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Imagine this: Your boss pats you on the back, congratulates you and remarks that, based on that huge last-minute sale you made, your year-end bonus will be the highest in company history! What your boss doesn’t know is that instead of your company borrowing money from the bank on its line of credit, your big “sale” is actually an arrangement you made to have the bank buy a bunch of widgets now and hold them in a warehouse until the end of January, at which time your company will buy them back. Should you still receive your bonus? Will your company’s stock price increase? If you worked for Lehman Bros. a couple of years ago, then perhaps the answer to these questions would be yes.

Lehman buzz is dominating the airwaves yet again nearly 18 months after the company’s spectacular collapse which arguably precipitated the stock market crash of 2008-2009. The current topic du jour stems from how Lehman may have parked “toxic” assets off balance sheet only to buy them back later. In other words, they sold bundles of mortgages
at the end of the year to make their balance sheet appear stronger, then bought them back early the next year. Essentially, they engineered a clever accounting maneuver termed Repo 105 to make their numbers appear stronger.

Over the next few months, accounting and legal experts will take a closer look at this practice to determine whether this was illegal or just highly unethical. The bigger issue, however, is why is this only surfacing now? Where were the auditors, regulators and investors when Lehman was hiding its debt? At the very least, a simple question posed on a Lehman conference call pertaining to Repo 105 may have saved billions of dollars in investor wealth and thousands of jobs. Did we learn nothing from Enron?

As the nation slips deeper into the depths of economic turmoil, virtually every media pundit and politician seems to have a theory as to why this happened and who is responsible. The newsrooms and congressional chambers are filled with banter about collateralized debt obligations, mark-to-market accounting and swap spreads. The problem is that invoking these terms in the context of such discussions is not the same as understanding them. As evidenced by recent congressional hearings, it is clear that our nation’s leaders have less than a basic understanding of finance and accounting. If they are truly committed to solving these problems, they will have to educate themselves as quickly as possible.

In the last several months, we have witnessed the former and current heads of the Federal Reserve Bank, US Treasury and some of the largest financial institutions testify before congress. In the standard questioning process, there seems to be a recurring theme. A question is asked by a member of congress that relates to some aspect of the financial crisis and as the response is offered, more confusion seems to arise. In a recent discussion between Fed Chairman Bernanke and a notable congressional leader, Mr. Bernanke was lambasted for injecting capital into several of our nation’s largest banks. The members of congress were irate over the fact that taxpayers are paying to bailout these institutions. Mr. Bernanke tried to explain that this was a capital injection and not an expenditure. Its intent was to solidify the company’s balance sheet and allow them to lend money. Exasperated by the puzzled looks from the congressional leaders, he sought to clarify the difference between capital injections and expenditures, something that fell on deaf ears. Former Fed chairman Greenspan also encountered widespread consternation recently when attempting to explain the complexities of derivative structures and their role in the crisis. Recognizing the daunting nature of this task, he too conceded limited understanding of these structures.

My professional experiences have taught me that even some of the most accomplished professionals have difficulty distinguishing between income and cash flow let alone recognizing derivative structures. Our leaders in Washington need to acknowledge their deficiencies in this area and do their best to correct them. Given the magnitude of the current crisis and the role our leaders play in maneuvering it, perhaps it is time we consider devoting a portion of the stimulus package to financial education for our leaders. We at Telestrat are prepared to heed the call.

Reuben Advani is a former investment banker, founder of Telestrat Education and author of The Wall Street MBA (McGraw-Hill). 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) inAccounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars inUnderstanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

There is a great deal of discussion and speculation about the current stock market. “Where is it headed?” is the question most of us are asking. Well, don’t look to me for precise answers because if I knew, I wouldn’t be writing this entry or doing anything work related for that matter. In fact, the only thing I do know for certain is that no one can predict what will happen in the stock market at this point. Now, more than ever, this holds true.

In the last few years, analysts and investors were able to offer substantive predictions with relative ease. Why? Economic growth was strong, consistent and predictable. Based on macroeconomic data, companies could effectively predict demand increases for their products and services. And with solid demand forecasts, costs and expenses could be budgeted as well. Put them all together and what you have is a well defined profit forecast for the next year.

With credible profit projections, a company’s stock price generally adjusts to fall in line with the industry average PE multiple (price to earnings). The PE multiple for a company is its stock price divided by its earnings per share. PE multiples for an industry are based on an average of PE multiples for all companies in the industry. When a company offers a projected earnings number for the next year, the company’s stock price should adjust to align with the industry average multiple. So in theory, this allows one to not only predict where a company’s stock will be trading at in the future but where the entire market will be trading at. This is because the market is an aggregation of individual stocks. Consider the following example:

Company ABC projects its earnings for 2009 to be $2 per share. If the industry average PE multiple is 15, then ABC’s stock price should reach $30 by year end in order for it to be in line with the industry. So if the current stock price is $20, we can predict a 50 percent increase in stock price over the next year.

In 2009, stock market predictions will be as accurate as those pertaining to a Vegas craps table. There are two reasons for this. First, companies are having a difficult time projecting their earnings. Given that we will likely remain in the throes of the Great Recession, it will be difficult to determine how consumer and corporate spending patterns will react. This will make it challenging to forecast earnings and, consequently, stock prices. Second, investors large and small have been scared away by the recent market tumult and may very likely keep their cash tucked securely under the mattress. It’s unclear when their confidence will be restored and more specifically, when their funds will return to the market.

What we are facing is a paradigm unlike any we have seen in a very long time, if ever. Therefore my prediction for the stock market in 2009 is as follows: it may go up or it may go down.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues. 

As I write this, stock markets around the world are teetering on the verge of major collapse. What only a few weeks ago was a topic of interest for Wall Street bankers and academics has become a global contagion affecting everyone. In previous blog postings, I discussed several topics including mark-to-market accounting and short selling, each of which has played a role in this crisis. But what is now at the forefront of both the diagnosis and treatment of this malady stems from simple human psychology: confidence. Few deny that the overriding lack of confidence in our financial system and leaders exacerbates the current economic crisis. But how has this lack of confidence brought us to where we are today?

Let’s recap what we know so far: banks loaned money to borrowers under very aggressive terms predicated on the notion that housing prices always go up. New home construction reached unprecedented levels causing an excess of inventory. As home values started to decline due to this buildup of inventory, home values started to decline. This created problems for home owners who financed their mortgages with nominal down payments. As interest rates started to rise, it became even more difficult to make the required mortgage payments. At this point, confidence started to erode in the housing market driving down home values in most markets.

What about the banks? With the banks buying and selling complex financial instruments that are based on home prices, concerns started to mount that perhaps the banks would soon feel the pressures of the housing market decline. Sure enough, thanks in part to an obscure accounting rule known as FAS 157, major financial institutions were forced to estimate the loss of value on these financial instruments and record any drop as a charge against earnings. This raised bigger questions: how were they determining these values and more importantly, were they underestimating them. This created a further crisis of confidence among the clients of these banks as well as the investors in these banks. As clients started to close accounts, investors started to sell shares of stock in these companies. These factors worked in tandem to literally collapse several major banks in a matter of days as they no longer had the ability to meet their required capital obligations.

With housing collapsing and the banks collapsing, equity investors grew fearful that businesses would no longer have access to capital. Furthermore, consumers would curb spending out of fear that their most valued tangible asset, their home, wasn’t worth what they thought it was. And more importantly, businesses in turn would curb spending out of fear that consumers would buy few products. Most of all, businesses would have difficulty gaining access to capital due to problems with the banks. All of this ultimately stems from a lack of confidence in the spending ability of institutions as well as individuals.

So here we are in the midst of one major crisis of confidence. How do we fix it? Simple, restore confidence. To do that, the government (Congress, the Treasury and the Fed) has:

1.) passed the $700 billion rescue package which will, among other things, allow financial institutions to sell their distressed mortgage-based instruments to the government and
2.) agreed to loan money directly to companies by purchasing their commercial paper.

Unfortunately, these steps have done little but further undermine confidence in our financial system and leaders. What happens next? Stay tuned. I have a feeling another blog entry will be posted sooner rather than later.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.

One week ago, the stock market surged, Wall Street was dominated by four large investment banks, and the largest insurance company in the world was enjoying a spike in stock price.

What a difference a week makes. One week later, the market saw its worst day in eight years, Wall Street is left with only two stand-alone investment banks, and the once largest insurance company in the world is fighting for its life. If you fell asleep at your desk last week and just awoke, I’ve got some news for you: the world has changed.

So what happened? Well among other things, companies have now been thrown to the market wolves, or bears in this case, and left to fend for themselves. Essentially, short sellers have taken hold of financials and continue to drive the market lower. How did so few become so powerful? Let’s consider the dynamics of short selling.

Short sellers make a bet that the price of a company’s stock will fall. To do that, they borrow shares of a traded stock (usually held by a brokerage house), and sell it with the intent of buying it back at a lower price. When the price drops, the short seller can buy the stock back and earn a profit on the difference between the sale price and the purchase price. Of course, if the price of the stock goes up, the short seller may have to close the position by buying shares of the stock to replace the borrowed shares at a higher price thus recognizing a loss. For example, a short seller sells shares of Lehman, the most recent market casualty, short at $4 per share. When the share drops to $.10 after the bank declares bankruptcy, the short-seller buys the shares to replace the borrowed ones at $.10 earning a $3.90 profit. Of course, had the stock gone up to say $10, the short seller may close the position by purchasing the shares at that price suffering a $6 loss.

Short-sellers are as much a part of an efficient market as the people who buy and hold shares of stock for an extended period of time. Unfortunately, the rules governing short-selling allow for short-sellers to push a stock to unprecedented lows in a very short period of time. This has created two contentious points:

1.)   The SEC’s standards for enforcement of “naked” short-selling are lax. Naked short selling means someone can sell short without even borrowing shares. In theory, it can allow a large short sale order to be placed which in and of itself, could push the stock price lower. As more, larger sell orders are placed, a stock price will collapse.

2.)   The uptick rule required that a short sale must be entered at a price higher than the last trade. The idea behind this is that it prevents the compounding downward pressure of progressively lower sell orders. The uptick rule was eliminated in 2007.

Short selling adversaries argue that there is a lack of regulation allowing for short sellers to essentially gang up and beat a stock down to nothing. Unfortunately, a falling stock price, while a technical problem, can easily become a fundamental problem in sectors such as financial services and insurance. In these sectors, a drop in stock price can trigger a ratings downgrade which can prompt liquidity concerns. If these issues are not checked, a complete collapse of a company can occur. 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.