May 30, 2008 1:21PM

Which Regional Banks are in Trouble?

By Elizabeth MacDonald

Yesterday, the Federal Deposit Insurance Corp. issued its quarterly banking profile, and it showed an increasingly grim picture of the state of regional banks.

I have more analysis on which regional banks in particular may be hitting tough times, plus more info on the FDIC data. The FDIC tends not to name banks in its reports.

However, the FDIC report is important, because it shows the depth and breadth of the housing and credit bubble reaching into the corners of the country. It reports trend data on commercial and construction loans given in record amounts nationwide. When added to the subprime securitization mess, the paper Kryptonite now giving seizures to auditors, investors can get a more complete picture of what is happening.

As I noted in a blog yesterday, the central reason why earnings at these FDIC banks plunged 45.7% to $19.3 billion from the $35.6 billion reported in the first quarter in 2007 is because the regionals have increased the amounts booked in loan-loss reserves to stave off future crises. The amount chucked in to these cookie jar reserves in the first quarter was more than four times higher than last year’s level.

Even more painful: Industry earnings for the fourth quarter of 2007 were previously reported as $5.8 billion, the FDIC notes, “but sizable restatements by a few institutions caused fourth quarter net income to decline to $646 million.”

That figure is “the lowest quarterly net income for the industry since insured institutions posted an aggregate net loss in the fourth quarter of 1990,” the FDIC says.

Meanwhile, the FDIC said the number of “problem” banks rose in the first quarter from 76 to 90, with combined assets of $26.3b (that’s only about $3b on average each). Three U.S. banks have failed this year, versus three for the whole of last year and none in 2005 and 2006.

FDIC chairman Sheila Bair said she expected more bank failures but emphasised that the number of problem institutions remained well below the record levels of the savings and loan crisis of the 1980s and 1990s - when one in 10 banks were on the FDIC’s problem list.

So far this year, just three more banks have failed, on top of the three that failed last year. The past quarter was the sixth straight quarter in which the number of problem banks has increased. The number of problem banks were at an all-time low of 47 in the third quarter of 2006.

Bair is worried that the number of problem banks may continue rising in the months ahead as credit quality problems grow.

One worrying trend on Bair’s mind: the declining “coverage ratio”, which compares bank reserves with the level of loans that are 90 days past due. This ratio fell for the eighth consecutive quarter, to 89 cents in reserves for every $1 of noncurrent loans, the lowest level since the first quarter of 1993.

Onto the regionals that one analyst says he is concerned about. Richard Suttmeier, founder of Global Market Consultants, is taking a hard look at “heavy concentrations” of construction and development (C&D) loans, notably those regional banks were he says C&D loans surpass 100% of their risk-based capital.

Meanwhile, C&D loans have increased 8.5% year over year to $632 billion, also up from $629b in the fourth quarter, strange as the increase is happening “while demand for new homes slump,” he says. “Banks keep lending to open commitments betting on a second half recovery, which I don’t see happening.”

Suttmeier says there are 643 publicly traded community and regional banks (up from 467 in the prior quarter) that have loans at 100% of risk-based capital and above. He says when you add in nonfarm and non-residential real estate loans, there are 839 publicly traded banks (up from 631 in the previous quarter) at 300% and above. Suttmeier says that nonfarm and non-residential loans increased 9.2% year to year, to $989b, also up from $969b in the fourth quarter.

He adds that there are 902 publicly traded FDIC-insured financial institutions that are overexposed to C&D Loans, commercial real estate loans, or both.   

Here are four banks with $50 billion or more in assets that Suttmeier says are overexposed:

Suttmeier says:

RF - Traded to a 52-week low on Wednesday.

BBT - Bottomed on January 9^th at $25.92 trading up to $37.85 into May 2, which sets a trading range.

MI - Bottomed at $20.92 on January 22^nd trading up to $29.07 into February 2 setting a trading range.

FITB - Traded to a 52-week low on Wednesday.

Problem regionals to watch out for: Dallas-based Comerica (CMA), lots of loan loss provisions due to its sour real estate development loans, notably in California and Michigan.

As I’ve noted before, watch out of course for IndyMac (IMB). Wells Fargo (WFC), too, which has exposure to home equity loans in California, a state hit hard by the housing crisis. And as I’ve said, KeyCorp (KEY) is not out of the woods by any means, neither are Washington Mutual (WM) and Wachovia (WB).

FOOTNOTE: Adam Shapiro, Fox Business’s Washington, DC correspondent, has been tracking bearish comments made by Eric Rosengren, president of the Federal Reserve Bank in Boston. Shapiro reports that last January Rosengren gave a very aggressive speech urging banks to “quickly” clean up their balance sheets so that the US economy could move through the housing correction faster, rather than drawing it out.

Shapiro reports, Rosengren is now concerned about the exposure of banks to second mortgages, home equity loans and home equity lines of credit (think Wells Fargo). Rosengren is pretty sharp, so I’ve put his quotes in bold type for emphasis–and thank you Adam, this is much much appreciated, excellent work:

“The rapid rise in delinquencies for home equity lines of and junior liens held at banks is occurring despite an unemployment rate of about 5 percent.”

“Should the unemployment rate rise and housing prices continue to fall, financial stresses caused by the housing correction could well spread beyond the large banks involved in complex securitizations and the smaller banks with sizeable portfolios of constructions loans to a larger set of financial institutions.”

“Problems could expand beyond securitized assets to have an impact on the nonsecuritized assets held by smaller banking institutions. It is possible that these institutions may not be able to tap additional capital quite as easily as larger institutions and if so they may be forced to constrain other lending to address any losses.”

“Lenders and loan servicers continue to be reluctant to provide modifications in a wholesale manner.”

May 30, 2008 7:46AM

Farm Bill’s Bid to Stop Oil Speculation

By Elizabeth MacDonald

The Commodity Futures Trading Commission says it launched a nationwide investigation last December into possible manipulation of the oil-markets.

The probe comes during an election year that has the country on high alert over record oil prices, now boomeranging over $130, a price that has doubled in the last year.

With voters taking to the roads this summer driving season, expect complaints to soar as average gas prices in a growing number of states surpass $4 a gallon. The spike in diesel costs has pounded the trucking industry and contributed to soaring food prices.

However, the $300b farm bill has some legislative fixes that could help stop oil speculation–a pipe dream as oil speculation will never be stopped given how large the market is. President George W. Bush may veto the bill due to pork and other concerns.

The farm bill would close a loophole oil traders have driven a Mack Truck through. It would hike margin requirements on oil trades and end the so-called Enron loophole that lets traders buy oil electronically outside of the United States.

Though market watchers say high oil prices are really a supply and demand issue, the bill aims to stop speculators thought to be artificially inflating the price of oil in order to cash in, which Sen. Carl Levin (D-Mich.) estimates adds as much as $35 to the price of a barrel of oil.

Senate Democrats want to increase the amount of money traders would have to put down when buying oil futures. Specifically, they want to jack up the margin requirement for energy futures trades, now ranging between a teensy 5% and 7% of the cost of a new position, versus 50% for stocks.

However, the bill apparently doesn’t give an upper bound limit to that margin requirement, as it only orders the CFTC to hike the margin requirement by a “substantial” amount.

Would increasing the margin suck liquidity out of the market, leading to volatility and higher prices, as critics cahrge? Debatable, given that central banks around the globe have been gunning the printing presses, and sovereign wealth funds, pension funds, private equity funds are chasing the next hot trade.

Next, Senate Democrats want to shut the so-called “Enron loophole” which lets traders purchase oil contracts electronically outside of the US. Bringing the trades onto the CFTC would stop oil traders from trying to get around the new margin limits by fleeing to electronic markets offshore.

The “Enron loophole” has been around since 2000, when the Commodity Futures Modernization Act was passed. It lets oil traders buy and sell oil futures contracts electronically in markets outside of the CFTC’s jurisdiction, such as the commodities exchange in London.

Essentially what’s going on here is oil traders of U.S. crude now can make electronic trades in offshore markets. US “computer terminals will be governed by US regulation, because the computer terminal is located in the United States,” Sen. Carl Levin (D-Mich) has noted.

For now, the CFTC says it struck a deal with the Intercontintental Exchange along with Britain’s Financial Services Authority to get more daily trading data on large trader positions in oil futures made on the ICE Futures Europe platform. ICE oil futures are traded electronically on computer terminals across the US, using prices linked to oil futures trades on the New York Mercantile Exchange. However, they are not subject to the same CFTC reporting requirements.

Whether any of this legislation will lower oil prices is unclear at this moment, as China and India suck up oil at record amounts and OPEC refuses to ramp up production (don’t you wonder whether OPEC members are saying to themselves, why invest in Citigroup or Merrill Lynch when we can let oil sit in the ground as oil will continue to rise?)

A stronger dollar would help, too, as the debasement of the US dollar has caused oil, traded in dollars, to rise. A rising dollar may have helped push oil prices lower Thursday, as crude futures for July delivery fell $4.41 to $126.62 a barrel in New York futures trading.

However, the CFTC’s dragnet could even sweep up large institutional funds, including pension funds, thought to be pumping up oil prices as their buying of futures contracts for oil and other commodities has moved apace.

Check out this testimony recently given by Michael Masters, a hedge fund portfolio manager, to Congress. He says the huge number of investor dollars flooding into the commodities markets has skewed the relationship between oil supply and demand.

Specifically he said that only $13b was traded in commodities indexes in 2003, soaring to $260b in March 2008. A longer version of his testimony is provided below, from a recent report:

Masters asserted that institutional investors such as corporate and government pension funds, sovereign wealth funds,and university endowments now account for a larger share of outstanding commodities futures contracts than any other market participant, after holding a miniscule position prior to 2003.

The severe bear market in equities from 2000 to 2002 led these investors to commodities, which historically trade inversely to fixed income and stock portfolios.

The result was a sharp jump in assets allocated to commodity index trading strategies, jumping from $13b at the end of 2003 to $260b as of March 2008.  Over that time span, the prices of the 25 commodities that make up these indices surged by an average of 183%, Masters says.

During that five-year period, speculators’ demand for petroleum futures has increased by 848m barrels, almost equal to the 920m barrel increase in demand from China, according to US Department of Energy figures.  While funds never take physical delivery of the oil, Masters said these amassed contracts are undoubtedly a factor in demand and the single largest force in the market today.

“The huge growth in demand has gone virtually undetected by classically trained economists who almost never analyze demand in futures markets,” he said. 

By his count, speculators have now stockpiled, via the futures market, the equivalent of 1.1b barrels of petroleum, or eight times as much as the US has physically added to its Strategic Petroleum Reserve in the last five years.

These investors do not care what the price of oil or any other commodity is, Masters noted. If they decide to allocate 2% of their portfolio to commodities, they will buy as many contracts as they need at whatever price necessary. Because commodity markets are much smaller than capital markets, these investments can have a far greater impact on prices.

In 2004, for instance, the total value of futures contracts outstanding for all 25 index commodities amounted to $180b, compared to the $44t value of worldwide equity markets. Speculators pumped in $25b into commodities in that year, equal to about 14% of the total market, Masters says.

Moreover, rising prices tend to attract more speculative activity. 

During the sharp run up in crude oil prices in the first quarter of this year, index speculators flooded the markets with $55b in the first 52 trading days alone.

“Doesn’t it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?”  Masters asked.

He said refiners have told him that the price of oil, excluding the impact of speculation, would be in the $65 to $70 range.

May 29, 2008 1:02PM

FDIC Says Regional Banks Still in Pain

By Elizabeth MacDonald

The Federal Deposit Insurance Corp. report out today on the problems at regional banks is one of the most overlooked yet one of the most important reports on the state of the housing and credit crisis today.

It shows the extent to which the housing bubble reached all corners of this country.

The numbers continue to be bad. The FDIC says there are now 90 banks on its problem list, up from 76 last quarter, and that loan loss provisions to take care of future problem loans at commercial banks and savings institutions insured by the FDIC increased to a record $37.1b from $9.2b a year ago.

The increase in loan loss provisions is the reason why the FDIC says its insured banks and thrifts reported net income of $19.3b in the first quarter of 2008, a decline of $16.3b (45.7%) from the $35.6b that the industry earned in the first quarter of 2007.

Delinquent loans are up to $136b in the first quarter versus $119b in the fourth and from $61b a year ago.

“To sum up, while we may be past the worst of the turmoil in financial markets, we’re still in the early stages of the traditional credit stress you typically see during an economic downturn,” said FDIC chairman Sheila C. Bair. 

Bair went on to say that “given the weaker economy and rising level of problem loans, we’re encouraging bank managers to stay on their toes. We’re urging all institutions to make sure their reserves are large enough to cover expected losses. We also want them to beef up their capital cushions beyond regulatory minimums given uncertainties about the housing markets and the economy.”

We are still waiting on the data showing the total number of banks where construction loans exceed total capital. The last time we visited that number a month or so ago, the total had risen from 1,179 institutions to 2,368 since 2003, according to the FDIC.

And about 467 publicly traded community and regional banks were overexposed at the time to construction and development loans (C&D), with $204b in loans exceeding risk-based capital by 185% on average.

Problem regionals to watch out for: Dallas-based Comerica (CMA), lots of loan loss provisions due to its sour real estate development loans, notably in California and Michigan.

Marshall & Ilsley Corp. (MI), a Milwaukee-based bank holding company with exposure to construction loans.

Branch Bank & Trust (BBT), a Winston-Salem, NC bank also has exposure to C&D loans. Analyst Richard Suttmeier has said that it “has a risk ratio of 182% of risk-based capital.”

Regions Bank, whose parent is Regions Financial Corp. (RF), also has a worrisome C&D risk ratio of 122% of risk-based capital, Suttmeier says. Watch out of course for IndyMac (IMB). Wells Fargo (WFC), too, which has exposure to home equity loans in California, a state hit hard by the housing crisis. KeyCorp is not out of the woods by any means, neither are Washington Mutual (WM) and Wachovia (WB).

May 29, 2008 9:17AM

Beware this Hot China Stock: China Finance Online

By Elizabeth MacDonald

It’s one of the hottest momentum stocks in China today.

It’s China Finance Online (JRJC), a Beijing company that’s due out with a profit report today that Wall Street has been anticipating for weeks now, as its American depositary shares soar ever higher in Nasdaq trading in anticipation of yet another rosy earnings outlook.

China Finance has been riding the stock mania that’s got indices on the mainland in bubble territory. Investors in China are pouring into stocks, grabbing returns while they can as they fear the Chinese government will punt on providing sufficient coverage for health care and retirement. China Finance is perched atop that wave.

The company purports to sell the best in financial information online, with news flashes and updates to investors on the mainland and abroad so they can get in on the action in China’s stocks too. Its website says it sells users “software tools” to “analyze financial and listed company information” on all sorts of stocks, bonds, and mutual funds.

Not so fast. There is a growing chorus of critics who say this stock is way too frothy. My read of its numbers shows it’s been bleeding losses for some time now. It’s got a negative 16% profit margin, a negative 6% return on equity, just a 3% return on assets, a tiny $5.7m in cash flow over the last 12 months on just $25m in trailing twelve month revenues.

This one might be a trade not an investment.

Here’s more analysis from Citron Research. See below. I tried to do what Citron did with China Finance Online’s website and met with the same results. Now I’m waiting for the lame telemarketing spam to hit my emailbox as well as arrive in snail mail. Why oh why do I do these things:

Folks, the company sells a group of newsletters to Chinese stock speculators with names like “Quick Profits” and “Storm” and “Stock Radar.” They sell by telemarketing, and they have plans to increase their telemarketing staff again next year.

If you hit the “Purchase” or “Free Trial” buttons, you can’t even order online. The form sends an email to a telemarketer who will presumably respond to your request and try to upsell you something.

The reality is there are hundreds of competing stock commentary publications in China. This has gone from silliness to nonsense. The chatrooms calling this the “Bloomberg of China” are well……out to lunch.

Now Breen Murray has raised its target from $25 to $35 while cautioning about the need for a “market correction” due to volatility.  What has changed since Breen put out its $25 target, which was a raise from $17 just the week before, except the momentum in the stock?  Did Breen’s analyst fail to understand this company as the “Bloomberg of China” until the stock price told him?

The JP Morgan analyst put a $29 target on this company as of Dec 08, with a very detailed revenue projection based on the company’s plans. Will he have the integrity to call a “sell on valuation” now, or will he raise his target because of the stock price?

After breaking its IPO price of $13 right out of the gate in late 2004, and languishing in low single digits for well over two years, this tiny company which publishes investment guides for Chinese stocks has this year rocketed to a 1000% gain on the mania surrounding the China stock market.

Most recently, shares rocketed higher on the purchase of a Hong Kong brokerage firm for about $3m. Recent momentum trading has now driven this company with revenues about $5m or $6m per quarter from newsletter subscriptions above an $800m dollar market cap.

Citron observes that management has not been able to execute over the past three years during the biggest boom in the China market while positioning themselves in a space with a low barrier to entry. We acknowledge they have now gotten their revenues up to $5m per qtr. But we doubt Bloomberg is jealous.

Now we are not issuing a wholesale critique of China stocks–a lot of them have some impressive growth rates to show for their skyrocketing valuations. It is just important to decipher what is a bubble and what is value.

Think of JRJC as Thestreet.com for China, yet even in the tremendous market boom the company was only able to generate $7.4m in revenue in all of 2006, and projects about $20m for the current year.

Comparatively speaking TSCM generated $57m in revenue and has a market cap of about third this name.

This has become a quintessential example of the uncritical cheerleading that Wall Street has become so famous for–and that has burned investors. So, don’t be surprised if Chinese stocks catch a cold and JRJC gets the flu.

May 28, 2008 10:16AM

What’s Next for the Airline Industry

By Elizabeth MacDonald

Merger talks between United Airlines and US Airways may be cooling off, with both sides reportedly still talking to AMR (AMR) and Continental (CAL).

The stalled merger talks in the airline sector should give investors pause. Yes, it’s debatable whether yoking together two hurting companies really creates a profitable company. It’s worth a shot, given that the prospect of a union-friendly Democrat in the White House next year may stop future airline deals done. And although oil prices seem to be trending down, now at $127, the price is still twice what it was more than a year ago, an incentive to do a Hail Mary merger.

So what’s next for the airline industry? Expect massive cost-cutting, less capacity, layoffs, and delayed purchases of new jets, raising new safety concerns, coming in the wake of the government stopping Southwest Airline flights to do maintenance checks.

All this is really tough for an industry that prides itself on its safety record. Industry analyst Robert Herbst, a commercial pilot who runs the website, AirlineFinancials.com, says: “US airline employees assume responsibility for the safe operation of over 20,000 flights each and every day which routinely deal with any type of weather and mechanical failure imaginable.”

JetBlue now says it will delay buying 21 new Airbus jets for four to five years. And JetBlue is not alone. The US airline sector’s weak balance sheets means that US airlines are staying put with the old airplanes they own.

Industry analysts estimate that Delta has 117 McDonnell Douglas MD-88s with an average age of 18 years; Northwest has more than 90 DC-9s with an average age of about 40 years. These planes swallow up 40% more fuel than newer planes, painful given the high price of fuel.

And check this out: Airlines also can’t replace their ageing fleets any time soon as production lines at Boeing and Airbus are fully booked until 2012, analysts note.

Airlines are in a tough bind as any wage concessions they have wrung out of their heavily unionized workforces are more than offset by fuel costs.

Just last September the International Air Transport Association, the group that represents the industry, said that US carriers were “vulnerable to shocks.” That was when oil was at $67 a barrel and the credit crunch had yet to slam the markets, analysts note.

The airline sector has already taken a battle axe to its operations. The industry has laid off nearly four out of 10 of its workers over the years and slashed wages by nearly a third. It’s also defaulted on about $20b worth of pension payments. 

Below are some interesting statistics from industry analyst Herbst to keep in mind when analyzing the airline sector. Herbst compared stats from 2007 to year 2000 for the seven largest US airlines, American (AMR), United (UAUA), Delta (DAL), Continental (CAL), Northwest (NWA), US Airways (LCC) and Southwest (LUV). Combined they control 71% of the US market share. See also his analysis on the terrific website Seekingalpha.com:

• Total Operating Revenue was nearly the same at around $95 billion.
• Capacity as measured by Available Seat Miles [ASMs] decreased by 7% (Southwest capacity increased by 66%).
• In the past 7 years, the average one-way passenger fare has only increased by $18 (+11%) going from $153 to $171. (Note: This is the passenger revenue kept by the airlines and does not include large increases in taxes, fees security charges etc. that airlines are required to charge but do not keep.)
• Fuel Expense increased by $15.5 billion (+128%) going from $12.1 billion to $27.6 billion.
• Employee wage/salary expense decreased by $7.6 billion (-30%).
• Employee wage/benefit percentage of operating revenue decreased by 22% going from 35% to 27%.
• The labor cost of the average one-way passenger fare decreased by $25 (-41%) going from $60 to $35.
• The fuel cost of the average one-way passenger fare increased by $34 (+154%) going from $22 to $56.
• In the last 7 years over 162,000 jobs (-38%) have been eliminated from the largest 6 major airlines as they went from 430,000 to 268,000 employees. (Southwest had an increase of 5,000 employees ending 2007 with 34,378 employees).
• While fuel costs rapidly increased and labor costs and total employment rapidly decreased, the average passenger ratio to airline employee increased by 430 (+36%) going from 1,198 to 1,628. In other words, that reservation or ticket agent or flight attendant must now, on average, resolve issues and provide customer service to 36% more passengers than they did seven years ago.
• During this same time period the average revenue productivity per employee increased by an astounding $107,442 (+52%) going from $206,370 to $313,812.

Data is for mainline operations and does not include contracted affiliates. Source: Securities and Exchange Commission and BTS reports.

May 27, 2008 4:46PM

The Circuit City-SEC Mystery

By Elizabeth MacDonald

Did Circuit City have to contend with an undisclosed probe from the Securities & Exchange Commission?

Disclosure Insight, run by John Gavin, is an independent research firm that prepares in-depth risk reports on public companies. This research includes information it acquires under the Freedom of Information Act [FOIA] filings it sends to the Securities and Exchange Commission.

Disclosure Insight, formerly known as SEC Insight, routinely files about 2,500 FOIA requests per year for investigative records from the SEC. It makes its findings available to anyone who registers for its complimentary alerts at http://www.disclosureinsight.com/.

Disclosure Insight sent a FOIA request to the SEC for information on Circuit City. The SEC then sent a letter back to Disclosure Insight noting that it was “withholding certain nonpublic records that may be responsive to your request” citing an exemption under securities law. Its letter adds: “This exemption protects from disclosure records compiled for law enforcement purposes, the release of which could reasonably be expected to interfere with enforcement activities.”

When Disclosure appealed that decision with the agency, it got a letter back from the SEC which reads that SEC “staff responsible for the commission’s investigation have confirmed that releasing the withheld information could reasonably be expected to interfere with an on-going commission investigation.”

The questions come at a time when Circuit City is at a crossroads. It now faces a buyout by video-store chain Blockbuster (BBI), which wants to purchase the beleaguered electronics retailer for $1.35 billion. Billionaire corporate raider Carl Icahn, a big Circuit City shareholder, recently said that he would buy Circuit City (CC) if Blockbuster (BBI) can’t get financing.

Both companies are unprofitable, but many investors believe a combination of the two–with Circuit City selling electronic devices and Blockbuster media content–would produce a viable company.

Circuit City initially resisted Blockbuster’s offer, saying it feared Blockbuster didn’t have the financial clout to carry out the deal. With Icahn on board, the situation may change.

Circuit City has been caught in the same downdraft that has dragged down other big-box retailers like CompUSA and Best Buy. Meanwhile Blockbuster has been socked hard by tough competition from Netflix and video streaming from Apple’s iTunes service. Last year, Circuit City’s decision to fire 3,400 of its highest-paid sales staff and replace them with lower-paid workers was met with negative headlines, as dumping high performers was seen as a risky strategy to cut costs.

In a conference call with William Cimino, Circuit City’s spokesman, and Jay Oakey, its assistant general counsel, I asked whether Circuit City had an undisclosed SEC probe on its hands. Prior to the call I e-mailed a list of questions, including the following:

“Can you please confirm that Circuit City is now dealing with an SEC probe?” and “What is the probe about, what are the issues?”

In response to these questions, Cimino said emphatically, “No there is no probe.”

But I worded the questions incorrectly. I then sent a follow-up email to Circuit City in which I stated: “You say there is no probe. At any time in the past year has CC had contact of any kind with the SEC’s Division of Enforcement?” and “If so, what did it entail, when did that contact first start, when was your last contact, and where does it stand today?”

Here’s what I got back in an e-mail from Cimino: “Our practice is to not comment on past or present regulatory actions of any nature involving the company, except as required by law.”

As Gavin points out, “companies are not required to disclose SEC probes. Investors think they are, that’s just a myth. They are, however, required to disclose matters deemed material.” Gavin adds that “The problem is that management is the judge of whether an SEC probe is material. That this company is in play changes the materiality threshold quite dramatically; that is, perhaps more than ever the company should be striving to make sure all parties involved know exactly what’s going on.”

Again, to be clear, Circuit City says there is no SEC probe. Gavin’s company thinks there was an undisclosed one. Investors won’t know what’s going on at Circuit City with regards to the SEC until the company chooses to tell us in its filings.

Circuit City has been under the gun lately, as was highlighted in a recent research report published by Disclosure Insight. In its recent annual report, it disclosed that it had identified “errors” in its internal controls overseeing its deferred tax assets, including the calculation of the company’s valuation allowance on deferred tax assets, during its fiscal third quarter of 2007.

Though the company says these errors “did not have a material impact on the financial statements related to the third quarter,” they “had the potential to do so,” and in turn concluded that this “deficiency constituted a material weakness in internal control over financial reporting” that could have resulted in “a material misstatement” of its financials.

It added: “The material weakness did not result in the restatement of the company’s financial statements for any period.” The IRS audited Circuit City’s fiscal 2001 through 2003 tax returns, an audit that is now complete.

Circuit City has a new chief financial officer as of July 30, 2007; the previous CFO left to join Petco. Its CEO was appointed on March 1, 2006, but the stock has declined 79% since then, having risen during that time as well.

What is the reason for the stock decline? Earnings performance, which has been dismal. Circuit City is vastly dependent on the domestic market, and the company’s earnings have been hurt due to its exposure to the weakening US economy. Circuit City has revenue concentration of 40.9% of domestic sales in the video category, which includes TVs, for the last 12 months for its most recent fiscal year.

For now, Circuit City plans to ask shareholders to expand its board of directors from 12 to 15, diluting the gains made by a dissident stakeholder last week.

The consumer electronics retailer would keep three directors thought to have lost their seats stemming from a potential proxy fight with Mark J. Wattles, president of Wattles Capital Management. Wattles now owns a 6.5% stake in Circuit City.

May 27, 2008 8:21AM

How Can Moody’s Survive as an Independent Credit Rating Agency?

By Elizabeth MacDonald

The Securities & Exchange Commission now says it will probe into the operations of the three top US credit rating agencies, in the wake of their questionable top-notch ratings of poor subprime mortgage bonds and a report about computer errors leading to erroneous triple-A ratings of European debt securities at Moody’s Investors Service.

But this story is bigger than the subprime bond ratings controversy and the computer error. The credit rating agencies have been a problem I have warned you about since last fall (”Market Regulators, Read This Now,” “What Congress Must Ask the Federal Clean-up Crew,” “How Congress Can Fix the Crisis” and ”Cleaning up Wall Street’s Housing Mess”).

The questions the SEC, the exchanges and investors should ask are these:

How does Moody’s, the second largest credit rating company, keep its government and stock market status as a nationally recognized statistical rating organization when its last quarterly report shows it has a negative book value of $903m and when it is in awash in short-term debt that it’s using for a planned $4b worth of stock buybacks, a debt position S&P now threatens to downgrade?

How does a rating agency so submerged in debt and with declining earnings, a company that has one of the most important stock market functions in the world, think it can publish investment ratings of Wall Street firms and their debt securities when its own financials are in such disarray?

How can market regulators think that Moody’s, now thoroughly dependent on the banking sector for its survival, can still issue ratings independent of the very banking sector it depends on to stay alive?

Isn’t the following worthy of inquiry too? Moody’s hired the law firm Sullivan & Cromwell to conduct a “thorough” external review of its process rating European constant-proportion debt obligations or CPDOs, due to the computer error.

However, last year Moody’s hired Sullivan & Cromwell to represent it in civil lawsuits relating to subprime lending. Isn’t this a conflict of interest?

Back to the computer error problem at Moody’s. Senior staff at New York-based Moody’s were allegedly aware in early 2007 that these European securities, backed by borrowed money to place bets on credit-default swaps, should have been ranked as much as four levels lower than triple-A, the Financial Times reported, citing internal company documents. A computer error triggered the inaccurate rankings, the FT said.

The SEC’s sudden change of heart is striking. It was only just recently that SEC chairman Christopher Cox said that, because the ratings for these European securities were handed out by Moody’s in Europe, the SEC may lack jurisdiction over the probe.

This, despite that fact that at least one CPDO deal I have documents on from the European firm ABN Amro was in fact offered in the US in October 2006, an offering ABN Amro notes up high in its marketing materials as one that carried a triple “AAA rating by Standard & Poor’s and Moody’s on both the timely payment of interest and the ultimate payment of principal.”

The SEC’s turnaround comes after US Senator Charles Schumer (D-NY) had urged U.S. regulators to investigate whether the credit-rating unit of Moody’s erroneously ranked European securities higher than the debt deserved and to fine Moody’s if it delayed disclosing mistakes.

The “revelations” are “indicative of a culture of shirking responsibility that must end,” Schumer, a New York Democrat, said in a letter to Cox. “I urge you to fully investigate this matter and impose appropriate sanctions on Moody’s for their failure to disclose their ratings errors.”

The SEC now says it will propose new rules in June to limit conflicts of interest at the credit rating companies and boost disclosure about assets packaged into securities.

Again, the credit rating agencies have been a problem I have warned you about since last fall. Lawmakers and market watchdogs had already heavily criticized Moody’s and Standard & Poor’s for handing out triple-A ratings to subprime mortgage securities like Kleenex, and then keeping those ratings well into the fall despite rising defaults on the loans backing them.

It was only last fall when the ratings agencies finally moved in any significant way to slash ratings on hundreds of subprime backed securities, down from the top notch grade to junk status. A conflict of interest has been that the credit rating agencies get paid by the issuers to rate their debt securities, so the fear is they may be more inclined to give higher grades to their clients’ securities.

Whether the SEC will back a quarterly report from the ratings agencies showing their performance, somewhat like a quarterly report card, remains to be seen. 

Again, the following is worth noting. As I’ve told you, Moody’s hired the law firm Sullivan & Cromwell to conduct a “thorough” external review of its “European CPDO ratings process.”

However, last year Moody’s hired Sullivan & Cromwell to represent it in civil lawsuits relating to subprime lending, notably, “putative class actions brought by Moody’s stockholders claiming that Moody’s and several of its executives violated federal securities law by failing to disclose that the agency’s subprime ratings were allegedly inflated,” according to Sullivan & Cromwell’s letter to clients dated May 12, 2008.

And again it bears repeating that S&P now may downgrade Moody’s A-1 rating on its commercial paper, (debt maturing in nine months or less), due to “recent press reports regarding potential problems with analytical models and methodologies used in Moody’s process for rating European constant-proportion debt obligations (CPDOs),” said S&P in a statement. S&P has put Moody’s commercial paper on credit watch and also noted the reports about the problems come at a time when expected declines in revenue and cash flow at Moody’s are likely to reduce its “flexibility in its leverage profile.”  

What S&P overlooks is the perilous condition of Moody’s balance sheet. Moody’s is a company awash in debt, it levered up its balance sheet at a time when it is conducting huge stock buybacks, $4b of which it has approved since 2006. All at a time when Moody’s earnings actually declined from 2006 to 2007.

I have to ask this again, according to Moody’s recent balance sheet, it has negative shareholders equity of $903m. How does a credit rating agency get to operate with a negative book value? Even small broker dealers must have at least $10,000 in net capital to trade.

Again the question for market regulators is this: How can a company so submerged in debt, with declining earnings, think it can hand out ratings of banks, investment banks and their debt securities when its own financials are in such disarray?

Again I ask you, how can market regulators think a credit rating agency so dependent on the banking sector for its commercial paper, can issue ratings independent of the very banking sector it depends on to to do its stock buybacks?

Warren Buffett, your company, Berkshire Hathaway, owns a 19.6% stake in Moody’s.

Are you listening?

May 23, 2008 3:09PM

Why Suing OPEC Won’t Work

By Elizabeth MacDonald

The US House of Representatives recently passed legislation that would let the government sue members of OPEC (the Organization of the Petroleum Exporting Countries) and other foreign states for colluding to restrict oil production in order to manipulate the price of oil.
A compelling idea for anyone experiencing sticker shock at the pump, especially given the widespread fear that we may see $5 gas by the fall.

Though suing OPEC is a pipe dream, and it may not help to lower gas and oil prices, a better way is to stop debasing the dollar (as oil is priced in dollars) and drastically expand its energy exploration and discovery on all fronts, including the outer continental shelf as well as renewable and alternative energy production.

Here’s the thinking behind suing OPEC.

Some argue that we should sic the US tort bar sharks on this oil gang, that’ll teach them to stop holding production in a blind crab-like fist. And maybe distracting the US tort bar will heave a sigh of relief through the corridors of beleaguered US corporations slapped silly for years by buckshot shareholder law suits.

The US tort bar could very well show Iran and Venezuela a thing or too, even Saudi Arabia, which largely refused President George W. Bush’s recent pleas for increased production.

Saudi Arabia’s King Abdullah has said he had ordered new oil discoveries left untapped to preserve oil wealth in the world’s top exporter for future generations, so there, all you US drivers of gas guzzling Hummers and SUVs (even though sales of gas-hogging light trucks and SUVs at places like Ford have plunged).

“I keep no secret from you that when there were some new finds, I told them, ‘no, leave it in the ground, with grace from God, our children need it,’” the king reportedly said.

An antitrust action against OPEC is not some addlepated, knee-jerk, angry populist idea, in fact, there have been a number of attempts over the years to sue OPEC under American antitrust law. Just last year Congress voted to sue OPEC for engaging in a “price fixing conspiracy” that has “unfairly driven up the price” of crude oil and in turn gasoline. A suit would have yanked sovereign immunity that protects the governments in OPEC from prosecution or asset seizures.

And antitrust cops, here and abroad, have attacked all sorts of international cartels with heavy fines, be they in telecommunications, construction, banking, even in vitamins, or graphite electrodes, even elevator makers, glass makers and lysine, an animal feed additive.

At any given time there are some 50 grand juries investigating international cartels, with targets located on six continents and in nearly 25 countries, the American Bar Association says.

Prosecutors report that they have uncovered cartel meetings in more than 100 cities and 35 countries, including most of the Far East and in almost every country in Western Europe.

There’s an argument to be made that an antitrust lawsuit against OPEC for once might compel the European antitrust police to grow a spine and go after the big guns, not just OPEC but Russia’s price-fixing Gazprom too, not the small bore stuff like torturing Microsoft or General Electric.

But set aside for now that any such law won’t pass a Bush veto.

Set aside too for now the fact that, if OPEC were found guilty of antitrust abuses in an American court, it would be extraordinarily difficulty trying to ascertain how the cartel would actually be punished or broken up.
Sovereign immunity, the act of state doctrine and other special international defenses typically preclude suits against OPEC and its member nations, analysts note.

Also there’s a heated debate over whether or not the Middle East is really tapped out. Some Middle East officials say there’s plenty of suppy; others privately say not so at all, as more capital investment is needed to pump all that there is out of aging oil fields and to rehabilitate geriatric refineries, notably in Iran.

Either way, supply and demand statistics out of the Middle East are poor, as secretive bureaucrats hoard data. And transparent data is non-existent notably in non OPEC countries like China and Russia.

Moreover, the higher oil prices soar, the less apt OPEC will pump, as oil in the ground is a more valuable asset than having its sovereign wealth funds investing in Citigroup or Merrill Lynch.

Eight members of OPEC are also members of the World Trade Organization, and a threatened new law allowing an antitrust suit could raise hackles at this worldwide body to get it to fight any such law. “The Venezuela-Iran-Ecuador axis might even cut production to spite the US, inflicting some pain on spot market prices,” says Tom Post, a top editor at Forbes Magazine.

Perhaps the US could ask OPEC countries that are not WTO members, such Libya, Algeria, Iran and Iraq whether, as a condition of WTO membership, they’d stop orchestrating an international price-fixing conspiracy. But who is to say they will listen?

Congressman Michael Conaway (R-Tex.) agrees that suing OPEC is “foolhardy,” he says, and “could have drastic consequences for the U.S. if the bill ever became law.”

Why? Because foreign governments would quickly take “retaliatory action against American interests” such as “discouraging investment in the U.S. economy and [they] may even limit the availability of gasoline to the United States,” Conaway says, adding that “if OPEC shifts away from pricing oil in dollars as a retaliatory action, the dollar’s value on the world market would plummet and inflation would skyrocket.”

Shifting away from pricing oil in dollars is already happening in Iran, OPEC’s second-largest producer, which has stopped conducting oil transactions in U.S. dollars, due to tension over Tehran’s nuclear program, the war in Iraq and a weakening US currency.

Since oil is priced in dollars on the world market, the dollar’s erosion in value has caused crude prices to soar and in turn has eroded the value of the Middle East’s dollar reserves.

The blogosphere in Saudi Arabia is hot with debate over inflation in Saudi Arabia and talk of pushing the royals to de-peg the riyahl from the US dollar.”The dollar has totally been removed from Iran’s oil transactions,” Iran’s oil ministry official Hojjatollah Ghanimifard has already said. “We have agreed with all of our crude oil customers to do our transactions in non-dollar currencies.”Iranian president Mahmoud Ahmadinejad called the depreciating dollar a “worthless piece of paper” at a summit last year in Saudi Arabia attended by state leaders from OPEC countries.

Iran has been pressuring other OPEC countries to price oil in a basket of currencies, but it has not succeeded as a number of members, including Saudi Arabia, are firm U.S. allies.

OPEC officials argue prices are beyond their control, with its secretary general blaming oil’s rise on investment funds moving to oil from other markets and the weakness of the dollar.”OPEC can’t do anything about that,” OPEC’s secretary general said. “We can’t stop people in the United States bringing their money to the oil market.”

It’s already been noted that the $600 fiscal stimulus checks already in the mail would have bought 190 gallons of gasoline instead of the 164 gallons now due to the weakening US dollar, and that if the dollar had maintained the same strength as the Euro, oil would be priced anywhere between $70 to $80 a barrel, not the $133 it is now.

Even so, it is an absurdity for OPEC to use as its official line, as it has done in prior antitrust lawsuits, that it is “a simple commercial entity.”

More irritating is the stated market manipulation that OPEC blatantly says on its own website, in its FAQs section, by way of answering the question, “why does OPEC set oil production quotas?”

The OPEC website reads that its statutes require “OPEC to pursue stability and harmony in the petroleum market for the benefit of both oil producers and consumers…If demand grows, or some oil producers are producing less oil, OPEC can increase its oil production in order to prevent a sudden rise in prices. OPEC might also reduce its oil production in response to market conditions.”

For the sake of argument, if a US law passes allowing an antitrust suit against OPEC, and the defendants are the members of the OPEC cartel, wouldn’t you like to see who takes the witness stand? And wouldn’t you like to see any court documents produced in discovery?

May 23, 2008 9:53AM

One Good Reason Why Yahoo! Postponed its Investor Meeting

By Elizabeth MacDonald

Yahoo! has postponed its shareholder meeting, even though it announced just two weeks ago the meeting would be held July 3. It now says the meeting will be held “around the end of July,” according to an SEC filing Thursday.

But the Internet giant has more than a nasty proxy fight on its hands with billionaire corporate raider, and new Yahoo! shareholder Carl Icahn, who filed an opposing slate of board nominees. Icahn has said that if the proxy board is elected, it will negotiate a deal between Yahoo! and Microsoft.

Yahoo! also must prepare itself for highly contentious, potentially embarrassing shareholder proposals which revisit ugly headlines over Yahoo!’s alleged help in disclosing the identity of a journalist to Chinese communist authorities, who was then jailed for 10 years.

All three proposals, which Yahoo!’s board flatly opposes, could portend a notably ugly and chaotic investor meeting.

Here are the proposals, with my commentary on each following:

*A resolution forcing Yahoo! to fight Internet censorship: The Comptroller of New York City wants Yahoo! to institute policies to better protect data that can identify users in countries that censor the Internet, where political speech is a crime.  The comptroller also wants the company to avoid censorship of all kinds, and to resist overseas demands for censorship, using any legal means necessary. It also wants Yahoo! to tell users how it is disclosing their data.

The board’s response: It punts on this one. While it says Yahoo! is “deeply concerned” about government censorship, it thinks that instead a continued dialogue with hostile countries is the best path, calling engagement “a powerful force in promoting openness and reform.”

It says Yahoo! “believes private industry alone cannot effectively influence foreign government policies on issues like the free exchange of ideas and open access to information,” and instead has established “a cross-functional team of Yahoo! employees” to deal with the “on a global basis” as well as  ”fellowship programs with two universities to promote the pursuits of journalists from press-restrictive countries and scholars exploring the link between global values, the Internet, and communication technologies.”

Commentary: A lily-livered response at a time when Internet users are facing gunshots to their heads just for speaking out. If you think latte-drinking, croissant-eating, bicycle-riding Internet executives or college students can take on thugs in North Korea, China, Syria and Iran, then you are the web surfer in the plastic bubble.  

Just last fall, Yahoo! chief executive Jerry Yang had to endure heated grilling in testimony before Congress over the fact that Yahoo! evidently provided information to Communist authorities in China that was allegedly used to identify and jail for 10 years Shi Tao, a 37-year-old journalist, for leaking “state secrets.”

Shi Tao’s violation: He was jailed for sending on to foreign websites an e-mail from the ruling Communist Party warning journalists not to cover the 15th anniversary of the Tiananmen Square massacre in 2004.

The Congressional panel also issued a stinging rebuke to Yahoo! for not giving full details to its probe, saying Yahoo! had been “at best inexcusably negligent” and at worst “deceptive” in evidence given to the House Foreign Affairs Committee last year.

Yahoo!’s Michael Callahan originally told Congress he did not know why China wanted the reporter’s details, then reportedly backed off that statement, saying information came to him after the fact. Yahoo! has previously said it had to comply with Chinese laws to operate in the country.

Read on.

*A plan for a new Yahoo! board committee on human rights: An individual investor, John C. Harrington has proposed that Yahoo! establish a new Board Committee on Human Rights which would review and make policy recommendations regarding human rights issues raised by the company’s activities and policies.

The investor cites the controversial, and dangerous, decision by Yahoo! to allegedly disclose Tao’s identity to Communist authorities in China.

Harrington says that “of the major Internet search engines operating in China, Yahoo! censored more terms, according to a limited test conducted by Reporters Without Borders.”

He adds that “in defining human rights, the new committee could use as a benchmark the “US Bill of Rights and the Universal Declaration of Human Rights” laid out by the United Nations.

The board’s response: Yahoo!’s board opposed an identical proposal brought last year, and stockholders overwhelmingly rejected the proposal, with over 95% of the votes cast voting against it. The board says it “continues to oppose the proposal because the Company already has policies that advance fundamental human rights issues.”

Commentary: Tell that to Shi Tao. And his mother and father, as well as the rest of his family.

*A new “pay-for-superior-performance” plan: Brought by The United Brotherhood of Carpenters Pension Fund, an investor in Yahoo!,  the pension fund says executives are overpaid versus Yahoo!’s rivals, that their pay is not tied to performance criteria, and that the executives should not simply get time-vested stock awards.

It wants Yahoo! to “adopt a pay-for-superior-performance” plan that sets annual and long term incentive compensation targets, which it says is now pegged “at or below” the median levels at Yahoo!’s peer or rival companies.

The pension fund gives this parting shot: “We believe the failure to tie executive compensation to superior corporate performance has fueled the escalation of executive compensation and detracted from the goal of enhancing long-term corporate value. Post-employment benefits provided to executives from severance plans and supplemental executive pensions exacerbate the problem.”  

The board’s response: It says the pension fund didn’t take into account the fact that Yahoo! chief executive officer Jerry Yang gets a nominal annual salary of only $1, and that last year he did not receive any bonus or other compensation and was not granted any stock options or other long term equity incentive awards. And it says that besides, Yang is one of Yahoo!’s largest stockholders, so a substantial portion of Yang’s net worth is already tied to the performance of the company’s stock.

It also says for other executive officers, “greater than 88% of each executive’s annual direct compensation already depends upon the achievement of financial goals, individual performance and/or Yahoo!’s stock price.”

Commentary: The executives are richly paid, period.

Yes, Yang gets a $1 token annual payment he has accepted for years, but that’s because the Internet company which he co-founded already has made him a billionaire. Yang’s stake in Yahoo by some estimates is currently worth $1.5 billion. And Yang isn’t the only Silicon Valley billionaire who work for a $1 salary each year. Apple CEO Steve Jobs and Google co-founders Larry Page and Sergey Brin all do, too.

Also, the Sunnyvale Internet firm handed more money to its top executives than any other Bay Area public company in 2006, according to The San Francisco Chronicle’s annual survey of executive pay at 200 local companies. Yahoo Inc.’s top five executives raked in $135 million in that year (mostly in restricted stock and stock options), though down from $155 million the year before, according to calculations from Equilar, a research firm that specializes in executive compensation.

In fact, the paper says that of the more than 1,000 executives in the survey, four of the seven highest-paid executives worked at Yahoo.

And former Yahoo! chief executive Terry S. Semel, who stepped down in June 2007, got $230.6m in salary and stock gains in 2005.

May 22, 2008 10:36AM

Bankers Cry Uncle

By Elizabeth MacDonald

The world’s leading banks are demanding stock market and accounting regulators relax controversial accounting rules in order to stop the “downward spiral” of huge writedowns during the credit and housing crisis, $335b and counting.

These massive writedowns have led to emergency fundraisings of $260b and garage-sales of assets. The proposals were sent to US and European central banks, governments and accounting watchdogs, the Financial Times reports.

It’s a controversy roiling the stock market and Wall Street, a serious debate I’ve warned you about already in prior blogs. The controversy has to do with mark to market rules, cheekily called “mark to myth” or “mark to make believe” as the rules let bank executives come up with their own internal models to arrive at these valuations for their asset-backed securities, (”The Reality Check That Bounced,” “The Answer to Who’s Next on Wall Street,” and ”What’s Really Rocking the Stock Market“).

The FT says the Institute of International Finance, an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank’s chairman, is promoting a plan that would let financial companies soften the blow of financial crises by valuing illiquid assets using historical, rather than market, prices.

The IIF says: “The writedowns required under current interpretations [of the accounting rules] may be substantially in excess of any actual or reasonably probable loss on many instruments.”

It’s a controversy now on the radar screen of top officials in Congress as well as the Federal Reserve.

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. Federal Reserve Chairman Ben S. Bernanke and Senator Charles Schumer (D-NY) at a Senate hearing several months ago debated the accounting rules as well, (Schumer suggested a six-month grace period on the mark-to-market rules, or use of some kind of moving average price instead, because “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.”)

The IIF plan would also let banks decide whether to hold asset-backed securities for as long as they want, freed from accounting rules that would force the banks to hold them to maturity. Instead, they would be able to book these securities on the balance sheet without taking the hit to profits, and then sell them after two years.

The bankers want the moon here.

I’ve told you already that Merrill Lynch used a neat end run, similar to what these bankers now demand, though the bankers now are clearly asking for more.

The move is perfectly acceptable under US accounting rules, which effectively lets companies bury some losses from their bad asset-backed securities on the balance sheet without taking the hit to profits. Merrill kept a recent writedown down to $6.5b by sluicing $3.1b in net pretax writedowns for securities backed by shaky Alt-a residential mortgages held at its US banks through an obscure financial statement line item called “other comprehensive income.” That $3.1b would have brought the $6.5b up to $9.6b, but here’s the thing. By slotting that amount in this line item, Merrill doesn’t have to book the writedown in earnings. Instead it goes to the balance sheet and hurts book value.

A number of banks are copycatting this move, Bloomberg News says, avoiding a total of $35b in profit hits.

Back to what the IFF bankers want. Senior bankers have long sought a change to the accounting rules, arguing that the requirement to mark the value of assets to the market price even when markets are illiquid or frozen creates a vicious circle of excessive losses, capital depletion and forced asset sales.

So far, US and European accounting standard-setters have not caved in to demands to throttle back on the fair value rules. And while these securities may very well have decent assets tossing off cash flow, the truth is, bankers enjoyed sweet profits–and outsized compensation in many instances–due to these very same rules while the bubble was inflating.

So the question is: How did the rules help create the housing and credit bubble? Are they overstating losses? Is it fair then to stop the rules now?

To be sure, as I’ve already reported, the use of the “mark to market” rules gets even crazier on closer look. I’m going to relay back to you what I’ve already reported to you on this subject.

Companies and their auditors typically use a market index to get values 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, that the houses, still exist?

The ABX is essentially throwing off prices based on perceptions, the perceptions 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.

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 price-tags 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?