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Trading Eludes Dodd-Frank as No Investors See Inside Black Box

Goldman Sachs CFO David Viniar
“I personally see the profit-and-loss statement of each of our 44 business units every single night.” Goldman Sachs CFO David Viniar said. Photographer: Andrew Harrer/Bloomberg

It took a Congressional inquiry this year to force Goldman Sachs Group Inc. to disclose how much it made in the mortgage market -- and that was only for 2007.

Goldman Sachs hasn’t revealed mortgage-trading revenue since then, leaving investors to guess how much it contributes to the fixed-income, currency and commodities division, or FICC, which also trades junk bonds, yen, oil and uranium, sells weather derivatives and operates power plants. The division brought in $23.3 billion last year, or 52 percent of the New York-based firm’s total, and by itself would rank 90th by revenue in the Standard & Poor’s 500 Index, just ahead of McDonald’s Corp., according to data compiled by Bloomberg.

The Dodd-Frank Act, designed to prevent future financial crises, does little to improve investors’ ability to analyze results at the five biggest U.S. firms that trade securities, which together lost $38.6 billion as markets froze in the fourth quarter of 2008. Since taxpayers may have to bail out banks again, firms should be forced to disclose more, said Tanya Azarchs, former head of North American bank research at Standard & Poor’s.

“The health of the banking system impinges on all areas of the economy,” said Azarchs, now a consultant in Briarcliff Manor, New York. “So their disclosure has to be top-notch.”

Hoarding Information

Wall Street firms’ tendency to hoard information about markets and how they make money has come under scrutiny after investors were caught by surprise in 2007, when confidence in everything except Treasury securities vanished and credit markets collapsed.

Lawmakers and regulators are pushing firms to move derivatives trades onto clearinghouses, where prices can be monitored, while demanding fuller disclosure on consumer loans, including mortgages and credit cards. In July, Goldman Sachs agreed to pay $550 million to settle Securities and Exchange Commission accusations the firm gave incomplete information about a mortgage-linked investment sold in 2007 that caused buyers more than $1 billion in losses.

More transparency might have provided clues about risk-taking that led to the credit markets seizing up and the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc. in 2008, said Peter Kovalski, a portfolio manager at Alpine Woods Capital Investors LLC in Purchase, New York, which oversees about $6 billion, including shares of Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Goldman Sachs.

“If you saw large revenue from an outlier, that should raise a question,” Kovalski said. “You’d like to see all the businesses contributing and growing at the same rate. If you saw one doing well and all the others struggling, you’d have to ask whether they’re trying to squeeze out a little more revenue there to offset the overall slowdown.”

Loss of Confidence

Opacity also may have contributed to a loss of confidence in the banks, said Richard Bove, an analyst at Rochdale Securities in Lutz, Florida. Investors who had been given few details about how the firms made money in the years before the crisis suddenly grew concerned that mortgage-trading losses might lead to insolvencies.

Bear Stearns and Lehman Brothers, which for most of the 2000s were the two biggest mortgage-bond underwriters, both imploded in 2008. Merrill Lynch & Co. had to sell itself to Charlotte, North Carolina-based Bank of America, and Citigroup got a $45 billion taxpayer bailout.

“They’re going to resist it, but they’re going to have to disclose more,” said former SEC Chairman Harvey Pitt, now chief executive officer of Washington-based consulting firm Kalorama Partners LLC. “If there’s one thing we’ve learned from the financial crisis, it’s that a lack of transparency is absolutely devastating.”

‘Nobody Believes’

Investment banks combine the results of trading categories to keep them secret from competitors and trading partners and to smooth out gains and losses from swings in individual markets, said Adam Hurwich, a former member of the Financial Accounting Standards Board’s Investors Technical Advisory Committee who’s now a partner at hedge fund Jupiter Advisors LLC in New York.

The resulting opacity undermines confidence in the firms’ results, said Brad Hintz, a former Morgan Stanley treasurer and Lehman Brothers chief financial officer.

“Nobody believes the brokerage firms right now,” said Hintz, now an analyst at Sanford C. Bernstein & Co. in New York. “When you’re mixing euros and yen and dollars together, and then on top of that you’re throwing in commodities, what I have is succotash, and it’s very difficult for us to analyze.”

Goldman’s FICC

The difficulty of analyzing the banks with the five biggest FICC divisions -- Goldman Sachs, Citigroup, JPMorgan, Bank of America and Morgan Stanley -- has taken on greater significance as those businesses have grown. The banks reported $79.9 billion in FICC revenue in 2009, more than double the amount in 2004, when breaking out the figure became standard practice. FICC accounted for 22 percent of the banks’ total revenue last year compared with 14 percent in 2004.

Goldman Sachs’s FICC division is the biggest, based on 2009 revenue and the percentage of overall revenue. Citigroup got $21.5 billion of revenue from the business last year, or 27 percent of its total. JPMorgan got $17.6 billion, or 18 percent; Bank of America got $12.7 billion, or 11 percent; and Morgan Stanley got $5.02 billion, or 22 percent.

Spokesmen for Goldman Sachs, Citigroup, Bank of America and Morgan Stanley declined to comment. Kristin Lemkau, a spokeswoman for New York-based JPMorgan, said the bank tries to “provide sufficient disclosure to allow investors to make informed decisions about our business.”

Shirts, Pants, Belts

U.S. accounting rules allow companies “quite a bit of latitude” in how much detail to disclose about business segments, said Regenia Cafini, a project manager at the Norwalk, Connecticut-based FASB, which sets bookkeeping standards.

According to FASB Statement No. 131, published in 1997, companies are supposed to break out business segments whose “results are reviewed regularly” by the “chief operating decision maker,” typically the CEO or chief operating officer. While advised to report on businesses that account for more than 10 percent of total revenue or 10 percent of assets, companies are allowed to combine as many segments as they want, according to the document.

A July proposal by FASB staff to be considered later this year would require companies to disaggregate income and expense items “so that the information is useful in understanding the activities of the entity and in assessing the amount, timing and uncertainty of future cash flows.”

Absent that, “there really aren’t rules per se on defining a segment,” Cafini said. “It’s how the company sees itself. I’m a manufacturing company, and I make clothing. I could segment myself by shirts and pants and belts, and have three different segments, or I could lump them all together.”

Analyst Estimates

The opacity makes it harder for analysts to estimate earnings. On average over the past five years, JPMorgan has beaten quarterly earnings-per-share estimates by 40 percent, according to Bloomberg data. The figure is 21 percent for Goldman Sachs and 10 percent for Bank of America. Citigroup on average missed estimates by 6 percent. By comparison, the five members of the S&P 500 Index with the greatest revenue beat estimates by an average of 4.6 percent.

More details on trading won’t necessarily lead to better earnings estimates because markets are constantly shifting, said Robert Albertson, a former Goldman Sachs banking-industry analyst who’s now head of investment strategy at brokerage Sandler O’Neill & Partners LP in New York. “You still wouldn’t know where the activity would be in the future,” he said.

Directional Hints

Goldman Sachs breaks out 12 revenue lines in its quarterly statements, among them FICC. Others include equities trading, asset management fees, securities services and investment-banking advisory. That’s about a fourth the number of revenue lines management sees: In an interview with Bloomberg Businessweek published in April, Goldman Sachs CFO David Viniar, 55, said, “I personally see the profit-and-loss statement of each of our 44 business units every single night.”

Goldman Sachs’s FICC division has “five principal businesses,” the firm said in its annual report in March. They are commodities; credit products, which include corporate bonds and credit-derivatives; currencies; interest-rate products, which include government bonds; and mortgages.

The firm gives directional hints about the performance of the businesses within FICC in press releases about its quarterly earnings. In a July statement about second-quarter results, Goldman Sachs said FICC revenue fell 35 percent from a year earlier to $4.4 billion because of “significantly lower results in credit products, interest rate products and currencies,” partially offset by “higher net revenues in mortgages, and, to a lesser extent, commodities.”

‘Eyes of Management’

That’s not good enough for Lynn Turner, a former SEC chief accountant who’s now a Denver-based managing director at consulting firm LECG LLC. Simply saying gains in one trading area were offset by losses in another “doesn’t seem to quite be adequate to me,” he said.

“Management has to provide the investor a view of the company through the eyes of management, so that the investor is really able to see what’s going on clearly with the business,” Turner said.

Citigroup CEO Vikram Pandit, 53, speaking in May at the graduation ceremony at the Johns Hopkins Carey Business School in Baltimore, said that “markets cannot function without transparency” and that improved disclosure of bond prices would help “revive and sustain confidence in our financial system.”

‘Volatile and Opaque’

Pandit’s plea for transparency in bond markets contrasts with the bank’s own disclosure about its fixed-income division, which includes mortgage-trading and securitization units that contributed to $25.7 billion of net losses from 2007 through 2009. In April, Moody’s Investors Service published a list of four “credit challenges” for the bank. Among them: “Citigroup has a large investment bank, which we view as inherently volatile and opaque.”

The pronouncement came after New York-based Citigroup reported a 43 percent decline from a year earlier in first-quarter fixed-income and equities trading revenue to $6.59 billion, about a quarter of the bank’s total revenue.

“Like its peers, Citigroup did not give clarity on how these revenues were generated,” Moody’s said.

The banks do a better job of breaking out revenue when they’re losing money than when they’re making it, said Azarchs, the former S&P researcher.

Merrill, Lehman

In 2006, Merrill Lynch began reporting that its stock-trading results were bolstered by “record” revenue from gains on investments in private companies. The exact amount wasn’t disclosed until May 2007 -- two months after Merrill filed its annual report for 2006 -- when trading chief Dow Kim said at an investor conference that the firm had garnered $1.5 billion of private-equity revenue the prior year.

Merrill started breaking out private-equity results on a quarterly basis as full-year revenue dropped to $400 million in 2007. The business had $2.1 billion of pretax losses in 2008.

Lehman Brothers, while expanding in mortgage trading and mortgage-bond underwriting during the 2000s, didn’t detail how much it earned from the business. Investors and reporters deduced that it was a leader in the business by analyzing rankings produced by third-party data collectors, including Bloomberg LP, parent of Bloomberg News.

‘One Fine Day’

The firm opened up in early 2007 as subprime-mortgage lenders, including New Century Financial Corp., lost their funding sources. On March 14 of that year, CFO Christopher O’Meara said on a conference call that the New York-based firm got less than 3 percent of its revenue from making subprime mortgages, packaging them into bonds and trading the securities.

O’Meara didn’t detail Lehman’s revenue from other types of residential mortgages, including Alt-A, which are a level between subprime and the safest borrowers. Nor did he detail how much the firm made from commercial real estate and lending, which contributed to Lehman’s bankruptcy in September 2008.

“One fine day you wake up and there’s a problem, and then they start to disclose it,” Azarchs said.

Banks should break out the revenue they get from each of the categories within FICC, said Bove of Rochdale Securities. Within each segment, they should further break out how much comes from commissions, how much comes from buying and selling securities, and how much comes from simply recording changes in the value of investments held on the books, he said.

‘Worst Assumption Possible’

More disclosure prior to the crisis might have helped prevent the panic that gripped markets in 2008 once mortgage losses began to emerge, Bove said. Lehman Brothers and Bear Stearns failed partly because trading partners backed away. In mid-September 2008, Bank of America cut Merrill Lynch’s trading lines in the days before it bought the securities firm, Merrill CEO John Thain told employees at the time. Citigroup in late 2008 had to borrow at least $9 billion from an emergency Federal Reserve credit facility set up after investors grew leery of its short-term debt.

“Not having any idea as to what the size of the losses would be resulted in a total breakdown of confidence,” Bove said. “You had no basis on which to make an assumption, so you made the worst assumption possible.”

In November 2007, after Merrill Lynch and Citigroup ousted their CEOs because of mortgage-trading losses, Goldman Sachs CEO Lloyd Blankfein, 55, gave an investor presentation showing that mortgage-trading was the smallest business within FICC, representing 7 percent of the division’s revenue since 1999.

‘Black Box’

Credit-trading accounted for 34 percent of FICC, followed by interest rates at 25 percent, commodities at 20 percent and currencies at 14 percent, according to the presentation. At an investor conference in February this year, the firm provided an update: Mortgages accounted for an average of 3 percent of FICC revenue from 2007 through 2009.

Investors got more detailed information on the mortgage unit in April, when the U.S. Senate Permanent Subcommittee on Investigations released more than 900 pages of Goldman Sachs e-mails and other documents obtained during its 18-month investigation of the financial crisis.

Among them was a page headlined, “Quarterly Breakdown of Mortgage P/L.” P&L is shorthand for the profit-and-loss statements produced by each trading unit.

The document showed results for the four quarters of 2007, with a final column showing $1.27 billion of fiscal year-to-date revenue through Oct. 26, 2007. Goldman Sachs’s fiscal 2007 ended on Nov. 30. The bottom of the page reads, “Confidential Treatment Requested by Goldman Sachs.”

No details were given for the rest of FICC, which according to a December 2007 press release had $16.2 billion of total revenue that year, 13 percent more than the record set in 2006, “reflecting strong performance in all major businesses.”

“That’s just one big black box,” said Mike Mayo, an analyst at Credit Agricole Securities USA in New York. “You can’t get around it.”

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