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SA Editor Eli Hoffmann
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I am Seeking Alpha's VP Content and Editor in Chief. Working closely with CEO David Jackson, I oversee all SA Content initiatives. I designed Seeking Alpha's Wall Street Breakfast and Market Currents news products, and contribute to them from time to time. I have followed the stock markets for... More
  • How do you like your fudge? 2 comments
    Apr 5, 2009 4:55 PM | about stocks: SPY, DIA

    Very interesting post from Eric Roseman recently about the decision to ditch fair-value accounting.

    The FASB, or the Financial Accounting Standards Board, decision to ease mark-to-market accounting rules yesterday provides an official open door policy for banks to fudge the books. This is not the way to regain bank or financial sector trust...

    In their desperation to boost confidence and lending in the battered banking sector, accounting officials have basically cleared the way for banking executives to hide or cover-up losses. This policy is the equivalent of allowing your kids to eat as much candy as they like and then telling them “it’s okay, no problem; it won’t do any harm.”

    Of course, consuming too much candy or sugar is unhealthy and ultimately leads to tooth decay and cavities. That’s how to best explain the rotten state of banking where executives can now formulate their own asset models and mark clogged assets to their “fair value” assumptions.

    Roseman says he's lost all confidence in regulators.

    On the other hand, was MTM really serving its purpose. Returning to his analogy, what if kids started dying from eating one candy? Would we say, "Well apparently candy has suddenly gotten much worse - no more candy for anyone, ever again."? Or would we assume that perhaps it's not the candy that's killing the kids, but some hidden poison?

    Last week, Andy Kessler had an article in WSJ in which he attributes much of the collapse to a bear raid on financials:

    This bear raid was different. Wall Street is short-term financed, mostly through overnight and repurchasing agreements, which was fine when banks were just doing IPOs and trading stocks. But as they began to own things for their own account (MBSs, CDOs) there emerged a huge mismatch between the duration of their holdings (10- and 30-year mortgages and the derivatives based on them) and their overnight funding. When this happens a bear can ride in, undercut a bank's short-term funding, and force it to sell a long-term holding.

    Since these derivatives were so weird, if you wanted to count them as part of your reserves, regulators demanded that you buy insurance against the derivatives defaulting. And everyone did. The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts.

    Because these derivatives were part of the banks' reserve calculations, if you could knock down their value, mark-to-market accounting would force the banks to take more write-offs and scramble for capital to replace it. Remember that Citigroup went so far as to set up off-balance-sheet vehicles to own this stuff. So Wall Street got stuck holding the hot potato making them vulnerable to a bear raid.

    You can't just manipulate a $62 trillion market for derivatives. So what did the bears do? They looked and found an asymmetry to exploit in those same credit default swaps. If you bid up the price of swaps, because markets are all linked, the higher likelihood (or at least the perception based on swap prices) of derivative defaults would cause the value of these CDO derivatives to drop, thus triggering banks and financial companies to write off losses and their stocks to plummet.

    General Electric CEO Jeff Immelt famously complained that "by spending 25 million bucks in a handful of transactions in an unregulated market" traders in credit default swaps could tank major companies. "I just don't think we should treat credit default swaps as like the Delphic Oracle of any kind," he continued. "It's the most easily manipulated and broadly manipulated market that there is."

    Complain all you want, it worked.

    Now you can take or leave the degree of the conspiracy theory, but do we really want banks scurrying to shore up their balance sheets because somewhere someone sold a similar asset to theirs at a depressed price? Will this increase the long-term health of the economy?

    Throwing away fair-value accounting may or may not be the solution, but that doesn't stop us from acknowledging there is a problem.

    Themes: mark-to-market, financial Stocks: SPY, DIA
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  • AlanBike
    , contributor
    Comments (12) | Send Message
    As Senior Editor, can you explain why the publication date is missing or buried and hard to find in so many SA articles? I frequently read something that looks hot only to realize that it was written 3 years earlier. Thanks.
    21 Dec 2009, 01:28 PM Reply Like
  • banker2002
    , contributor
    Comments (7) | Send Message
 follows many of the smaller banks still trading at 50% of book value/ cash value that will make it.
    14 Apr 2010, 10:08 AM Reply Like
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