Several years ago, a large US bank had a little trouble. In the early 1980s, the bank had been a leader in Latin American lending. By the mid-1980s, it was a leader in Latin American losses. Among other things, the bank was sitting on a portfolio of $200 million of Bolivian national debt. At least, that was its book value. The market value in a then-emerging secondary market in New York was about 10 cents on the dollar.
One weekend, a senior manager at the bank received an unexpected call. A large non-financial company wanted to buy a large amount of Bolivian national debt as part of a (totally legitimate) trade and tax deal that it was negotiating with the government.
It needed an immediate answer, so was offering roughly twice the going market rate – about 20 cents for every dollar of face value.
He had sufficient authority to make such a decision. The secondary market was stable with no reason to expect it to go up or down.
You have as much information as that manager. What would you do?
The senior manager had no doubts. He saw this as an opportunity to make a clear profit of about $20 million (the difference between achieved price and market price) and become an instant hero.
He accepted the deal.
The following Tuesday he was fired by the CEO. The reason? He was working to the wrong metric of value. The bank had just engaged in a transaction that showed its book-value records were out of date. By the accounting and regulatory rules of the time, they had to be updated (and had not needed to be updated until the transaction occurred). The Bolivian deal wrote off $160 million in capital reserves. A bank’s capacity to do business is limited by its capital, so the consequences of the write-off were significant. Far from being a hero, he had displeased the Board, the Federal Reserve Bank and his colleagues.
He thought he had made a profit of $20 million. Everyone else saw it as writing off $160 million. Book capital was of much more value than extraordinary earnings at that time.
Even in a relatively simple, “profit-driven” environment, characterised by only a handful of numbers and basic arithmetic, the Value Metric may not be uniformly obvious.
Heritage: A story often told by Michael Black, VP at CSC Index in the mid 1990’s.