Security Analysis and Business Valuation on Wall Street,: A ... - lib

Financial Industry Stocks 297Above all, the analyst remembers that financial assets are contractual in nature.Contracts, in the U.S. <strong>and</strong> elsewhere, are rarely 100 percent enforceable according totheir terms. Thus, when a corporation stops repaying a $100 million loan or bond,the foreclosure process doesn’t begin immediately. Rather, this nonpayment is thestart of a negotiation. Similarly, a property <strong>and</strong> casualty insurer is circumspect inhonoring a large claim. The firm defers payment until it investigates the situation,<strong>and</strong> it may contest the size <strong>and</strong> validity of the claim, depending on its interpretationof the policy. The analyst acknowledges firstly that financial assets are not governedby an absolutist legal framework.Furthermore, the economic value of financial assets—whether they are bonds,stocks, or derivatives—is subject to systematic change. Bond prices are directly influencedby movements in interest rates, which impact common stock values also.Derivative prices exaggerate the movements of the underlying security or commodity.The historical accounting presentation may not accurately reflect such changesin economic value, <strong>and</strong> the accounting values (supplied every three months) may beout-of-date when provided for public consumption. By way of example, in the threemonths between September <strong>and</strong> December 2008, the value of State Street Bank’ssecurities portfolio dropped $5 billion.As noted earlier, the valuation of many financial assets has a high degree ofsubjectivity. To reduce the leeway of financial statement preparers, the federal government<strong>and</strong> the FASB developed a three-tier methodology by which securities canbe categorized <strong>and</strong> valued. Even so, the valuation of thinly traded assets <strong>and</strong> privatelyplaced securities remains highly judgmental. For example, in November 2008,private equity firms reported their interests in Harrah’s Entertainment, a faltering$17 billion LBO, at anywhere between 25 <strong>and</strong> 75 percent of original cost. All ofthese firms had access to the same public <strong>and</strong> private information.Independent auditors are not expert in underst<strong>and</strong>ing the nuances of complex securities<strong>and</strong> derivatives, <strong>and</strong> most audit clients complain about the cost of third-partyappraisers so the auditors are reluctant to use them. Thus, management flexibilityin defining operating results is alive <strong>and</strong> well in the financial sector. The securitiesanalyst is alert to the possibility of inflated asset valuations, as well as the likelihoodof deflated bad loan estimates or faulty insurance underwritings.Another issue to consider is the sheer number of loans, contracts, <strong>and</strong> investmentsowned by a sizable institution. Outside auditors are in the spot-check business;they can’t review every document. Internal risk managers, meanwhile, lack the resourcesto verify every trade. A simple, five-page derivative contract can fall throughthe cracks <strong>and</strong> cost an institution millions. Modern risk management systems relyheavily on business unit managers to self-assess potential problem areas, <strong>and</strong> that isa weakness in the framework, according to Dominiek Vangaever, risk adviser to theInter-American Development Bank: “The system is so complex, <strong>and</strong> that makes ithard for someone on the outside to verify that no mistakes have been made.”In sum, the daisy chain of paper shuffling, the complicated nature of legal contracts,the inherent uncertainty attached to financial asset values, <strong>and</strong> the quickmanner in which large sums of money change h<strong>and</strong>s make the financial industry afertile area for misstatements, promoters, <strong>and</strong> charlatans. Most publicly traded firmsuphold reasonable st<strong>and</strong>ards of operation, but the experienced analyst guards againstthe disreputable managers who take advantage of the weak links in the reportingsystem.