“Earnings Management and Initial Public Offerings: The Case of the Depository Industry” Adams, Carow and Perry CFR Workshop October 25, 2006 Discussant Timothy J. Curry, FDIC

Story Line Story Line Accounting story! –Conclusion: Insiders of mutual thrift organizations (legally) shade the books in IPO offerings to extract rents!

Story Line Story Line Tale of two incentives (Banks vs.Mutuals): - Maximin vs. Minimax strategies for IPO offerings! -banks max. gains; min. losses (best foot forward) to increase value and IPO price (“net sellers”) -Mutual thrifts min. gains; max. losses (worse foot forward) to reduce value and limit the IPO price (“net buyers”)

Story Line Story Line How do they do this? Through discretionary accounting adjustments to loss provisions and loan loss reserve accounts! Results: insiders make excess rents with demutualization's! First day trading returns 21.2 % for sample thrifts

General Comments! Results are plausible; many historical examples of insider abuse and windfall rents at the expense of depositor/(owners) during mutual conversions; (Unal, 1997); this is a new twist; All investors in thrift conversions earn rents to some extent because depositors/owners get nothing for accumulated book equity! supervisors do not permit the issuance of shares to depositors! (e.g. P/B 66.6% vs % Table II) Be circumspect using the words like “equity claim”, “equity claimants” etc.

General Comments! General Comments! Data suggests that something is going on w/accounting data before thrift conversion s! Story is consistent with literature involving in management buyouts (Jones, 1991);(Perry and Williams (1994); develop more sources along these lines if available Good start: well presented; important subject; no problem w/the modeling; straight forward approach -

Specific Comments/Concerns! Specific Comments/Concerns! Story needs more development -Describe how conversion process works! –How are deals structured? How much do insiders get (10%)? depositors/owners? outsiders? –Role of stock options? –Role of the underwriter? –Tell us about the appraisal process? –What is the role of the supervisor? Gets to bless the deal?

Thrift mutual conversions : -Incentives are to keep offering prices relatively low! All parties benefit; (insiders /depositors /investors) -results may not necessarily be associated with accounting adjustments! -underwriters often low ball IPO price especially for small/unknown firms to assure successful subscription offering and capture rents during subsequent trading for insiders /investors -Stock options to insiders: keep strike price low -Fighting a “head wind” in the model

Other issues -Cyclical effects: sample period ( ) was good period for financial institutions; 74 percent of the sample banks went public after 1994; 66 percent for mutuals. Accounting adjustments may reflect improving economy -Segment the samples ( )- ( ) to test for cyclicality of results and to see if trends hold up; time dummies may not be enough to account for changing economic conditions

Variable ((NPA t-1 )/Loans))non-performing assets or loans? How defined? Differs from section to section Robustness checks: What happens to IPO price during the first year? Do rents persist? Where are the examiners/regulators during all of this? OTS/SEC? Learning curves? How widespread is the problem? Comment

Conclusionary statements unclear: “…detecting earning management in highly regulated industries is important because it demonstrates that to the extent earnings management is a problem, regulatory solutions may not be the answer” Explain. “We believe our results shed light on whether regulators “see through” earnings management…” Explain.