Ooh That Smell

Ooh, ooh that smell
Can't you smell that smell?
Ooh, ooh that smell
The smell of death surrounds you.

~ Lynyrd Skynyrd

There a rotting smell on Wall Street and it may be the toxic assets on bank balance sheets. Bloomberg columnist, David Reilly discusses a topic often covered by yours truly. If his commentary sound familiar it should as it is exactly what I have been saying since 2007. Mr. Reilly writes:

Banks Demand Perfume for Rotting Balance Sheets: David Reilly

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Commentary by David Reilly

April 1 (Bloomberg) -- Investors crave clarity about what banks are really worth.

Accounting-rule makers aren’t giving it to them.

If anything, proposals to relax mark-to-market accounting and sidestep recognition of some losses will only confuse investors. When lumped with the Treasury Department’s bank- bailout plan, the proposals will make it even more difficult to gauge bank strength.

This will give investors new reasons to shun bank stocks and debt, for fear of being blown up by dangers they can’t see or understand.

The problem stems from banks’ refusal to face up to losses, and a congressional directive that the Financial Accounting Standards Board “fix” mark-to-market accounting. What Congress, at the urging of bankers, really meant was, “Make bank losses disappear!”

The FASB is due tomorrow to debate proposals aimed at doing just that. The board is so desperate to please Congress, it didn’t give investors time to consider the plans.

Congress isn’t worried about that. It seems to believe that if banks can hide the gangrenous rot on their books, investors won’t turn away.

Mark-to-market accounting is a roadblock because it requires banks to use often-depressed market prices to value some assets. That makes it a sometimes painful reality check.

Massage Marks

The funny thing is banks don’t mark most of their balance sheets to market prices. Still, many want the FASB to allow them to massage the marks they do take.

That would be in keeping with banks’ preference to use prices based on their own views of value, which often overlook the consequences of shoddy lending.

Investors have given up on that approach. A March 24 report from Goldman Sachs Group Inc. analyst Richard Ramsden shows why. He estimated that Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. are all carrying commercial mortgages at 100 percent of face value.

Yet commercial mortgages may be the next shoe to drop for banks. “Commercial credit losses are likely to be quite onerous during 2009,” Friedman Billings Ramsey Group Inc. analyst James Abbott wrote in a report this week. These losses “will be significantly larger than what most are expecting.”

Room to Monkey

No surprise then that many investors don’t want banks to have room to monkey around with mark-to-market values. Yet this is what the FASB plans to give them.

To understand how requires a look at mark-to-market mechanics. When a bank prices mark-to-market holdings, it discloses the reliability of the values used, grouping them into three different levels.

Level 1 prices are securities such as publicly traded stocks. Level 2 contains instruments that don’t have easy-to-see prices, but whose worth is based on things that have observable values.

Level 3 contains hard-to-value assets, or ones that trade infrequently. Prices for these rely heavily on management estimates. That is why this category has been called, among other things, mark-to-make-believe.

Banks want to move even more assets into this bucket because they can come up with their own values. Banks can’t do this unless there are few if any trades in a security, or they can argue that transactions are distressed sales that should be ignored.

Helping Hand

The FASB plans to help out by letting banks consider many sales to be distressed unless proven otherwise. Or banks could ignore prices if there are only a handful of trades. (That, by the way, seems to conflict with Securities and Exchange Commission guidance.)

The FASB’s approach is predicated on the idea that today’s markets are abnormal, so prices and trading often aren’t realistic. This ignores that what we considered normal in recent years was a mirage brought about by the biggest housing and credit bubble of all time.

In light of that, today’s market conditions might be the new normal. Accountant rules shouldn’t try to decide whether this is the case or not.

Nor should they try to distinguish between distressed and orderly sales. This supposes that banks and auditors can divine a seller’s intent and situation.

They can’t. Because of this, the FASB is forced to come up with vague criteria that give banks leeway to disregard prices they don’t like.

Higher Value

Or as the CFA Institute’s Center for Financial Market Integrity said in a comment letter, “This is an almost certain invitation to having toxic and other problem assets being reflected at a value much higher than actual market value.”

There is also the issue of the Treasury’s bailout plan. Will prices resulting from purchases of bank loans and securities be considered market values? Will banks have to use them for similar holdings on their books, even if that results in losses?

The FASB’s proposal makes it more likely banks will argue these sales don’t represent market values they have to use. In that case, banks may be able to use the Treasury program to cherry-pick values they like while disregarding those that would cause balance-sheet pain.

The FASB’s mission is to craft rules that give investors clear, relevant financial information. Its latest proposals are nothing more than sops to the banks.

If adopted, they will only confirm for investors that markets are now a rigged game.

(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: David Reilly at dreilly14@bloomberg.net



Mr. Reilly is correct in his assessment. The banks want the ability to cover up the stench. Kind of like a pocket full of posies to cover the stench of the . He also mentions the three levels of assets, including my oft mentioned "Level III" which is used by banks to bury the rotting assets. The FASB is being coerced by heavily lobbied politicians to permit banks to ignore and even cover up problems on their balance sheets. All the perfume and flowers in the world will not cover the stench of these putrid assets.

Of course, equity investors don't care. They just want a reason for a rally. Once a rally is underway, they can unwind long positions profitably. However, rallies tend to feed on themselves and the irrational exuberance sets in. Once it is realized that the rooting assets continue to spoil balance sheets the correction could be severe and painful.

Still retail doesn't learn. On article in this evening's online Wall Street Journal reports that retail investors are strong buyers of Citi. Reasons given by these Wall Street wizards include Citi CEO Vikram Pandit's comments that the bank will not need more capital and that things can't get much worse for the bank. I say: wait for the stress test.

When I first started in the business as a trading assistant at E.F. Hutton, the traders told me of the so-called "odd-lot contrarian indicator". The thinking is that whatever retail is doing, do the opposite. This has served me well over the years. During my days as a retail corporate bond trader at the late great Wertheim Schroder, I would spend sleepy summer days being the other side on various retail trades I thought to be foolish. This went a long way to padding the ol' P & L. Keep that in mind the next time a client or a retail stock jockey comes up with the next trade idea.

There has been much confusion among retail investors and advisers with regards to GMAC's relationship to GM. Let's be clear. GMAC is not the same as GM. They do not share capital structures. They never have, not even before the 51% sale to Cerberus. This is not uncommon in the corporate world. Such relationships are found within companies such as Verizon, AT&T, Entergy and Southern Company where the parent does not guaranty the debt of the subsidiaries or vice versa.

Notice how there has been no mention of GMAC bondholders negotiating recovery with GM or the government? This is because GMAC bonds are not involved! GMAC is a separate entity (a similar situation exists between Ford and Ford Motor Credit). Also, GMAC is a bank holding company, received $5 billion of TARP money last December and can (in theory) issue FDIC-backed TLGP bonds.

There is little hope of a GM recovery (inside or outside of bankruptcy) without a functioning GMAC. GMAC provides financing not only for consumers, but also for dealers who borrow to finance inventory. No GMAC means no dealers which means no GM. The thinking is that once it is determined that GM will definitely building cars (even in Ch. XI if necessary), GMAC could be given the go ahead by the government to issue TLGP bonds. This is why short-term GMAC bonds continue to trade in the $70 to $90 range depending on the structure and maturity. GM bonds are trading in the teens. The Wall Street Journal reported that a group of large GM bondholders were seeking recovery of 33 cents on the dollar (most of which would be paid in the form of stock and new debt). This group of bondholders were rebuffed by GM and were told to lower their expectations. GM bonds have almost no chance of paying off at par.

GMAC bonds do have a chance of paying off as planned, at least in the near term. As long as GM is building cars, GMAC will probably be around. However, if GM bondholders and the UAW play hardball and GM ends up in a Ch. VII liquidation, GMAC would likely have to separately file for bankruptcy protection. This is unlikely, but possible.

It is also possible that GM is permitted to fail several years down the road. If the economy is on a more solid footing and GM is not profitable and not systemically (or politically) as important, the company could be permitted to fail. This would drag down GMAC. This is why longer-dated GMAC bonds are trading between $30 and $60 depending on structure and maturity. Also, GMAC Smartnotes, which are senior notes (as senior as any large global issue) trade as much as 10 points lower than their large global brethren. These facts make it difficult for many investors to make decisions as to what they should do with their GMAC bonds.

In my opinion it comes down to suitability. If one cannot take the heat, get out of the kitchen. However, those who have a more aggressive tolerance of risk may want to hang on. It is unlikely that GMAC bonds will be worthless at any point and, due to political reasons, it is unlikely that GM would be permitted to shut its doors in 2009. The likely result is that GMAC 2009 bonds will pay on schedule even as GM bonds are worked out at cents on the dollar.