Financial Armageddon

Not the Exceptions to the Rule

In yesterday's post, "Bad C's," I highlighted a few reports that lent further weight to the notion that the financial sector has not been a paragon of virtue, to put it mildly. Yet while many banks and brokers have engaged in some pretty bad behavior -- which, among other things, helped bring about the worst financial crisis this century --they are apparently not the exceptions to the rule, as jr deputy accountant reveals in "Accounting 'Irregularities' on the Rise in the Recession":

Reuters is reporting accounting fudging and fraud are on the rise in the US as a result of "pressures" for companies to perform despite the hostile economic environment.

Sure, there's that and then there are also the auditors but we'll leave them be for now, it's Friday and we're feeling nice.

Reuters:

Corporate balance sheets may be showing signs of the wear and tear from the prolonged U.S. recession as accounting irregularities are starting to surface at growing numbers of U.S. companies.

"When things get difficult companies tend to stretch even further and utilize whatever games that they can get away with and sometimes they don't get away with them," David Tice, chief portfolio strategist for bear markets at Federated Investors, said in an interview with Reuters television on Wednesday.

Accounting irregularities are increasingly showing up in U.S. regulatory filings and corporate announcements.

Shares of Apollo Group Inc (APOL) sank 18 percent on Wednesday after the parent of University of Phoenix said the U.S. Securities and Exchange Commission had launched an informal inquiry into its revenue recognition practices.

Apollo is just one of several big name companies that have disclosed they have accounting issues over the last few weeks.

Internet retailer Overstock.com (OSTK) said last month that it was under scrutiny from government regulators over the way it accounted for some expenses. The company restated financial results in 2006 and 2008.

New York Sports Clubs owner Town Sports International Holdings Inc (CLUB) said last month that the SEC was formally investigating its deferral of certain payroll costs related to membership sales.

And jewelry chain Zale Corp (ZLC) said it will report fourth-quarter financial results on Thursday, after it twice-delayed its earnings results due to an accounting review of prepaid advertising costs.

"Statistically you can show any time you have a recession or some type of tremendous decline in an economy you're going to see financial pressures on companies," said Bruce Dorris, program director at the Association of Certified Fraud Examiners, noting that corporate employees can sometimes be motivated to be overly aggressive with accounting or commit outright fraud to meet targets, particularly in difficult economic times.

Fraud in non-financial sectors? Say it ain't so. Well why should auditors and management be committed to truthful accounting if the example set by our powers that be is to deny, deny, deny?

Professor of Economics and Law at the University of Missouri and senior regulator during the S&L crisis of the 1980s, William Black blamed "a massive fraud" for the economic crisis on Bill Moyers earlier this year:

[They] don't want to change the bankers, because if we do, if we put honest people in, who didn't cause the problem, their first job would be to find the scope of the problem. And that would destroy the cover up....

Geithner is ... covering up. Just like Paulson did before him....

These are all people who have failed. Paulson failed, Geithner failed. They were all promoted because they failed....

Until you get the facts, it's harder to blow all this up. And, of course, the entire strategy is to keep people from getting the facts....

[Question] Are you saying that Timothy Geithner, the Secretary of the Treasury, and others in the administration, with the banks, are engaged in a cover up to keep us from knowing what went wrong?

[Black] Absolutely....

They're deliberately leaving in place the people that caused the problem, because they don't want the facts. And this is not new. The Reagan Administration's central priority, at all times, during the Savings and Loan crisis, was covering up the losses.

[Question] So, you're saying that people in power, political power, and financial power, act in concert when their own behinds are in the ringer, right?

That's right. And it's particularly a crisis that brings this out, because then the class of the banker says, "You've got to keep the information away from the public or everything will collapse."

Move along now, nothing to see on these cash flows...

Talking Out of Their You-Know-Whats

In "Current Market Boom 'Can't Be Trusted,' Robert Shiller Says," posted earlier this week at Yahoo! Finance's Tech Ticker, the author of the bestselling publication that essentially called the top of the dot-com era bull market raised some concerns about the headiness in share prices:

Are we on track for a repeat of irrational exuberance?

With the stock market up more than 50% since March and the Standard & Poor's Case/Shiller Index on the rise for the last three months, it's a worry, says Yale Professor Robert Shiller. "Somehow we got into this really speculative mentality and I don't think we're out of it yet."

Given the current economic environment, "these booms [in the housing and stock markets] that we're seeing now can't be trusted to continue," Shiller tells Tech Ticker in the accompanying video [at the TT site], taped at last week's Buttonwood Gathering.

The author of Irrational Exuberance and Animal Spirits characterizes the stock market rally as an "amazing rebound" without much historic precedence, "you have to go back to the Great Depression to see such a turnaround in the stock market."

According to his cyclically adjusted P/E valuation model - stock price divided by average 10-year earnings - stocks are overvalued today, but "not massively overvalued."

The market's rebound isn't likely to be derailed by valuation in the short term, Shiller says, but if one looks to the classic bear market rally of 1933-1937 as a guide, stocks may eventually crater as they did then.

That said, some long-time market watchers might take issue with the professor's assertion that stocks aren't priced at historical extremes. In its latest weekly commentary, "Stock Market Significantly Overvalued," Comstock Partners argues that, compared to where they have traded in years gone by, equities are anything but cheap:

In recent weeks we have been pointing to the unsustainability of the economic recovery as a key reason for doubting the surge in stocks since the March lows.  In this comment we will show why we believe the market is also considerably overvalued on the basis of earnings.

The media, both in print and on TV, rather consistently maintain that the market is either cheap or, at worst, reasonably valued.  With consensus 2010 S&P 500 bottom-up operating earnings currently estimated at about $74 (up 35% from 2009) the P/E ratio comes out at 14.8, a valuation that sounds reasonable at first glance. There are, however, a few problems with that logic. The long-term history of P/E ratios on the S&P 500 is based on actual reported trailing (GAAP) earnings rather than forwardly-estimated operating earnings. (As most of you know GAAP stands for generally accepted accounting principles and includes write-offs whereas operating earnings exclude write-offs.) Reported earnings are audited numbers, while write-offs are whatever companies say they are. In the past decade companies have gotten a lot more creative about what items they can write off and now a large number of expenses that used to be considered as normal expenses are now called unusual even though these write-offs are taken year after year. In other words, in too many cases what is called operating earnings is really pure fiction.

The average long-term P/E ratio of trailing reported earnings over the 73 years prior to the stock market bubbles of the last decade was 14.5 (round to 15).  Operating earnings did not even exist until the mid 80s.  Since operating earnings almost always exceed reported earnings, often by significant amounts, even if we had such results going back further in history the average P/E on them would be much lower than for reported earnings. Moreover, if we used forward rather than trailing earnings, the long-term P/E ratio would be even lower, most likely somewhere around 11.  In this case even a 14 or 15 P/E ratio on forward operating earnings would indicate substantial overvaluation.

Given these considerations, where do we stand in terms of valuation at today's closing S&P 500 of 1092 compared to a historical average P/E of 15? On estimated 2009 reported earnings of $40, the P/E is 27, while the P/E on estimated 2010 earnings of $46 is 24. Even on estimated 2009 operating earnings of $55, the P/E is an overvalued 20.

Some argue that calculating the P/E on earnings that may be unduly depressed distorts the true value, and they do have a point.  Therefore, in both strong and weak earnings environments we have long used a method to smooth earnings over an entire cycle or more.  On this basis we come up with a smoothed trendline reported earnings number of $60, resulting in a P/E ratio of 18.2, still well over the historic norm of 15. The conclusion: anyway we look at it, the market is overvalued.

Yet even Comstock Partners assessment sounds somewhat tame if you contrast it with the opinions expressed by one old market hand, an independent economic advisor who for many years toiled at the fund management arm of a venerable British financial institution called S.G. Warburg & Co., in an FT Alphaville post entitled "The US Stock Market Is Overvalued by 40%":

Andrew Smithers, of London-based research house Smithers & Co, is not a man who has any truck with nonsense. Particularly when it comes from the mouths of stockbrokers.

In his latest report, The US Stock Market: Value and Nonsense About It, he takes to task those who claim US equities are still cheap:

As we have remarked before, valid approaches to value are disliked by many practitioners as they get in the way of business. As is inherently likely, and as a glance at Chart 1 will confirm, the stock market has been underpriced around 50% of the time. Those who sell shares would rather it were cheap 100% of the time and therefore prefer invalid metrics. The ones used vary from time to time, as those employed are restricted to those which currently give the desired answer that “stocks are cheap”.

Smithers says there are only two ‘valid’ ways to value the market. One is by using a cyclically adjusted PE ratio and the other by using the Q ratio, which compares the market capitalisation of companies with their net worth,  adjusted to current prices.
Whichever technique is used, the answer is the same: the US stock market is overvalued by around 40%.

Smithers explains:

As the valid measures of the US market show that it is currently around 40% overvalued, some ingenuity is needed to claim otherwise. The EPS for the past 12 months on the S&P 500 is $7.51 so, with the index at 1071, it is selling at a trailing PE of 142. This is far higher than it has ever been before, as the previous end month record is a PE of 47. But current multiples are no guide to value; when depressed, or elevated, they need to be adjusted to their cyclical norm.

This is how the cyclically adjusted PE (”CAPE”) is calculated and when its current value is compared with long-term average, using the geometric means of EPS and cyclically adjusted PEs,6 it shows that the market is 37.7% overpriced using 10 years of earnings’ data and 45% if 20 years are used. This method is therefore of no use to those who sell shares, or have made faulty claims about value in the past. The following are among the most common approaches to circumventing the problem this presents. Some produce relatively small distortions, but these can amount to a substantial degree of misinformation when combined.

Valuation isn't all that matters, of course, when it comes to which way share prices will go. Nonetheless, those bulls who cite valuation as a reason to be positive on stocks would seem to be talking out of their you-know-whats.

Bullishness at a Contrarian Extreme

As a long-time student of the markets, I've learned that traditional "fundamentals" don't always tell the full story. For me, at least, it's also important -- essential, actually -- to take technical, sentiment, and macro factors into account when trying to figure out which way prices are headed.

That doesn't mean I always get it right. In fact, I've had more than my fair share of bad calls, especially when it comes to the shorter-term outlook. Regardless, I've found that my odds tend to improve when the aforementioned elements are all pointing in the same direction.

With that in mind, the following chart (courtesy of Elliott Wave International) and remarks by Tim Knight, from a post at his Slope of Hope blog (another long-time favorite of mine), entitled "Some Insights from EW," suggest that bullishness has reached a contrarian extreme:

The [following] chart shows the perverse relationship sentiment has with stocks. In early March, when stocks were a ridiculous bargain and multi-thousand percentage gains were just waiting to be plucked, the sentiment reading was an unheard-of 2% bulls.

Now, however, with stocks at (in my opinion) insanely-overpriced levels, and with all those multi-thousand percent gains already part of financial history, people are ga-ga about stocks.

Getting Close to a 'Recalibration'?

Many people are cheering the fact that the Dow Jones Industrials Average has reached an apparently signficant milestone -- 10,000 -- and are suggesting that it means good news for Main Street.

Yet even during more "normal" times, the relationship between the stock market and the economy has been rather tenuous, at least in the short run. Think back to the feeding frenzy that was occurring just over two years ago, when clueless traders pushed equity prices to all-time highs as the financial world and the real economy were undoubtedly falling apart.

Generally speaking, share prices can be influenced by any number of factors, not least of which is the mood of traders -- what some refer to as "animal spirits" -- and the amount of cash that is available for speculation -- er, investment. Conditions on Main Street don't always enter into it.

In the end, of course, if the fundamental reality fails to match or catch up with the exuberance of the trading crowd, then that sets the stage for a "recalibration"of some sort, which can be swift and violent if the differential has reached unusual extremes.

Is that where we are now? If you read the following sampling of commentaries discussing what I would describe as the Wall Street-Main Street disconnect, I think you'll find that the answer jumps right out at you:

"Why The 10,000 Point Dow Doesn’t Matter" (Bill George's Blog)

The Dow is at 10,000.  Reporters glow.  Retirees relax.  Investors sigh: “Whew, we’ve made it.”

They’re wrong.  This purported milestone isn’t a victory.  It’s nonsense.

The market is the wrong place to look when measuring the health of our economy.  The collective wisdom of mutual fund analysts was wrong in 1999, wrong in 2006, and it’s wrong right now.

The best investor in the United States basically ignores Wall Street.  Warren Buffett has billions he could trade in and out of stocks.  Thousands of analysts would clamor to give him hot tips.  But Buffett ignores it all.  Serene, he sits in his office, reading annual reports, newspapers, and thinking about opportunities for growth.  He isn’t drinking champagne tonight.  And you shouldn’t be either.

We are far from out of the woods.  Large companies are still laying off employees.  When we cross the 10% unemployment line, consumer spending (now down to 70% of GDP) may contract even further.  It probably should.  Consumer spending in the UK is 65% and in China it’s only 40%.

Haven’t we learned something from this crisis??  Wall Street sold the world worthless securities, trillions of dollars of wealth evaporated, and now Wall Street is cheering this “new” bull market.  Now the bulls say it’s all okay again?!

What you’re watching now is a bull market on government spending.  What you should be watching is the real report card:

• Inflation: There is $50T in unfunded liabilities on the country’s balance sheet. If the USA played by corporate America’s accounting rules, we’d be bankrupt. The laws of gravity still apply. We will experience significant inflation within 3 years.
• Job Growth: Since the start of the recession in December 2007, we’ve lost 7.6 million jobs. Millions more have stopped looking for work. The analysts keep saying this downward trend will stop. But it hasn’t.
• Innovation: The credit contraction makes it harder for entrepreneurs and small businesses to invest in growth. This segment of the economy is where a rebound will start. Don’t watch the Dow, watch small business credit (contracting) and patents filed (contracting).
• Education: The important word in “Gross Domestic Product” is product. We must have highly skilled knowledge workers to compete against other economic innovators. A third of high school students aren’t graduating. This is the HR pipeline??

Yes, we have stepped back from the abyss.  But some very smart people thought the same thing in 1932.  Then 1933 happened.  Not so fast, Wall Street…

This battle is far from over.  Let’s dig deep, focus on the long haul, and make the substantive policy and business improvements the economy needs to really rebuild.  Then, the Dow will take care of itself. 

"Art Cashin: How Today's Market Is Like Dot-Com Bubble" (CNBC Stock Blog)

The stock rally could have legs after a line of better-than-expected third-quarter earnings reports, but Art Cashin, head of floor operations at UBS, said he isn't yet convinced.

"The banquet looks stupendous, I hear the wine is great," he said. "You guys can party on, but some of us are going to sit on the sideline like wallflowers."

Cashin said he doesn't think the economy is moving as much as data shows, and he's worried there are billions of dollars in excess reserves from people not borrowing.

He added that although it's difficult to compare today's environment with any other time in history, it reminds him of the dot-com bubble, when people refused to believe the markets would go anywhere but up.

"I said, 'I've never heard of a tree growing straight to Heaven except in Jack in the Beanstalk and that was a fairy tale,'" he said. "And unfortunately [the bubble] turned out to be that way."

"Don't Trust Dow 10,000" (CNNMoney.com)

The stock market is supposed to be a leading indicator, predicting what happens next. But the rally doesn't mean the nation's economic woes are over.

As the Dow closed above 10,000 for the first time in more than a year Wednesday, economists cautioned that the blue-chip average shouldn't be seen as giving a green light to the economy.

The stock market is what is known as a leading economic indicator, as investors place bets on how strong they believe company results and the broader economy will be in the near future.

Lately, there has been a growing consensus among both investors and economists that the battered U.S. economy hit bottom and turned around earlier this year, and is now in a recovery.

The Federal Reserve said economic activity has "picked up" in its statement after its Sept. 23 meeting, and about 80% of leading economists surveyed by the National Association for Business Economics agreed in a survey earlier this month that the recovery has begun.

But even economists who agree the economy is in recovery say that growth will be slow and difficult, with continued job losses, tight credit and further declines in home prices. And even some who believe that the current Dow 10,000 level is justified say there's still a significant risk that the economy will take a step backward.

"One of the great challenges is whether consumers and small businesses come along with this recovery," said John Silvia, chief economist with Wells Fargo. "If they don't, you either sit at 10,000 or slip back to 9,500. To sustain another double-digit (percentage) gain to Dow 11,000 is asking too much from this economy and the risks we still see out there."

There are also economists who question whether the economy is truly in recovery, given that it continues to lose about a quarter-million jobs a month. They say the more than 50% rally in the Dow since it closed at a low of 6,594.44 on March 5 is only a reflection that the fear of the economy toppling into a full-fledged depression has abated.

"We're not at Armageddon anymore, so of course you should have some kind of rally," said Rich Yamarone, director of economic research at Argus Research. "But I think there's a bubble-like atmosphere going on here in the rush back to 10,000. Caution should rule the day. We're not out of the woods yet."

Several experts point out than many of the relatively strong earnings reports helping to lift the markets in recent days are being driven by cost cuts, rather than strong revenue growth that would be a better indicator of consumers and businesses being willing to spend again. If businesses keep cutting costs to make the numbers that Wall Street wants to see, that can only put more downward pressure on jobs and wages, and result in weaker economic growth or another downturn.

"The companies are cutting fat, and in many cases cutting bone and muscle. There's no organic economic growth there," said Yamarone.

Barry Ritholtz, CEO and director of equity research at Fusion IQ, said that despite their reputation as a leading indicator, the stock markets do a terrible job forecasting the economy.

"Beware of economists pointing to the stock market," he said. "The rallies tend to be false starts because it's a reaction to what came before. The sell-offs tend to be overdone because, as they gain momentum, they lead to panics."

Ritholtz said comparisons of current earnings to those of a year ago or stock levels to the lows of earlier this year greatly exaggerate the strength even the market sees in the economic outlook.

"It's like saying the Detroit Lions have better year-over-year comparisons because they're no longer winless," he said about the football team that went 0-16 in 2008, but has won one of five games so far this year. "But they're still in last place and they're not winning the Super Bowl."

Another reason that comparisons to Dow levels of a year ago are risky is that two of the more troubled components -- General Motors and Citigroup (C, Fortune 500) -- were dropped and replaced by stronger companies such as Cisco Systems (CSCO, Fortune 500) and Travelers Cos. (TRV, Fortune 500) in June.

Without those changes the Dow would be almost 100 points lower now than it is with the stronger companies, although precise comparisons are difficult since GM shares are no longer traded on the New York Stock Exchange.

"You take out the worst, put in the best, and by definition you'll get better numbers," said Yamarone.

"Why the Dow Broke 10,000, and Why You Should Still Watch Your Wallet" (Robert Reich's blog)

How did the Dow break 10,000 when the rest of the economy is in the toilet?

1. Corporate earnings are up -- mainly because companies have been cutting costs. Payrolls comprise 70 percent of most companies' costs, which means companies have been slashing jobs. In the end, this is a self-defeating strategy. If workers don't have jobs or are afraid of losing them, they won't buy, and company profits will disappear.

2. Federal borrowing has filled the gap that consumers and businesses created when the latter began to reduce their debt. Federal debt, in other words, has kept the economy from tanking. Can't keep up forever, though.

3. With such horrid employment numbers, Wall Street figures the Fed will keep interest rates low for some time, and continue to flood the economy with money. That's good news for the Street because it means money stays cheap -- and with cheap money the Street can make lots of bets on almost everything under the sun and moon. As a result, the Street's earnings are way up. But this, too, is temporary. At some point the Fed is going to worry about inflation and a falling dollar.

4. Investors of all stripes want to get in early and ride the wave. Pension funds, mutual funds, and other institutional investors figure the bull market has more oomph in it because, well, other investors will jump in. Think Ponzi scheme. Nice for now, but watch out if you're one of the last in.

In other words, this is all temporary fluff, folks. Anyone who hasn't learned by now that there's almost no relationship between the Dow and the real economy deserves to lose his or her shirt in the Wall Street casino.

Not What They Expect

Whether you call it a reality check...

(Image source: http://co2realist.com/2009/04/.)

...a wake-up call...

(Image source: http://www.subhub.com/articles/Publishers-Wake-Up-to-Online-Publishing.)

...or a splash of cold water reality,...

(Image source: http://travel.webshots.com/photo/1116592582051969644bWvzZM.)

...based on the following MarketWatch report, "October Surprise from Bank Earnings?" it appears that lots of people are going to be caught out when banks announce their earnings in the weeks and months ahead (I guess they've been listening to the gang that couldn't rate straight):

Some experts worry results may be much more negative than investors expect

Bank stocks surged during the third quarter, but as companies prepare to report results from the period, several industry experts remain concerned.

"We are very early on in this credit cycle," Timothy Long, chief national bank examiner at the Office of the Comptroller of the Currency, said at a recent conference.

"That statement caught everyone by surprise," said Nancy Bush, a veteran bank analyst who attended the conference.

J.P. Morgan Chase kicks off the bank-reporting season on Wednesday.

The KBW Bank Index , which tracks shares of lenders, including Bank of America, Citigroup and Chase, jumped 30% in the third quarter, as investors bet that huge increases in bad loans from the mortgage meltdown and broader financial crisis were easing.

Thinking the worst is behind the industry, investors began looking to 2010 and 2011 when banks should be a lot healthier, according to Richard Bove, an analyst at Rochdale Securities. Third-quarter results will make that leap of faith harder to maintain, he said.

"Third-quarter earnings for most banks, particularly the regional lenders, will be extraordinarily negative," Bove said.

He estimates that about 60% of banks will report losses in the period as nonperforming assets continue to grow and charge-offs remain very high. Lenders will also have to increase reserves because they didn't bolster them enough during the second quarter, Bove added.

Loan growth will likely remain sluggish and net interest margins won't increase much, partly because funding costs have already dropped so much that they can't fall much further, the analyst explained.

"None of this bodes well for the third quarter," Bove said. "Once the market is faced with the reality of how bad the earnings are, it will be interesting to see whether investors will be able to hold on to these stocks at these price levels."

'Bogey-bear'
Bush is concerned that commercial real estate problems may begin to escalate, while consumer credit losses linger.

At the end of September, K.C. Conway, a real-estate expert at the Federal Reserve Bank of Atlanta, warned of big commercial real-estate losses and said banks will be slow to recognize the severity of those losses, according to a presentation to bank regulators reviewed by The Wall Street Journal.

More than half of the $3.4 trillion in outstanding commercial real-estate debt is held by banks and vacancy rates in the apartment, retail and warehouse sectors have already exceeded levels seen in the real-estate collapse of the early 1990's, the newspaper noted.

"That's the big bogey-bear staring us in the face," Bush said. "But when I ask banks about their commercial real-estate exposure, they all say the same thing -- that they don't have many major problems. Then you read the Fed report and it's completely different. I don't know which to believe."

Regional banks are particularly exposed to commercial real estate loans because they didn't sell them through securitization as much as larger rivals, according to Keefe, Bruyette & Woods analyst Julianna Balicka.

These types of loans make up more than 35% of regional banks' total loans, up from 25% in 2000, she said in a recent note to investors.

The California bank units of Zions Bancorp and Western Alliance had more than 40% of their loans in commercial real estate at the end of June.

At Center Financial , Hanmi Financial , Nara Bancorp and Wilshire Bancorp those types of loans accounted for more than 70% of total loans, according to KBW's Balicka.

But it's not only regional banks that are exposed. Commercial real-estate loans made up 12% of large banks' total loans at the end of June, up from 9% in 2000, the analyst noted.

J.P. Morgan Chase , which is due to report third-quarter results on Wednesday, recently gave up trying to sell One Chase Manhattan Plaza, a 60-story skyscraper in lower Manhattan, after bids came in too low, according to a person familiar with the situation. The landmark office tower was one of 23 U.S. office properties J.P. Morgan was trying to sell, according to Bloomberg News, which noted the remaining properties are still for sale.

At the end of June, the bank had almost $65 billion of wholesale loans extended for real-estate related purposes, according to its latest quarterly regulatory filing.

Consumer drag
However, J.P. Morgan is more exposed to consumers, holding over $85 billion in credit card loans at the end of June.

Consumer loan losses from the subprime mortgage crisis have begun to abate, but Bush is concerned that rising long-term unemployment in the U.S. will mean lingering consumer credit problems for banks.

"I'm not convinced consumer credit will improve a lot," she said.

Indeed, the OCC's Long said this past week that the severe threat from last year's financial crisis has been replaced by a more traditional unemployment-driven economic cycle, which may be in its early stages, according to Robert Garsson, a spokesman for the regulator.

J.P. Morgan Chase is expected to make 49 cents a share in the third quarter, according to the averaged estimate of 19 analysts in a Thomson Reuters survey.

Profit will come mainly from the bank's capital markets and investment banking businesses, while credit costs remain high, Matt O'Connor, an analyst at Deutsche Bank, wrote in a note to investors earlier this week.

Provisions for credit losses will likely come in at $8 billion during the third quarter, in line with the second quarter. Credit card losses could rise to 11.5% in the third quarter, from 10% in the second, the analyst estimated.

Still, J.P. Morgan has more capital than most of its peers, O'Connor noted. And those rivals likely struggled more in the third quarter.

Citigroup , which reports on Thursday, is expected to lose 21 cents a share in the third quarter, according to the average estimate of 17 analysts polled by Thomson Reuters.

Citigroup had more than $67 billion of credit card loans that weren't covered by a government guarantee at the end of June, according to KBW analyst David Konrad. Potential losses on these exposures could reach almost $18 billion through the current credit cycle, which Konrad expects will end in the fourth quarter of 2010.

Konrad reckons Citigroup faces total potential losses of more than $124 billion before the cycle ends. The bank has taken $5.7 billion in net charge-offs so far, the analyst pointed out in a note to investors on Oct. 2. He's forecasting annual losses for Citigroup through 2011.

Bank of America , which reports results on Oct. 16, is forecast to lose 6 cents a share, according to a Thomson Reuters poll of 22 analysts.

Deutsche Bank's O'Connor expects Bank of America to lose 42 cents a share. The bank had $13.4 billion in loan loss provisions during the second quarter and it could set aside the same amount or slightly less during the third quarter, the analyst said. Reserves could be bolstered by $3.5 billion, down from $3.7 billion in the second quarter, he added.

Bank of America's credit-card business could be one of the main drags this quarter. Losses in this area could reach 13.5% in the third quarter, up from 11.7% in the second, O'Connor forecast.

Wells Fargo , scheduled to report on Oct. 21, is expected to make 36 cents a share, according to the average forecast of 23 analysts surveyed by Thomson Reuters. That's down from 57 cents a share in the second quarter.

The bank's mortgage business will likely generate about $3 billion in revenue during the third quarter, up from $2.5 billion in the second, O'Connor forecast.

However, credit losses will continue to weigh on the San Francisco-based bank. O'Connor sees loan loss provisions rising to $6.2 billion in the third quarter, from $5.1 billion in the second.

Charge-offs may jump 15% to 20%, the analyst added. Although that would be down from a 35% surge during the second quarter.

Goldman Sachs: The "Smart" Money?!

U.S. stocks rebounded today, aided by a rally in financials. Why was the group strong? Because a team of analysts at a well-known Wall Street firm upgraded the large banks sector. And why did they do that? Bloomberg gives us the lowdown in "Wells Fargo, Biggest U.S. Banks Raised by Goldman":

Wells Fargo & Co., JPMorgan Chase & Co. and the biggest U.S. banks were raised to “attractive” from “neutral” by Goldman Sachs Group Inc., which said share prices don’t reflect prospects for earnings growth.

“We believe this difference in earnings power hasn’t been fully reflected in share prices,” New York-based analysts led by Richard Ramsden wrote in a note to clients today. “We estimate that normalized earnings for large banks are 39 percent higher than in 2007 despite the 36 percent decline in share prices.”

Wells Fargo, based in San Francisco, was upgraded by Goldman to “buy” from “neutral” after its tangible assets per share increased 70 percent in the second quarter. “The reason is simple: Wells bought Wachovia at a depressed price,” Ramsden said. Banks have increased earnings with acquisitions that will add to earnings over the “long term,” he said.

Wow, pretty powerful stuff, eh? Then again, maybe not. You see, if you go back and look at what Goldman said in late-January, when most bank stocks were trading at far lower levels than they are now, the firm wasn't exactly upbeat on the group. Again, Bloomberg had the details in "U.S. Banks May Be the ‘New Utilities,’ Goldman Says":

Large U.S. banks risk becoming the “new utilities” as governments introduce greater regulation and force lenders to increase capital ratios, Goldman Sachs Group Inc. analysts said.

Return on equity at the biggest U.S. banks will be limited by higher capital requirements and greater regulatory controls, analysts led by Richard Ramsden in New York said in a report to clients today. The measure of how effectively banks invest earnings may shrink to between 10 percent and 12 percent, from the 15 percent banks generated between 1990 and 2006, they said.

U.S. Bancorp was cut to “sell” because the Minneapolis- based company, while “a good bank,” is already highly valued, the analysts wrote. Goldman also re-instated its sell rating on Citigroup Inc., saying “investors should avoid the stock given no core earnings power clarity.”

Bank of America Corp. was cut to “neutral,” the same rating given Morgan Stanley, Wells Fargo & Co. and PNC Financial Services Group Inc. The analysts recommend buying JPMorgan Chase & Co., which they said may show earnings improvement as the economic cycle turns.

Large banks, particularly Citigroup, U.S. Bancorp and Bank of America, have “thin” capital cushions compared with Goldman’s estimates for losses in the industry, the note said.

Not long after, the shares began a sharp recovery, and those crackerjack Goldman analysts probably felt pressure to reconsider. In May, after the sector had rallied more than a third from when the firm had issued its negative call, the banks team bit the bullet -- sort of -- as Bloomberg reported in "Goldman Sachs Upgrades Large U.S. Banks to 'Neutral'":

Goldman Sachs Group Inc. upgraded large U.S. banks to “neutral” [Note: to Bloomberg editor: might be helpful if readers knew the prior rating], saying strong mortgage and capital markets earnings will likely continue into the second quarter and new capital raised reduces leverage.

U.S. trust banks were upgraded to “attractive,” as the Goldman Sachs analysts led by Richard Ramsden determined revenue will recover from the first quarter. The analysts also raised their recommendation for U.S. credit card companies to “neutral” and reiterated their “cautious” stance on U.S. regional banks, which are “not out of the woods yet.”

Bank of America Corp., the biggest U.S. bank by assets, has more than tripled in New York Stock Exchange trading since hitting a low on March 6, while JPMorgan Chase & Co., the second largest, has more than doubled in the period. Regulatory stress tests of the 19 biggest U.S. lenders led firms to raise more than $100 billion in capital, the Goldman analysts said.

Unfortunately, Goldman's relative lack of enthusiasm for large bank shares -- after all, they were neutral -- meant that those who took their advice to heart likely missed the subsequent double-digit percentage rally in the sector.

In sum, while markets cheered today's news that Goldman Sachs -- who many consider to be the "smart money" -- was upgrading the large banks, based on their track record so far this year, shouldn't investors have been selling those shares -- and the overall market -- instead?

Double Helping of the Astute Mr. Rosenberg

In Wednesday's Huffington Post column, "Feeding the Ducks on Wall Street," I referenced data and reports detailing the varied list of players, many with intimate knowledge of what is occurring on Main Street's front lines, who have viewed the run-up in share prices as an opportunity to raise (and hoard) cash.

That raises the question, of course, of "Just Who Is Buying this Rally?" which happens to be the title of the following post from FT Alphaville:

Here’s an insightful question from David Rosenberg of Gluskin Sheff on the matter of the current rally in global equities.

Who is actually doing the buying?

As Rosenberg notes:

• It’s not private clients - stock funds registered net outflows of $1.33bn last week.
• It’s not corporate insiders - heck they’re selling like crazy.
• It’s not buybacks - S&P reported they were down to the lowest level since 1998.

Nope indeedy. This leaves him to conclude it must be:

Very likely it is still a combination of program trading, short coverings and portfolio managers desperately trying to make up for last year’s epic losses.

And, just to leave you with a scary fact for the weekend, he adds:

While it is now considered to be in very bad taste to say anything negative about an equity market that is seemingly on a one-way ticket north, by the time the S&P 500 was up 60% in the last cycle, claims had already fallen to 300k. And, in the cycle prior to that, claims had drifted down to 350k by the time the market had rallied 60%. The market is so overextended that it is now 20% above its 200-day moving average, which is a technical condition that has not occurred in 27 years.

Still, as I noted in my own commentary, just because the buying is of poor quality doesn't mean the market can't go up. Eventually, though, cold, hard fundamentals get in the way, as FT Alphaville -- which I gave props to several weeks ago -- reveals in another post, “This Overvalued, Overbought, Overextended Market…,” featuring the insights of the former North American economist for Merrill Lynch:

Here’s some more from Gluskin Sheff’s David Rosenberg, because his latest “Breakfast with Dave” note is just so good.

He is NOT buying this stock market - remember, bear market rallies “are to be rented; never owned…”

Imagine that six months after the depressed lows we have a situation where:

• The trailing price-earnings ratio on operating EPS is 26.5x. At the October 2007 highs, it was 18.8x. In addition, when the S&P 500 is trading north of a 26x P/E multiple on trailing operating earnings, history shows that at these high valuation levels, the market declines in the coming year 60% of the time.
• The trailing price-earnings ratio on reported EPS is 184.2x. At the October 2007 highs, it was 23.4x. In fact, just prior to the October 1987 crash, the P/E ratio was 20.3x (not intended to scare anyone).
• The price-to-dividend ratio is 53x, where it was at the 2007 highs. Again, the market is trading as it if were at a peak for the cycle, not any longer near a trough. Once again, and we don’t intend to sound alarmist, the price-to-dividend ratio just prior to the 1987 crash was 12x, and at the time, the S&P 500 was viewed in many circles to be at an extended extreme.

Bullish analysts like to dismiss the actual earnings because they are “depressed” and include too many writeoffs, which of course will never occur again. Fine, on one-year forward (operating) earning estimates, the P/E ratio is now 15.7x, the highest it has been in nearly five years. At the peak of the S&P 500 in the last cycle — October 2007 — the forward P/E was 14.3x, and the highest it ever got in the last cycle was 15.4x. So hello? In just six short months, we have managed to take the multiple above the peak of the last cycle when the economic expansion was five years old, not five weeks old (and we may be a tad charitable on that assessment). As an aside, the forward multiple on the eve of the 1987 stock market collapse was 14x and one of the explanations for the steep correction was that equities were so overvalued and overbought that it was vulnerable to any shock (in that case, it came out of the U.S. dollar market). It certainly was not the economy because that sharp 30% slide took place even with an economy that was humming along at a 4.5% clip.

In other words, valuation may not be the best timing device, but it still matters. If the S&P 500 was in a 700-750 range, de facto pricing in zero to 1% real GDP growth, we would certainly be interested in boosting our allocations towards equities. But at 1,060 and over 4.0% GDP growth effectively being discounted, we will be spectators as opposed to participants, understanding that the key to success is to NOT buy at the peaks. So the strategy is to sit on the sidelines, be selective in our equity choices, and wait for the correction to come or for the fundamentals to catch up with this overvalued, overbought, overextended market. Remember, the reason why the tortoise won the race was because the hare got tired.

One more thing, when people look back at this period, they are very likely going to ask themselves why it was that they never paid attention to the volume data, which, like the bond and money market, never confirmed the veracity of this very flashy bear market rally. We reiterate, Japan enjoyed four of these 50% power surges in the context of a market that is still down over 70% from its highs of two decades ago. So remember, rallies in a bear market are to be rented; never owned. For those that never took the opportunity to get out at the lows today have this glorious chance to do so at much better prices, but the question is whether greed has overtaken their long-term resolve, especially now that Gordon Gekko is making a return to the big screen.

Skating on Thin Ice

Today, we had more "good news" on the economic front. Another 550,000+ Americans filed initial jobless claims -- the 35th straight week above the half-a-million mark.

As usual, data that should be seen as a cause for concern seemed to be the catalyst for renewed buying of equities, and the S&P 500 index climbed to its highest level in six months -- up 54 percent since March 9th.

For me, the current disconnect between Wall Street and Main Street brings back memories of the fall of 2007, when share prices were racing to new highs as credit markets were unraveling and the economy was imploding.

That is not the only reason to think there is something wrong with this picture, of course. The points raised in the following commentaries -- from Minyanville and The Pragmatic Capitalist, both of which are regular stopping points of mine -- also suggest the bulls are skating on very thin ice:

"Answers I Really Wanna Know: Is a Tech Wreck on the Horizon?" (Minyanville):

If technology stocks led the market higher and the semiconductors lead tech, what can we read into...

• Altera (ALTR) recently raised guidance and the stock was flat.

• Diodes (DIOD) recently raised guidance and the stock was flat.

• Microchip (MCHP) recently raised guidance and the stock is flat.

• Texas Instrument (TXN) substantially raised guidance and the stock is up a dime.

• Since Intel (INTC) raised guidance on August 28th, the mother chip is .40 higher (and well below the initial surge).

• 85% of portfolio managers are bullish on tech in a recent survey.

• An ISI Group survey indicates 88% of respondents believe we’re in a bull market.

• The Bank of America-Merrill Lynch (BAC) fund manager survey finds “a feast for contrarian tactical bears” due to “the strongest market sentiment in two years” by those with “skin deep optimism” and the highest equity allocation since October 2007.

• TrimTabs reports that insider selling grew to $6.1 billion in the month of August, the highest since May ’08 when the DJIA was at 12,000, and the insider selling to buying ratio is 30:1, the highest-level evah.

• According to Goldman Sachs (GS), hedge funds have increased net long exposure to pre-Lehman levels (technology is the most popular spot and there is no short base in the financials).

• Can I officially thank Minyan 3M for his help with the above data?

• Can I share this paragraph of insightful reporting from the NYT article last week?

“Just before stocks turned around in early March, only 2 percent of investors were optimistic, according to the Daily Sentiment Index, which measures the mood of small traders and is run by Jake Bernstein, an independent market analyst. Now, the index shows that about 89 percent are feeling bullish. Investors were equally cheery when the Dow hit its record high in October 2007.”

• Given everyone is short Armageddon, are the conditional elements of a crash higher now than they were in March?

• What are 1000 banks and 2000 credit union failures in the next two years amongst friends?

"5 Reasons the Rally Is Built on Quicksand" (The Pragmatic Capitalist):

From the desk of David Rosenberg this morning [note: TPC's comments are in italics]:

1. This remains a hope-based rally (with strong technicals). I say that because during this six-month 50%+ rally in the S&P 500, the U.S. economy has shed 2.4 million jobs, which is almost as many as we lost during the entire 2001-02 tech wreck — in just six months. The market’s ability to shrug off the loss of 2.4 million jobs is either a sign that it is treating this as old news or sees the cost-cutting as good news for profits. Either way, what we are seeing transpire is without precedent — the magnitude of the employment slide versus the magnitude of the market advance. Truly fascinating stuff.

It’s remarkable to add that jobless claims were 550K this morning – a staggering number this deep into a recession.  But fear not – it was “better than expected”.

2. Companies have not really been beating their earnings estimates — only the very final estimates heading into the reporting quarter. For example, the consensus view for 3Q EPS at the start of the year was $21.00, last we saw the estimates were down to just over $14.00. But there is a deeply rooted belief that earnings are coming in better than expected. This is a psychology that is difficult to break. It is completely unknown (for some reason) that corporate revenues are running at a -25% YoY rate, which compares to the -10% we saw at the worst part of the 2001-02 bear market and the -3% trend at the most negative point in 1991.

It’s also interesting to note the very real weakness in corporate revenues.  The bottom line can be manipulated, but revenues never lie….

3. Valuation is a poor timing device but even on “normalized” trailing 10-year earnings, the S&P 500 is trading near 18x, which is now above the historical average of 16x.

Market value matters less to me at this juncture.  If we were to get a much stronger than expected recovery you could easily argue that the market is cheap.  PE ratios are a moving target based on guesses.  That is what makes them poor market timing indicators.

4. All the growth we are seeing globally this year is due to fiscal stimulus; not just here in Canada and the U.S., but also in Korea, China, the U.K., and Continental Europe too. For 2010, the government’s share of global growth, by our estimates, will be 80%. In other words, there are still very few signs that organic private sector activity is stirring. For a Keynesian, government stimulus is necessary, but the question for an investor is the multiple one attaches to a global economy that is still relying on a defibrillator. The problem is that governments do not create income or wealth, and today’s stimulus is really a future tax liability. Curiously, that future tax liability is likely going to pose a roadblock for the return to a “normalized” $80 operating EPS estimate that strategists are now starting to pen in for 2011.

This will become a major concern in mid-2010 when the stimulus is done.  Whether the U.S. consumer can carry the torch has yet to be seen.

5. While Mr. Market may be pricing in a fine future for the U.S., but when the 3-month Treasury-bill yield is 13bps north of zero, which is completely abnormal, you know that there are still substantial fundamental imbalances that need to be worked through.

I should also add that the credit markets have recovered substantially from their extremely low levels.  Nonetheless, the bond market does continue to forecast a very weak recovery.  Perhaps weaker than the one the equity market has priced in….

Source: Gluskin Sheff

He's Shown Me

Although I'm not from Missouri, my attitude towards those who hold themselves out as experts and pundits worth paying attention to mirrors the state's unofficial slogan: "Show me."

To me, it's not the biography or alleged credentials that matter. What counts is what comes out when a person opens his (or her) mouth or puts pen to paper (or, I suppose, keystrokes to screen).

Based on what I've seen so far, Bloomberg News columnist Jonathan Weill is proving to be one of my favorite financial commentators. In "Investors Find Love in $260 Billion Black Hole," he covers the farce that has been taking place in one corner of the financial universe.

Some things I’ll never understand.

How can a show called “Flip This House” still be on television? Why didn’t the Utah Jazz basketball team change its name after leaving New Orleans? And why in the world did the common shares of Freddie Mac and Fannie Mae go berserk last month?

The last of those questions is by far the most difficult to answer.

In case you hadn’t noticed, America’s worst financial companies were the market’s best-performing stocks until a few days ago. The price of Freddie’s common shares more than tripled in August, as did Fannie’s, although this week they have given up some of their gains. It was the same story at their fellow ward of the state, American International Group Inc.

While the stock-market values of these government- controlled companies have soared this summer, it’s debatable what those values are.

For instance, you might say Freddie’s market capitalization is about $1.1 billion, based on the company’s $1.64 stock price and the 648.3 million common shares outstanding that Freddie disclosed on the cover page of its latest quarterly report. These are the inputs investors normally use to calculate market caps.

It also would be accurate to say Freddie’s market cap is $5.3 billion. That figure is based on the fully diluted shares outstanding of about 3.3 billion that the company used to calculate its loss per common share last quarter.

Pick a Number

Similarly, Fannie’s market cap is either $1.5 billion or $7.8 billion, depending on which share count you use. (The stock closed yesterday at $1.37.) The larger share counts include warrants issued to the U.S. Treasury that would allow the government to buy 79.9 percent stakes in the companies’ common shares at a nominal cost. As of yet, those warrants haven’t been exercised, and so the shares haven’t been issued.

The situation at AIG is even more confusing. The cover page for its latest quarterly report shows 134.6 million common shares outstanding, which is about the same as the fully diluted share count on its income statement. Yet in a footnote to an Aug. 13 press release, AIG also disclosed a hypothetical share count, assuming that someday it would have to convert a big slug of the preferred shares it pledged to the government into common stock.

Why Pay?

AIG had 697.4 million common shares using that method. Thus, depending on which figure you use, its market cap is either $5.1 billion or $26.5 billion, based on AIG’s $37.95 stock price. All three companies are leaving investors to sort out for themselves which share counts are the right ones to use. Go figure.

The larger question is why anyone would pay anything to own any of these companies’ common shares. Elsewhere in their disclosures, Fannie and Freddie tell you straight up that their common equity is worth less than zero.

Unlike other companies, the two government-backed mortgage financiers publish quarterly fair-value balance sheets showing estimates of the real-world values for all their assets and liabilities. (Fair value is the price at which an item would change hands in an orderly, arm’s-length transaction.) As of June 30, Freddie said the fair value of the net assets attributable to its common shareholders was negative $122.6 billion.

At Fannie, the number was negative $138.1 billion. Together, from the standpoint of a common shareholder, the two companies amount to a $260 billion black hole. The only place you’d find a bigger deficit is the federal budget itself.

No Recovery

By comparison, from 1990 through 2007, before they were seized by the government, Freddie and Fannie reported total net income of $35.9 billion and $59.8 billion, respectively. Even if the companies returned to their former glory, there is nothing in their histories to indicate they have the ability to earn their way out of their present deficits. Hope springs eternal anyway.

As for AIG, the insurance company’s common shareholder equity was negative $35.4 billion as of June 30, once you take away its $44.2 billion of deferred customer-acquisition costs and $6.4 billion of goodwill. Those assets exist only on paper and can’t be sold by themselves.

In effect, what we have here are three extremely expensive Powerball tickets. Perhaps the bet is that the Treasury might bestow a gift on the common shareholders one day, by forgoing some of its ownership rights in the event the companies can’t repay all their debts to taxpayers. Or maybe the recent rally was just the result of a monstrous squeeze on short sellers who were forced to cover their bearish bets. There’s no way to know what’s going on in Mr. Market’s head at the moment.

At least when you play the lottery, the odds of winning and losing are measurable.

A Sight to Behold

I've been around long enough to know that the day-to-day -- and even the month-to-month -- action in the stock market is often detached from fundamental realities -- you know, silly little details like earnings and revenues, or a multi-trillion-dollar crash in housing values.

Still, I have to admit that today's rally in the banking sector -- the benchmark KBW Bank Index closed up 3.1 percent -- and, in particular, Regions Financial -- up 7.9 percent to a three-month high -- in the face of the following commentary by Bloomberg columnist Jonathan Weil, "Next Bubble to Burst Is Banks’ Big Loan Values," was an exercise in Wall Street impudence that was truly a sight to behold.

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

So, if it weren’t for the inflated loan values, Regions’ equity would be less than zero. Meanwhile, the government continues to classify Regions as “well capitalized.”

While disclosures of this sort aren’t new, their frequency is. This summer’s round of interim financial reports marked the first time U.S. companies had to publish the fair market values of all their financial instruments on a quarterly basis. Before, such disclosures had been required only annually under the Financial Accounting Standards Board’s rules.

The timing of the revelations is uncanny. Last month, in a move that has the banking lobby fuming, the FASB said it would proceed with a plan to expand the use of fair-value accounting for financial instruments. In short, all financial assets and most financial liabilities would have to be recorded at market values on the balance sheet each quarter, although not all fluctuations in their values would count in net income. A formal proposal could be released by year’s end.

Recognizing Loan Losses

The biggest change would be to the treatment of loans. The FASB’s current rules let lenders carry most of the loans on their books at historical cost, by labeling them as held-to- maturity or held-for-investment. Generally, this means loan losses get recognized only when management deems them probable, which may be long after they are foreseeable. Using fair-value accounting would speed up the recognition of loan losses, resulting in lower earnings and reduced book values.

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

Widening Gaps

The disparities in those banks’ loan values grew as the year progressed. Bank of America said the fair-value gap in its loans was $44.6 billion as of Dec. 31. Wells Fargo’s was just $14.2 billion at the end of 2008, less than half what it was six months later. At Regions, it had been $13.2 billion.

Other lenders with large divergences in their loan values included SunTrust Banks Inc. It showed a $13.6 billion gap as of June 30, which exceeded its $11.1 billion of Tier 1 common equity. KeyCorp said its loans were worth $8.6 billion less than their book value; its Tier 1 common was just $7.1 billion.

When a loan’s market value falls, it might be that the lender would charge higher borrowing costs for the same loan today. It also could be that outsiders perceive a greater chance of default than management is assuming. Perhaps the underlying collateral has collapsed in value, even if the borrower hasn’t missed a payment.

The trend in banks’ loan values is not uniform. Twelve of the 24 companies in the KBW Bank Index, including Citigroup Inc., said their loans’ fair values were within 1 percent of their carrying amounts, more or less. Citigroup said the fair value of its loans was $601.3 billion, just $1.3 billion less than their book value. The gap had been $18.2 billion at the end of 2008.

Covering Liabilities

History provides some lessons here. A common problem at savings-and-loans that failed during the 1980s was that they relied on short-term funding at market rates to finance their operations, which consisted mainly of issuing long-term, fixed- rate mortgages. When rates rose sharply, the thrifts fell in a trap where their assets weren’t generating sufficient returns to cover their liabilities.

The accounting rules also left open the opportunity for gains-trading, whereby companies post profits by selling their winners and keeping losers on the books at their old, inflated values. Had the thrifts been marking loans to market values on their balance sheets, their troubles would have been clearer to outsiders much sooner. (The FASB didn’t require annual fair- value footnote disclosures until 1993.)

Arbitrary Accounting

If nothing else, today’s fair-value gaps highlight the arbitrariness of book values and regulatory capital. Banks already have the option to carry loans at fair value under the accounting rules. For the vast majority of loans, most banks elect not to, on the grounds that they intend to keep them until maturity and hope the cash rolls in.

Consequently, the difference between being well capitalized and woefully undercapitalized may come down to nothing more than some highly paid chief executive’s state of mind.

Fair-value estimates in the short-term can be a poor indicator of an asset’s eventual worth, especially when markets aren’t functioning smoothly. The problem with relying on management’s intentions is that they may be even less reliable.

At least now we’re getting some real numbers, even if you have to dig through the footnotes to get them.