Shortly after the conclusion of the recent G-7 meeting, intelligence agencies belonging to Western governments were ordered to use their slush funds held in secret locations to shore up stock prices globally to divert the attention and wrath of urban consumers from the rising food prices, and to shore up the global financial system with higher asset prices. By the end of last week, they had succeeded in the short term although they might have gone a bit overboard in pushing up the Google stock by 21%, or $96, in a single day. Sounds far-fetched? Perhaps, or perhaps not. I just thought I would emulate American bankers and write down my credibility capital as quickly as they write down their moral and financial capital. I guess I am clumsier in doing so.
But, bankers are continuing to harbour the fond hope that they could lie their way through the crisis even while raising capital to pay for the mistakes made through earlier lying. JPMorgan’s first quarter earnings met expectations thanks in no small measure to the one-off gains made from the initial public offering of Visa shares and a write-back of “gains” from the declining value of debt issued around $600 million. The latter needs explanation.
Usually, prudent and conservative accounting principles require that assets are valued at cost or market, whichever is lower. Liabilities should be valued at cost or market, whichever is higher. American GAAP allows companies to treat the erosion in market value of debt issued by them as “revenues”! Among other reasons, debt drops in price because the perceived risk of repayment rises. But, American accounting principles allow deterioration in debt value to be counted as revenue. It is also legally flawed since the debt cannot be repaid at the market price but at par value only. Yet, in recent times, most American financial institutions have met or exceeded earnings expectations using this source of revenue.
On top of that, the bank, shortly after the conference on first quarter earnings, came up with an announcement for $6 billion of preferential share issue that raised more questions than answers. There is an elegant dissection of this issue by Felix Salmon on the “Market Movers” blog (www.portfolio.com/views/blogs/market-movers/2008/04/17/jp-morgan-6-billion-capital-raising-is-routine). Of course, Standard and Poor’s downgraded the sovereign credit rating of Iceland because its commercial banks would have difficulty funding their maturing obligations. Iceland does not have a credit rating agency that could reciprocate the courtesy to the United States of America.
Citibank announced results for the first quarter showing $5.1 billion of losses. It wrote off assets worth a little more than $15.1 billion spread across many business divisions. Again, Felix Salmon digs deeper to infer the value that the bank had assigned to the Auction Rate Securities (ARS) that were supposed to be as riskless as cash. It looks like the bank has valued them at 20% discount. Just as well that the New York state attorney general has ordered an investigation into the sale of auction rate securities. Readers wanting to understand what ARS is all about could visit Wikipedia.
Then came the revelation that banks providing quotes to the British Bankers’ Association (BBA) on the interbank offer rate were under-reporting their true costs of funding lest it revealed their desperation and sickness. BBA warned that under-reporting (lying) banks would be banned from providing quotes. At the end of the week, the spread between the yield on the US dollar Libor Future and the Federal Funds rate for December 2008 jumped to 91.5 from 58.5 basis points on 11 April. The spread between the spot 90-day USD Libor rate and the 90-day American treasury bill rate has also jumped from 1.32% to 1.56% in two weeks. These higher spreads are indicative of the risk that financial institutions perceive in lending to each other. They should know.
Prices of commodities are rising relentlessly. Data up to February reveal that China continues to import steadily rising quantities of refined copper and copper alloys, iron ores and concentrate, and crude oil. The anecdotal survey of economic conditions in the US released two weeks before the Federal Reserve meets to set monetary policy shows that most American enterprises, on balance, find input costs rising faster than output prices, squeezing margins.
It is in this milieu that equity investors in the US believe that financials are unjustifiably oversold and commodities are unjustifiably overbought. It is rather consistent that in today’s make-believe world, greed keeps going up even as trust and reliability keep going down. Just as the phoney housing boom did, this too shall end in tears. Smart investors know what to do with pyrrhic rallies.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org