Accountants are changing the rules governing most of the shadow banking system and almost no one is noticing. About 10 days ago the Financial Accounting Standards Board confirmed that by year end “securitization accounting” will be different and the changes are likely to have a bigger effect on financial institutions than mark to market accounting. The new accounting rules will make it much harder for financial institutions to count securitizations as “off balance sheet” transactions and will reconsolidate, i.e., put onto the balance sheet, a large number of transactions that are currently accounted for as off balance sheet.
When financial institutions securitize assets and elect off balance sheet accounting treatment they are pretending that neither their securitized assets nor their related secured debt exists. Like a deadbeat dad denying paternity, securitization accounting is designed to avoid admitting responsibility by securitization sponsors.
Most securitizations are a form of secured borrowing executed by banks and other financial institutions. However, “form over substance” securitization accounting encourages securitization sponsors to act as if secured borrowings are really asset sales and thereby decrease the reporting of both their asset size as well as their debt.
When institutions use off balance sheet accounting for secured debt transactions financial ratios are distorted, and transparency is destroyed. No one can tell if securitizing institutions are well capitalized or not and whether their operating performance is consistent given the scope of their operations.
As a result of securitization accounting financial institutions like Bear Stearns, Lehman Brother, Citigroup and Merrill Lynch appeared much less leveraged, and much more profitable, than they really were. The “granddaddy” of securitization shops, Citigroup, at one time had more than $1 trillion of assets that it reported as “off balance sheet”. Citigroup pretended that the $1 trillion of off balance sheet assets were orphans; they just appeared one day on Citigroup’s doorstep. Simple financial measures such as net interest spread and asset quality and profitability ratios were vastly distorted by Citigroup’s orphans.
The securitization accounting rules also facilitated the “originate for sale” shadow banking system that lead to sub-prime and other consumer and commercial lending abuses.
The new securitization accounting rules are supposed to enhance transparency and make it much tougher for financial institutions to pretend that they don’t own their assets. But, no one is really sure how the changes will play out in the real world marketplace. The new rules may enhance transparency. On the other hand, mechanical application of new and complicated rules may confuse already incomprehensible reporting. Retro-active application of the rules may highlight how dangerously undercapitalized some financial institutions remain and may spark a new round of loss of confidence. Simplifying the rules may help restart the securitization marketplace and help the economy, but then again they may be another nail in the capital markets coffin.
I don’t know what this all means because I never understood the old rules and don’t know what the new rules will do to financial reporting. There is a Wall Street sub-culture that holds itself out to be “securitization accounting” experts. Personally, I never bought the “snake oil” that these guys were selling. I don’t think that the so called experts have a clue what is going to happen when the new rules are enacted and if they don’t know the media certainly has no clue which is why there hasn’t been much reporting of this accounting change.
It’s a good idea to fix securitization accounting rules and I support the effort; just not the way that reform is playing itself out. In fact on December 4, 2008, I wrote a letter to then President Elect Obama suggesting that reforming securitization accounting needs to be a cornerstone of financial institutions reform. The following is from my December 4th letter:
If accounting rules matter, bad regulatory accounting rules matter even more. About 20 years ago bad regulatory accounting rules were enacted that apply to all banks and have the unintended side effect of encouraging the worst excesses of the securitization market. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penalizes banks that want to create well capitalized investment structures. These bank regulatory rules virtually mandate the “originate and sell” model of finance and need to be fixed immediately. Generally accepted accounting practices have run amok trying to work around the bad bank regulatory rules. The accounting industry is about to “reform” the rules relating to securitization accounting in FAS rule 140 but the new rules continue to make a mess of things. An interagency initiative is needed to fix this mess. And, interagency cooperation will only happen with Presidential leadership.
The problem with the current securitization accounting reform initiative is that it isn’t interagency reform but rather unilateral work of the Financial Accounting Standards Board which has at best mixed motivations. Until securitization reform is a joint effort of all constituencies that are affected it won’t work.
The U.S. needs a joint task force to address this issue including the SEC, OCC, FDIC, Federal Reserve and state insurance commissioners. Regulatory and statutory accounting rules must be conformed to financial accounting and disclosure. Securitization reform is needed but ad hoc and piecemeal reform is probably worse than no reform and what we are getting is ad hoc reform.
As you get closer to inauguration I would like to make a few suggestions for your administration and its future economic policy.
Everyone knows that the economy is in trouble and confidence in the future is low. Confidence in the United States economic system and government is our nation’s most important asset. Unfortunately, this asset has been squandered through ad hoc and poorly communicated public policy initiatives. You need to focus on restoring confidence in our economic system and government. How you administer economic policy will count almost as much as the substance of your policy in restoring confidence. I believe that communication skills matter, details matter and discipline matters. Also, Truman was right when he said “The Buck Stops Here”. Making tough decisions and explaining them to the American public is your job and cannot be delegated to lower level officials. It’s your administration and your economic policy, not the Treasury Secretary’s.
Enacting the below recommendations will require tough decisions and a thick skin. You will be criticized by the “talking heads” who are more interested in stirring up controversy than finding solutions. Stimulus alone isn’t enough to solve our problems. Without fundamental changes in how we do things, I believe the current economic problems will get progressively worse in wave after wave of bad news.
My suggestions for fixing the economy are below.
1. Pass fiscal stimulus now and make sure it is massive. The economy is rapidly falling into a deflationary death spiral. Deflation is like pouring hydrochloric acid on the economy. Half measures won’t work; you need to force feed demand. So please, go for the gusto. $500 billion+ is needed. If the stimulus is too small or doesn’t force demand to rise it will actually make the problem worse because confidence will be destroyed, people will get more scared and further hoarding of cash will take place. While immediate and massive stimulus is needed, it would be nice if the spending also was in projects and programs that actually might have some long term benefit.
2. Go slow on banking and securities regulatory overhaul; Push hard on enforcement. The United States has plenty of rules and regulations but lacks the will to enforce them. It is inexplicable why the SEC and other Federal regulators have refused to enforce existing rules that promote full and fair disclosure, discourage market manipulation, mandate safe and sound banking practices prevent consumer fraud and have other common sense objectives. For some reason, tried and true enforcement was sacrificed on the altar of “free markets”. But, free markets aren’t supposed to be crooked markets and it is time that Federal regulators did their jobs and enforced existing law and regulation. I believe that when the current rules and regulations are enforced you will find that the regulatory gaps are small.
Oh, by the way, the SEC is a basket case and needs to be restaffed with professionals that believe in its mission of protecting the little guy, making sure that markets are free and fair so that the capital markets work to everyone’s advantage and not just for a few Wall Street insiders.
3. Accounting rules matter; Suspend mark to market accounting and reform securitization accounting. Please get rid of mark to market accounting now; it is a bad accounting rule. When you announce that you are considering getting rid of this rule, watch who gears up the PR campaign opposing its elimination. They will be the people who have been profiting from mark to market accounting. I am willing to bet that almost all of the lobbyists will be bankrolled by traders and fund managers that make money from the rule’s carnage. After all, mark to market accounting makes betting on corporate value destruction a near certainty.
If accounting rules matter, bad regulatory accounting rules matter even more. About 20 years ago bad regulatory accounting rules were enacted that apply to all banks and have the unintended side effect of encouraging the worst excesses of the securitization market. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penalizes banks that want to create well capitalized investment structures. These bank regulatory rules virtually mandate the “originate and sell” model of finance and need to be fixed immediately. Generally accepted accounting practices have run amok trying to work around the bad bank regulatory rules. The accounting industry is about to “reform” the rules relating to securitization accounting in FAS rule 140 but the new rules continue to make a mess of things. An interagency initiative is needed to fix this mess. And, interagency cooperation will only happen with Presidential leadership.
4. Immediately outlaw naked credit default swaps and other credit derivatives that aren’t tied to ownership of underlying assets. Whatever benefit we get from naked credit default swaps is more than offset by market abuses from the casino mentality they encourage. In a naked credit default swap neither counterparty owns any of the underlying securities of the company whose credit is being wagered upon. Generally, the big money proponents of naked credit default swaps are speculators who justify themselves by claiming that “price discovery” can only be achieved in the CDS casino. I think that prices should be established by buying and selling actual assets. There is no reason to have CDS bookies tell us what things are worth. By the way, I can’t find anyone who is an insurance expert that can explain why credit default swaps aren’t a form of insurance contract and why they shouldn’t be regulated as an insurance.
5. Form government sponsored bond insurance companies and return Freddie Mac and Fannie Mae to their original mission. Bond insurance companies played an important role in the development and operation of the capital markets. For years these privately held companies were the grease that made the wheels of municipal and consumer finance turn. It is not a coincidence that since the collapse of the “AAA” rated bond insurance companies the capital markets have been a shambles. For decades the bond insurance companies had a good business model. Unfortunately for a few years the bond insurance companies did a bad job and as a result blew themselves up. But, a few years of bad execution doesn’t change the fact that the basic business model provided value. The government needs to form and capitalize new bond insurance companies with the goal of privatizing them within 5 years when the capital markets recover. By the way, this will be the lowest cost and biggest “bang for the buck” market stimulus that the Government can do to free up the capital markets.
When they were formed Freddie Mac and Fannie Mae were a form of bond insurance company that made it easy for investors to purchase mortgages and mortgage backed securities. However, over the last 20 years Freddie Mac and Fannie Mae experienced “mission creep” and started directly investing in massive amounts of mortgages. As their balance sheet exploded, Freddie Mac and Fannie Mae crowded out banks, thrifts and other mortgage lenders and became the world’s largest investor of residential mortgages. The original idea behind Freddie Mac and Fannie Mae was sound and if re-implemented in a rational manner will provide private investors with a chance to again put money to work in the insured mortgage market.
Mr. Obama, hopefully you agree that my suggestions strike a balance of short term stimulus and structural reform so that we don’t have a repeat of the last few years. Good luck as you lead the nation in what will hopefully be a new and great chapter in our history.
Last week I had lunch with Marty Schiffman who told me that “If I live 1,000 years, I will never understand that accounting rule! It’s dishonest!” Marty was, of course, talking about the application of mark to market accounting rules by major financial institutions. Marty Schiffman is not the “average” man on the street; he is the head of the Real Estate Group at Carl Marks and is a senior finance professional. In short, he knows what he is talking about.
As I have written in several previous blog articles, mark to market accounting is perhaps the dumbest and most misleading set of accounting rules ever promulgated by FASB. In my prior blogs, THEEARNINGSILLUSION – FASSTATEMENT 157 ANDFASSTATEMENT 159 and FASSTATEMENT 157 ANDFASSTATEMENT 159 – CORPORATEEARNINGSMEETTHEWIZARDOFOZ, I discussed some of the more inane provisions of these two accounting statements including the ability of companies to manufacture earnings by pretending that they don’t have to repay their debts.At lunch, Marty told me that bad financial reporting causes a loss of confidence. He doesn’t understand why mark to market accounting isn’t transparent.He explained that as the result of the rule, investors practically have to have a PhD in forensic accounting in order to figure out corporate earnings changes in a 10Q. Marty got really animated (and loud) when he told me that it was dishonest for financial institutions to mark their liabilities to market and manufacture earnings by pretending they aren’t going to pay back their debts.
Of course, Marty and I agree that the integrity of financial statements and reporting is essential for investor confidence. The US banking and financial systems are based upon “confidence” which, if lost, will tank the systems.
We only need to look at the crisis that beset the US in 1933 to understand what happens when we lose confidence and stop believing. As Franklin D. Roosevelt stepped forward to address the nation in his first inaugural address, a loss of confidence had paralyzed the nation and was destroying the fabric of society.
Below are some of FDR’s timeless words from that famous 1933 inaugural speech which words seem entirely appropriate today:
“…[asset] [v]alues have shrunken to fantastic levels…our ability to pay has fallen…the means of exchange are frozen in the currents of trade…the savings of many years in thousands of families are gone..
…Yet our distress comes from no failure of substance… no plague of locusts… the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence…[p]ractices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.
True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish…
…there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, on unselfish performance; without them it cannot live…
…there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency….
…the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”
Marty understands that accounting rules make a difference, that honesty and integrity are important, and that confidence is being destroyed. That’s what he told me at lunch. Why is it that as we enter the second year of the credit crisis our national and economic leaders do not understand what Marty knows? Let’s hope that we never again need a President to give another speech like FDR’s inaugural address.
Yesterday on FOX Business Network I was interviewed by Connell McShane and discussed the Federal Reserve’s “regulatory fixes” for the sub-prime mortgage market. During the interview, I suggested that the new Federal Reserve regulations are a joke and make us a global laughing stock. I stated that the “US doesn’t have a shortage of laws” but that our regulators and the Administration need to be serious about their jobs as market “cops”. The clip is presented at the bottom of this blog entry.
Since the interview I have received e-mails and calls criticizing me for complaining about Washington but not providing suggestions that can help the problem. So after two days of criticism here goes… five regulatory fixes that can happen immediately and without additional legislation.
FIX #1 — Restore transparency by enforcing securities disclosure laws including Sarbanes Oxley. Full and fair disclosure of all relevant information to make informed investment decisions is the cornerstone of free markets. For decades the SEC was a dedicated and diligent disclosure cop. For the past several years they haven’t been on the job. Management teams aren’t held accountable and daily “surprises” are taken for granted from the banks and brokerages.
The SEC’s enforcement failures sanction “bad” corporate behavior and make the SEC a cheerleader for “moral hazard” in action. Disclosure and transparency are so weak that management teams don’t even know what their companies are doing or why.
Financial services reform starts with active and persistent enforcement of the securities laws, some of which have been on the books since the 1930’s. No additional legislation is necessary for this change to be enacted immediately.
FIX #2 — 5 year phase in of regulatory and accounting consolidation of all off balance sheet assets, liabilities, derivatives and credit default swaps. As off balance sheet items are consolidated with the owning institutions, existing capital requirements will kick in and require adequate levels of capitalization. During the phase in period pro forma disclosure with full management explanations should be required so everyone can evaluate risk. The reason that a phase in period is necessary is because many banks and other financial services companies would be insolvent without time to recapitalize and repair their balance sheets.
The SEC, Federal Reserve, OCC, OTS and state banking regulators have the regulatory authority to immediately make this accounting change on call reports, including bank holding companies, and the SEC has the authority to require this for all public companies (by amending Rule S-X and Rule S-K). No additional legislation is necessary for this change to be enacted immediately.
FIX #3 — Direct regulation of large broker dealers by the Federal Reserve through amendment of Primary Dealer Agreements. All of the large US brokerage firms are primary dealers and have a “contractual relationship” with the Federal Reserve. It is important for the primary dealers to maintain their “special status”. In order to maintain their primary dealer status, all such firms need to adhere to certain capitalization and safety and soundness standards. Amending the primary dealer minimum standards will provide the Federal Reserve with the necessary oversight that they need to make sure that the large brokerage firms are adequately capitalized and don’t create systemic risk to the financial system.
Suggested modifications to the relationship between the Federal Reserve and the primary dealers include enhanced capital and operating requirements, adherence to safety and soundness requirements, enhanced disclosure requirements and consolidated capital requirements (i.e., including all affiliates of the broker dealer taken on a consolidated basis). Currently, brokerage firms have the option to not be primary dealers and the Federal Reserve can exclude any firm from being a primary dealer if it doesn’t comply with Federal Reserve requirements. But all of the large firms need to be primary dealers for valid business reasons and they will all comply with reasonable requirements to maintain that status. No additional legislation is necessary for this change to be enacted immediately.
FIX #4 — Fix mark to market accounting rules. The SEC has the ability to unilaterally and immediately fix the mark to market accounting rules by amending Rule S-X and Rule S-K. Mark to market accounting rules need to be changed so that they don’t apply to investments where there isn’t a “market” (hence nothing to mark to). And, the fantasy of marking liabilities to “market” as if they aren’t going to be repaid by the borrower is a ridiculous and dangerous application of what I believe is the worst accounting rule ever. No additional legislation is necessary for this change to be enacted immediately.
FIX #5 — Require all regulated entities and publicly traded companies to stop outsourcing their credit decisions to rating agencies. While ratings are a valuable tool that when properly used are extraordinarily important to the credit evaluation function, banks, brokerages and other regulated and/or public companies cannot continue to completely outsource their credit decisions to the rating agencies. Credit evaluation policies and procedures must be amended, disclosed and followed. No additional legislation is necessary for this change to be enacted immediately.
Sunshine’s Fixes rely on a common sense approach to application of regulatory authority that will have an immediate impact on investor confidence. Our financial markets don’t have to continue to be the global laughing stock and it is essential to our economy that we improve immediately.
How about if the regulators start this process now?
Sometimes reality is stranger than fiction and mark to market accounting is one of the strangest realities in generations. By adopting FAS Statement 157 (Fair Value Accounting) and the related FAS Statement 159 (the Fair Value Option for Financial Assets and Liabilitites), the Financial Accounting Standards Board (“FASB”) has made corporate earnings a trip down the Yellow Brick Road to the Emerald City in the Land of Oz. Only the accounting rules of Stalinist Russian (also based upon lessons learned by watching the Wizard of Oz) make less sense than FAS Statement 157 and FAS Statement 159.
While there are many things not to like or respect about mark to market accounting, the dumbest is the requirement to mark to market liabilities of a borrower. Basically, if the market value for a company’s debt goes down, the company gets to book a gain equal to the amount of the decrease in market value. As an example, if a company borrows $100, it will record a $100 liability on its balance sheet. However, if for any reason the market value of the debt goes down (as an example to $80), the company will record a gain of $20 and reduce its liability to $80. Of course, the company still owes $100 to its lenders, but under FAS Statement 157 it gets to “pretend” that it only owes $80. Over time, the $20 gain will be recaptured as an expense so that when the company pays back its $100 obligation it will neither record a gain nor a loss on such payment. As such, earnings from the marking to market of liabilities aren’t earnings at all, they are a manipulation of revenue, expenses and net worth. And, FAS Statement 157 and 159 is a shameless exercise in accounting deception.
The application of FAS Statement 157 and FAS Statement 159 to liabilities flies in the face of most of the major tenants of accounting. No longer should we assume that companies are “going concerns” that will repay their debts when due. Nor should the discerning reader of financial statements take for granted that revenues and expenses are related to the fortunes of the company that is reporting (as contrasted with all of the other reasons that debt trades above or below par) or has any relationship to the time period being reported upon.
“Earnings” from the marking to market of liabilities (if one can even call them earnings) are of such low “quality” that when analyzing the financial statements of companies such gains must be backed out of both book value and income. Similar adjustments need to be made when expenses rise because gains from mark to market adjustments are recaptured in future periods (as they will be). And, alternate sets of financial statements that don’t reflect “Oz accounting” need to be prepared and maintained by investors and stakeholders.
While FASB is playing the part of the Wizard of Oz, what role is the SEC playing in this fiction? The SEC doesn’t have to go along with FASB. It has the legal right and ability to require different accounting and disclosure standards for reporting companies that would be logical, clear and transparent. Simple clarification of Rule S-K and Rule S-X would take care of the problem and the SEC requires no additional legislation to effect this change.
So again I wonder, who is the SEC trying to be in this real life version of the Wizard of Oz? Maybe the SEC is trying to play the part of the Cowardly Lion since it seems afraid to stand up to the scary technocrat accountants at FASB. Or, maybe the SEC is the Scarecrow (I have often suspected the SEC looks up to the Scarecrow as a role model) and simply has no brain.
Some day we will all know who the SEC is because it surely isn’t an intelligent regulator that believes its mission is to protect the public interest through full, fair and reality based disclosure.
But one thing is clear “…..we’re not in Kansas anymore”.
I have been an outspoken critic of too much leverage in the financial system for the past several years. On CNBC and Fox Business Network I have spoken out against the dangers of bank and brokerage over leverage and suggested that such over leverage could cause a repeat of the Great Depression. Like a giant oil slick, the financial services sector of the United States has been an inch deep and a mile wide for years. Clips of some of those interviews can be found at http://www.firstcapital.com/financial_news.html. Regulators don’t seem to care about management strategies that have driven the economy into the ditch and shareholders don’t seem worried about managers that lack both common sense and basic financial training.
The events of the last 12 months have seemed so unbelievable to me that I have started to wonder if there are ANY minimum standards of knowledge and training to be the CEO or CFO of a global United States based financial institution.
Many jobs in the United States have minimum educational and training standards. Doctors attend medical school and get licensed. Lawyers are trained in law school and take the Bar Examination. Even the people that take care of our pets, fix toilettes and build our houses have standards that they must meet before they can hold themselves out as experts.
But, what about the executives of large banks and brokerages? What are their minimum educational or competency standards and do they meet such standards?
It turns out that pretty much the answer is CEOs and CFOs do not pass any examination, are not licensed and have no minimum educational standard. Who is qualified to be a bank CEO or CFO has been pretty much left up to the Board of Directors of each institution.
With no “national standard” for bank and brokerage CEOs and CFOs I decided that I would create my own standards and benchmarks for measuring competence. So, this blog is about the standards that I think should apply to the leaders of global financial institutions and whether or not CEOs/CFOs meet such standards.
Education. I think that educational standards fly in the face of this country’s “Horatio Alger” ethic and are “elitist”. After all, Abe Lincoln only had about 1 year of formal education and was perhaps the greatest President of the United States (http://showcase.netins.net/web/creative/lincoln/education/glance.htm). Lincoln probably could have run a bank or brokerage (after all he ran a civil war). Vincent McMahon, CEO of World Wrestling Entertainment, is able to run a large and successful corporation and he probably doesn’t have any formal educations (other than perhaps in pharmacology). If McMahon can run wresting he can run a bank. George Bush went to college (and graduate school) but pretends that he didn’t. President Bush runs a whole country!! And, Howard Hughes didn’t graduate from college even though he was pretty smart. I am certain Mr. Hughes could have been a banker in today’s environment.
And, since college isn’t required neither should knowledge of economics, finance, accounting or economic history. Nor will requirements include higher level math such as Algebra, calculus or statistics. CEO/CFO candidates shouldn’t be expected to master more than basic addition, subtraction, multiplication and division (with a calculator).
Work experience and/or apprenticeship requirements. Abe Lincoln didn’t have a lot of executive experience before being President, so neither should bank CEOs/CFOs. Hedge fund managers, i.e., the “Kings” of corporate finance, don’t need any prior experience (and many of them don’t have any). So why should a higher standard be imposed on CEOs/CFOs of global financial institutions?
Minimum reading and general knowledge and where to find it. There are some standards that I think should apply in terms of general knowledge and minimum reading material. However, given no real education, work experience or apprenticeship requirements, these standards need to be “reasonable”.
After rejecting the local public library as a source of reading material for high level financial executives (remember I want to have reasonable standards for our nation’s financial leaders and most books in the library have “big words”), I decided to go to Barnes and Noble. If it is important to know it is probably found in the extensive selection at Barnes and Noble.
In the business section of Barnes and Noble I found two business books that seem perfect. Neither book used big words or a required lot of math, and to understand them an advanced degree (like an Associate’s Degree from Palm Beach County Community College) wasn’t required.
The first book I chose, The Little Book of Value Investing is part of the “Little Book” series published by Wiley.
In the dust cover the publishers ask “Do you care about your money?” Well, bank and brokerage CEOs and CFOs are suppose to care about money. The publishers claim that that only an IQ of 125 is necessary to understand the book. In fact, The Little Book of Value Investing says that that any IQ greater than 125 is “wasted.” Well, an IQ requirement was a new concept but one that I decided is reasonable. But what “sealed the deal” for The Little Book was the fact that the publishers claim that the reader will “[learn] to put your money to work like a banker” (and since we are searching for proper standards of knowledge for bank CEOs and CFOs….). And, for readers that have trouble reading, there is an audio version of this book. Barnes and Noble features The Little Book of Value Investing on their web site at http://search.barnesandnoble.com/booksearch/results.asp?WRD=the+little+book+of+value+investing.
The second book, Value Investing for Dummies, is even more natural for money center bank CEOs/CFOs. Value Investing for Dummies claims to teach how to “detect hidden agendas in financial reports.”, “understand financial statements” and “assess a company’s value”. The book explains “fundamentals and intangibles”, has “tear-out cheat sheet(s)” and features “a dash of humor and fun”.
The Dummies series of books are well known reference books for discerning readers and learners. After all, the Dummies series has mastered such esoteric and difficult topics such as seasonal addictive disorders in their Seasonal Addictive Disorders for Dummies (a must read for all mental health professionals), the conundrum of the human genome in their groundbreaking Genetics for Dummies work (I understand it is required reading at most medical schools), the mystery of the 1980s personal computer in their newly revised DOS for Dummies (finally an easy to understand reference book for people with a computer phobia) and how to kill time while waiting in an airport in the seminal work Su Doku for Dummies (if only I had this on my last trip to Asia). The most authoritative list of Dummie books can be found on the Barnes and Noble web site at http://browse.barnesandnoble.com/browse/nav.asp?visgrp=nonfiction&n=1000005131&ne=1000005131&Ns=SERIES_NUMBER.
So, what about those minimum standards for the global financial leaders?
What should they know about leverage?
According to The Little Book of Value Investing quite a bit.
In the “Little Book” chapter titled “Sifting Out the Fool’s Gold” I learned
“The first and most toxic reason that [companies don’t do well] is too much debt. In good times, companies with decent cash flow may borrow large amount of money on the theory that if they continue to grow, they can meet the interest and principal payments in the future. Unfortunately, the future is unknowable, and companies with too much debt have a much smaller chance of surviving and economic downturn.”
The Little Book chapter titled “Give the Company a Physical” continues to teach and illuminate in terms that everyone can understand.
“Much as a doctor consults patients’ charts to see what condition they are in, look to the balance sheet to see what shape the company is in. The doctor needs to know all the vital signs to make a diagnosis. A balance sheet is effectively a company’s medical chart….”
Readers are told that they
“….want to make sure that the company is not overly burdened with debt, and that there is enough capital to stay in business during bad times.”
Leverage trends are identified as important in the Little Book when it continues to state
“…it is useful to observe trends over the past few years. Are liabilities growing faster than assets? This could be an indication that the company has to borrow more and more money just to stay afloat…”
However, Mr. Browne (the author of the Little Book) appears to be a purest (which is perhaps a controversial position) when he states that he
“…prefer(s) to subtract intangible assets from [equity]” when calculating the amount of debt to equity because equity less intangibles gives him “…a better picture of how much actual equity there is in a company that could potentially be realized if needed.”
The Little Book of Value Investing continues to warn
“In general a high debt-to-equity ratio means that a company has been financing its growth by borrowing. Leveraging the company by increasing debt levels is a double-edged sword….there is a real danger of default and bankruptcy down the road. The less debt on the balance sheet, the grater the margin of safety.”
In conclusion the Little Book points out
“A strong balance sheet is a good indicator of a company’s stamina, its ability to survive when the going gets tough.”
Value Investing for Dummies has similar lessons for CEOs/CFOs when in “Fundamentals for Fundamentalists” it asks and answers the “age old” question of “How much [debt] is too much?”
“[The] excessive use of debt signals potential danger if things don’t turn out the way a company expects them to. Leverage is a good thing when things are going a company’s way. Debt financing can be used to produce more ….profit and, in the end, a bigger business….But as everyone knows, this can work the other way….Industry standards and common sense apply to debt-to equity ratios.?”
Later in Value Investing for Dummies the reader is again warned that
“Financial leverage can be a good thing – to a point, and as long as things are going well.”
So, how do the CEOs/CFOs some leading banks and brokerage firms stand up the standard of knowing and applying the information found in The Little Book of Value Investing and Value Investing for Dummies?
Let’s start with the management team from Bear Stearns. As it turns out, when it failed Bear Stearns had the highest debt levels of any of the major brokerage firms. At 33.53 to 1 at the end of 2007 Bear Stearns was massively overleveraged and apparently didn’t understand that with so much debt “there [was] a real danger of default and bankruptcy down the road.” (from The Little book of Value Investing). And the trends for the past 5 years of leverage were bad. Management didn’t realize that they were increasing the risk of a failure and up until the very end had little idea of the trouble that they were in. Moreover, common sense would suggest that when the company was “burning down” playing tournament bridge probably wasn’t the best crises management strategy. Clearly, the management team at Bear Stearns needed to spend some time at Barnes and Noble honing their skills and as a result failed the competency test (not a big surprise).
The Lehman Brothers team in place during 2007 also failed the competency test. With leverage at approximately 30.70 to 1 (and having added material amounts of additional leverage during 2005, 2006 and 2007) they only seem to have a marginally better understanding about risk and leverage than the Bear Stearns team (maybe that is why Lehman Brothers almost failed like Bear Stearns). However, Lehman’s new CFO Erin Callan seems to pass the competency test. Since she took over as CFO the firm has been reducing its debt burden while at the same time increasing its equity and improving its “Net Leverage” ratio by almost 25%. By the way, Erin understands that when calculating Net Leverage she is supposed to deduct goodwill and other intangibles from equity as suggested by The Little Book. Erin appears to be the star of the Lehman Brothers executive suit.
At Citigoup the team headed up by Chuck Prince clearly didn’t know what was in either the Dummie or the Little Book series and were appropriately terminated. However, the new team lead by Vikram Pandit seems to have the “right stuff.” He is raising capital and reducing debt as fast as humanly possible. I guess his team has been hanging out at the Starbuck’s in his neighborhood Barnes and Noble.
What about First Capital? First Capital operates at a Net Leverage Ratio of about 3 to 1 (which is about 1/10th of Lehman Brothers’ ratio after Ms. Callan began to perform her magic and 1/15th of Citigroup’s Net Leverage Ratio at December 31, 2007). We didn’t increase our leverage over the last 5 years and are careful to manage both debt and equity to maintain what is considered to be a “fortress” balance sheet. I guess we pass the leverage competence test.
In future blogs I will discuss additional CEO/CFO competency tests using criteria found in The Little Book of Value Investing and Value Investing for Dummies. I am confident that First Capital will continue to pass the test but less confident about others.
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