Saturday, August 1, 2009

Saturday Links

Loyal Readers,

My advice for the day is to keep doing your own work. Don't rely on the direction of the stock market to lead you to investment decisions. Smart investing still requires disciplined digging. Be skeptical of news that both fits your beliefs and that goes against your views.

On that pleasant note, enjoy today's links:

1. FASB looks the redeem itself: As discussed by Bloomberg’s Jonathan Weil, the FASB looks poised to drop a bombshell on the banking industry. After bowing to Congressional pressure to ease the mark to market accounting rules for financial companies earlier this year, the FASB appears to be putting together a proposal that would require more assets to be marked at fair value. By ending the distinction between held to maturity and held for sale assets, if passed, this change could cause all financial assets to be valued at fair or market value. What this means is that the valuation would reflect current market conditions that may include illiquidity, which of course negatively impacts prices. As further discussed by the Atlantic’s Daniel Indiviglio (hat tip to Seeking Alpha), this could be a huge problem for banks who have been relying on mark to fantasy to keep their assets greater than their liabilities and their capital levels above the minimum requirements. I have no idea why this isn’t front page news on every financial website. Not only would the assets side of the balance sheet be hit, but also the income statement, as certain losses would appear on the income statement in a line item called Comprehensive Income. It will be interesting see what the bank’s capital levels look like if this goes through and it will be especially fascinating to compare them to what the government stress tests concluded.

2. AIG is self re-insuring? Not sure this is a good thing: In Thursday’s NY Times, Mary Williams Walsh had a very interesting article on AIG. Anyone who has followed this never-ending saga knows that AIG has many subsidiaries all around the world. In a sense, this diversification could be a good thing. As long as they weren't interconnected and dependent on one another, multiple revenue streams from various locals could breed stable earnings. But, of course this is AIG so nothing is that simple:

“They show that A.I.G.’s individual insurance companies have been doing an unusual volume of business with each other for many years — investing in each other’s stocks; borrowing from each other’s investment portfolios; and guaranteeing each other’s insurance policies, even when they have lacked the means to make good. Insurance examiners working for the states have occasionally flagged these activities, to little effect.”

Although these subsidiaries all are required by regulators to be able to stand on their own, the fact that these companies are re-insuring against each others losses is sort of like transferring risk from one pocket to another in the same pair of pants. If nothing goes wrong then these arrangements will probably not blow up in their face. But, as we have learned over the past few years, traumatic events have the tendency to cause unexpected correlations between assets and to force hidden guarantees to be honored .

In addition to re-insuring one another, they are also so desperate for business they are driving prices down in the entire market.

“A.I.G.’s premiums have, in fact, been declining in important lines. Its ratings have fallen, and customers tend to steer clear of lower-rated insurers. To woo them back, A.I.G. has in some cases lowered its prices, competitors say. A.I.G. executives insist they would rather lose a customer than drive down prices dangerously.”

This confirms what Markel’s Tom Gayner said at the annual meeting in which he indicated that the presence of AIG’s carcass was driving down prices irrationally for the whole market. This can be dangerous for taxpayers (who now own AIG) as writing insurance for the sake of revenue likely leads to mispricing of risk. Accordingly, this is something to keep your eye on as investors and taxpayers.

3. Read beyond the headline GDP: GDP came in at –1% versus –1.5% expected. Hurray! The recession is over and we can all go back to maxing out our credit cards and buying useless trinkets. Well, since this is not CNBC, you should expect that the data is a little less reassuring than the headline number would indicate. As highlighted by The Market Ticker’s Karl Denninger, here are a few reasons why you should be less optimistic:

1. Q1 GDP was revised down from –5.5% to –6.4%, a fact that indicates that the free fall seen in Q4 2008 continued into 2009
2. After increasing .6% in Q1, personal consumption fell 1.2% in Q2. What stimulus?
3. Real government expenditures and gross investment increased 10.9%. This is not at all surprising but we would all be much better off if that spending was coming from the more efficient private sector
4. Private business inventories decreased by $141.1B in Q2 versus a $113.9 drop in Q1. Wait, I thought companies were rebuilding inventories? I thought we were going to have a technical rebound because inventories could not go any lower? I guess not in Q2.

These are just a few data points and I suggest you do your own work. There is a lot of information out there and the tone is obviously biased by the source. Therefore I implore you to make your own assessments of the GDP data as you try to ascertain whether the current levels of stocks are justified by the underlying economics.