Saturday, November 3, 2007

Do you want to understand what's driving all the write-offs with SIVs, Conduits, etc?

I think everyone reading this has heard about the turmoil in the credit markets that became incredibly obvious this summer.

Now we're seeing a domino effect as fears run rampant.

While I was well aware of Special Purpose Entities (SPEs) and other off-balance sheet structures generally, it wasn't until this summer that I heard of Structured Investment Vehicles (SIVs). A SIV is a special type of SPE (aren't acronyms great?).

Recently we heard that some banks, with the support of the Treasury Department, were creating MLEC (a sort of "Super-SIV"), however no specifics were ever announced (and may not have been agreed). Of course this didn't stop bloggers and columnists from coming out with their opinions on it (mostly negative). I merely voiced the opinion that I didn't see how it would work unless there were specific guaranties made by the institutions creating the entity. I am in favor of giving market players an opportunity to figure out what they own so they can clean up the mess.

I have some specific comments to make about one recent column, but more on that later.

Merrill Lynch shocked the market with $8.4 billion in write-downs last week, $4.9 million more than they had estimated on October 5th. Why did this happen?

Rachel Beck of AP wrote an article today that may answer that question.

On October 3rd, the Center for Audit Quality, an organization founded early this year by the American Institute of Certified Public Accountants (I earned my CPA, but am not presently a member) and eight audit firms, issued three white papers. These were Measurements of Fair Value in Illiquid (or Less Liquid) Markets, Consolidation of Commercial Paper Conduits, and Accounting for Underwriting and Loan Commitments.

These white papers, which I am in the process of reading (but which are described by Fitch Ratings in a very timely report), provide guidance to auditors on how to interpret recent, and not so recent, statements and interpretations by the Financial Standards Accounting Board and the AICPA, principally FASB-157, FIN 46(R), and CON 7 . Fitch also notes that IAS-39, issued by the International Accounting Standards Board, is being employed by some financial institutions.

If you have trouble sleeping, I highly recommend that you read the FASB documents. It might give you nightmares, but you might understand what the financial institutions are actually saying in their filings (a lot of this is relatively arcane, but the original pronouncements can provide a sort of Rosetta Stone).

While quarterly reports are not audited, it is apparent that the new guidance led several institutions, including Merrill Lynch, to make more conservative estimates in anticipation of the year end audit. It is highly likely, in my opinion, that when Merrill made their original estimates they had not yet read (and/or implemented) the October 3rd guidance.

In a way, it appears that E. Stanley O'Neal lost his job over the timing of a change made by a new audit industry governing body. Of course the magnitude of the losses might have created the same environment, even if they had been part of the pre-announcement. Reports, however, seem to point to concerns due to the huge difference from the initial estimate within such a short period of time.

Oh well. He got a good severance package.

I'm really looking forward to reading/skimming these documents together with the SEC filings to get a better picture of actual exposures (at least what is disclosed).

I figured it would be better to provide this information now and give readers a chance to make their own assessments rather than waiting for me to read all that material.

Enjoy. If nothing else, I highly recommend that you read Rachel Beck's article and the Fitch report.

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