Twist and Shout

On the way to the hospital this evening (my other half twisted her knee playing racquet ball. She is ok), I was listening to Kudlow & Co. on Sirius Radio (I am long that dog of a stock). The program turned to a discussion on today's FASB decision to modify mark to market accounting. As expected Larry and his pal Steve Forbes extolled the virtues of modifying MTM as it would permit banks to value their assets based on cash flows instead of being subject to the vagaries of the market. Making a valid defense of transparency was Jim Glassman (President, World Growth Institute and former Undersecretary of State).

Mr. Glassman expressed concerns that the markets could be come concerned that banks may over value toxic assets and could be encouraged to take more risks. Mr. Glassman is not alone. The CFA Institute (members of which make up the majority of securities analysts) also has spoken out against modifying or eliminating mark to market.

Mr. Glassman was in the midst of a valiant defense of MTM when Kudlow and Forbes began twisting. They both began harping that banks usually hold loans until maturity and that they should not be marked to market. They then cut off Mr. Glassman. The twist was not in Mr. Kudlow's and Mr. Forbes' argument that banks usually hold loans to maturity (although that is not always the case), but rather because banks often do hold loans to maturity, they WERE NEVER REQUIRED TO MARK LOANS TO MARKET. Here lies the rub.

Modifying MTM permits banks to now not mark securities to market if the bank believes the market price does not reflect the true value of the security. What a great idea. I wish I had that ability when I was trading. Will others be permitted to do this as well? We have all tried to get bids for illiquid securities that we or are clients own. Sometimes, because of illiquidity, market bid prices are low. One can even see this in securities such as GMAC Smartnotes. Because of illiquidity, GMAC Smartnotes are often bid 10 points or so lower than their global-sized brethren even though Smartnotes are as senior as any GMAC senior debt. Try telling your client that their bond is worth 10 points more than the bid when they are asking you to value their account.

There is another problem with not marking securities to market. Many securities positions backed by toxic assets have been purchased with leverage. Most leverage is in the form of short-term financing. What happens when leverage is more difficult to obtain or becomes more expensive? That could result in banks being forced to sell "hold to maturity" securities to unwind trades which are no longer profitable. At prices do you think the assets will be sold, at market prices or at the banks valuation? Pretty easy question eh?

As I mentioned earlier in this piece, the CFA Institute was against modifying MTM accounting. Already, some analysts are negatively viewing the accounting changes. I was on a conference call today conducted by bank and finance analysts from both the equity and fixed income sides of the business and both stated that they believe that the change to MTM will not materially improve bank prospects and that bank equity price rallies may be short-lived.

The analysts also point out that the government, as part of the stress tests, does not consider unrealized losses when reviewing the banks. Changing MTM or not will not affect the government's decisions after reviewing the banks. My guess is that the government will review assets and "advise" banks to hit bids when the government believes it necessary and will inject more capital into affected banks in the form of convertible preferreds. What the banks think their assets are worth will be irrelevant when it comes to the governments review. If CFA chartered analysts believe that banks conjuring up their own asset values to be problematic, we could see less positive research reports from around Wall Street.

Does this mean bank bonds, or even trust preferreds, should be avoided? Heck no! JPM bonds and preferreds are cheap and are suitable for investors with moderate risk tolerances. Those who can withstand some volatility should consider GE Capital and Merrill Lynch senior notes. Political as well as economic realities make the aforementioned bonds more volatility instead or viability concerns.

Lastly, I do appreciate my readers efforts to spread the word about the existence of this publication. However, please remember that this is an underground publication. E-mailing me on the desk at work asking to be added to the list is not good for my employment prospects.