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Wednesday, September 19, 2007

MMBS: Mountain-Molehill Befuddlement Syndrome

by Tanta on 9/19/2007 11:30:00 AM

To supplement our regular reporting on MMI (Muddled Metaphor Index), we present our inaugural post on Mountain-Molehill Befuddlement Syndrome. MMBS is characterized by an inability to resist making a front-page story out of anything with 1) "mortgage-backed security" in it plus 2) one quote from some hedge fund guy (whose position is disclosed only in dollars, not in, like, who's getting shorted in the swap market). It's probably incurable, but we fight the good fight here anyway. Call us Quixotic.

Karen Johnson of the Wall Street Journal has a bad case of MMBS:

When fruit-spread purveyor J.M. Smucker Co. started buying mortgage-backed securities in 2004, they seemed like a safe way to diversify some of its investments.

Now, however, that asset class is in a bit of a jam.
Shares of banks and brokerages have fallen sharply since the markets cooled for commercial paper and other securitized debt that might hold mortgage-backed loans. But they aren't the only players with home-loan-related holdings.

In recent years, Smucker joined the ranks of other nonfinancial companies such as Garmin Ltd., Microsoft Corp., Netflix Inc. and Sun Microsystems Inc. by investing in what had been viewed as relatively safe investments that produced slightly better returns than cash and government bonds -- and could be sold quickly if needed. Many of these companies are cash-rich, looking for a secure place to park their millions. And none are expected to cash out any time soon.

The issue for investors is how these companies determine the "fair" value of their mortgage-backed securities in the current environment, and whether they are telling the whole story about how easily these assets can be liquidated -- and for how much.

"It concerns me from the standpoint of transparency, whether the cash stated on the balance sheet is a true representation of the cash available to the company," said Jeffrey Diecidue, a hedge-fund manager at UCA LLC in Short Hills, N.J., who has less than $100 million in assets.
Oh, man, this is just not sounding good. Jelly makers hiding the sticky details of MBS holdings. According to some guy who runs a little bitty hedge fund in "Short Hills."

You might as well get off the edge of your seats here, folks.
The amount of mortgage-backed securities owned by nonfinancial companies as a proportion of their total assets is low, and some, like Smucker, say they invest in only highly rated loans. But in the current environment, just saying investments have high credit ratings gives investors little comfort. As the traditionally staid commercial-paper market has shown recently, even triple-A-rated debt can be backed by subprime loans, causing investors to balk, prices to fall and trading to seize up.

At the end of July, Smucker had $41.5 million in mortgage-backed debt classified as noncurrent marketable securities available for sale, which are assets the company intends to sell for cash if it is needed for future operations. While that debt is just 1.2% of Smucker's total assets, it makes up 22% of the company's total marketable securities and 100% of its noncurrent marketable securities.
Hoooo-eee. $41.5 million. 1.2% of assets. You get bonus points here if you know that "noncurrent" in this context has nothing to do with performance. And double-extra bonus points if you have any idea why the metric of percent of noncurrent marketable securities means anything important, useful, or sinister. If you enjoyed the slide from "investors in Smuckers, Inc." to "investors in MBS," vis-a-vis who is balking about what, you win the whole PBJ.
Other companies with mortgage-backed securities, including Biomet Inc., Microsoft, Novell Inc., Netflix and Sun Microsystems, declined to comment. Semiconductor maker LSI Corp. didn't respond to requests for comment.

John Olson, chief financial officer of memory-chip maker Xilinx Inc., said the company buys only diverse high-grade securities and no collateralized debt obligations, or CDOs, which are debt pools that can carry triple-A ratings while still being backed entirely by subprime debt. "Fortunately, our treasurer was smart enough to know that CDOs aren't always what they say they are," he said. Mortgage-backed securities make up $24.3 million, or 2.5%, of Xilinx's $963.8 million in short-term investments.

Still, complicated investments have hurt other companies in the past. In 1994, for instance, Procter & Gamble Co. sustained heavy losses from derivatives on its balance sheet and sued its financial adviser, Bankers Trust, for selling these complex contracts to the consumer-products company.
So, the CFO guy says, we aren't holding the complicated ones and we aren't holding derivatives of the complicated ones. Therefore the very next paragraph says . . . "still."
For the moment, investors will pretty much have to take companies at their word when they say such mortgage-backed financial instruments are liquid and their stated fair-value estimates are based on market prices. Most nonfinancial companies classify their mortgage-backed securities investments as available for sale, meaning they aren't required to record changes in fair value on the income statement, which is followed closely by investors and analysts.

Instead, changes in fair value of such securities are recorded on the balance sheet in "other comprehensive income," which affects shareholders' equity but is less of a focus for Wall Street. Those disclosures will begin to change next year, when a new accounting rule kicks in for U.S. companies. This rule, which will first be required of companies with financial years beginning after Nov. 15, calls for companies to provide more information about financial instruments for which they apply fair, or market, values.

For investors like Mr. Diecidue, the rule can't come soon enough.

"The current market volatility in connection with these asset-backed securities presents a conundrum to the investors, because it's harder to know the true book value of a company," he says, referring to the measure of a company's assets minus its liabilities.
Well, you know, if you're worried about it, you could get out the back of the envelope and write down 100% of Smuckers' MBS holdings, which would reduce assets by 1.2%. Then you could go back to worrying about somebody who has substantial enough MBS holdings to get your knickers in a twist over.

Or maybe you could ferret out some "news" about corporate balance sheets that is somewhat less mortgage-obsessed? Nah . . .