Saturday, February 21, 2009

Follow the Cash

Examining the cash flows of a business helps to cut through the noise. It's easy for accounting to distract from the crucial economic characteristics of a great business. As an example, Buffett in his 1983 letter to shareholders, explains the difference between economic and accounting Goodwill.

With this in mind, I'd like to consider something Dick Bove said Friday in an interview on CNBC that seemed to get very little attention.

In the interview, Dick Bove states that banks do not have to be nationalized and if people would focus on cash flows in the US banking industry they would understand that. Bove goes on to make the point that the pretax cash flows of the US banking industry were actually $ 59 billion in the most recent quarter....but this cash earning power was reported as only $ 1.5 billion of pretax operating earnings on an GAAP accounting basis. 

First of all, I think most industries would like to earn that much cash in a good year (never mind in such a tough environment). Naturally, it is fair game to challenge Dick Bove or any analyst on such an important number. I personally have a similar view. Banks are going into a very difficult period but the largely incorrect perception of imminent trouble has turned a serious but manageable situation into a crisis. Banks will need some time for their cash flows to absorb growing credit losses. Those huge cash flows over time and regulatory forbearance can fix most of the banks (the US auto industry has no such luxury). The situation is not unmanageable.

Yet.

The term credit comes from the Latin credere meaning "to trust or believe". Allowing the belief that banks are going over a cliff to persist when they are not does real franchise damage to the banks and, most importantly, material economic damage to the US.

We are all participants in a potentially self-fulfilling but largely unnecessary outcome.

Finally, mark-to-market is only a part of this problem but it does make the situation worse. In some sense, this is more about the inherent limitations of accounting in my view.

Always...follow the cash.

Adam

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