'No Bank's Books Are Trusted': Bloomberg's Weil is Imagining Things

by: Tom Brown November 11, 2008 | about stocks: XLF    
Tom Brown

Tom Brown

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Twenty years ago, then-Wells Fargo (WFC) CEO Carl Reichardt impressed on me the distinction between the value of the cash flow a given asset will generate over time, and the market value of that same asset at any given moment. There can be a difference, and occasionally it will be large. For assets held for a long period of time, Reichardt emphasized, it’s the cash flows that matter, regardless of what happens to asset’s market value in the interim.

This distinction came to mind this week when I read an October 30 story on Bloomberg by Jonathan Weil with the ominous-sounding headline: “Wachovia Shows Why No Bank’s Books are Trusted.” No bank's? Wow! Weil seems to imagine a great conspiracy of banking executives, regulators, auditors, and securities analysts, all dedicated to the project of systematically misrepresenting the balance sheets of the nation’s banking industry. It really is quite something. At the root of Weil’s imaginings, it turns out, is his inability to understand the distinction between market values and cash-flow values that Reichardt emphasized to me all those years ago.  

Jonathan Weil, you may recall, is Bloomberg’s resident accounting skeptic. He made a name for himself earlier this decade when he blew the whistle on Enron. Frankly, I don’t know if his reporting was better back then than it is now, or if he was just lucky for being negative at the right time. What I do know, as an accounting graduate who’s been following banks for 28 years, is that his analysis of the banking industry today couldn’t be more wrong-headed. From what I’ve seen from Weil’s stories about accounting, Bloomberg shouldn’t be holding him up as an accounting expert.

Anyway, Weil’s main piece of evidence that bank accounting is crooked is the fact that—are you ready? —both Wachovia and National City were sold for less than their book values. That’s it. It’s proof, he says, that current accounting practices allow banks to overstate the “market value” of their assets.   

“The reality is,” Weil says ominously, “that Wachovia’s management team . . . still won’t admit the company’s balance sheet is a farce, and has been for a long time. More worrisome, though is that nobody with any authority is calling them on it, even today. That includes Wachovia’s auditor, KPMG, as well as the Securities and Exchange Commission, and banking regulators such as the Federal Reserve and the FDIC.” Green eyeshades meet black helicopters! 

There is of course, another more benign explanation: the bank, its auditors, and regulators are all simply following GAAP.  

Weil’s game here, of course, is to pretend that near-term movements of stock prices have vindicated his views about the long-term cash-flow economics of bank assets. But that’s crazy. The fact is, asset price movements can (and do) diverge from the asset’s underlying economic fundamentals all the time. If you doubt it, remember that some of the loans regulators forced banks to write down to zero during the banking crackup of the early 1990s are still generating cash flow today.

Or, to look at the situation in a different way, how would Weil mark Berkshire Hathaway’s assets to market if Berkshire were sold under conditions similar to the Wachovia sale?  What would the value of the company’s holdings in American Express, Coca-Cola, Washington Post, Wells Fargo, and the rest be if the entire portfolio had to be sold over a single weekend, and there were only two willing buyers? Under those circumstances, their prices would be much lower than in a normal, non-stressed market. But the divergence would happen because it was the market that was stressed, not the assets.  

To Weil, though, all this is beside the point. His M.O. seems to be to focus on what happens in the short term, and then try to give it a Larger Meaning. In particular, he finds companies having plain, vanilla operating problems and then he argues that the problems are really evidence of an accounting fraud. For this, he is an accounting “expert.” It will interesting to see his—and Bloomberg’s—reaction as the cycle finally plays out.

Jonathan Weil (and other reporters, such as the Wall Street Journal’s  Peter “always negative” Eavis) consistently confuse cash-flow value with market value. Corporations in the U.S. operate under GAAP. It is not a perfect accounting method, but I don’t know what method is. Current GAAP does not require that all assets and liabilities be marked to market. In particular, loans need not be. Weil could argue for a change in GAAP if he wants. But he’s off base when he says are banks are being devious by not marking all their assets to market. 

In this bear market people like Weil and Eavis seem to simply assume that, in every case, lower short-term market value must mean deteriorating underlying fundamentals. That’s a mistake. In an environment like this one, where every investor on earth is deleveraging, the number of sellers will overwhelm the numbers of buyers, and asset prices will come under severe stress. But that’s the result of screwed-up market mechanics, not underlying deterioration in the cash flows the underlying assets generate. The Weils and Eavises of the world should understand that. But they don’t.

By now, I am tired of the people like Weil and Peter Eavis justifying their negative views by pointing to falling stock prices and nothing else. If you’re going to put yourself out as expert, you ought to be looking at something besides just stock charts.

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This article has 7 comments:

  •  
    Nov 11 01:26 AM
    Good job.
    Reply | Link to Comment
  •  
    Nov 11 07:03 AM
    Tom, short term price movements tell you very little of the real fundamentals for the simple reason that its a case of the tail wagging the dog. Stock prices is the tail. The company is the dog. The capital markets have all gone upside down and many have lost focus....sadly....
    Reply | Link to Comment
  •  
    Nov 11 09:10 AM
    Nice to observe the US commercial banks alsways use GAAP...

    I did not know that.

    Oh, just by the way, were there not a lot of companies that used the mark to market rule to write down on their own debt obligations?
    This to the tune of over 200 billion US$, is that 'GAAP' too?

    And last week the Federal Reserve passed the two trillion US$ mark in accepted collateral, as far as I know reality the mark to market rule is not used when it is parked as collateral.

    All this time I never found a clue that the rule is used upon offered collateral...

    We see a bit of the truth coming out when the US government has taken over: Frannie and AIG both reporting Quarter losses in the order of 25 billion, may be GAAP is used there?
    Reply | Link to Comment
  •  
    Nov 11 09:13 AM
    Oh, what I forgot:

    A few months back the Fortis commisioner chairman reported that in the USA about 6000 small banks were going to the cliffs.

    Why would the Fortis chairman report such an utter lie if all cash flows are safe and sound & if these cash flows are so good, why are there constantly all those reported losses? Is that GAAP?????
    Reply | Link to Comment
  •  
    Nov 11 01:26 PM
    Maybe the accounting distorts reality. But given the choice between believing the market and believing Tom Brown, I will take the market!

    Tom Brown: "financial stocks bottomed on 7/15/08." (Intraday low on the XLF of $16.77)

    The market: XLF now threatening the low since his call of $12.79 on XLF. That's a drop of 20%+ in 4 months for anyone drinking the Tom Brown kool-aid.
    Reply | Link to Comment
  •  
    Nov 11 07:18 PM
    Cash flow is the mother milk of the value of any investment. Cash flow will always snap any market mispricing back to reality in a hurry, sometimes it seems at the speed of light.
    Reply | Link to Comment
  •  
    Nov 12 04:33 PM
    This is a case of glass half empty and glass half full. Weill is saying that GAAP accounting does not reflect market value of bank books and therefore cannot be trusted as an accurate reflection. This largely does not contradict Brown. The key fault in Tom Brown's logic however is found in the following conclusion that the devaluation of these cashflows is simply "the result of screwed-up market mechanics, not underlying deterioration in the cash flows the underlying assets generate." Here we have the rub. All else being equal then if these cash flows continue being generated then Brown is correct; however all else is not equal. The very mechanics of the market have and are of themselves creating substantial deterioration in the cash flows. For instance loans are to GM - a company essentially at bankruptcy point partly BECAUSE of the 'screwed up market mechanics'; many of the loans are to oil product 'pipeline' entities such as Semgroup - bankrupt because of the 'screwed up market'. Loans to SLM - a company whose existence depends on low cost of capital and funds to make student loans but whose secondary market debt shows market pricing on its borrowing cost at 13% - way above where it can realistically lend to students. Other loans are backed by commercial real estate - essentially underwater because of the 'screwed up market' which has reduced commercial real estate prices by as much as 50%. whilst the ability of such entities to continue to generate cash flow to sustain a par valuation of those loans on bank books must be extremely doubtful. Was it any coincidence that Basle II was in the midst of implementation at the time of the credit crash and therefore from a GAAP point of view removed (on paper anyway) substantial value, capital from bank books and created the market rush to deleverage?
    Reply | Link to Comment
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