpoena.  Put that way you have to ask “who in BofA will be forced to resign?”

More pertinently – this could be spotted by a (very) careful reading of annual and quarterly reports from Australia.  Everything needed to demonstrate that there was something strange about quarter ends could be done by someone with the published annual reports and quarterly summaries.  If anyone on BofA’s board carefully read the accounts they would have spotted the same thing.  (I guess that this demonstrates that the entire BofA board did not or was not capable of undertaking such a careful reading of their own accounts.)

My original post did this for 2006.  In 2006 as I showed the quarter end assets were substantially less than the assets averaged over the quarter.  In some quarters the difference is 46 billion dollars (substantially more than the 10 billion admitted to in 2007-2009).  The same incidentally is true of 2005 and I think (though I have not rechecked) that I first spotted this in 2004.  So far BofA has not come clean about those years.  But then again we now know that head office did not know that within the bank parties were entering transactions designed to thwart internal balance sheet limits – so if BofA cares to check they will find that the problem exists over many years. 

My estimate is that – as a result of this transaction – BofA’s looked like it required about 2 billion dollars less capital than it should have been carrying had it stated its balance sheet fairly.  2 billion in capital is significant – but is remains small in the overall problems that BofA had during the crisis.  This is – in an accounting sense – a second-order issue.  But as a statement about BofA’s control culture it is not good.  [The culture of hiding risk taking however should – in a post-crisis environment – be relatively easy to address…] 

The unnamed counterparty

These transactions were done – according to press articles – with counterparties unknown.  It is passé these days to charge the prostitute but not to charge the John.  The press however would often prefer to report on the (high profile) John than the prostitute.  Either way I wish this were corrected.

The transactions designed to hide quarter-end assets and debt were described as “roll transactions”.  I guess I am new at this game but I had not previously heard that jargon.  Anyway – with a “roll transaction” there has to be a counterparty who is willing to prostitute their balance sheet and allow the “assets” (at least temporarily) to be stuffed in.  The willing whore in this case was almost certainly Japanese – at least for some quarters.  Japanese banks typically had average balances of securities LOWER than end period balances (Mizuho is an exception).  I once meticulously went through the quarterlies of MUFJ and found exactly this trend.  In their SEC filings MUFJ tends to report its capital (or at least it did in those days) as average capital to average assets.  (I guess that makes sense when their end-period assets are stuffed with assets parked from American banks.)

Still if some trader at BofA (or someone else wanting to skirt BofA’s internal controls) wants to park assets at quarter end – and to pay good money for that privilege – then who am I to suggest that otherwise lowly profitable Japanese banks should say no?  

 

John

 

Disclosure:  I have never thought that we should use the blog to “talk our book”.  We will occasionally explain why we own things (which I guess is talking our book) but we are happiest discussing what is wrong with our positions.  Our biggest position remains long Bank of America (and it is more-or-less the only stock I suggest when people want a stock tip).  BofA might argue that with friends like us they don’t need enemies.  Maybe that is true – but perhaps they need board members that can read accounts. (I am offering…) 

Also – for the SEC – note that BofA shareholders have suffered much already because BofA took too little capital into the crisis.  What you should be seeking from BofA is not penalties – it is a process for fixing their internal controls so that head office can ensure that divisions are not entering transactions designed to thwart internal controls.  Surely that is far more important than a rap over the knuckles? 

Hey – the SEC should not need to seek this.  BofA should just do it.  I anticipate being a shareholder in a decade – so this matters to me.