Update

Apologies to everyone for not posting in a while.

I am working on a few pieces that you should find interesting, but I'm currently traveling in Asia (Taiwan, China) for three weeks.

Some things you can look forward to:

• How exactly did Bernie Madoff pull off such a large fraud?
  
• There are too many articles on the financial crisis to interpret them all. So I'm writing an article that will help you interpret them all;
  
• Taiwan/Chinese trade relationship - a surprising amount of hostility from what is officially considered a Republic of China;
  
• An ideas paper on the future of Canada's economy: the World won't look the same in 10 years economically. What are the risks to Canada?
  
• I want to personally challenge a day-trader. I believe that I can make more money betting on baseball than a daytrader can in the stock market. I had a net return of almost 100% last summer betting on baseball.
• I might sneak in some non-financial writing too.
  

As you probably noticed by now, I'm not a true blogger.
My pieces are more like essays; It's research wrapped in my opinion.
I promise to reward your patience.

Thank you everyone for the positive feedback and support.

Dr. Doom

Courtesy of the Globe and Mail, I recommend everyone watch this 20+ minute keynote speech delivered by Nouriel Roubini. It's unfortunate that he gets tagged as "Dr. Doom" or a "Bear" economist; he's just telling it like it is. The fact that he even has this label shows you how the media can quickly classify and dismiss even the most insightful people. He's been making predictions about an economic downturn for years, but people are only now realizing he's not pessimistic, he's actually correct.

He makes fantastic predictions about how long this recession could last, talks about how severe deflation will be, and most importantly he intelligently analyzes whether governments are doing the right things, among other topics.

Accounting Shame

The Financial Accounting Standard’s Board in the US decided that it would relax the rules on Mark-to-Market accounting. I touched on this concept only briefly in a previous piece (Toxic Plan), but given what has transpired since, it is worth a more in-depth look.

The story begins with Geithner’s proposed plan to buy toxic assets. Regardless of whether this plan was good or bad for America, the purpose of the plan was get banks lending to distressed corporations by:

1. Providing an incentive to private investors to purchase mortgage-backed securities from distressed companies (this includes banks as well as other corporations). By creating a market to sell these toxic assets, this would provide much needed liquidity to troubled companies that are currently stuck with the securities;
2. Simply from having actual market transactions again, the entire mortgage-backed world has fresh market transactions with which to value these toxic securities. With existing mark-to-market accounting rules in place, the market values of these securities will rise on troubled balance sheets as a result of real market transactions.

There are many critics of the plan, and rightfully so, but among all the attacks, what has been lost is that Geithner’s plan works with existing accounting rules. If there are willing buyers for these toxic assets – whether a bank decides to sell them or not, all holders of toxic assets would benefit. The beauty of the mark-to-market accounting rule is that valuations of these assets were never entirely in the hands of the companies holding them. The value of these assets is a reflection of what an impartial investor is willing to pay for them.

However, Wall Street banks currently holding toxic assets don’t agree with the rule. They argue that there is no market for them today because of the financial crisis and it’s unfair to value them at zero or close to zero. They point out that if they were to hold these mortgage-backed securities until maturity, they would still receive 50-75% of the total underlying loan values, if not more.

[This is true. Assume a bank is holding one mortgage backed security that is made up of 5 mortgages valued at $200,000 each. If foreclosure rates go as high as 20%, which is outrageous, that means only one of the underlying mortgages is worthless – which means $1 million worth of mortgages should be revalued at $800,000. But this is in the long-term. Like, really long-term. It will probably take Americans 25+ years to pay down the entire mortgage, and some even had durations of up to 40 years. However, as long 80% of Americans keep making mortgage payments, this bank continues to receive interest and principal, every month, on the underlying mortgages of its mortgage-backed security]

So what the banks have asked for is the ability to set the value of these securities themselves. Despite Geithner’s plan, the Financial Accounting Standards Board decided that Wall Street is right. Rather than waiting for the market to come to the conclusion that these assets aren’t actually worthless, they have given the discretion to distressed banks. An accounting mechanism that is meant to correct itself has been usurped by the lobbying power of Wall Street big-wigs. I’m not exaggerating, this blog entry in the NY Times describes a disturbing account of how the rule changed. Not to mention, if FASB was going to change the rule, why didn’t they simply change it when banks needed it the most – last fall during the market collapse? What’s the point of doing this now, after Geithner already made a plan to work in unison with the old rule?

As an accountant, it’s disappointing to see this kind of a rule change. It’s a permanent accommodation of a temporary situation. Even if you agree that these assets have a different value if they were held until maturity, most companies that have been harmed by toxic assets need to get rid of them now, not 25-40 years from now. By putting the cart before the horse, companies holding toxic assets are hoping to boost their values up using subjective valuations. Although this won’t help them sell the assets, they are hoping it improves their balance sheets enough that banks lend them money to pay the bills.

What’s more interesting is that because of this accounting change and Geithner’s plan, economists and analysts out there have done some groundwork to see what kind of an impact this will have on balance sheets. Paul Kedrosky points out that maybe this mark-to-market thing is blown out of proportion - GE only has 2% of its assets currently being marked-to-market. But that 2% could shoot up to 20% if GE “feels” like its toxic assets are being unfairly valued by the market. We will only know the true impact of this revised accounting policy once companies revalue their balance sheets using the new subjective rule. Who knows, maybe GE will use “sentimental value” instead of market value, which should yield a better result.

A national accounting standard’s board should never react this way. Accounting, by definition, is the recording of financial transactions. It is a record of what happened. Complex financial instruments make accounting challenging, but adopting new rules on-the-fly to accommodate private interests make accounting useless.

Accounting should always strive to implement and cling to rules that encourage and achieve objectivity. A market transaction is an objective piece of information. It’s an observable benchmark that the world can see. A buyer and seller have inherent biases, but when the two are able to shake hands – that represents a true market value of the asset in question.

This accounting rule change has nothing to do with accounting. In fact, this rule change will lead to a misrepresentation of financial transactions. Maybe stocks will soar because of improved first quarter earnings as a byproduct of this change? Maybe the next move is for Wall Street to strong-arm lenders, accusing them of not lending even though everyone’s balance sheets are clearly healthy again? All of this is irrelevant, though. The most damning result will be that Financial Accounting Standards Board lost its integrity by implementing this change.

Buy American

Canadian banks have money, and our Prime Minister wants everyone to know it. Apparently he believes this is a good time to buy foreign banks. In this piece from the Globe and Mail, Harper outlines how this is a great time for Canadian banks to expand their modest empire. The logic is that there are several financial institutions in the US with stock values so low that our banks can theoretically swoop in and acquire them - an action that was previously impossible before the financial crisis.

So how did our banks become so "relatively" wealthy? As Harper suggests in the article, tight regulations in the Canadian banking sector is a major reason why our banks are not as stressed as the American ones. The reserve ratios are much higher for Canadian banks. This restricts how leveraged our banks can be, relative to the American banks. Stricter regulations also means that when times are good, our banks can't grow as fast as the US ones. Don Drummond of TD Bank covers all the angles of why our banks are awesome in this piece he wrote for the Star.

Without doing anything, the big five Canadian banks have all found themselves among the top 13 banking companies in North America. To put this into perspective, our largest bank (Royal) used to be only a third of the size of a large American bank (like Citigroup). Now, Royal Bank is more than twice as large as Citigroup. The relative values of Canadian banks versus American banks has changed drastically. But just because something’s ridiculously cheap – should you buy it?

Experience tells us that the recessions bring about tremendous opportunities, simply because asset prices are depressed. When everyone is scared to buy – that is exactly the right time to buy.

[An aside: I personally believe in Dollar Cost Averaging, which refers to purchasing an investment in little pieces over time, rather than purchase it all in one lot. For example, if I had $5,000 that I wanted to invest in a Canadian Equity mutual fund, rather than trying to figure out when Canadian stocks will bottom-out, I would blindly purchase $200 of the mutual fund each month. This is what they refer to in the investment industry as being a "scaredey-cat." The reality is by the time our phsyches are ready to invest, it's already too late - economic recovery is well on its way. That's why the best way to remove the psychological element from investing is dollar-cost averaging. Let the experts pick the market-bottoms (and then change their mind, and then pick them again, and so on). By averaging your purchases, you'll have participated in the market bottoming out process, which ensures that you're buying low.]

But I'm not concerned about timing. I'm concerned about the quality of the assets they could potentially buy. Let's not forget last fall when Lehman collapsed, the entire American banking system was lined up to follow, like dominos. If it wasn’t for that blank-cheque financial bailout package that everyone is now criticizing, Lehman would have been the first of several casualties. They were all guilty of borrowing to the max in order to invest in mortgage backed securities althewhile failing to have enough reserves for any potential losses or impairment to their assets.

[Another aside: It’s easy to criticize how poorly that bailout package was written, but the fact of the matter is Congressmen were holding the government hostage because its passing was essential to prevent imminent bank failures.]

As it stands, it’s very difficult to value of one of these banks while they are getting so much assistance from the US government. The reason the value of these stocks is so low is due to the uncertainty surrounding their financial assets. There is so much uncertainty that the stock prices are not likely a good indicator of the true value of these American banks.

Although AIG is not a bank, it would be naive to think what killed AIG doesn't also ail other financial institutions. Even though it is obviously not a target for a merger, right now it serves as a powerpoint presentation to the world as to how deranged the American corporate system can be, and how easy it is for these banks to deceive the public about their financial situation.

Naturally, before a takeover, there has to be some thorough due diligence performed on these American bank assets. If one of the big Canadian banks is interested in taking over Citigroup, for example, they would need to determine exactly how many of these "toxic" assets Citibank actually owns, and how much they're really worth. They will also need to determine the degree to which Citi is affected by credit default swaps. Once they do that, they would be prepared to make an appropriate bid on the true value of the company. Basically, they just need to do what US government has been trying to do for about half a year now.