To Understand the Market, Understand Accounting Rules

Over the last several days at "A Dash" we have been developing some important themes that will help investors in 2008.  Today's events provided strong support about each of the following ideas:

1. The gap between perception and reality, on the market, the Fed, and the economy;
2. The overwhelming negativity of sentiment; and
3. The perverse effect of FAS 157 accounting rules on corporate behavior.

We shall eventually return to each theme (and also continue the New Year's Resolution Series), but the accounting question is a good illustration of each key point.  We know that it seems boring.  When you read about doing some homework -- well --- this is it!  You can learn a little more than the  rest of the other investors.

Background

In our analysis of the change in executives at Bear Stearns, we agreed with Barry Ritholtz's general idea, but pointed out that Bear would be ill-served by dumping "garbage" at distressed prices.  Barry  thinks that the marked-to-model prices used for Level 3 are a "fairy tale."  Today on CNBC's Squawk Box Barry repeated his thinking on this point.  (Readers should check out the entire video of Barry's segment.  He got some well-deserved accolades for his 2007 forecasting and made some interesting picks for 2008).

Our view is that marking to model is  actually more accurate than fire sale prices.

Most investors have paid only cursory attention to the FAS 157 accounting rules.  The chorus from the bearish pundits was that November 15th was some kind of D-Day. It did not happen.  The truth is that companies have not been conservative about taking losses.  If anything, they have been aggressive.  Prodded by their accountants (formerly the Big 7, then the Big 6, now the Big 4) companies need to comply.  The remaining accounting firms all remember Arthur Andersen.

Our conclusion here is not an empty assertion.  It is based both upon personal service as a board member of a public company, and consulting work with companies forced to meet various FASB rules.  The average market participant is still living in 2000 when it comes to understanding accounting.  People think that companies can exaggerate and do anything they want and that accountants will go along.  Investors who do not live in the past have a real edge.

Do you really think that professional accounting partners would risk losing their lifetime partnership stakes in a situation like Arthur Andersen?

Today's Events

Brian Wesbury of First Trust Advisors stated on Kudlow tonight (no link yet) as follows:

One of the issues that we have today and I don't think it is talked about enough, is this whole idea that we have to mark to market and that we have to run the losses through our income statement....(T)hat makes our capital situation look a lot worse.  These bonds that are selling at thirty cents today, they're worth seventy cents, but the market's dysfunctional and that is causing a problem.  So in other words our FASB accounting rules are causing problems.

This is exactly the point, and most market participants do not get it.  Financial institutions have chosen to keep distressed securities on their balance sheets rather than sell at bad prices.  To do so they have had to solicit foreign investors and to borrow using the Fed's TAF program.

It is working.  It may also have had something to do with Bank of America (BAC) buying Countrywide Financial Corporation (CFC).  We expect further consolidation to clean up distressed paper.  A legitimate trading market in these securities may still be a long way off.

Other Views on Distressed CDO's

Last month the Wall Street Journal did an analysis of the ABX, frequently used to estimate the losses at major banks.  Here is a key comment:

Some analysts contend the value of some ABX indexes imply a catastrophic outcome for the subprime-mortgage market that seems remote. For instance, Wachovia Capital Markets analysts Glenn Schultz and John McElravey say the price of the ABX that tracks AAA-rated mortgage debt implies losses of around 49% among pools of subprime mortgages issued in 2006. A cumulative loss of 49% would be achieved if all 2006 subprime mortgages were to default and recover only half their value after foreclosing on the homes, or if half were to default and recover nothing.

Most Wall Street analysts expect 10% to 15% in cumulative losses for these loans. As of August, the delinquency rate on all subprime loans was around 20%. For 2006 subprime mortgages, around 27% have already been paid down, many through refinancing, and 2% have defaulted.

This differs dramatically from the disaster scenario predicted by many pundits.  The real issue is whether financial institutions will be forced to sell, whatever the price.

Felix Salmon at Portfolio.com is even sharper in his criticism in two excellent articles.  He wisely points out that there is no easy way to do an arbitrage on the ABX.  He also points out weaknesses in calculation and the likely short life of the index.

UPDATE

Check out David Merkel's comments on another relevant index, the CBMX.

Sector Update

Rapidly changing events create havoc for any sector method that relies on identifying trends.  When news stories play upon market fears, especially at key points of support and resistance, it is a difficult market.  The updated TCA-ETF report reflects this.  The results remain within our tested range.  We know that the biggest returns come when there is a new major trend for markets and sectors.

Conclusion

Investors who take the time for a little study of the real impacts of FAS 157 will have a better understanding  of the difference between sentiment and reality.  They will also have an insight into the likely strategies of leading financial institutions, including those under new management.

[No position in stocks mentioned]

Comments

[alanj878]

Trends that might develop is our currency might one day be switched backed to gold

[oldprof]

Shrek-

You ask a question on the minds of many.

First, let us keep in mind that these companies had many ways of earning profits before the advent of SIV's.

Next, most have laid off people to reduce costs in these areas. Their profits are geared to people and costs.

Finaly, the demand for yield continues. There will be a new era of SIV's, with less complicated structure and better agency ratings. How long will it take? Months, not years, I suspect.

Some may disagree with this viewpoint, but I think stocks like GS and MER reflect little of this upside.

Great question -- thanks.

Jeff

[oldprof]

Josh-

Josh - Thanks for pointing this out. One of the biggest shortfalls in investor understanding is the big writedowns. If/when there is some real performance, the earnings will spike. There is a mindless approach to evaluating the forced marks.

Thanks for your comment, and I would welcome more discussion on this point. Few understand it.

Jeff

[shrek]

Where are the profits going to come from for Ibanks and places like CITI?

[Josh Stern]

The dislocation of the AAA ABX index is even more extreme than you describe, since most if not all of those senior contracts start out with over 10% subordination - that's how they became an AAA tranche of sub-prime. So 10% have to default with zero recovery or 20% with 50% recovery before the AAA tranche even starts taking losses. So at 50% of par, that means at least 60% default with no recovery (or 100% default at 50% recovery and another 10% of par goes to a liability settlement with the municipality of Cleveland).

[Luis Prieto]

Hello, I have a new blog, and would be interested in exchanging links.
I am Spanish and my blog covers the analysis of many equity markets.
I think it could be beneficial for both.

Greetings