Wednesday, September 24, 2008

A Rolling Loan Gathers No Loss

One of the major accounting principles during the S&L fiasco was that a rolling loan gathers no loss. If you have a bad loan, you simply exchanged it for another bank's bad loan. In that way, an S&L could fool an auditor into thinking that the loan exchanged had actually been paid off.

My thoughts are that the same type of scams are very prevalent today. It's possible that some of these collateralized debt obligations could be exchanged in the same types of scams. Let's say Lehman had bad CDOs that they were underwriting. And Merrill had bad CDOs. Let's say Lehman sells the underwritten securities to Merrill Lynch in one transaction and then buys bad CDOs Merrill Lynch is underwriting in exchange. Or buy CDOs in Merrill's existing portfolio.

Now you might say this is crazy. How could Lehman be stupid enough to buy bad CDOs so that they could keep underwriting more CDOs and book the profits on those underwritings? That's suicidal. Are Lehman employees stupid enough to buy 1 billion dollars in CDOs to obtain 40 million in underwriting revenue. No, but they are smart enough to realize that Lehman can book profits on those underwriting revenues. And, the employees are well aware of how much in bonuses they can make.

Its possible that once the losses reached 5 to 10 billion dollars on the CDOs at Lehman, then management decided the hell with it. They were going to lose their jobs if they did the honorable thing and stopped this spiraling explosion. So they decided to try and prop things up so that they could keep on raking in bonuses and have a chance to unload their stock before the whole thing collapsed.

What leads me to this theory is Lehman's investments in CDOs went up from 57 billion in Nov. 2006 to 89 billion in Nov. 2007. Now what could have possibly prompted Lehman to do this?
The only reason I can think of to keep on buying CDOs at that time was to help out their underwriting. Otherwise, what they were doing was pure stupidity.

The mistake some observers make is that they believe that employees and firms will act rationally. However, for the people in the Lehman underwriting department, the behavior is rational. They can make huge bonuses from each offerring. So they
have an incentive to push through "swaps' to do so. For the company, the behavior isn't rational. But its the employees and management whose motives control.