FASB Grows Marbles - Pros & Cons

The treatment of securities and loans on balance sheets is not a simple matter. Investors wish for transparency and owners reject recording losses, but welcome the upside pro-cyclical features...go figure.

In my own opinion, a middle ground needs to be reached on the fair market value rule. The concept of mark-to-market is investor friendly and transparent so long as you can trust the firm is marking prices honestly. However, FASB is proposing fluctuations in those securities, whether gains/losses are realized or not, flow to the income statement. This is true for securities classified as hedges as well.

While I applaud FASB's new found post-pubescent courage, their treatment leaves me wanting. "Fair value" marks change constantly and often erratically. While these changes should be clearly marked on the books as compared to cost, having in many cases unrealized gains/losses flow to the income statement is erroneous, even when labeled as "comprehensive income". Not only will this add more volatility to earnings, but also less predictability, especially for companies with large securities held on their books. Gains/losses should be recorded when they are realized.On the subject of recording fair market value on the balance sheet and income statement, Bloomberg reports:

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.

...

While balance sheets might be simplified, income statements would acquire new complexities. Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses. So would fluctuations in all debt instruments with derivatives embedded in their structures.

Other items, including fair-value fluctuations on certain loans and debt securities, would get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement, below net income. Comprehensive income now appears on a company’s equity statement.

Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be less likely to publish quarterly earnings estimates using comprehensive income.

Imagining the Impact

Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

Gold & Deflation

While not agreeing with this author's definition of deflation, his arguments and historical references are informative. I understand his logic in using the CPI index to track deflation (CPI flawed as it is), he falsely actually defines deflation as such.

His conclusions about gold are incredible though and I agree completely. That is, high levels of uncertainty, lack of confidence and credit deterioration all contribute to gold demand. This is true for inflation or deflation. The 23 pages are well worth your read, especially for the history lesson.

Written in 96', he noted the bubble like characteristics even then....this credit bubble has not yet finished bursting.

Behavior of Gold Under Inflation

Leading Indicators Turning Up, Bullish?

Astute investors are considering the recent data out on The Conference Board Leading Economic Index:

LEADING INDICATORS. Seven of the ten indicators that make up The Conference Board LEI for the U.S. increased in June. The positive contributors – beginning with the largest positive contributor – were interest rate spread, building permits, stock prices, weekly initial claims (inverted), average weekly manufacturing hours, index of supplier deliveries (vendor performance), and manufacturers' new orders for consumer goods and materials*. The negative contributors – beginning with the largest negative contributor – were real money supply*, manufacturers' new orders for nondefense capital goods*, and index of consumer expectations.

The Conference Board Leading Economic Index™ (LEI) for the U.S. increased 0.7 percent.

Based on revised data, this index increased 1.3 percent in May and increased 1.0 percent in April. During the six-month span through June, the leading economic index increased 2.0 percent, with five out of ten components advancing (diffusion index, six-month span equals 50 percent).

A quick look at the chart above begs one large question:

• The LEI declined 5 of the first 6 months in 2006, but no recession followed

I'm well aware of the predictive ability, but skeptics do joke that the index has predicted 9 of the last 6 recessions. The index is not perfect, but commands some respect. Let's break down the contributors I highlighted in red:

Interest Rate Spread - This is the largest contributor to the index and no one can doubt the significance of such a steep yield curve (difference between the 10 vs 2 yr treasury yields) in predicting economic upturns. Why?

1. Expectations of higher growth
2. Expectations of higher inflation (not a positive)
   
3. Banks earn profitable spreads, encourages lending

With regards to the first point, it can happen, but only as a result of a statistical anomaly in calculating GDP. Inflation fears have been growing rapidly since the beginning of 09', so no surprise there. As for the third, well....Bank Fail To Make Adequate Loan Loss Provisions Moody's Says:

July 20 (Bloomberg) -- Banks have failed to make adequate provision for the losses on loans and securities they face before the end of next year, Moody’s Investors Service said.

U.S. banks may incur about $470 billion of losses and writedowns by the end of 2010, which may cause the banks to be unprofitable in the period, the ratings company said in a report published today.

“Large loan losses have yet to be recognized in the banking system,” Moody’s said. “We expect to see rising provisioning needs well into 2010.”

Banks and financial firms worldwide have reported losses and writedowns of $1.5 trillion since the credit crisis began in 2007, according to data compiled by Bloomberg. New York-based Citigroup Inc. has reported $112 billion of writedowns, more than any other firm, the data show.

Any economic recovery is likely to be “weak and bumpy hook-shaped,” Moody’s said. Banks will also be challenged in an environment where government support is replaced by tighter regulation, the report said. Higher credit and funding costs may force a re-pricing of credit, Moody’s added.

“The fundamentals of financial institutions are still traveling on a downward slope,” Moody’s said. “No-one should consider recent improvements as assurance that the current rebound can be sustained.”

It's safe to say banks are constrained to lend and consumers are mostly unwilling to borrow.

Building Permits - In the bust of the biggest housing boom ever, increases in building permits can be viewed of as a negative considering the huge overhang of inventory that needs to be worked off, not to mention CRE's impending bust. For more on this please read 7 Reasons Why Housing Isn't Bottoming Yet.

Stock Prices - The rally in stocks has been impressive and its no wonder they're showing up in the LEI. However, this rally is guilty until proven innocent.

Weekly Initial Unemployment Claims - The contribution to the LEI from this statistic might be explained by emergency unemployment compensation (EUC). Mish had a great post on this, let's revisit:

Around the country, the number of people exhausting their benefits is piling up. By the end of September, more than 500,000 people will exhaust their benefits checks, with the biggest groups in Pennsylvania, California and Texas, according to estimates by the National Employment Law Project, an advocacy group for low-wage workers based in New York City. That number will nearly triple by the end of the year, the group said.

As Mish explains in his post, EUC is NOT included in the continuing claims. He also has some interesting commentary from David Rosenberg within the post regarding seasonal adjustments in the claims and slow downs in layoffs related to auto workers affecting the weekly claims, I encourage all to go and read the post. To summarize, Rosenberg postulates that with the auto factories shut down, there's no one to lay off when during normal seasonal patterns there would be.

The LEI may prove to be right down the road in 2009, but considering the above points one has to wonder whether this would lead to a real recovery where jobs, profits and sales increase, or whether this would just be a recovery in a statistical sense bearing no resemblance to reality.

The coincident index has remained negative through all of 2009, but rate of decline is slowing. By far the most important contributor to the LEI is the steep yield curve, but considering banks are far from profitable outside of one time gains and accounting shenanigans, how significant is that?

Developing State Budget Crisis

Generally, you may feel all warm and fuzzy inside about the prospects of the economy. After all, Dennis Kneale has officially declared the recession is over and inventory restocking is all the rage (despite still above trend inventory/sales ratios). Banks are reporting large profits again from lucrative proprietary trading desks, churning $100 million trading days. Reflation is indeed on...or is it?

State Budget Crisis

It's truly blasphemous how little attention this is receiving, but let it be known that green shoots are dying in the summer heat. By autumn seasonal change will begin to take hold setting the stage for the deadly winter cold. To expect the effects of state budget adjustments not to have material effects on the economy is naive to put it nicely. Some highlights:

• Budget cuts often are more severe in the second year of a state fiscal crisis, after reserves have been largely depleted
• Expenditure cuts and tax increases are poison for the economy, especially during a severe recession
• In this recession states have already drawn down much of their available reserves; the available reserves of states with deficits are likely to be depleted in the near future
• State budget shortfalls of remaining 2009, 2010 and 2011 are estimated to total between $350 - $370 billion

What this looks like:

Bigger picture, commercial real estate is still deteriorating, total public debt is still outrageous and Fed monetary infusions have only been funneled into the wallets of phat cats at brokerage firms resulting in mini booms aka large rallies (and that's all they are). Now use you imagination and ask yourself "has employment bottomed?", "will consumer spending come roaring back?"

State Budget Problems Worsen