Author Archives: david.goodman

Steve Lohr, in “Wall Street’s Extreme Sport…” an article published in the New York Times on November 5^th, 2008, highlights both the shortcomings of risk analysis modeling of mortgage-backed securities as well as the misuse of these models by management.  From our review of the financials of CHFC in 1996, we saw that the company held close to 3 million dollars of mortgage-backed securities as a small part of their larger $440 million portfolio composed mainly of T-bills.    While these securities were not necessarily as risky or exotic as the “credit-default swaps” which ultimately brought down the financial industry, they can provide an illustration of management incentives for selling available for sale securities.

We learned that, by classifying securities as available for sale, management can carefully control the impact of investment gains or losses on reported earnings by choosing when to sell.  For example, CHFC may have boosted revenues by selling securities that gained, while holding back a decrease in revenue by not selling securities, such as the held-to-maturity mortgage backed securities, that suffered a loss.

The discretion inherent in the held-to-security vs. available-for-sale securities vs. trading securities decision is one way that management can manipulate earnings, but, at least the value of the securities is publically available to users and has a clearly-defined highly liquid market price.  In the case of credit-default swaps, there is no way to determine price outside of models which “failed to keep pace with the… intricate web of risk”.  Furthermore, the incentives of management are frequently to maintain growth parity with the competition regardless of the long-term impact.  Issues related to corporate investment holding and trading that are raised in Mr. Lohr’s article merit further attention of both the SEC and FASB to ensure that management has an incentive to be both conservative and forthright about the risks inherent in their investment strategies.

Addendum:

Interestingly, while Lohr’s article was published after the collapse of Lehmen caused the Dow to fall below 10,000 (as shown below in the chart from yahoo.com), it was during a brief period of relative stability which returned to a steady drop to March 9, 2009 when the Dow Jones bottomed at 6500.

For those interested in further research on the topic, I discovered that Baruch has a financial engineering program which includes faculty member Leon Tatevossian who has expertise in risky asset management and mortgage-backed securities.