Is Mark to Market a bad idea?

I wrote about this last month, and it’s been in the news again this past week, because there’s once again discussion to “relax” the mark to market accounting rule known as FAS 157.  I expect that the discussion in Washington is what’s behind the rally in financial stocks this past week.  It doesn’t really matter, as the financials are no where near the end of their crash.

They will be going lower no matter what accounting mechanism they use, because eventually they need to fess up and pay their debts – unless we keep giving them billions.  In that case, we’ll all go down with them.

I read an article on CNN.com a few minutes ago titled “Quit whining about accounting!”  which reminded me of the discussion, and the story has some good quotes.

Sure, mark to market may be prolonging the problems for big banks such as Citigroup and Bank of America, because as long as these companies are stuck with soured mortgage-related assets on their books, they will need to keep taking huge writedowns that cause them to report massive losses.

“The problem with the mark-to-market rule is that it requires you to value assets under the presumption that you are going to liquidate everything today in a fire sale. Most financial institutions are not liquidating,” said Richard Ebeling, senior research fellow for the American Institute for Economic Research and a professor of economics at Trinity College in Hartford.

He has a good point. But changing the rules to make these assets look more attractive than they currently are – because they might one day be worth something again if you click your heels three times and chant “There’s no place like a foreclosed home” over and over – is not the solution to the banking crisis.

I agree.  Changing the valuation so you can just make something up for the value of an asset is dumb.  That’s Enron accounting.

“Those who oppose mark-to-market rules say it exacerbates the downside because it is giving a false signal about the economic value of securities. But the truth is that’s not the case,” said Patrick Finnegan, director of the financial reporting policy group for the CFA Institute, a nonprofit organization that administers the Chartered Financial Analyst exam for investment professionals.

Finnegan argues that current market values are the only way to reflect assets on a bank’s balance sheet, since anything else would be mere guesswork.

In my previous post, I referred to this “guesswork” as Mark to Myth, because that’s what it is.  It’s saying “I paid $1 million for this 2 years ago, and I say it’s still worth $1 million – It doesn’t matter if my neighbor just sold his $1 million home for $500k, Mine is still worth $1 million.”  That’s ignoring reality, and that’s dumb.

“Companies are fighting for their survival and they want to use accounting to obfuscate their true financial position. Who’s to say their view is more sound or fundamentally reliable than what the market thinks?” said Finnegan.

The call for changing accounting standards, much like the blame game that’s being played with short sellers, shifts the focus from the real problem. Banks aren’t struggling because the rules are stacked against them; banks are struggling because they made bad decisions throughout the bubble years.

A moratorium on mark-to-market accounting would only reward bankers for their reckless behavior of the past.

What’s more, it only would serve to delay what obviously must be done: banks need to get rid of the assets soon — whatever the short-term cost — instead of sitting on them indefinitely.

The really sad thing is that someday the value of these assets may actually rise, and if the banks change the accounting rules, they won’t get to claim the increased valuation because they’ll be using a different model.  These are the same short-sighted idiots who got us into this mess, and right now they’re looking for any rope at all to grab – even if it has the shape of a noose.

gk

Financial Follies

In going through the financial news stories on various sites tonight, this one from the NY Times struck me as particularly insightful.  Lets see what they have to say about the state of the financial institutions….

The story starts with this: Somehow, $4.4 billion just evaporated at Merrill Lynch. Less than two weeks ago, Merrill Lynch valued the toxic mortgage investments on its books at $11.1 billion. Now, it is selling those investments for $6.7 billion — and financing most of the purchase to boot.

So two weeks ago, Merrill Lynch claimed that the value of their mortgage holdings (the bad ones anyway – they haven’t disclosed all of them) were worth $11 billion.  Today they’re supposedly worth only $6.7 billion.  That’s $4.4 billion utterly gone, destroyed by the decrease in value of the underlying assets.

I say “supposedly” because you haven’t heard the best part yet – Merrill is financing $5 billion of the sale of these assets (which are worth 40% less than two weeks ago) to Lone Star Funds.   I can’t find where I read it right now, but I think Merrill owns a big part of Lone Star Funds.  If this is true, they’re selling these toxic CDO’s to themselves in order to get them off the books.  Not good.

Here’s something from FoxNews on the story:  Lone Star Funds, a Dallas-based distressed-debt investors based run by John Grayken, will acquire asset-backed securities with a nominal value of $30.6 billion for $6.7 billion. The sale will help cut Merrill’s exposure by $11.1 billion from its level on June 27, leaving $8.8 billion of these securities on its books.

That’s 22 cents on the dollar.  The NY Times story linked above puts it into perspective: Executives at Citigroup, JPMorgan Chase and Bank of America began reviewing the bundles of mortgages, known as collateralized debt obligations, or C.D.O.’s, that their companies hold on their books. Those companies may have to lower their valuations, and take additional charges, if their assets are similar to those sold by Merrill.

Of the companies they mentioned, I personally think Citigroup is the one most likely to pull a Bear Stearns and disappear.

The NY Times story also said: Still, financial stocks rallied on Tuesday, as investors hoped the deal at Merrill signaled the troubles plaguing banks’ balance sheets might be coming to an end.

Anyone want to bet on that?  How many times are these analysts going to say that the troubles are over, that this is the kitchen sink quarter, that this must be the bottom?  I can find dozens of examples over the past 10 months.

In just one month, Merrill had to drop the value of some of their CDO’s from $30.6 billion to $6.7 billion.  What does that say about the honesty of their accounting?  Damn near everyone knew they’d have to write these assets down last year – but Merrill tried to delay their day of reckoning.

Regardless of the way the market reacted today, there’s no way Merrill is worth more today than last week.  But that’s what the stock price says.

I am forced to conclude that many investors are stupid, that they are betting on a short term gain, or that they are smoking crack – because the numbers just don’t add up.

If I’m right Merrill (which closed today at $26.25) will be lower a week from now after investors have had time to understand what this really means for Merrill.  Bank of America ($32.22) and Citigroup ($18.46).

One of these days I’ll have the guts to short individual stocks and make some money off of these things that should be obvious to everyone, but I’m chicken.  I have no position in any of the stocks mentioned in this post.

There’s a lot more to say regarding the market and financial stocks, but I’m calling it a night.  Stay tuned.

gk

The running of the bulls

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities – and their higher default rates coming this year and next – are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed “take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout – because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no – because of the reasons listed above – but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  🙂 

gk

Grasping at Straws – Take II

Just yesterday I mentioned the CNBC report about Ambac that caused a major market revesal a couple of weeks ago, and now it happens again today.  How many times are these people going to cry wolf?  And (perhaps a better question) when do people stop believing what CNBC says?

Perhaps the strangest part of today’s story is who they are counting on for the bailout….  Citigroup!  But the market was way down this morning partly because of a report that Citigroup needs a lot more money to stay afloat.  The report said:

Sameer Al Ansari, Chief Executive of Dubai International Capital told delegates at a private equity conference thatit will take more than the combined efforts of the Abu Dhabi Investment Authority, the Kuwait Investment Authority and Saudi investor Prince Alwaleed bin Talal to save the bank.

“It’s going to take more than that to rescue Citi,” Ansari said. He added that more write downs are expected and that Gulf investors would be required to bolster Citi.

Pardon my ignorance, but just how exactly is a financially troubled bank supposed to bail out anyone?  The answer of course is by borrowing money via the Fed’s Term Auction Facility (TAF) which doesn’t need to be disclosed. 

My take is that the longer we prop up this house of cards, the longer it will take to put it behind us – and the harder the crash when they do eventually fail.  We should let these businesses (and investors and borrowers) go under now.  It’ll be a terrible quarter or two, but it’ll be done with.  The way this is going, these financial problems are going to drag on for years,

gk