Nixing Mark-to-Market Accounting Is Not The Solution

I am a little confused. How will removing the mark-to-market accounting rule, an idea that is rapidly gaining traction, help solve the problem? If balance sheets are not prepared with market prices, it will allow companies to arbitrarily assign a price to the illiquid assets it holds. What kind of price are they going to select? Obviously, a high one!

To me, this will just lend less credibility to bank balance sheets because investors will assume the banks are choosing artificially high prices for the assets they get to assign values to. Will sovereign wealth funds, private equity funds, and hedge funds all of the sudden start to offer new capital injections into firms that are doing this? I highly doubt it.

One reason why WaMu, Wachovia, and Lehman Brothers went under was because nobody trusted their balance sheets enough to invest in them. Marking up those toxic assets arbitrarily would hardly result in more confidence than there is today.

Full Disclosure: No position in any of the companies mentioned at the time of writing

An Alternative Bailout Plan

Now that both sides of the U.S. House of Representatives cannot agree on Hank Paulson’s $700 billion TARP package, the need for an alternative idea is clear. One of the ideas I have heard sounds pretty interesting to me.

Essentially, rather than buying $700 billion worth of mortgage-backed securities, the plan would be to have the government issue insurance on them and guarantee the holders against realized losses. How is this any better than the current plan? From what I can tell, in at least two ways.

First, it would cost far less to insure mortgages than it would to buy them outright, so the taxpayer would save money versus the current plan. Many people believe the current prices these bonds are fetching (if trades occur at all) are not reasonably reflecting the ultimate losses from the mortgages underlying the securities. If that is true, the losses that the U.S. would insure against would be far less than the current marks on these mortgages are predicting.

Second, and perhaps more importantly, if we woke up tomorrow and these mortgages were insured by the U.S. government, there is a very good chance that demand for them would increase significantly. All of the sudden a market for these securities would not only exist (essentially one does not now), but prices would likely rise and the banks could reverse some of their mark-to-market losses and write-up the value of their assets. With more clarity on the value of these assets, even more capital raising would occur in the banking sector.

So, what do you think? Would such an idea convert some of the naysayers of the current plan?

Witnessing History

Can you recall the last time the Dow fell 777 points in a single day? Well, it never has, until today. This post will be brief. I am going to forget about the market and focus instead on the Ravens/Steelers game tonight (I am from Baltimore, but moved to Pittsburgh earlier this year) to try and take my mind off what happened in Congress today. In coming days we will likely see another bill come up for a vote, perhaps better, perhaps worse, than the current one. The Republicans will vote for it and hopefully we can make back much of today’s loss in relatively short order. Hopefully people will begin to realize that this kind of bill does far more than pad the wallets of Wall Street (heck, 40% of the big 5 firms have gone belly up already). The banks we all hold our money with are not Wall Street. Rather, they are the lifeblood of Main Street.

The Strong Banks Survive, Get Even Stronger

It appears the FDIC has decided that in order to protect taxpayers and customers of the weaker banking institutions, it needs to coordinate private deals to boost confidence and limit the government’s deposit insurance losses. So far they are doing a pretty good job given the current turmoil in the banking industry.

So who are the winners and losers? Well, it’s not rocket science. Poorly run banks are paying the price and the strong banks are getting really sweet deals to take over deposit bases, bank branches, ATM networks, etc for pennies on the dollar or are simply gaining market share as customers find new banks to use.

As for investment strategy, those people who have avoided the bombshells and focused their financial services allocations on those perceived as the stronger players have done relatively well if their analysis proved accurate.

From Peridot Capital’s perspective, I have thus far avoided the disasters (knock on wood). Rather than avoiding banks altogether, however, Peridot is invested in four institutions with strong deposit bases and manageable bad loan exposures. I have mentioned all of these names on the blog over the last couple of years, but below is a recap of the banks that Peridot owns along with their stock performance in the current quarter (Q3 2008):

*Bank of America (BAC) +57%
*Capital One Financial (COF) +45%
*PNC Financial (PNC) +34%
*U.S. Bancorp (USB) +30%

Now, am I piling into these names at current prices? No. They have had huge runs this quarter because they are the stronger players and capital has flocked to the likely survivors. However, strong banks should be on investors’ radars because there will be more financial shocks and during widespread financial share price weakness, everyone gets hit hard, presenting opportunities for those who want to separate the baby from the bath water.

Full Disclosure: Peridot was long all of the companies mentioned at the time of writing

Thoughts on the “Bailout”

A reader asks:

“Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?”

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers’ expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced “nominal” with “notional” -CB) value. By doing so, we are converting unrealized losses on the banks’ balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn’t functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn’t want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don’t understand why anything needs to be done or are misguided in their belief that all we are doing is “bailing out Wall Street.” The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

Buffett Treads Lightly With Goldman Sachs Investment

If one of your first reactions upon hearing of Warren Buffett’s $5 billion investment in Goldman Sachs (GS) was, “Wow, I didn’t think Goldman was a Buffett-type company,” you are probably not alone. Warren has typically preferred consumer-related businesses with wide moats (high competitive advantage and barriers to entry). He often tells people that he would feel perfectly fine owning Coca Cola (KO) or Wrigley (WWY) if the stock market closed down for five or ten years. It would be hard to have the same level of confidence with Goldman Sachs.

So before you go out and load up on GS common stock on this news, let’s review exactly what Buffett is getting, and more importantly, the price he is paying. The $5 billion deal involves two parts:

1) $5 billion in preferred stock

These preferred shares are senior to common stock and pay a 10% annual dividend. Think of them as unsecured bonds paying 10% interest. He is not buying common shares with the initial $5 billion. In addition, if Goldman ever wants to retire these preferred shares (companies typically “call” preferred shares when they have excess cash), they have to pay Buffett a 10% premium to their face value. The vast majority of normal preferreds are callable at par, not at a premium.

2) Warrants to buy $5 billion of common stock at $115 per share

Buffett has the option to buy $5 billion of common stock at $115 per share at any time over the next five years. Keep in mind that while this part is common stock, there is absolutely no risk for Buffett on these warrants. Five years from now, Buffett earns a profit of $43 million for every dollar GS stock trades above $115 per share. If the stock is below $115, he does not lose a dime, as there is no risk on his part. These warrants are essentially call options he is getting free of charge.

From the terms of this investment, we can see why Buffett has decided to invest in an investment bank even though he typically goes for much safer and predictable operating businesses. Goldman does have a superior management team and great talent, but investment banking is not a business I would expect Berkshire to expand into anytime soon.

While he is taking a bit more risk by banking on Goldman’s survival, consider how the landscape has changed for Goldman in recent days. Not only has the government indicated they are willing to take dramatic action to help these firms survive, but it also has allowed Goldman to become a bank holding company. Goldman may very well use this new capital to build out their commercial banking operation.

With this deal, Buffett is banking on government intervention succeeding in greatly lowering the risk that Goldman Sachs gets into deep trouble. For such a bet, I’d say Buffett got a great deal by waiting things out and not investing until he figured the odds were stacked strongly in his favor.

Full Disclosure: No positions in the companies mentioned at the time of writing

U.S. Economy: Widespread Recession or Financial System Crisis?

Most of the steps taken by the Federal Government so far have been an attempt to prevent the current financial market crisis from getting worse, which would undoubtedly spill over to Main Street and the rest of the economy. The reason why there is a debate about whether we are in recession right now, or whether we will fall into one next year or not, is because the problems thus far are contained to a few areas. If those problem spots can be resolved to any measurable degree, we could get a quick economic and market recovery. If they spread, we are in for a prolonged and expanded downturn.

To see exactly how well most areas of the economy are holding up, we need to look no further than a breakdown of S&P 500 earnings by sector. Below is the breakdown of earnings from 2006 through current 2009 estimates:

Notice what while S&P 500 earnings will be down this year, for the second straight year, eight of the ten sectors are expected to have earnings gains for the third consecutive year in 2008, as well as further gains in 2009. This data shows exactly how much impact the financial sector’s woes are having on the market. The consumer discretionary sector is an obvious casualty of such fallout, but everything else is fairly strong.

Personally, I think 2009 earnings estimates remain too high, though they have come down some already. Although I think the odds are remote, it is easy to see that, when one assumes the financials will rebound sharply, such a high S&P earnings number is possible in 2009 because the other sectors remain on firm footing.

Our economy is not yet in a widespread recession. Financial services are in trouble and are spilling over to the consumer sector. It might not be very comforting, but if we can get the financials consistently back in the black, even if they earn half the amount they did a few years ago, the economy and markets could hold up okay next year and beyond.

Morgan Stanley Becomes A Bank, Gets Overseas Investment

Thanks to the Fed’s actions last week, Morgan Stanley (MS) has averted an emergency sale to Wachovia (WB), received permission to become a bank holding company, and has sold a minority stake to Japan’s Mitsubishi. The company is going to try to remain independent, for now anyway.

With the competitive landscape having changed in recent days, namely fewer competitors in the investment banking marketplace, the stronger players who can whether this liquidity storm will clearly be in a great position to take market share in this volatile environment.

It will be interesting to see if Goldman Sachs (GS) seeks a partner of some kind, or simply builds its bank holding company on its own. Outright mergers with banks are less likely now with the Fed’s intervention, but leverage ratios and funding sources still need to be refined to protect against future shocks to the financial system, which are certain to occur.

Given the uncertainty of how all of these things play out, my view on the investment banks has not changed (see my piece entitled Investment Banks Nothing More Than Black Boxes). I still prefer commercial banks due to more transparency of how they make their money, as well as far lower leverage ratios. If leverage falls meaningfully and investment banks disclose more in the future about what they hold, that opinion could potentially shift, just not yet.

Full Disclosure: No position in GS, MS, or WB at the time of writing

Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

The SEC’s 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let’s be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company’s fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It’s that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don’t have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they’ll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country’s largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won’t be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

What To Do In Times Of Panic

Is “panic” too strong of a word to describe the markets in recent days? I don’t think so. Consider a couple of examples outside of the investment banking space:

1) Constellation Energy (CEG)

My old utility company when I grew up in Baltimore, Constellation is the parent of Baltimore Gas & Electric. CEG gets 20% of their earnings from energy trading and had contracts with Lehman Brothers. Although CEG’s net exposure to Lehman’s bankruptcy was immaterial, investors panicked and sent the stock down from $60 last week to as low as $13 on Tuesday. Today Warren Buffett’s 88% owned MidAmerican Energy agrees to buy CEG for $26.50 in cash, or about 75% of the company’s book value, in a deal that alleviates counterparty concerns over CEG’s liquidity.

2) State Street (STT)

State Street fetched $68 before 10:00 this morning and hit $29 shortly after 1:00pm. State Street is listed as a large holder of all the troubled financial stocks, which worried people, but STT is a custodian for their clients and index funds and does not own the vast majority of the stocks in question. They simply act as custodian and collect fees for doing so. STT issued a press release this afternoon trying to clear things up and assured investors their money market funds had not dropped below $1 in NAV.

There is no doubt in my mind that we are simply in the midst of a worldwide financial panic. The UK just restricted all short selling in financial stocks until the dust settles. Fear and mostly unsubstantiated rumors are driving price action right now.

So what should an investor do in this environment? It might surprise you, but I have been making very few moves during all of this craziness. Trading when fear, panic, and rumors have taken over doesn’t make much sense because prices are not based on reality but rather perception. Lack of confidence and uncertainty about what is true and what is not is a deadly combination for financial markets and many firms. It doesn’t matter if Morgan Stanley (MS) is not in trouble. If clients think they might not be, they will pull their money and set off a “run on the bank”scenario. That very situation will likely forced them to sell the company in the heart of the panic, regardless of what the reality is.

As long as you know and understand what you own and have done adequate fundamental analysis, I would suggest standing pat and waiting for things to settle down. Like LTCM, the Asian financial crisis and every other financial market panic, this one too will be over at some point. When that happens we can get back to good ol’ fundamental investing. Fortunately, most of the people reading this blog, as well as myself and my clients, can wait for the storm to pass.

Full Disclosure: No positions in any of the companies mentioned at the time of writing