Tuesday, July 28, 2009

Underreported and Underestimated Forces

There's a few stories that I believe have fallen under the radar over the past week, and I will attempt to tie them together.

I mentioned a few weeks ago the importance of transparency in accounting as primary in not only unravelling the mess we are in, but also in preventing it from happening again. I argue that taking the oversight of this out of bought-and-paid-for regulators and putting it in the hands of the courts is probably the best way of accomplishing this.

In the meantime, however, we are stuck with the FASB (Federal Accounting Standards Board). And their prerogative is now to either make themselves heard or become obsolete. They are not a government organization per se, but rather the role of determining accounting standards has been delegated to them by the SEC. They were criticized heavily in April after succumbing to congressional and lobbyist pressures to suspend "mark-to-market" accounting rules for financial services companies. This criticism has led to a questioning of their independence, and therefore, relevance. So their choice is to grow a pair or be dissolved. It appears they are choosing the former.

Jonothan Weil reports:

July 23 (Bloomberg) -- Turns out America’s accounting poobahs have some fight in them after all.

Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging.

It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements.

Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

“They know they screwed up, and they took action to correct for it,” says Adam Hurwich, a partner at New York investment manager Jupiter Advisors LLC and a member of the FASB’s Investors Technical Advisory Committee. “The more pushback there’s going to be, the more their credibility is going to be established.”

Broad Consequences

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.

The FASB’s approach is tougher on banks than the path taken by the London-based International Accounting Standards Board, which last week issued a proposal that would let companies continue carrying many financial assets at historical cost, including loans and debt securities. The two boards are scheduled to meet tomorrow in London to discuss their contrasting plans.

Differing Treatment

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.

The debate over mark-to-market accounting is an ancient one. Many banks and insurers say market-value estimates often aren’t reliable and create misleading volatility in their numbers. Investors who prefer fair values for financial instruments say they are more useful, especially at providing early warnings of trouble in a company’s business.

‘Religious War’

“It’s been a religious war,” FASB member Marc Siegel said at last week’s board meeting. “And it’s been very, very clear to me that neither side is going to give, in any way.”

So, the board devised a way to let readers of a company’s balance sheet see alternative values for loans and various other financial instruments -- at cost, or fair value -- without having to search through footnotes. At last week’s meeting, FASB member Tom Linsmeier called this a “very useful approach that addresses both sets of those constituents’ concerns.”

This will not satisfy the banking lobby, which doesn’t want any significant expansion of fair-value accounting. “I guess the nicest thing I can say is it’s difficult to find the good in this,” Donna Fisher, the American Bankers Association’s tax and accounting director in Washington, told me.

If the bankers don’t like it, that’s probably a good sign the FASB is doing something right.

The implications of this are massive and not to be understated. Knowing what is actually on the balance sheets of large institutions would be a large step in the direction of liquidating these malinvestments - a necessary precursor to any lasting recovery. This battle is likely to get nasty, so I would keep it on your radar.

In other news, we learn that insiders have continually been selling shares over the past few weeks at the highest levels since October and November of 2007 - the all-time highs.

Courtesy of Mark Hulbert of Marketwatch:

Corporate insiders are a company's officers, directors and largest shareholders. They are required to report to the SEC whenever they buy or sell shares of their companies, and various research firms collect and analyze those transactions.

One is the Vickers Weekly Insider Report, published by Argus Research. In their latest issue, received Monday afternoon, Vickers reported that the ratio of insider selling to insider buying last week was 4.16-to-1, the highest the ratio has been since October 2007.

I don't need to remind you that the 2002-2007 bull market topped out that month.

To be sure, the weekly insider data can be volatile, especially during periods like the summer, in which the overall volume of insider transactions can be quite light. That is one of the reasons why Vickers also calculates an eight-week average of the insider sell-to-buy ratio, and it currently stands at 2.69-to-1. That's the highest that this eight-week ratio has been since November 2007.

To put the insiders' recent selling into context, consider that in late April, the last time I devoted a column to the behavior of insiders (and when the rally that began on March 9 was still only six weeks old), the comparable eight-week sell-to-buy ratio was just 0.72-to-1.

It is true that insider selling is not a perfect leading indicator, as insiders will sell for many different reasons (as this paper outlines quite well). It may just be that with their own property values collapsing and debts coming due, they are needing to sell anything liquid - even their own company's stock. Corporate bigwigs are human as well and no less susceptible to the workings of a credit crunch.

But if the wealthy are now being forced into selling their stock to make good on other commitments, that does not exactly speak too well of their ability to continue spending conspicuously as they have previously - meaning headwinds for the economy in general.

Along similar lines, we are seeing that CFOs are Not on the Recovery Bandwagon Yet. CFOs have a very good predictive record on the economy. Brian Pretti follows them regularly for that reason. And until that record turns sour, so will I. From the article:

As financial markets embrace the idea that economic recovery is drawing near, CFOs are not as infused with optimism — indeed, many are downright skeptical that better times are right around the corner. That sentiment was clearly evident in the first two weeks of operation of the CFO Prediction Market.

The forecasting tool, which uses technology from Redwood City, California-based Crowdcast, aggregates the opinions of anonymous finance executives on important economic indicators and trends.

Take the numbers for second-quarter gross domestic product, due to be released this Friday. On average, forecasters project that economic output will be reported to have shrunk 1.5% in the second quarter, less than the first quarter's 5.5% drop, according to a survey by the Federal Reserve Bank of Philadelphia. But 168 Prediction Market participants think, on average, that the shrinkage is going to be larger — 1.88%. "I don't see a silver lining yet," comments one executive. "Business outlook is still grim and everyone is talking of a recovery only post-December."

Indeed, asked "When will real GDP grow again?" 32% of 168 participants project the fourth quarter of this year. In contrast, forecasters surveyed by the FRB of Philadelphia say the third quarter will be the turning point. Another 27% of the same participants in the Prediction Market peg the first quarter of 2010 as the point at which output rises into positive territory, with 17% saying a rebound won't happen until the second quarter of 2010.

"First quarter is the earliest it will grow," says one. "The drag from continued increases in unemployment and underemployment, as well as the increase in consumer savings will contribute to anemic consumption and lack of growth."

Indeed, the unemployment rate is a statistic that finance executives track closely, according to betting on the Prediction Market. More than 450,000 virtual dollars have been bet on July's outcome. (No real money is bet.) The Prediction Market is a speculative market created for the purpose of forecasting. With each bet placed on a forecast, the odds grow that the consensus "prediction" will prove correct. Prediction markets have proven so accurate that they have been used by top corporations, the U.S. military, and the National Association of Business Economists.

On average, 186 participants think the unemployment rate will hit 9.98% this month, but many think the number could creep even higher, hitting double digits. "I think we are going above 10%," comments one executive. "Revenues have not yet started to rebound and so companies are going to continue to lay people off." Indeed, unemployment has already topped 10% in 15 states, according to data from the Bureau of Labor Statistics. On Monday Verizon announced another 8,000 job cuts.

One area where additional layoffs will play out is in a higher number of applications for unemployment insurance. CFOs are projecting this week's tally of initial applications to be as high as 582,000, which would be a 40,000 increase from last week. (Economists, on average, are forecasting 570,000, according to a Bloomberg News survey.)

Another area that I see being massively underestimated in its influence toward the long-term trend of the economy is the generational/demographic waves that roll through over 20-30 year periods. I don't know why its importance is systematically avoided. Perhaps it is the unalterability and endogenous nature of it that makes most analysts and economists uncomfortable.

I have touched on this subject numerous times in the past. I see the huge wave of baby boomers retiring as a massive deflationary force on the economy as they liquidate assets to cover living expenses. The generation they are supposed to be selling to, myself for example, are seemingly assumed to pick up the slack in not only consumption but in debt accumulation. Add this to the many assumptions going into neoclassical economic models that will not prove wise. Just as anyone had assumed in the 60s that the boomer generation would automatically embrace the social values of their parents - and were dumbfounded at the rejection of such values with the anti-war movement, racial equality, women entering the workforce, careless sexual expression, etc. Such differing generational attributes are common to every generation - yet it is always assumed to be unchanging.

Those who underestimated the influence of the enormous generation entering adulthood in the 70s likely missed the inflationary implications by a mile. Now that the same generation is retiring, the same people are likely to miss its opposite and equal force - deflation.

A recent article in BusinessWeek describes this reality:

When 79 million people—nearly a third of Americans—start spending less and saving more, you know it won't be pretty. According to consulting firm McKinsey, boomers' conversion to thrift could stifle the economy's hoped-for rebound and knock U.S. growth down from the 3.2% it has averaged since 1965 to 2.4% over the next 30 years. "We would have gotten here in 5 or 10 years as boomers retire, but we pushed it up," says Michael Sinoway, managing director of consulting firm AlixPartners. "Now [companies] are scared things won't come back." And that's why everyone from Mercedes to Nordstrom (JWN) to designer Vera Wang are scrambling to remake themselves for the Incredible Shrinking Boomer Economy.

Not so long ago, boomers were never going to die. Filled with a self-confidence born of unprecedented prosperity, many thought rising markets would assure their future. If the economy faltered, well, it would rebound more strongly than ever, as it had so many times before. And so boomers spent—and borrowed—as if there were no tomorrow.

Meet Tim Woodhouse, 56. He owns Hood Sailmakers in Middletown, R.I., a business that helped finance a plush life. Woodhouse owns a boat, five Ducati motorcycles, and every few years treated himself to a new Porsche 911. He figured he'd retire when he felt like it. Then the markets crashed, the economy tanked, and suddenly Woodhouse felt a lot poorer. In April, with business slowing and his real estate holdings leaking value, Woodhouse hit the brakes. "I was scared," he says. "My net worth took a real hit." Woodhouse sold the Porsche and bought a Mini Cooper. The boat spends more time tied up these days than out on the water. He and his wife dine out less often, and they don't entertain at home much either.

Woodhouse and millions of boomers like him are doing what people normally do when they near retirement: They're living more frugally. Companies have long factored in this actuarial reality, gradually tweaking their products and marketing to appeal to the next generation. With boomers, however, many companies became complacent. It wasn't that they ignored younger consumers but that they counted on boomers to keep spending longer. And why not? Until recently boomers typically reached their spending peak at age 54, according to McKinsey. Contrast that with the previous generation—a thriftier bunch whose consumption typically peaked at 47.
Can younger consumers pick up the slack? Consider the demographics. Generation X, Americans born between 1964 and 1980, is generally estimated to be about two-thirds the size of the boomer cohort. And with boomers working longer, especially since the crash wiped out many retirement funds, it may take longer for Xers to move into their prime earning (and spending) years. And what about Generation Y, the 81 million-strong group born between 1981 and 1994? Right now, 14% are unemployed and will have their own hole to claw out of when the economy revives, according to Edward F. Stuart, who teaches economics at Northeastern Illinois University. In other words, companies will need boomers for years to come.

The trick will be finding a way to fulfill the needs and wants of a generation that is used to being catered to—but is now on a budget. Timothy Malefyt, an anthropologist who studies consumer trends for the ad agency BBDO New York (OMC), argues that boomers, having ridden a wave of technological change, are highly adaptable and well versed in problem-solving. (Or at least they see themselves as such.) Already, he says, they are making a virtue of value shopping, once viewed by this group as hopelessly déclassé. For many boomers it's no longer about keeping up with the Joneses, it's about outthinking them. "If you make boomers feel they've failed, you'll lose them," Malefyt says. "They want to feel they've outsmarted the system or their circumstances.

That's why some companies are coalescing around "cheap chic," a marketing conceit that has become synonymous with Target (TGT) but also has been tried by the likes of JetBlue, Ikea, and Mini. The latter is owned by BMW, another classic boomer brand. BMW didn't plan it this way, but the Mini is one solution for a company whose cars are becoming too pricey for many boomers. A fully loaded BMW 3 Series costs $40,000 plus change; a comparably equipped Mini: $25,000. The Mini, while a feat of engineering and retro style, can't compete with a BMW, which the company bills as "the ultimate driving machine." But the Mini possesses cheap chic in spades. In recent months, says BMW, fiftysomethings have been trading in their Bimmers and other luxury brands for Minis.

Expect that trend to continue.

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frank said...

Deflation or inlfation. The Dark Years ahead.


mannfm11 said...

Quite a debate you were having on Debt Deflation site. I don't know if those guys have read much Austrian economics, though I get the idea Keen leans that way sometimes.

Matt Stiles said...


Yeah. Every once in a while I get a kick out of challenging other's core beliefs. But rarely does it do any good. A collectivist minded person and an individualist will never agree on anything ideological.

Keen's site brings forward an interesting mix. He's a post Keynesian and rails against neoclassicals, which obviously appeals to Austrians. But he has Marxist leanings as well.

Essentially, the Austrian School from which Mises and Hayek came split into two branches, with Schumpeter and Wieser embracing a sort of "market-socialism" and the former turning toward anarcho-capitalism.

Keen and the Minsky/Schumpeter supporters are from that other branch. I like the alternative point of view.

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