Accounting vs. Reality
You know what makes me nervous? When everybody is saying don’t be nervous…
And that’s where we are in the aftermath of Silicon Valley Bank failure. Yes, depositors have been made whole, equity and bond holders are mostly wiped out. And all the analysts, strategists and economists are out there saying don’t worry, there’s little risk of widespread problems in the banking system…
As if they really know.
But as the esteemed Barry Ritholz wrote this morning “…lots of people all talking their books tends to provide little illumination.”
So, with that in mind…
We all know that companies use all kinds of accounting gimmicks to make their earnings numbers look good…
We see companies report what’s called “Non-GAAP earnings per share” at the end of every quarter. GAAP stands for “generally accepted accounting principles,” and it is common practice for companies to leave one-time charges like, say, restructuring costs, out of the formula for calculating earnings.
For instance, EBITDA is a pretty common form of Non-GAAP earnings calculation. EBITDA is an acronym for “earnings before interest, taxes, depreciation and amortization.” So when a company offers up an EBITDA earnings per share number, it just means they are leaving out items like the income tax they will pay in order to focus on how the business is growing.
It might sound sneaky, but think about it in terms of your own salary (if you haven’t retired). If somebody asks you what you make a year, you’ll probably say the gross number, before taxes and insurance. If you say you make $100 grand a year before taxes instead of the after-tax number of $75 grand (or whatever), you’re technically reporting a Non-GAAP revenue number…
Everyone understands this. We all have a tax burden, and we know that a reported $100k salary is not the same thing as take-home pay. It’s a convention that we use for comparison’s sake…
But at the same time, the $25K difference between salary and take-home pay has a big implication for a standard of living…
Don’t worry: I’m not about go all “forensic accountant” on you. Most of the time, these accounting gimmicks don’t have much real-world impact. That is to say, whether or not Apple (NASDAQ: AAPL) includes the taxes it pays in its earnings per share number is kind of irrelevant. What we’re most concerned with is how many iPhones Apple sells, and how much money it’s making on those sales.
But there are times when accounting practices really matter. And in fact, an accounting practice called “mark to market” is a big reason that Silicon Investment Bank just failed…
Accounting Reality
On Friday, we talked a little bit about Tier One Capital at banks. The gist of it is that banks are required to keep 6% of account holders money in very safe “cash equivalent” investments like Treasury bonds. The point of keeping money in “cash equivalents” is so the bank can quickly and easily come up with cash for account holder withdrawals and whatever other payment obligations the bank has. And most big banks keep their Tier One Capital higher – for Bank of America (NYSE: BAC) it’s more like 12%.
But the thing is, banks aren’t required to constantly change the value of all of their “cash equivalent” holdings to reflect those holdings’ current market value. Instead of “marking them to market” (that is, constantly changing their value to reflect the current market value), banks can report the value of a portion of their cash equivalent bond holdings as if they will hold them until they mature…
Because when you buy a bond, say a 5 year Treasury bond, you will get all your money back in 5 years, plus whatever the interest rate is. So, if you bought a Treasury bond for $100, does it really matter if the market value of that bond falls to $90 one day if you’re not selling it and will get your $100 back when the bond matures?
Not really…
But if you do have to sell when the value is lower, well then you might have a problem…
And that’s what happened to Silicon Investment Bank. Simply put: the Fed’s interest rates have lowered the value of Treasury bonds. And the accounting reality for Silicon Investment Bank was that it had to sell assets at a loss and couldn’t raise as much cash as it needed.
Questions that Need Answers
One question we might ask is: how come nobody knew that Silicon Investment Bank might be in a tight spot?
Well, it seems to me that at least some people did know. The CFO of Silicon Investment Bank sold 575,000 shares at $287 a share on February 2. And the CEO sold 3.5 million shares of his company’s stock on the same day.
Of course corporate officers sell stock from time to time. But the fact that neither the CFO or CEO had sold any significant amount of their stock over the last two years and then suddenly cashed out 6 weeks before the bank went belly up is…interesting.
And the fact that the bank paid out bonuses just hours before the regulators shut it all down is also…interesting.
These two items haven’t been discussed much in the Silicon Investment Bank news so far. It will be interesting to see if insiders bailing and getting paid as the bank circled the drain gets any more attention…
Another question we discussed on Friday was whether this bank failure, and the failure of Signature Bank (NASDAQ: SBNY), will have an impact on the Fed’s rate hikes. Well, early last week, the odds for a 50 basis point hike at the Fed meeting next week was 80%. Today, Goldman Sachs is predicting the Fed won’t hike rates at all.
That’s a pretty significant “about face” and it begs the final question: is the Fed shifting into panic mode about the impact that higher interest rates are having on the economy?
It sure looks like it. The Fed is flip-flopping…
Back in January, the Fed only delivered a 25 basis point hike and took a “mission accomplished” theme in its statement.
Then after inflation data jumped higher Fed Chair Powell had to go back to the tough talk on rates during his Congressional testimony last week.
But now, less than a week after that tough talk, there may be no hike at all at the March 21-22 Fed meeting.
I’d love to tell you to back up the truck on Bank of America (NYSE: BAC) stock right here, as it trades below $30 a share. But the simple fact is: if inflation data later this week comes in hotter than expected, it will be painfully obvious that the Fed is completely out of control.
And somehow, I don’t think the market is gonna like that very much…
That’s it for me today, take care and I’ll talk to you on Wednesday…
Briton Ryle
Chief Investment Strategist
Pro Trader Today
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