Another point of view

I received this in the mail today. It makes a lot of sense. What do you think?

Artificial Earnings Growth - How Long Before Investors Catch On?
By Simon Maierhofer, Co-Founder
“The whole damn industry lost its moral moorings,” was Charlie Munger’s - Warren Buffett’s business
partner - response when asked about Goldman Sachs’ “socially undesirable” business dealings. He added:
“They were very competitive in maximizing profits in a competitive industry that was permitted to operate
like a gambling casino.”
Munger’s assessment echoes what Timothy Geithner said when interviewed by the Today Show in March:
“What happened in our country should never happen again...people were paid for taking enormous risks. It
was a crazy way to run a financial system.”
Blackmailing America
Jim Reid, a Deutsche Bank AG strategist in London, noted, “it seems incredible that financials are now
scaling their 2006-07 heights again. The dramatic imbalances that fueled the credit crisis are re-occurring.”
The question back to Mr. Geithner should have been: “If it was so crazy, why do you allow it to happen
again, even though you said it shouldn't?” Simon Johnson, professor of MIT’s Sloan School of Business
and author of 13 Bankers, claims that bankers even leverage their position to blackmail the nation. Any
time there is mention of a banking or financial reform, you’ll hear the banks respond, “oh my goodness,
there maybe a double-dip recession.”
Obstructing the truth
But we know that banks don’t just indirectly blackmail the nation, they actively work on obstructing the truth,
and as allegations against Goldman Sachs show, do whatever it takes to get ahead. On March 19, 2010,
the U.S. Court of Appeals in Manhattan ruled that the central bank must release documents
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pertaining to the central bank’s $2 trillion emergency lending extended to financial institutions in 2008.
Paul Saltzman, the banking group's general counsel, said they would repeal the decision. If the ruling is
again unfavorable, the bank group will petition the Supreme Court. Why all this resistance? Saltzman says:
“Our member banks are very concerned about real-time disclosure of information that could cause a run on
the banks.” Wow! That’s a heavy-duty statement. By the way, member banks include Bank of America,
Citigroup, BNY Mellon, Deutsche Bank, HSBC, JPMorgan, PNC, UBS, U.S. Bancorp, Wells Fargo, etc.
Buffett on ethics
Another red flag is Warren Buffett’s resistance against legislation that would force companies to put up
collateral for existing derivatives positions. Berkshire Hathaway owns a $63 billion derivatives portfolio and
Buffett himself has warned of the dangers of derivatives, famously branding them “financial weapons of
mass destruction.” It is understandable that Buffett, a shrewd businessman, wants to avoid setting aside
cash and doesn’t want the rules to be changed after the game started. However, the fact that Nebraska
Senator Ben Nelson proposed the exemption is suspect. Ben Nelson owns an estimated $6 million worth of
Berkshire stock. Additionally, Berkshire is Nelson’s largest campaign contributor.
At Berkshire’s annual shareholder meeting, Buffett took a lot of his most faithful fans aback as he gave a
full-throated defense of Goldman Sachs. Whether or not Goldman committed outright fraud, Goldman’s
me-first attitude and conflict of interest are beneath Buffett’s ethical standard, you’d think. Munger
assessed Goldman’s activities politically correct as “socially undesirable.” Our March 2010 newsletter
stated the following regarding Goldman Sachs: “By the time this recession is over, GS will have morphed
from powerhouse into scapegoat.” The Wall Street Journal explains why all the rage against Goldman:
“The development comes amid public calls for more Wall Street accountability for the industry's role in the
financial crisis.” Such public calls are one facet of crowd behavior set in motion by a larger bear market.
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The fact that such calls persist despite a 75% rally in equities is testament that the bear market is not yet
over.
Focus on earnings
Despite turmoil in the financial industry, earnings have been nothing short of outstanding. Profits from the
financial sector soared 300%+ year-over-year while total U.S. corporate profits are up 50%+ year-over-
year. Financial sector profits account for roughly 80% of the overall increase in corporate earnings. Without
financials, the rebound in corporate profits would be minimal. With financial profits being the big story, it
makes sense to read between the lines and see if those profits are real. Not all that shines is gold.
Repo 105 – How Lehman almost got away
The bank-appointed examiner’s report on Lehman Brothers released in mid-March 2010 revealed some
startling accounting maneuvers. Lehman took advantage of Repo 105, an accounting trick that hid its
leverage. In a nutshell, here’s what happened: The Repo market is a way for banks to borrow money
against collateral, i.e. a bond. If the borrower goes bankrupt, the lender gets to keep the bond. If the
borrower repays the loan as planned, the lender gets to keep a fee and interest. In reality, the bank isn’t
really selling a bond, its simply borrowing money. But Lehman wanted to hide how much money it was
borrowing. To do just that, Lehman would sell a bond that was worth $105 on the repo market for $100
(Lehman put up collateral equal to 105% of the cash it received. Hence the nickname Repo 105). For
accounting purposes, Lehman got the cash infusion, which was used to pay off debt. Then, after it had
issued its quarterly report, Lehman would borrow more money to repurchase the bond.
As per Lehman’s bankruptcy examiner’s report, it did not disclose its use of Repo 105 to the government,
to its rating agencies, to its investors, or to its own Board.” In fact, according to MarketWatch, Lehman
couldn’t get a single U.S. firm to sign off on the practice, so it went to a U.K. law firm to OK the move.
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MarketWatch also reports “there are plenty of ways financial firms can massage the numbers to make them
look more profitable, stable and solvent than they really are.” Let’s take a look at another loophole.
Rule 157 – License to survive
Imagine you bought a house for $500,000 that is now worth $300,000. Rule 157 for banks is similar to you
being able to sell your house for $500,000.
CFO.com reports that the change to rule 157 allows banks with impaired financial securities to move
billions of dollars in losses off of their income statements, which will benefit their regulatory capital
calculations and artificially increase profits.
The rule revision approved on April 2, 2000, addresses how companies account for assets whose market
value has fallen below the reported balance-sheet value. Although companies will still record the paper
loss, it will no longer affect their bottom line. As always with accounting, you can make things more
complicated. For those who want to understand the implications more fully, we’ll do our best to decipher
the CPA lingo.
Credit loss vs noncredit loss
Before we get into this, it is probably best to define credit loss and noncredit loss. In an oversimplified
example, bank A holds a securitized pool of mortgage-backed assets originally valued at $100. After
modeling the future cash flow of the pool, the bank determines it will ultimately collect $95. The credit loss
is $5. However, due to economic factors, the MBA pool is currently worth only $40, a $60 loss. The
difference between the two calculations ($60 - $5) is the noncredit loss - $55. As a result of the revised rule
157, banks can grab all their noncredit losses and dump them into a balance-sheet bucket called other
comprehensive income (OCI). OCI is comprised of income and expenses (realized and non-realized) that
are not recognized in the income statement. The noncredit losses that wind up in the OCI appear on the
balance sheet but are not run through the income statement. (The balance sheet details an entity’s
financial condition and lists assets and liabilities. The income statement provides the current years
revenue/expense and profit information.) That means that noncredit losses never hit earnings. Reported
earnings therefore do not include much of the noncredit, real estate related losses.
How big is the noncredit loss problem?
How high are such noncredit losses? Nobody knows for sure but a look at the FDIC’s list of failed banks
provides a scary glimpse of what might be ahead. Frontier Bank was closed by the Washington
Department of Financial Institutions on April 30, 2010. According to the FDIC’s website, Frontier Bank had
approximately $3.5 billion in totals assets and $3.13 billion in total deposits. Subtracting the liabilities from
the assets, the bank’s book of business should be worth around $370 million. The FDIC’s website states
the following: “The FDIC estimates that the cost to the Deposit Insurance Fund (DIF) will be $1.37 billion.”
Where does the $1.74 billion difference come from? Apparently the bank’s actual assets where less than
reported, 50.3% less.
Another example is Champion Bank, which was closed by the Missouri Division of Finance on April 30,
2010. According to the FDIC’s website, Champion Bank’s had approximately $187.3 million in total assets
and $153.8 million in total deposits. The bank’s book of business should be worth around $33.5 million.
Yet, the FDIC had to cough up $52.7 million, apparently because Champion Bank overstated their actual
assets by around 28%. There are plenty more examples available on the FDIC’s website, in plain sight of
investors. As a point of reference, Bank of America, Citibank, JPMorgan and Wells Fargo have about $7.5
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trillion in combined assets. Assuming those banks are overvaluing their assets by just 25%, about $1.8
trillion of unrealized losses could yet be waiting to hit the fan.
Fool me once, shame on you. Fool me twice …
Guess who gets swindled and doesn’t even know it? It’s the American taxpayer. But it doesn’t stop there.
Darrell Issa, the ranking member of the House Oversight and Government Reform Committee, said in a
letter addressed to GM Chairman and CEO Edward Whitacre (obtained by the Detroit News), that the
company “has come dangerously close to committing fraud and that you might have colluded with the U.S.
Treasury to deceive the American public.” GM ads featured the GM CEO touting that “GM repaid our $6.7
billion government loan in full, with interest, five years ahead of the original schedule.” In reality, GM
received $50 billion in U.S. government bailout funds. About $43 billion of the funds were swapped by the
government in exchange for a 61% stake in GM (GM now nicknamed Government Motors). Senator
Charles Grassley wrote in a FoxNews.com column that “it is far from clear how GM and the Obama
administration could honestly say, much less trumpet in prime time television ads, that GM repaid its TARP
loans in any meaningful way.”
Grassley said lawmakers are being told government losses on GM are expected to exceed $30 billion. The
TARP inspector general, Neil Barofsky, bluntly told the Senate Finance Committee that the repayment “is
just other TARP money” and lawmakers should not exaggerate the feat. Senator Tom Carper hits the nail
on the head with his astute observation that “it sounds like they’re kind of taking money out of one pocket
and putting it in the other.” The last I checked, the Senate is still waiting for a response from Timothy
Geithner about why GM was allowed to run this ad.
On April 26, 2010, Bloomberg reported that “Bankers said anything to get a high rating.” It seems like
corporations and the government will do anything to give the economic recovery an heir of legitimacy.
Ripple effects of the new healthcare bill
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Carl Denninger wrote an interesting post about the ramifications of the healthcare bill. The promise was
that there would be no “material” healthcare related impact to finances until 2010.
Caterpillar, John Deere and AT&T already announced non-cash charges of $100 million, $150 million and
$1 billion for 2010 (AT&T’s filing with the SEC): . This is based on the impact this bill has on forward retiree
health care costs. Again, it pays to put things into perspective. Caterpillar reported profits of $895 million,
John Deere’s profit was $912.80 million and AT&T’s profit was $12.54 billion. The unexpected healthcare
charges make up 11%, 16% and 8% of profits. These expenses should eventually hit the earnings per
share (EPS) and by extension the P/E ratio. Based on the above three examples, stocks could be
overvalued by 8% - 16%. The above-mentioned charges were for retired employees only. Current
employee healthcare costs were not considered yet.
Conclusion
When reading between the lines, two themes become obvious: 1) Corporate earnings, especially from the
financial sector, seem to be overstated, and 2) You cannot believe everything you see or hear. We started
out with one of Charlie Munger’s tasty quotes, thus it seems fitting to conclude with more of his words of
wisdom: “If you give human beings flexibility to do anything they damn well please, they will go plum crazy.”
Thus far, rising stocks have kept a lid on investors’ disappointment with the government and corporate
America. Once the market begins to fall, the combination of falling prices and negative news will bring more
“oddities” to the fore and create a negative feedback loop a la 2008. Bear markets are always the best
auditors.
Did we forget to mention that the respective trading desks at Bank of America, Citigroup, Goldman Sachs
and JPMorgan Chase recorded a "perfect quarter?" According to regulatory filings, all four banks had zero
days of trading losses in Q1 2010.