Accounting adds to mortgage confusion

By DAVID MOON, Moon Capital Management.
December 16, 2007

A popular topic of conversation these days is the turmoil in the banking and financial-services stocks. A lot of people around here know that First Horizon (parent company of First Tennessee Bank and some other financial-services companies) has declined 53 percent in the last ten months.

That may be a little more extreme than some of its regional banking brethren, but First Horizon is hardly alone. SunTrust is down 25 percent. Regions and BB&T are off 39% and 18%, respectively.

It's not just regional banks. Zurich-based brokerage giant UBS has been under financial pressure as a result of a combined $14.4 billion in write-downs in the third and fourth quarters. To shore up its finances, it received $11.5 billion in new investment capital last week, $1.8 billion from an unnamed Middle East investor and the other $9.7 billion from the investment arm of the government of Singapore.

How could things get this bad this quickly?

How did a ship the size of the Titanic sink so quickly? It didn't. It took on water for hours while Leonardo DiCaprio and that other guy chased Kate Winslet around the vessel.

I'm not suggesting any of the aforementioned financial firms are experiencing Titanic-esque difficulties. But like water pouring into the hull of a mighty ship, when bad loans and bad borrowers collide, the consequences are predictable, even if not immediate.

One of the many problems, however, is that generally accepted accounting principles often fail to accurately describe an economic collision.

In the last 12 months, First Horizon's reported earnings have declined 69 percent.

That's true in accounting sense, but not in economic reality.

Each time a bank makes a loan it sets aside a reserve for an amount it expects not to collect on the loan. Borrowers are seldom thoughtful enough to inform you on the front end if they plan to default on their loans. The lender has to guess...er...estimate.

For years First Horizon guessed wrong.

In 2005, First Horizon increased its loans by more than $4 billion and its allowance for loan losses by $32 million. But it actually wrote off $37 million in bad loans. In 2006, it wrote off $55 million.

Had the company been reserving an amount that would have adequately covered its eventual loan losses, it would have reported lower earnings in those years.

They didn't break any laws; it was all in complete accordance with the accounting rules.

If you're loaning more money to people whose financial statements suggest they can't pay it back - even if real estate agents say otherwise - believe the financial statements.

There is a bright side. If companies were overstating their real earnings before the mortgage market decline, then their earnings really haven't declined as much as it first appears; that's because they weren't as high as they originally appeared several years ago.

Confused? I'm afraid that might not be a complete accident.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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