What’s Really Rocking the Stock Market

It’s the most serious problem facing investors today.

It’s the reason why we are witnessing spectacular bank writedowns never seen before in the history of the stock market.

It’s an issue that, once you understand it, you’ll see why the red ink swamping the stock market and your stock portolio is now increasingly being talked about by accounting experts, economists and corporate executives as both flawed and absurd. At minimum, it's one of the factors behind the record volatility in trading.

Say you bought a house for $200,000. History tells you that things like population growth and inflation will cause your house to increase in value. For the sake of this explanation, say the housing downturn hasn’t happened yet, (most economists agree housing will come back, however far off in the future).

Say derelict teenagers lit a fire that roasted the woods near your house, and a pestilence has descended in the form of a neighbor who enjoys murdering silence by playing round the clock Whitney Houston’s brain-scraping “I Will Always Love You."

Say the Steineckes up the street now keep every Christmas decoration they could find at Home Depot on the roof until August, and say garden moles are riddling your front lawn with potholes.

Your house has dropped in value. Sell today and you’d get $150,000. But you know that time will bear you out, that these neighborhood blights will be gone one day. Wait five, ten years, you know you’ll get that $50,000 back, and then some.

But say a new government rule dictates that you must immediately deduct that $50,000 loss from your bank account as if you were selling your house today. You say to yourself, hey, why should I have that lower price jammed down my throat, even though that is not the price of what my home is really worth? Sounds absurd, right?

That’s a sense of what’s going on with these massive bank writedowns.

Financial firms and their auditors are now dealing with a relatively new set of controversial bookkeeping rules during the worst credit crisis in the history of the stock market.

To date, the accounting rules, which have their origins in the late ‘80s, have triggered a record $180bn in writedowns and torched hundreds of billions of dollars out of investors’ portfolios.

Here’s the tally to date: Merrill Lynch (MER) has taken $24.5bn in writedowns, Citigroup (C) $21.bn, UBS (UBS) $18.4bn, HSBC (HBC) $10.7bn, Morgan Stanley (MS) $9.4bn, Bank of America (BAC) $7.9bn, Washington Mutual (WM) $6.5bn, Credit Suisse (CS) $5bn, Wachovia (WB) $4.7bn, Societe Generale $3.6bn, JPMorgan Chase (JPM) $3.2bn, and Barclays (BCS) $3.1bn.

With the auditors wrapping up their work now, more is on the way. Citi's shares recently got socked, sliding to a nine-year low, after an analyst estimated the world’s biggest bank would take a further $18bn write-down. The rules forced Credit Suisse to report an embarrassing $1bn hit to its first quarter profits, indicating its mortgage-backed bonds had been inflated by $2.85bn, just a few days after telling analysts its 2007 results came away unscathed.

A growing chorus of thoughtful, reasonable critics--including experts who help write accounting rules--are saying it’s time these rules were amended. Yes banks profited big time from problem loans and securitizations. Yes they and investors are paying the price, with many of these pummeled lenders sheepishly going hat in hand to sovereign wealth funds in the Middle East and Asia, as well as private equity firms.

The question is, are the rules causing massive writedowns that are as inflated as the profit figures they tossed off during the bubble? Is it right to have these gigantic pendulum swings socking investors in the head?

After the S&L crisis, market regulators and accountants cracked down on inflated real estate valuations rampant during that binge period and demanded new accounting rules forcing instant price-tagging of all assets based on what the market would immediately deliver. Companies would have to “mark to market’ these assets and then record these valuations in their books, no matter if those assets were being held for the long term, because owners didn’t need to sell.

The problem is, you can quickly get a price on a stock because there is a ready, liquid market, people trade in and out of stocks daily. You can rapidly get a price on oil or gold, too.

But housing is stickier, people don’t sell their houses on an everyday basis, and prices historically move in cycles, with rapid- or slow-growth periods. That makes it harder to get the correct price-tag for long-term, complicated asset-backed securities based on housing assets.

Because there is no market for these securities right now, the writedowns so far are based on guesswork. And auditors are being pretty tough because they are fearful of another post-Enron, Arthur Andersen-type takedown by the government and because they are increasingly being criticized for sanctioning sizable profit figures during the housing bubble.

Even though the credit market has largely frozen over, the rules say the banks must book prices on these bonds as if they were being sold today. You can’t get a price tag when there is no market.

As the markets remain in blackout mode, companies can’t do mark to market accounting for them because there is no market to mark them to.

This sounds like a bad Abbot and Costello routine. This isn’t mark to market. It’s mark to madness.

And now, the Securities and Exchange Commission plans to tell publicly traded companies that, while they still must use market prices for many of the instruments they hold no matter how bad those prices look, they can also give investors a wider range of the possible values for those asset-backed securities.

Chairman of the House Financial Services Committee Barney Frank, (D-Mass), has already said that there is an urgent need to review the "mark-to-market" rules as he says they are exerting a "downward pull" on the economy. Frank, who has said he is in touch with market regulators, plans to hold a hearing on the issue next month.

A welcome start, accounting pros say. Because the use of the "mark to market" rules gets even crazier on closer look. Companies and their auditors typically use a market index to get prices for bonds backed by subprime mortgages. Banks generally use the ABX index, a thinly traded index that is barely two years old and is thought to be behind the chaos.

The ABX is a synthetic credit derivative index, or a basket of credit default swaps that are basically high-priced gambling bets on where investors think the direction of the underlying bonds backed by subprime mortgages are headed.

I know this is complicated, but bear with me, it’s important. The swaps in the ABX are basically bets on the prices of the 20 supposedly most liquid (not saying much) subprime mortgage-backed bond deals. It’s an understatement to say booking prices based on this index is accounting that is more art than science.

It’s not just that the index was historically used to grab a quote, and not as a regulatory cudgel deployed by auditors.

Can an index based on values for just 20 bond deals legitimately be used for an asset class approaching $1.3tn in size? An index that historically undervalues the cash bonds it purportedly represents? An index noted for its negative sentiment and one that is routinely used by short sellers to attack these securities? An index, depending on how you look at it, that is tossing off wildly different ranges of losses for the financials, anywhere from $220bn to $300bn to $400bn? An index that seemingly doesn’t take into account that the underlying assets, the houses, still exist?

The ABX is essentially throwing off prices based on perceptions, the perception of traders who are looking at the credit rating agencies who are looking at the auditors who are looking at the banks who are looking at the traders. All locked into a claustrophobic graveyard spiral. All calamitous for stocks.

So it’s either this dizzying turntable of bearish fears, or a distressed sale, that Holy Grail of the capitulation event Wall Street has been searching for, a washout that would finally tell the world what these bonds are really worth and would let investors put the crisis in the rearview mirror.

Instead investors are being subjected to a slow dribble of mini-capitulations, starting with the meltdown of two hedge funds run by Bear Stearns last summer. Investor water torture.

Yes, Moody’s says 3.5mn homeowners in the next two and a half years maybe face foreclosure. It’s why lots of bonds backed by subprime assets are now paper Kryptonite. And of course, those foreclosed-upon housing assets trigger writedowns of securitizations, as they will and should. Again, though, those houses have not been vaporized off the planet, they still exist. Cash flow could still come in the door once those houses are bought, however far down the road. And this 3.5mn figure is an estimate--no one knows for sure what the end result will be, but the pain, to be sure, will be significant.

And many asset-backed bonds are being wiped out even though they have no link to subprime—just look at the commercial backed market in the United Kingdom, where no deals have been done since last summer, the worst since 1991.

So should the banks be allowed to book values for these securities based on the date they were issued or bought? Too inflated, yes, a rational argument, of course, don’t allow bubble prices.

But how about a percentage of that value based on estimates of where housing is headed, given that the pricetags now being used are based on estimates anyway?

When auditors, no lie, are allowed to make “assumptions about assumptions market participants would use” when determining values, as certain accounting guidance reads?

Now even AIG’s auditor, PricewaterhouseCoopers, believes the torpedo in the boiler room the giant insurance group recently took for its credit derivatives portfolio in fact did not obliterate those holdings entirely, arguing they will come back in value.

Under protest, AIG, the country’s biggest insurance group, recently raised estimated losses on mortgage related securities to $5bn from $1bn, saying it didn’t expect to eventually realize many of the losses. After the announcement of these losses, the stock plunged, wiping out $15bn in market value.

Ok let’s think this “mark-to-market” madness through. Let’s flip it around.

In a perfect “mark-to-market” world, couldn’t it be argued that a bank holding that mortgage on a deteriorating asset would be allowed to say to the homeowner, the borrower: “I have determined the fair market value of your home, based on comparable sales in the area, and it is worth a lot less. You are now upside down in your loan, your mortgage is worth more than your house. So I, banker, get to take from you more money for that asset to support my loan I gave to you. Even if you are not selling.”

Of course, that’s not what is happening. Fed chairman Ben Bernanke is asking banks to now write off the principal on millions of mortgages that can’t be paid, on top of the writedowns they’re already taking from the subprime mess, because voluntary loan modifications aren't doing enough to stop foreclosures.

Ok but what does Bernanke say about the quixotic accounting rules causing the chaos?

Check out this exchange between Federal Reserve Chairman Ben S. Bernanke and Senator Charles Schumer (D-NY) at a recent Senate hearing.

The senator said he had heard “from many people” that the accounting rules may be forcing banks to book “artificially low” values on thinly-traded bonds when they mark them to market. That leads to a vicious cycle, he said, in which the writedowns leech bank capital from the balance sheet and banks "can't do any more lending and everything's frozen up.''

Bernanke replied that the inability to value such assets on the basis of actual trades is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it.''

Schumer suggested one response might be to have a six-month grace period on the mark-to-market rules. "You really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it,” he said, suggesting the use of some kind of moving average price instead.

Bernanke replied: "The risk on the other side is that if you do too much forbearance or delay mark-to-market, the suspicion will arise among investors that you're hiding something,'' he said, adding, "This is really an accounting board responsibility.''

So forbearance for borrowers, and not for banks?

Once housing finds its bottom, watch for the bank write-ups--and the Bernanke backlash from the banks to begin.