Twenty years ago, then-Wells Fargo (NYSE:WFC) CEO Carl Reichardt impressed on me the distinction between the value of the cash flow a given asset will generate over time, and the market value of that same asset at any given moment. There can be a difference, and occasionally it will be large. For assets held for a long period of time, Reichardt emphasized, it’s the cash flows that matter, regardless of what happens to asset’s market value in the interim.
This distinction came to mind this week when I read an October 30 story on Bloomberg by Jonathan Weil with the ominous-sounding headline: “Wachovia Shows Why No Bank’s Books are Trusted.” No bank's? Wow! Weil seems to imagine a great conspiracy of banking executives, regulators, auditors, and securities analysts, all dedicated to the project of systematically misrepresenting the balance sheets of the nation’s banking industry. It really is quite something. At the root of Weil’s imaginings, it turns out, is his inability to understand the distinction between market values and cash-flow values that Reichardt emphasized to me all those years ago.
Jonathan Weil, you may recall, is Bloomberg’s resident accounting skeptic. He made a name for himself earlier this decade when he blew the whistle on Enron. Frankly, I don’t know if his reporting was better back then than it is now, or if he was just lucky for being negative at the right time. What I do know, as an accounting graduate who’s been following banks for 28 years, is that his analysis of the banking industry today couldn’t be more wrong-headed. From what I’ve seen from Weil’s stories about accounting, Bloomberg shouldn’t be holding him up as an accounting expert.
Anyway, Weil’s main piece of evidence that bank accounting is crooked is the fact that—are you ready? —both Wachovia and National City were sold for less than their book values. That’s it. It’s proof, he says, that current accounting practices allow banks to overstate the “market value” of their assets.
“The reality is,” Weil says ominously, “that Wachovia’s management team . . . still won’t admit the company’s balance sheet is a farce, and has been for a long time. More worrisome, though is that nobody with any authority is calling them on it, even today. That includes Wachovia’s auditor, KPMG, as well as the Securities and Exchange Commission, and banking regulators such as the Federal Reserve and the FDIC.” Green eyeshades meet black helicopters!
There is of course, another more benign explanation: the bank, its auditors, and regulators are all simply following GAAP.
Weil’s game here, of course, is to pretend that near-term movements of stock prices have vindicated his views about the long-term cash-flow economics of bank assets. But that’s crazy. The fact is, asset price movements can (and do) diverge from the asset’s underlying economic fundamentals all the time. If you doubt it, remember that some of the loans regulators forced banks to write down to zero during the banking crackup of the early 1990s are still generating cash flow today.
Or, to look at the situation in a different way, how would Weil mark Berkshire Hathaway’s assets to market if Berkshire were sold under conditions similar to the Wachovia sale? What would the value of the company’s holdings in American Express, Coca-Cola, Washington Post, Wells Fargo, and the rest be if the entire portfolio had to be sold over a single weekend, and there were only two willing buyers? Under those circumstances, their prices would be much lower than in a normal, non-stressed market. But the divergence would happen because it was the market that was stressed, not the assets.
To Weil, though, all this is beside the point. His M.O. seems to be to focus on what happens in the short term, and then try to give it a Larger Meaning. In particular, he finds companies having plain, vanilla operating problems and then he argues that the problems are really evidence of an accounting fraud. For this, he is an accounting “expert.” It will interesting to see his—and Bloomberg’s—reaction as the cycle finally plays out.
Jonathan Weil (and other reporters, such as the Wall Street Journal’s Peter “always negative” Eavis) consistently confuse cash-flow value with market value. Corporations in the U.S. operate under GAAP. It is not a perfect accounting method, but I don’t know what method is. Current GAAP does not require that all assets and liabilities be marked to market. In particular, loans need not be. Weil could argue for a change in GAAP if he wants. But he’s off base when he says are banks are being devious by not marking all their assets to market.
In this bear market people like Weil and Eavis seem to simply assume that, in every case, lower short-term market value must mean deteriorating underlying fundamentals. That’s a mistake. In an environment like this one, where every investor on earth is deleveraging, the number of sellers will overwhelm the numbers of buyers, and asset prices will come under severe stress. But that’s the result of screwed-up market mechanics, not underlying deterioration in the cash flows the underlying assets generate. The Weils and Eavises of the world should understand that. But they don’t.
By now, I am tired of the people like Weil and Peter Eavis justifying their negative views by pointing to falling stock prices and nothing else. If you’re going to put yourself out as expert, you ought to be looking at something besides just stock charts.