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State Street to Investors: Heads I Win, Tails You Lose


Yet another bank converts one-time "cashless" charges into future "real" earnings.

Yesterday, State Street (STT) announced that it would be consolidating approximately $22.7 billion of off-balance sheet assets, taking a $3.7 billion charge in the process - effectively converting an unrealized off-balance sheet loss on the portfolio to one realized on balance sheet.

Between the increase in assets and the charge, State Street's Tangible Common Equity ratio would have fallen from 5.9% to 2.2%. So, from my perspective, notwithstanding a clean bill of health from the stress test regulators (pro forma Tier-1 Common was still a robust 9.0%) I think State Street did the right thing yesterday by raising common equity – and per their press release on a pro forma basis, once the stock offering is complete, the bank's TCE ratio will be 3.4%.

But did State Street really do the right thing?

In its press release, the bank goes on to say:

"Based on its credit assessment of these assets, State Street expects that a vast majority of the after-tax loss recorded upon consolidation will accrete as interest revenue over the lives of the assets into the consolidated income statement. Based upon management's current prepayment assumptions, State Street expects approximately $475 million pre-tax to accrete as interest revenue in 2009."

If I understand this right, State Street is taking an "extraordinary" $3.7 billion loss on assets its "acquiring," diluting existing shareholders by raising $1.5 billion in common stock, all the while expecting to get back the $3.7 billion loss through earnings over time.

As I have written before, accounting is not about whether a loss does or does not happen; it is about when it's reported. And looking at State Street's press release, I can't help but feel like investors are celebrating yet another bank's ability to magically convert one-time "cashless" charges into future "real" earnings. Moreover, I'm stunned by boards of directors' willingness to pay executives as if these one-time charges never occurred.

In this regard, I would note the following, also from the State Street's press release:

"Estimated operating-basis results for 2009 exclude the extraordinary loss recognized upon the consolidation of the asset-backed commercial paper conduits, but include an estimated $0.75 per share of accretion as interest revenue from the conduit assets as they mature or pay down, offset by the expected impact of the offerings and a contemplated re-establishment of a reserve for discretionary incentive compensation in the second half of 2009, subject to company performance."

If the regulators want to create an environment of prudent risk-taking within our banking system, I believe it must begin with all parties (executives, directors, investors, analysts and the regulators themselves) recognizing that reserves are a basic operating cost of being a bank - not something to be posthumously recorded in some prior accounting period or disregarded as an "extraordinary" charge so that future earnings can be upsized.
Position in JPM
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