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Thursday, January 17, 2008

The Subjective Nature of Wall Street Write-Downs

Fourteen billion. That's the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren't under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill's and Citi's write downs is how it exemplifies the subjective nature of Wall Street's accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now "retired" CEOs Stan O'Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O'Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe "uncertain market conditions" are to be blamed?

The point is, strategy shouldn't influence when and how much to write down losses. What Wall Street's earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street's books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the "Big Four" accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman's sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, "This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years' numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC's overall compensation."

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O'Neil has some explaining to do because investors should not accept that Merrill Lynch couldn't have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street's favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you're on a wing and a prayer.

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