First, the term, arbitrage. Per wikipedia:
In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets.People have already used the term regulatory arbitrage or jurisdictional arbitrage, and I won't go into detail on those usages, except to say that they are a generalization of the more basic, literal meaning of arbitrage.
What I am talking about is based on some well known and frequently discussed phenomena. Namely that the accounting value for a transaction can and frequently differs from its economic value. This has been clearly articulated by Warren Buffett as follows:
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principlesThis is only one example of accounting conventions deviating from economics. US GAAP has been around a long time, and is fairly robust. It has been able to deal with a general external economic environments that have placed extreme pressure on businesses. It has evolved to work in the real business world, and tends to be more practical then theoretical. And, like most social constructs that evolve from practice, contains certain inconsistencies and contradictions that are unavoidable.
than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable).
If we go back to Warren Buffett's observation, and accept the fact that it crops up in more situations then simply accounting for acquisitions, or the amortization of goodwill, then consider a manager with the opposite philosophy. The person on the other side of that trade -- who is more motivated to seek accounting earnings then economic earnings.
In a sense, this is hardly news. Managers have tried to game accounting since the Italians developed double entry bookkeeping. However, consider the following -- in order to realize or monetize economic profits, they frequently need to be mediated by an accounting framework. The proposed definition:A simple and perhaps trivial example of a reporting differential is the differing accounting treatment of corporate debt. Consider a 5%, 10 year fixed rate investment grade corporate debt that could be financed either by a bond issue or by a bank loan. The cash flows on this hypothetical debt are identical. At issue, the financial reporting is identical -- there is no immediate arbitrage opportunity. However, if interest rates rise, the financial reporting value of the bond will decline (assume that it is a listed, traded bond) for the bond owner, remain the same for a loan, and the liability of the firm issuing the debt will remain fixed. A current example of this occurring can be seen with REITs buying their bonds at 10 to 20% discounts from par in order to improve their balance sheets.
In economics and finance, financial reporting arbitrage is the practice of taking advantage of a financial reporting differential of the same or similar economic transactions between two or more valuation frameworks.
At this point, one might wonder what is so unusual about a firm changing their capital structure -- especially since a firm never makes a change without labeling it a benefit. Yet we know that stock buybacks have proven a disaster for financial firms over the last few years. In the above case, the optics of the REIT's balance sheet has improved, but its cash position has worsened and it has less financial flexibility. All they have done is recognize the economics of their bonds, which must be carried at par on their balance sheet.
A more interesting example of financial reporting arbitrage occurred when banks insured CDO's with bond insurers. Banks were forced to mark structured finance products to "market" and the insurers were able to account for them based on modeled loss estimates. As long as the insurers maintained a AAA rating, the banks could report the assets at par and the insurers could report them using their modeled loss estimates. The fact that this didn't work over an extended period of time and included a whole host of problems other then the embedded financial reporting arbitrage makes this example more complex. However, the financial reporting arbitrage was the motivating factor in a lot of the bizarre activity seen a year ago.
Instead of simply developing a new term for age old tendencies, this term points to activity that is at the heart of what went wrong. Arbitrage is a capital market term. Risk free arbitrage can't exist in an efficient market, and any inefficiencies quickly disappear under normal circumstances. However, the aggressive capital markets thinking that began to dominate finance led to innovation that overwhelmed traditional accounting and regulatory practices. Where they couldn't simply be bowled over, they went around traditional institutions, by simply disintermediating those institutions. For example, instead of banks originating mortgage, which they would then hold on their books, independent brokers originated mortgages which were then securitized -- bypassing traditional, regulated lending institutions.
Most of the financial businesses have to deal with inherent mismatches in the duration of assets and liabilities. A typical financial structure is to fund long term assets with short term liabilities. With a positive yield curve and leverage, it is highly profitable. The S&L crisis stemmed from a mismatch in low yielding, long duration assets (5% residential mortgages) and high cost, short term funding (demand deposits with increasing costs). A good deal of enterprise risk management was developed in response to this problem, which focused on nominal interest rate changes driven by inflation. To some extent, huge resources went into a financial Maginot line to protect against this specific risk.
Risk management was inverted and used to determine maximum risk that could be accommodated at a particular price. It was like that was a competition to see who could create the absolute worst AAA credit.
Accounting can't explicitly quantify risk within the confines of a balance sheet or income statement. This is hardly a surprise and people have been dealing with this for a long time and had become fairly adept at it. However, capital markets innovation gave people the tools to deconstruct, rearrange, and re aggregate risk in new ways. Markets became very efficient, not at allocating capital, but at arbitraging the various limitations in financial reporting. A quantum leap from old fashioned fraud, or more recent creative accounting.
And there you have it -- financial reporting arbitrage.