Another Gift from the FASB

Try this line: "I'm from the Financial Accounting Standards Board and I'm here to help you."

Not very persuasive? We are not surprised.

Background

FAS 157 is a well-intentioned attempt to clarify derivative accounting and increase transparency. Had it been introduced at a different time, the transition might have been smoother. Instead, the major Wall Street firms adopted the new rules early in 2007, just as the impact of the various mortgage derivative issues was becoming clear. It might have made sense to delay the implementation for a while, but the conspiracy folks were already out in force.

There were many predictions from your favorite bearish media sources and blogs that November 15, 2007 would be a Doomsday of reckoning. That prediction was wrong, and so has the rest of the scaremongering about illiquid assets. There is an element that wants readers to believe that anything in Level 3 (no comparable trades) is suspect and probably worthless. These same sources want you to think that the SEC is out to mislead the average investor while allowing companies to do whatever they want in valuing assets. We were surprised, and a bit discouraged, to learn that a very astute group, the regular commentators of "A Dash," have fallen for this rhetoric.

Here are a few facts:

• The SEC is trying to assist investors by making sure that accurate information is available. They have delegated accounting rules to the Financial Accounting Standards Board.
• FASB is trying to do the same thing. They are a bunch of accountants. They are not conspirators.
• Companies and their accountants have legal obligations under these rules. They are following them. Each move is noted and publicized. The notion that this reduces visibility is silly. For the record, none of them want to go to jail, and they all watched the 2000-era events.
• Those who pull a single sentence from SEC rules, ignoring the visibility requirements, and creating far-fetched schemes of what companies will do ---- well --- they are mistaken. (We cannot seem to summon up the colorful and quotable language of others. Modest language does not mean "wrong.")

The Issue

Despite extensive discussion, many market participants do not understand the FAS 157 rules. A subtitle on CNBC today highlighted Level 3 assets as illiquid and subject to write-downs. It fanned the flames of sentiment -- that companies are hiding something, and that these assets are overstated in value. Since by definition they are difficult to value, a defense is nearly impossible. Since the models used have funny names and are complicated, everyone disparages the theoretical work done to evaluate the holdings (i.e., mark to myth). Shoot first! Don't bother to analyze the method, since that would require work instead of a slogan.

Most importantly, people ignore the fact that Level 3 includes many standard assets that do not trade, and may even include offsetting holdings.

Today's Trading

We have written extensively on FAS 157 and complained that the mainstream media has not done a good job of explaining the issues. We are therefore delighted to cite a first-rate article from Bloomberg's Yalman Onaran which provides a balanced and careful account. The article begins with a factual account of an announcement from Goldman Sachs (GS), and a description of the market reaction. Anyone interested in successful investing should give a very careful read to the entire article, but here are a few key excerpts, with our comment in brackets:

"Just because an asset is defined as Level 3 doesn't mean we're uncomfortable with the value of the asset,'' said Lucas van Praag, a spokesman for Goldman Sachs. ``It also doesn't provide any insight into the relative risk of the underlying asset.'' [If one thinks that all companies lie, do not bother reading further. If one believes that companies recognize legal obligations, this has some meaning.]

Under accounting rules, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets are placed into the Level 3 category when there are hardly any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses. [A good, objective explanation.]

The new standard doesn't change the way firms value their assets. It only creates clear-cut categories and is intended to increase transparency about valuations. [Well stated, and not well understood.]

``The uncertainty of Level 3 asset valuation is already priced in the stocks of brokerage firms,'' said Steve Roukis, managing director at Matrix Asset Advisors Inc. which oversees $1.8 billion of assets in New York. ``We expect more writedowns in coming quarters, but they're not going to be huge numbers like the past quarters.'' [Some might think that the market has priced in more than the expected write-downs. Many of the Level 2 assets are marked to unrealistic prices from indices with no good arbitrage, like the ABX.]

Trading Reactions

The announcements generated a typical trading reaction, sending shares of Goldman Sachs, Lehman (LEH), and Morgan Stanley (MS) lower on the day, along with other financial issues.

This is not a surprise. Even those of us who find the interpretation mistaken understand what the short-term market reaction will be. Bids are pulled. Potential buyers wait for the right opportunity. The market decline serves as a false confirmation for those with a wrong-headed approach to the issue.

Conclusion

Investment managers face a dilemma of timing. For us to have a long-term advantage, and many of us do, we must discover and act on market mis-perceptions. Despite this, we are all respectful of market forces and the reaction to news.

All of the financial stocks are subject to rumors and gaming by hot-money traders and hedge fund managers. Many of the blog and media accounts fan the flames.

We have an underweight position in financials, (including Goldman Sachs), but we expect to step up to an overweight posture quite soon. We noted yesterday that sentiment is "sticky" and there are many applications. The catalyst for buying is when the sentiment is confronted with fact.

None of the best investment opportunities come easily. Those who are willing to do an hour or so of homework -- objective reading and thinking -- about these issues will be richly rewarded.

Comments

[NI123]

Objectivity is surely key - But are you including all of the information on the housing market in your analysis, or just your belief that L3 assets have been unfairly marked down?

[NARSpin]

>Many of the Level 2 assets are marked to
> unrealistic prices from indices with no good arbitrage, like the ABX.]

This is a poorly researched article. That is completely inaccurate. Banks are not marking to the ABX. They may use the ABX as a guide, but do not mark to it.

Proof is in the pudding - UBS, Citi and Goldman all dumped assets in a firesale that they had carried on the books at *SIGNIFICANT* difference to what they were ultimately sold for. In UBS case, they were carrying toxic alt-a paper at .96, and sold to Billy Gross for somewhere around .80.

[TrueValue]

I’m going to have to disagree that there is not more paper coming down the pipeline to fill the L3 holding tank.

Sorry, but the figures the banks have written down are not even the bulk of the delinquencies. The majority of subprime ARM resets occurred in Oct 07 and will go thru 6/08. This is fairly well documented. It also takes about 6 months from a reset before a borrower is even classified in default (3mo before borrower cannot keep treading water and 90 days past due before bank starts becoming aggressive and marks it down). In some banks cases, like Wachovia, they are refusing to count anything under 180 days as a write-down (a recent article pointed out they had 5.1 billion in loans that were 120-179 days past due they were refusing to write down). This is in comparison to the 1.1 billion or so they have written down.

The numbers and timing of current defaulted loans are PRE-BULGE of the distribution of ARM resets; throw in some creative accounting (Wachovia may not count the loan as in default on its books, but it seems to count it as a default on credit reports and court actions - dbl standard there) and fact of the matter is, the major banks have alot more to come.

Too many people are trying to dismiss the recession/bear market and say it’s over. FYI, the S&L crisis of the 80s took years to work out and it took the major banks about 6 quarters of heavy losses to swallow - and that was with partners who had balance sheets (albeit light ones) to help shoulder the load of holding bad paper on your bal. The current model, next to none of the major originators had any amount of capital worth mentioning in their capital structure.

In short, the banks have alot more write downs, the bulk is to come and is not behind us, and there is no one else to dump it on. Confidence is a key piece of the US banking system and I certainly understand the govt's and the exec's attempts to build it back up. But until they come clean, they will not have it. The losses will have to be written off eventually - else we really risk becoming like the Japanese during the 90s (big banks refusing to write off loans, govt bailouts, no growth and possibly even deflation, near zero interest rates, etc.)

Hmmm, kinda sounds like what we are doing now.