How to make money as an investment bank, part 1

  1. Generate worries about your solvency
  2. Notice that the value of your debt has decreased, because of worries you may go bankrupt
  3. Notice that your debt is an obligation, therefore a decrease in its value is an increase in your firm's net value
  4. Declare a profit

Thanks to Lehman Brothers for the idea, as described in Lehman's Debt Shuffle:

For several quarters, all the investment banks have been taking gains on their liabilities. Say you owe $100 to your friend. But you run into severe problems and your friend starts to figure you can only afford to pay back $95. If you were an investment bank, the magic of fair value accounting dictates that you could get to reduce your liability. What’s more, that $5 gain gets added to earnings. Because investors thought Lehman was more likely to default, its liabilties fell in value and Lehman garnered earnings from this. How much did Lehman win through losing? $600 million in the quarter. How much was its net income? $489 million.

Lehman and all the other investment banks are following the accounting rules on this, but that $600 million is hardly the stuff of quality earnings.

As an equity holder, I don't think I'd feel too reassured about the firm's financial status by the "profit" of an increased chance of going bankrupt. As a holder of put options, though, I'm eagerly anticipating further such "profits".

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