by booking assets at a higher price than the market would offer, the banks reported earnings that never existed

TO BE NOTED: From Forbes:

"Debt Markets

Chanos: Prosecute Bank Execs

05.07.09, 05:45 PM EDT

At a conference Wednesday night, fund manager Jim Chanos accused banks of exagerating earnings for years.

James Chanos

James Chanos, a well-known short seller and hedge fund manager, said banks knowingly booked inflated earnings when selling the financial products that led to their downfall and the government bailout. The earnings wound up in bonus pools and banker's pockets.

"It's the heart of one of the greatest heists of all time," he said, without naming specific banks. Their executives probably won't be prosecuted because explaining how investment banks created and sold collateralized debt obligations and other structured financial products would test a jury's attention span. "The jury's eyes would glaze over."

The top underwriters of collateralized debt obligations from 2005 to 2007 were Bank of America ( BAC - news - people )-Merrill Lynch and Citigroup ( C - news - people ) with $237 billion of the $724 billion sold during that period. Representatives from both banks either didn't return calls or declined to comment.

Chanos, president of Kynikos Associates, was an early critic of Enron and rating agencies, reportedly shorting Moody's in 2007. Last year, he argued against proposed changes to mark-to-market accounting rules and made enough smart bets in the downturn to come in ninth on Forbes' list of top earning money managers with an estimated $300 million (see "Wall Street's Highest Earners").

During a discussion over the roots of the financial crisis at New York University Wednesday evening, participants spread the blame on rating agencies, the tight connections between Wall Street firms and elected officials and federal regulators. Chanos put banks' underwriting structured financial assets at the heart of it. (see "The Junk Alchemy of CDOs.")

Like many pools of asset-backed products, collateralized debt obligations are sliced into tiers, called tranches. The highest tier was considered safe, often sporting a AAA-badge from credit rating agencies, and paid out the lowest yield compared with riskier tiers ranked below it. In Chanos' telling, the banks typically kept a 3% to 5% cut as their fee for orchestrating the deal. He said sometimes the fee came from the lowest-ranking section, the equity tranche. "In many cases, the fee was a toxic tranche," he said. "They were immediately worth 30 cents on the dollar, but not priced that way."

In effect, by booking assets at a higher price than the market would offer, the banks reported earnings that never existed, he argued. The earnings wound up in the bonus pool and were then paid out. "There's no doubt in my mind that this is fraud," he said. "This was the bezzle," he added, using the late economist John Kenneth Galbraith's term for the hidden embezzled inventory that piles up in boom times.

Brad Hintz, a senior analyst at Sanford Bernstein and the former chief financial officer for Lehman Brothers, disputed Chanos' characterization of the underwriting process. Banks kept the top tranches thinking they were the safest, he said. And the problem, as Merrill Lynch found out, was that those AAA-rated securities turned out to be toxic. The rest of the story is well known: Bear Stearns, Lehman and Merrill couldn't move asset-backed securities off their books. "One of the key mistakes was putting illiquid assets on their balance sheets, not realizing fixed income markets could become illiquid."