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
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