Pulling the curtain back on window dressing

There has long been a distasteful practice on Wall Street known in the parlance as “window dressing.”  As a quarter nears its end, banks and other financial institutions (like mutual funds) will take advantage of the massive liquidity of most financial assets and sell those assets that would appear distasteful to investors and regulators and buy assets that would appear to be more palatable to investors and regulators.

As we all know a lot of the blame for the recent deep recession and the creepingly slow recovery had to do with the high amounts of worthless debt assets that banks had purchased (read: mortgages).  One would hope that banks had learned their lessons.  However, what has been occurring (as exposed by the Wall Street Journal) is that Wall Street’s big banks have continued to use massive amounts of leverage to drive their quarterly profits.  Then at the end of the quarter they have sold those risky assets and replaced them with conservative looking assets.

This practice is possible because balance sheets are a snapshot of the assets of a business at one time and one time only: the end of the quarter.  So as an investor in these institutions the balance sheet you are using for your analysis is kind of like a fake photo, or photo of a less receded hairline, being put up on a singles site.  You think you are getting one thing, but instead, you are buying something entirely more disappointing.

Fortunately, the Securities and Exchange Commission has agreed to take up discussion of new rules that would target “window dressing,” thus pulling back the curtain on this all-too-common and manipulative practice.  One thing under consideration is that financial institutions would have to disclose more than once a quarter what their debt loads looked like.

My opinion is that this would simply lead to more volatility and trading on the part of the banks.  Let’s face it, the debt markets are extremely liquid and these banks are expert at trading.  So to sell out the unattractive asset and buy in the “attractive” asset is not much of a trick.  My thought is why not require banks to report their average debt level, their peak debt level, their trough debt level, and their standard deviation debt level.  Standard deviation for the non-statistician among you is the variation from the average.  Let me explain.

Suppose you are hiking and you want to cross a river but you want to know the average water level so that you can cross safely.  There is clearly a big difference between rivers that are both an average of 5 feet in depth when one of them is mostly shallow at 3 feet in depth but has a 35 foot drop off, and the other is pretty consistently 5 feet with no major drop off.  That’s standard deviation.  The river that is mostly 3 feet in depth, but with the 35 foot drop off has a higher standard deviation because its depth variation is more volatile.  Does this make sense?  Thought so.

Whatever the SEC ends up deciding, I am pleased that they are poised to end this charade on the part of Wall Street banks.  Remember the old Smith Barney commercials: “We earn money the old fashioned way, we earn it.”  New rules that truly take the stuffing out of these stuffed numbers will ensure a return to that credo, as opposed to: “We earn money the old fashioned way, we manipulate it.”

Jason