LRG Capital Report

When in Doubt, Blame the Accountants

                     

In our first post, we touched on how the auto and airline industries use high oil and gas prices as red herrings for their struggling stock prices. Unfortunately, some executives in the financial industry are now using similar red herrings to excuse their companies’ poor results. Last month, the Dow Jones Industrial average fell through the lows set in March and crossed into Bear Market territory, or a decline of 20% from its peak. The selling pressure has been relentless over the past six weeks, with June 2008 closing out as the worst June for the Dow since 1930. Investors continue to be uneasy over record high oil prices and further write downs in the financial sector. Last weekend, we learned that a plan was in the works to bail out Fannie Mae and Freddie Mac with taxpayer money. Furthermore, the SEC issued an emergency rule to prevent investors from making “naked” short sales of some of the biggest financial stocks. One of the most controversial and publicly debated plans came from Steven Schwarzman, the Chief Executive Officer of Blackstone Group. Mr. Schwarzman and others believe that accounting rule FAS 157, or Fair Value Measurement rules, is the major reason why the financial system has fallen on hard times. In our opinion, this is a convenient excuse to shift the blame from the upper management of some of the world’s leading financial institutions to, of all people, the accountants.

FAS 157 was introduced in November 2007, as a guideline for how companies must determine market values, or fair values for financial securities. The summary as stated by the FASB can be found here: http://www.fasb.org/st/summary/stsum157.shtml.

Some of the key points can be found here:

This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, this Statement establishes a fair value hierarchy that distinguishes between (1) market participant assumptions developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances (unobservable inputs). The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

A security is worth what the market is willing to pay for it. The rule continues by stating some assumptions about valuating risk:

This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability.

Again, this is pretty straightforward. When banks value a CDO, or collateralized debt obligation, they must mark to market and adjust the risk premium to where the market values it and not to a number that an analyst comes up with based on assumptions and inputs into a computer model.

In the case of the CDO’s that banks and brokerages are now holding, the market has become nearly illiquid, putting the value of the security at zero, which forces the bank to mark the security on their books down. Some people believe that the market is overstating the downside of the value of the CDO’s which causies the banks to mark down much more than they should. In our view, this is a false assumption based on the sole fact that if the market is truly undervaluing these assets due to a lack of liquidity, you would have a few deep value investors buying the securities as we speak. As of last month, there were a couple notable managers beginning to buy the distressed CDO’s including Bill Gross of Pimco.

May 21 (Bloomberg) -- Pacific Investment Management Co., the manager of the world's biggest bond fund, bought mortgage-backed securities from Israel's biggest bank for $2.55 billion as the firm snaps up mortgage debt to profit from slumping prices.

One of the major reasons FAS 157 was introduced was to provide transparency and accuracy in reporting. Before FAS 157, managements were able to assign a value on their portfolio of CDOs. When the CDOs were increasing in value, the banks levered up, which allowed them to lend to consumers (who never should have been able to borrow in the first place) which drove up the values of home prices. Now that the reverse is happening, people are crying foul and looking for someone to blame. The truth of the matter is that, had the managements used more foresight and caution in their models and balance sheets, we would probably not be in this situation today. The problem is not, and has never been the FASB when it comes to CDO’s. The problem stemmed from hypothetical/ theoretical valuations, and the bankers, lawyers and brokers who were only interested in fees and quotas instead of understanding what they were selling or buying. The models and products just became so complex, that no one really knows who is holding what anymore.

A prime example of a firm that has marked to market for years now is Goldman Sachs. In Goldman’s case, management’s decision to mark to market much before its competitors equated in a stock price that hasn’t suffered nearly as much as its competitors. Another prime example is Wells Fargo, who released earnings last week. The San Francisco based company blew away expectations and raised its dividend at a time where their competitors are cutting them. Wells Fargo Corp stock was up over 30% in one day which sparked the biggest rally in the history of bank stocks. There was no mention of FAS 157 or bailouts for a change.  

We will most likely continue to see more write downs and bank failures over the coming months and years. Last week, Merrill Lynch and Citigroup wrote down $9.4 billion and $11.7 billion respectively. The losses were less than the market had anticipated and the stocks were up. We must take into consideration that banks have been failing since the beginning of time. Bailouts and accounting gimmicks will only provide temporary relief. Perhaps a shakeup in management is exactly what these banks need right now. Everyone in the story is to blame equally for the reckless lending and over-leveraging of the past five-plus years. We all know that a house is only worth as much as the next person is willing to pay for it. The chickens are coming home to roost as the old saying goes.

www.lawrencegoldfarb.com or www.larrygoldfarb.com

Relevant Articles:

http://www.informationarbitrage.com/2008/07/getting-it-wron.html

http://dealbook.blogs.nytimes.com/2008/07/09/dimon-vs-schwarzman-the-great-accounting-debate/

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aiZ4C0cWe7.g

 

Is the US entitled to its own auto industry?

With our inaugural post we ask a simple question about a not so simple car company in a not so simple industry. Last week, General Motors shares fell below $10 for the first time since 1954. GM shares are down about 60 percent this year alone and rumors are swirling that the automaker will ultimately file for bankruptcy. From peak to trough, the company’s market cap has dropped from $24.1 billion to $5.73 billion. Analysts have warned that GM is burning through cash faster than investors realize and that the company will have to raise between $10 and $18 billion to fund its operations through 2009. There will always be those who will see only a depressed stock price and potential value opportunity.  The bigger question is does the United States need an auto industry at all?

There are many reasons why this downturn may turn out to be much more costly to GM and the entire US auto industry as a whole for that matter. It is obvious that the current cost structure is not working and that the entire industry must retool if it is to survive. Gone are the days of cheap credit, 0% financing, and international mega mergers. For example, in September 2007, Cerebrus Capital Management took ownership of over 80% of Chrysler Group, after Chrysler’s failed and short lived marriage with Daimler-Benz. Just last week, analyst Himanshu Patel of JP Morgan said that Chrysler was in the worst shape of all of the Big Three, and that the company could potentially face a “major liquidity event” by the second half of 2009. The analyst added that a bankruptcy filing at any major U.S. automaker would be catastrophic for the broader industry, resulting in widely lower vehicle prices and dealing a severe setback to auto parts suppliers. The reality is that the Daimler Chrysler merger was doomed from the beginning. It is now in the category of other infamous deals (think AOL- Time Warner). The problem with merging two companies in a declining industry is that all you are left with is a bigger company in a declining industry.

In the case of General Motors, the harsh reality is that over the past few years, while Toyota and Honda were aggressively engineering and marketing hybrid and more recently hydrogen powered vehicles, GM stayed the course with huge gas guzzling SUV’s like the GMC Yukon, and the infamous Hummer. Finally, last week after yet another earnings report disaster, GM announced that it would close four of its pickup truck and SUV factories and shift its engineers to focus on more fuel efficient vehicles. When asked if GM should have moved more quickly to smaller vehicles, the companies president and COO, Fritz Henderson said he doesn't spend time looking in the rear view mirror. 

We here at the LRG Capital Report think that is exactly the kind of thinking that got The Big Three into this mess. Whether it was poor forecasting, lack of flexibility, or apathy by management, somewhere along the line the US auto industry has lost its way. The effect of these missteps on our economy are tremendous from the employees, to the capital markets (that for some reason still find a reason to throw good money at this company), and obviously to the environment. Just this morning for example, the AP is reporting that, “GM said to consider more cuts as market shrinks”. The company said that it may make further white collar job cuts, sell off some of its brands, and speed the introduction of small cars to the US auto market. The article continues by stating that, “Critics have said GM still has too much fat in its middle management, despite cutting white-collar employment to 32,000 last year from 44,000 in 2000.” No one is happy to see people lose their jobs, but when a company or industry can no longer compete, changes must be made. Still, one has to wonder why it took so long and a loss of so much shareholder value to begin the process.

As we usher in this new global era, perhaps no other industry (other than possibly the US airline industry), will face the kinds of challenges as the US auto industry. Only time will tell whether or not the US auto industry can and/or will exist at all. The managers of the US auto industry need to finally come to grips with the fact that if they are to survive, simple band aid fixes will not work and that the entire industry must be restructured from the ground up (regardless of gas prices – the industry was a debacle long before rising gas prices compounded the existing problems and became the excuse of the day). The consequence of not making extraordinary changes, and/or a complete restructuring of the entire US auto industry, is that the US may not (and maybe should not) have an auto industry at all!

www.larrygoldfarb.com or www.lawrencegoldfarb.com