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By Martin Hutchinson
Director of Global Investing Research
The $8.4 billion write-down announced by Merrill Lynch & Co. Inc. (MER) last week was just the latest in a series of similar revelations by Bank of America Corp. (BAC), Citigroup Inc. (C), The Bear Stearns Cos. (BSC) and Lehman Brothers Holdings Inc. (LEH). And it underscores the key challenge investors continue to face: You don't know what a company's assets are really worth, so a company's portfolio can explode into a mushroom cloud of red ink at any given time.
Even worse, the problem is not limited to the banks and brokerages that have already suffered explosive write-downs. It could well include the top-drawer institution, Goldman Sachs Group Inc. (GS), which hasn't yet reported a big write-down. Later on, I'll tell you why.
Until Wall Street cleans up its act in the risk-management area, there's really only one smart thing to do: Stay as far away from the sector as possible - perhaps even seeking shelter in the Wall-Street-proof emerging markets.
Accounting for Future Assets
When the first round of write-offs came out, investors figured that one bad quarter would put the subprime mortgage problem in the rearview mirror, and allow Wall Street to get back down to business - making its routinely obscene profits and pulling down its even-more-stunning year-end bonuses. After all, modern financial reporting techniques forced banks to write their securities portfolios to market price, so if the market dropped the loss amounts should be clear. Furthermore, the new lower market price should reflect all the additional risks that had been uncovered, so there should be no reason to expect additional bad news.
Case closed. Right?
For small players, this is correct. Japan's Nomura Securities Inc. (NMR) exited the U.S. mortgage business altogether, reducing its exposure from $2.4 billion (266 billion yen) in June to $120 million (14 billion yen) in mid-October, of which only $1 million is still related to subprime mortgages.
By writing off $610 million (73 billion yen), and recording a third-quarter loss, Nomura put its U.S. mortgage woes behind it, and can now focus on its very attractive core business of being the largest investment bank in the world's second-largest market - the rapidly expanding economy of Japan.
For larger players, the solution isn't quite so clear. For one thing, they can't maneuver as quickly as Nomura because the Big Boys still have large holdings of financial rubbish on their balance sheets. That's not easy to purge.
Starting Nov. 15, we will have a new arrow in our quiver to help us divine just how financial toxic waste a company is holding. The new accounting rule, Financial Accounting Statement 159 (SFAS 159), requires banks to divide their tradable assets into three "levels," according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme are Level 3 assets, which have only unobservable inputs to measure value, meaning they must be valued by the bank's own proprietary models.
The problem with Level 3 asset pricing is quite obvious. Who writes the models that are used to value the assets: Bank employees, of course, the same bozos that get paid huge profits if the bank's quarterly profits rise. In the old days, assets were recorded on the books at historical cost, and their value was only changed if something bad happened, in which case the values were either written down or written off.
In today's fine world, the values can actually be written up if their "market value" increases, even though that market value is determined only from a model that bonus-receiving employees have designed. In a bull market, of course, when assets generally go up in value, and there's lots of money sloshing around, optimism naturally takes over and reported book values soar. In a down market, however, a bank with lots of Level 3 assets will give its shareholders a series of nasty surprises, or - in extreme cases - go bust.
I hate to depress you further about our finest financial brains, but this isn't a small problem. Wall Street doesn't have to report these numbers until its fiscal years starting after Nov. 15; so few banks have yet disclosed the amount of Level 3 assets in their balance sheet.
I would think they would be forced to do so in their first quarter results, typically the period that ends either Feb. 28 or March 31. However, Goldman Sachs, in the midst of preening itself about its remarkable write-off-free third quarter, disclosed its Level 3 assets: $72 billion. True that's only 8% of Goldman's assets. But it is twice the investment bank's total capital of $36 billion.
Do you see where I'm headed with this? Not all Goldman Sachs' Level 3 assets are subprime mortgages, of course. But not all Nomura's mortgage assets were subprime mortgages, either. In fact, it was only 27%. Yet Nomura, to exit the business, wrote off 28% of mortgage assets, more than its entire subprime exposure. If Goldman Sachs is forced into pessimism, it too may have to write off 28% of the value of Level 3 assets, or even more. That would give Goldman a write-off of slightly more than $20 billion - or more than half its capital. Of course the Fed and all the other big banks would rally ‘round - to avoid a banking-system collapse - meaning Goldman would probably survive. But you wouldn't want to be a shareholder.
As other banking firms disclose their Level 3 assets, compare the total to the bank's asset figures. Banks with Level 3 assets that are 50% of capital and lower are probably sound. Any higher and it's probably time to sell. [At Goldman, Level 3 assets are 200% of capital].
Let Wall Street have its fantasies of wealth and sudden unexplained collapses, and put your money in markets and in businesses that don't have the right to "invent" values for their asset portfolios. That's true of the emerging markets, for instance, and especially those developing economies that are growing rapidly and that are highly liquid such as Korea and Taiwan, just to name a few. And in terms of developed markets that share the same fine financial characteristics, consider Nomura's home market of Japan.
Profit Plays to Make
Indeed, if you want to be invested in financial services - and you should be - give Nomura a close look. Look also at Korea's largest financial institution, Kookmin Bank (KB), which trades on the New York Stock Exchange as an American Depository Receipt (ADR). If you aren't so keen on financial services, but want to benefit from economic growth that's relatively untouched by Wall Street's machinations, consider an exchange-traded fund (ETF), or a similar index fund for an economy that specializes more in high-tech than finance, such as the iShares MSCI Taiwan index (EWT).
The Taiwan economy includes such emerging high-tech stalwarts as Acer Inc., which just passed the Lenovo Group Ltd. (LNVGY) to become the world's No. 3 personal computer vendor. It is also home to Hon Hai Precision Industry Co. Ltd., the world's No. 1 contract-manufacturer of consumer-electronics products, and the company that makes the Apple Inc. iPhone (AAPL), motherboards for Intel Corp. (INTC), and all three of the rivalling computer gaming systems now duking it out in the world markets. Business Week has labelled Hon Hai as an "earnings machine." But because of restrictive Securities and Exchange Commission rules, the only way U.S. investors can buy into Hon Hai is through such vehicles as this ETF.
Not a bad move. You access greater growth than in the slumping U.S. market, earning profits from faster-growing companies. You'll sleep better. And your early morning breakfast or daily stop at Starbucks won't be ruined after you read of some new, and wholly unexpected write-offs in banks in which you're a shareholder.
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