Sunday, April 19, 2009

The Legal Scam of FASB Statement 159

1. Set up Company, go IPO.

2. Sell $1B bond.

3. Spread rumor of Company's demise. Or better yet, actually run Company almost into ground. Quickly.

4. Buy Company's bond at $40 on $100 par.

5. Book $600M profit, and pocket the $600M extra cash from bond issuance.

6. Retire as a rich hero.

BTW, you don't even need to actually buy the bond in order to book the profit, thanks to the infinite wisdom of FASB (aka FASB Statement 159). Yes, the $600M profit will disappear into thin air by bond maturity, if Company survives, that is. But who cares about next quarter, not to mention 10 quarters later. In any case, the extra cash is real if you manage to drive Company almost into ground faster than spending the bond issuance proceeds.

And if you can recycle these paper as cash through the Fed, you don't even have to worry about financing. Spend the bond proceeds, buy back paper, give it to Fed as collateral for cash, buy back more paper. Zero cost, zero risk, much reward.

This applies to loans just as well, as long as it's securitized and traded on secondary market.

In reality, it takes good research to locate current bond holders and may take some persuasion to buy it from them. But if the gloom looks real enough and you're crafty enough (e.g., gradually over a period of time, through a third-party broker), it can be done without raising too much suspicion.

It gets better. Once you have bought back almost all of your bond, you can set up a phony market price whereever you want.

Companies have actually bought back their bonds on the secondary market. I'm not saying any of them did it intentionally, as outlined above. But this doesn't change the fact that such scams are legal and plausible.

Unless the bond is callable, the issuer should be forbidden to purchase it on the secondary market, be it at discount or premium, and such accounting games cannot be played.In terms of interest rate risk, buying one's own bond from the secondary market is equivalent to having an embedded call option, which otherwise would result in a higher coupon. In terms of credit risk, it is equivalent to selling one's own CDS or life insurance (not considering differences in financing), it doesn't make sense, nor should it be legal, except in the wonderland of modern financial accounting and regulation.


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