Saturday, April 4, 2009

Eating Crow. Or More Appropriately, Sushi.

I had an interesting conversation Friday night over drinks with the individual that runs my company’s investments. The path led unavoidably to the mark-to-market pseudo-suspension with the very new relaxed nature of the rules. His perception was one that I believe many others have.

And that is, that the market has failed in its duty to correctly price the applicable assets because of fear that overwhelms natural greed.

I couldn’t disagree more. And recent history proves it.

Make no mistake, we may very likely soon be living the Japanese experience. One of lost decades in markets. One of economic stagnation despite a robust export base. This is what happens when you try to game markets by removing the little faith that remained. As much as apologists for this current course of destruction like to disassociate our circumstances with the Japanese, there are crucial commonalities that are most prescient. Among those was the allowance of banks to hide their losses through arbitrary and inflated valuations. And our policymakers lambasted the Japanese for taking the same counterproductive measures that we are now.

One of the best lessons I ever received in my youth was during the process of selling the first car that I owned. It had been listed for what I naively considered a fair price, based on the original purchase cost, the outstanding loan balance, and a general feel for sales ranges. After months of futility, I lamented the fact that I couldn’t get what I felt was fair market from a buyer. The answer my father gave me was an obvious one that seems to escape our leaders and talking heads: I wasn't selling at market value - it was only worth what someone would pay. Someone should re-visit these basic (read: simple enough for a teenager to understand) lessons of economic value with FASB, our politicians, and bankers. Assets are worth what buyers will enter the market for. Nothing more.

So, where would fair market value derive from for these assets on bank books?

Only from the expected value of future income streams (interest) and future repayment of principal, based on the likelihood of each. That's why another argument that I've heard - that if these were classified as "Held to Maturity," then the banks could avoid unfair valuations in the present and realize much higher values in the future as the loans came to term - is patently untrue. The cash flows do not lie.

If you think for a second that funds, other banks, and countless private investors haven’t run extensive modeling to arrive at this value, you’re delusional. One of the most powerful forces in markets is the ability for market participants to effectively identify market anomalies (i.e., mispricing) and arbitrage it away back to an efficient state.

If just one party had felt that the likelihood of future cash flows made these assets a solid investment, they would have entered the market and paid the higher bank valuations long ago. That was the shortcoming in my colleague’s argument. Fear is easily abated when A) It’s not your money, B) There is a strong case for profit potential, or C) Both.

And yet they haven’t. And we have heard it’s because of a lack of liquidity. And yet it’s not as John Paulson has noted.

So what has happened is identical to Japan in that we allow our financial institutions to game their balance sheet to appear solvent. But it didn’t work in Japan. And it won’t work here.

And the simple reason is because all that has been done is changing the timeframe of coincidence between ‘realized’ and ‘recognized’ losses. Not the losses.

The grim economic situation of out-of-work Americans that can’t pay their mortgage is the same. The further price declines that will make it more economically prudent to walk away from houses will be the same. The adjustments in NegativeAm and OptionARM mortgages, where regardless of interest rates, payments balloon because principal is now included remain the same. In other words, the future defaults precluding cash flows that the banks can now pretend they will receive will stay the same.

What it will accomplish is playing dress-up with bank stocks. Temporarily. If you choose to ride the rally that I do expect, make sure it’s a short-term trade with a clear and legitimate price target and/or tight stop. A buy-and-hold investor should tread very lightly. When the ride is done, strong hands will sell into weak before the wave crashes down, and that may be you.

We are Japan. So we might as well grab some sake and try to enjoy it.

FASB relaxes accounting rules for banks on assets
By MARCY GORDON
"WASHINGTON (AP) — The board that sets U.S. accounting standards on Thursday gave companies more leeway in valuing assets and reporting losses. The changes should help boost battered banks' balance sheets and financial stocks rallied on Wall Street, but the rules may undercut a new financial rescue program.

...But others said the changes by the Financial Accounting Standards Board could undermine a crucial new rescue program mounted by the Obama administration, in which the government is joining with private investors to buy from banks hundreds of billions of dollars in toxic assets — especially the securities tied to high-risk subprime mortgages at the heart of the financial crisis.

In the short run, banks would benefit by raising the value of the assets. But higher values could drive away prospective private investors — who don't like to overpay, even though the government will absorb most of the risk.

"I do think the timing is terrible," said Sue Allon, the CEO of Allonhill in Denver, who works with hedge funds and investment banks to price assets.

...Joshua Shapiro, chief U.S. economist at MFR Inc., was more blunt, saying the FASB decision "allows financial institutions to use fictional valuations on many of their toxic assets" and further obscures their "true position."

...The FASB issued new guidelines under the so-called mark-to-market accounting rules, which require companies to value assets at prices reflecting current market conditions. The changes, which apply to the second quarter that began this month, will allow the assets to be valued at what the banks project they might sell for in the future, rather than in the current, distressed environment.

Still, investor advocates and other critics assailed the FASB, which took the action — with some dissension — at a public meeting of its five-member board at its headquarters in Norwalk, Conn. The critics said the board had sacrificed its independence and buckled to pressure from lawmakers carrying water for banking industry interests.

The FASB received hundreds of comment letters opposing the moves in the two weeks since it proposed them from mutual funds, accounting firms and others contending they would damage honest financial reckoning by masking the deficiencies and risks lurking within the system.

A House panel last month wrung a pledge from FASB Chairman Robert Herz to try to issue guidelines in three weeks that would relax the mark-to-market rules to bring relief to the nation's banks in the financial emergency. The head of the House Financial Services subcommittee, Rep. Paul Kanjorski, D-Pa., had held out the threat of legislation to pressure the standard-setting board to take the steps.

...The new guidelines remove the presumption that if there isn't a current active market for assets, they must automatically be considered distressed. They also will allow banks to avoid reporting some losses on securities by splitting them among factors like anemic markets or fluctuating interest rates that won't have to be counted toward net income or loss.

Two of the five FASB board members, Thomas Linsmeier and Marc Siegel, voted against the change in reporting of such impaired assets. Siegel said "the pressure keeps on coming back to us." They argued it was the sort of decision federal bank regulators should make, because it could affect how much capital banks would need to hold, and that the FASB had been pressured by Congress to take it.

"This is a huge mulligan for banks with junky securities," said Jack Ciesielski, an accounting expert who writes the financial newsletter The Analyst's Accounting Observer.

A key concern is the impact of the changes on the government's new program in which it is joining with private investors to buy up about $500 billion in toxic assets from banks.

With the banks now able to keep assets impaired by market factors from affecting their bottom line, they'll be more likely to hold onto them. "Buyers will be willing to buy them," possibly at less than 30 or 40 cents on the dollar, Allon said. Some investors prefer a mix of higher- and lower-quality assets, she noted.

If the assets remain on banks' books, they may continue to be reluctant to lend as they fret over the assets' future performance. That could work against the purpose of the government's program: to break the logjam in lending and get the economy pumping again, which would hurt consumers and small businesses caught in the credit squeeze."

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