Derivative
Risks of Financial Stocks
by
Henry
Lu
03/28/2005
Tough Market in March
SP&500 went straight down over past few weeks. Piling upon this tought market is continuing Saga of finanacial scandals in AIG, Fannie Mae (FNM). You can find news headlines of recent financial company scandals pretty easily: "JP Morgan settles for 2 billions Worldcom case", "AIG may have up to $3B in accounting mistakes".
There were tons of reports on FNM or AIG, JPM related scandals in financial magazines or Wall Street Journal. It is tough to track the details. However, it is utterly important that investors need to learn lessons from the scandals and scrutinize the risk in their investment in financial stocks.
The common word in those AIG, FNM scandals is: "Derivatives".
What is derivative?
Here is online dictionary definition: "Derivative" is an asset that derives its value from another asset. An option contract or a future contract is derivative, even a convertible bond is also derivative.What are the scandals really about?
Fannie Mae (FNM) scandal and the recent AIG scandal all are similar in its nature: the company managements wanted to hide truth from public or investors.
Here is what happened to FNM or AIG in a short illustration. The CEO of a big financial was unhappy with financial statement,say short of earnings. As we know, the CEOs' compensation largely comes from stock options, which are largely related to stock price performance. In order to artificially boost the earning and therefore to make big money, the unethical CEOs made derivative transactions to do that.
The company would pay a special entity or third party certain amount, say 100 million, plus 5 million fee for the derivative service, and then the third party would pay back 100 million to the company in return. The trick here was the money received (100 million) was considered earning in the quarterly report, and the money company paid out (105 million) would not be considered as cost. The 105 million paid out would either dissappear in the balance sheet (special entity), or it will be in liability part of balance sheet as reserve or other liability.
In reality, the company paid 105 million, received 100 million, the company lost 5 million. But in earning report, the company would report 100 million fake earning to deceive investors!
Of course, sometimes the manipulation was time manipulation. For example, in the above example, the derivative could be structured in a way that company make 100 million income today, and company will lose 105 million in next 10 years. Therefore, the cost of 105 is deferred to future time and the earning is immediately booked.
You want to hear positive 100 million earning today? No problem with this derivative. You want to hear negative 10 million loss this Q? No problem, go with that derivative, the same company can be losing money this Q.
In essence, with derivative, a financial company can report whatever earning it wants today! But in the end, 5 million extra cost was slapped at shareholders' face plus an artificial high stock price to boost CEOs' bonus and pocket.
Derivative is huge risk for value investors
Take JP Morgan (JPM) as one example. This company is involved in all kinds of financial business: real estate, commodities, future and options, investment banking.When I looked at its annual report, I can not figure out how much money JPM truly made or lost each year. JPM reported 4.4 billion net income in 2004, but do we really know how much JPM made in 2004?
Avoid financial stocks with complicated books
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* Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut. Visit http://www.BlastInvest.com for FREE "how-to" investing assistance, web services and more.