Morgan Stanley (MS): Greedaholism?

As part of the aftermath of 2008's economic crisis and bailouts, the Fed is being forced to show that it will be different next time - a variant of the most dangerous words in investing - "it's different this time."

An article on Bloomberg News highlighted a remarkable comment. John Mack, CEO of Morgan Stanley (MS), stated, "We cannot control ourselves. You must step in and control the Street." In 2007, as markets were running wild and Mack's compensation exceeded $40 million, Mack was silent.

The first step of the 12-step program of Alcoholics Anonymous states, "we admitted we were powerless over alcohol - that our lives had become unmanageable." Apparently Mack now feels the same way about greed.

Later in the article, he states, “We have probably 15 to 20 Fed regulators in our building 24 hours a day. They test our models. They question everything we do. I’ve never been regulated like that before. It’s a different environment. Someone said to me, ‘What do you think of it?’ I love it.”

It is disconcerting that the guardian of our financial system (the Federal Reserve) has been forced to post 24 hour a day, on-duty guards. If this financial institution lacks the capability to police itself, how is it possible that the Fed will be able to do so?

Aussie Approach is Standard & Poor (MHP)

Today's Sydney Morning Herald has reported that credit ratings issued by Standard & Poor's, the rating agency subsidiary of McGraw Hill (MHP), will not be available to retail investors after January 1. The rating agency has withdrawn its retail license application in response to a move by the Australian Securities and Investments Commission (ASIC) to withdraw protection from liability for ratings.

A move like ASIC's has been anticipated by many in the investment community. The question has been what the rating agency response would be. That is now answered. It would be peculiar if Moody's and Fitch did not follow Standard & Poor's. The issue is what the rating agency involvement will look like, if all three bow out of the "retail" market, but are available for the "wholesale" market.

Some have argued for greater accountability on the part of the rating agencies. Yet, it is not clear how such a model would work. Rating agencies provide opinions with limited information and an insignificant amount of compensation relative to the value of the securities rated. To be held to a downside risk with a nominal fee for an upside puts the rating agencies in the position of an insurance company with inadequate premiums. The appropriate response, then, was for Standard & Poor's to bow out.

ConocoPhillips (COP): Goodwill Impairment

Like many of us, ConocoPhillips (COP) had a tumultuous 2008. In the 2008 COP annual report, the most dramatic change is a $25 billion decline in assets. Always starting with the balance sheet, I look to the stability of assets because earnings are so volatile. On inspection, COP's balance sheet showed that the decline occurred almost wholly in Goodwill.

Goodwill typically shows up on the balance sheet when a company has acquired another company. The price paid in excess of the tangible assets, such as property and plant, is carried in a category labeled "Goodwill."

Before 1970, this item simply stayed on the balance sheet. After 1970, accounting of Goodwill changed, leading to what Ian Cumming and Joseph Steinberg (co-chairs of Leucadia) described, "too much complexity robs simplicity and thus understanding." Warren Buffett also highlighted how the accounting of Goodwill diverges from economic reality in the 1983 BRK annual report.

FASB, seemingly believing that Goodwill should be eliminated, effectively calls for either its long term writeoff or its short term impairment. But all writeoffs are not alike; some are absurd.

When the stock market declined in the fourth quarter of 2008 (the time for impairment measures), the entirety of the powerful Exploration and Production segment was written off as impaired. To highlight the absurdity, this accounting impairment was identical to an event that occurred last year: Venezuela's expropriation of COP's assets. Is it possible that accounting cannot distinguish between stock market volaility and dictatorial asset appropriation?

Radical Economics

Bruce Greenwald, professor of investing at Columbia, has analyzed the current crisis and developed conclusions which contradict those of just about every known economist. His contrarian streak alone is a joy to my rebellious, defiant and profit-seeking heart.

Since most economists describe the innovative, but untested financing of subprime housing as the cause of the current crisis, the logical approach to fixing the crisis is twofold: re-regulate so that such "nonsense" never occurs again and use monetary tools (i.e., get interest rates down to zero) to revive the economy so that banks are allowed to make high spreads between the borrowing costs (now zero) and lending income.

Greenwald essentially debunks the use of monetary tools as the solution. He argues that dropping interest rates to zero did not work in Japan, did not work in the Asian crisis and did not work in the German crisis. Rather, he argues that building the equity capital of the banking system is the only solid approach. He demonstrates that Malaysia and Sweden used recapitalization of banking as the basis for a rapid recovery.

He theorizes that the deregulation of the banking industry removed an effective means of recapitalizing banks from the economic system. Prior to deregulation, monetary tools were effective because the increase in zero interest demand deposits created a de facto equity class for the banks. Since deregulation, raising equity, at the time needed, has become extraordinarily difficult for banks.

He posits that the availability of such de facto equity prior to deregulation was responsible for the effectiveness of monetary tools, demonstrating the closeness of monetary impulses and economic outcomes. After deregulation, monetary policy and economic outcomes have little correlation.

All of this is news to us, because, as Professor Greenwald says, "Chairman Greenspan is given credit for steering the economy, but, in reality, the steering wheel was disconnected from the economy and moved of its own accord." If Professor Greenwald is correct, re-regulation and monetary tools will not produce the rapid recovery that all would like to see.

Greenwald's World

Over the past couple of years, I have added a name to my list of cochamim: Bruce Greenwald. He teaches at Columbia in the same program where Benjamin Graham taught Warren Buffett - a strong cultural legacy. This video captures the essence of his teaching and is worth watching:

http://www.youtube.com/watch?v=pgE6i8JHbUs

Recently, he has dedicated some of his instruction time to a discussion of what has caused the current crisis. Despite the common consensus of politicians and media, he submits that the economic crisis is not based in poorly developed financial structures, but in real fundamental economic ones. If he is correct (and I think he is), then much of the re-regulation going on is misguided and will not help avoid future crises.

Accounting Problems: SFAS 109

Our accounting system is riddled with numerous problems. These are inevitably the result of attempting to numerically capture the essence of a business whose management attempts to put that essence in the best light. In order to improve honesty, accounting rules have attempted improved precision. Unfortunately, this has led to heightened complexity, reduced understanding and, ironically, increased opportunities for dishonesty.

SFAS 109 is a good example. SFAS 109 requires that the future benefit of Net Operating Losses (NOLs) and other tax deductions be estimated and put on the balance sheet as an asset called Deferred Income Taxes. This estimation and capitalization may increase both earnings and volatility significantly.

For example, as long as a company has NOLs, it will report income tax expense far greater than is paid, and must also reduce the previously capitalized deferred tax asset. To even further obscure matters, every year a company must re-estimate the usability of the remaining NOLs and other tax deductions and, if necessary, adjust the deferred tax asset. It was much simpler to report paying very little tax and disclose in the financial statements that it had NOLs.

Aetna (AET)

AET's latest guidance was significantly downward, yet the e"bull"ience of the market has been so strong that its stock price has not been affected. Founded in 1853 as a fire insurance company and named after Mt. Etna, the Sicilian volcano, AET continues to forge on, with Value Line describing their ratios as "exceptable"[sic].