Coming in the near term, I should have articles on the following:

• The economics of Central Banking (can the Fed go broke?)
• A critique of the Barron’s article on the Ratings Agencies
• The Fundamentals of Market Bottoms (companion to this RealMoney article, The Fundamentals of Market Tops)
• Predicting Consumer Price Inflation — What Works Best?  (Does anything work?)

That’s what is on the current schedule, together with other articles/events in the news flow.  I will be publishing through the so-called holiday season, so you may see some of this on Monday through Wednesday.

Also, in the near term, my left sidebar will include links and the Amazon widgets from my book reviews.

Thanks for reading me.  I really appreciate your patronage of my blog.

I’ve seen a number of articles recently about what dangers the investment banks face from counterparty risk.  Counterparty risk is what happens when an investment bank enters into a derivative transaction with another party (the counterparty), and when the investment bank ends up on the winning side of the trade, the counterparty is unable to make good on the necessary payments to the investment bank.

Think about history here for a moment.  Investment banks do take losses.  We saw that in the past week.  But almost all of that came from their own risk-taking, not from counterparties.  Now think about hedge funds that have gone bust.  What was the final trigger event?  The investment banks moving to foreclose when there was still enough margin to do so.  (LTCM, Granite, Amaranth, Neiderhoffer (how many times?) and more… the investment banks are very good at protecting their own hides.)

I have a few concerns about counterparty risk, but they aren’t big.  I worry more about mispricing within derivative books.  The risks that no natural counterparty wants to bear must be held by a speculator, who gets a bit of a bargain for taking down the risk.   Speculators are usually not thickly capitalized, so the investment banks, while grateful that they got the toxic waste off their books, watches the margin of solvency like a hawk, and more so for larger players.

The record of the investment banks of cutting off leverage to the impaired is pretty good.  There is some modest reason for concern here, but I think the investment banks have more potent means of shooting themselves in the foot.

I’ve never enjoyed surprise lists that much.  The concept is this: name a bunch of things that you think there is a better than 2/3rds chance of occurring that the market seemingly has less than a 1/3rd probability on.  Here are my problems with the concept:

• First, the probabilities are squishy.  Who’s to say what the probability of a given event is?  Even if you have a prediction market going, those are subject to a variety of biases.
•  Second, often the interpretation of whether one is correct or not is fuzzy as well.  Not all of the surprises are sharp events.
• Third, an unlikely event can be more likely than it seems if it is spread across multiple parties, or if there are multiple legs to the prediction.  As an example, a prediction that “a major country will drop its dollar peg in 2008,” should be regarded as a decent probability, if only by accident.
• Finally, I don’t find them easy to make money from.  Many of them are either not very actionable, or my relative payoff from being right versus wrong does not seem to compensate for the large number of times that the conventional wisdom proves correct.

All that said, surprise lists make for excellent journalistic copy because that have many “man bites dog” sound-bites.  That’s why we hear about them, and why they get promoted for publicity purposes.  But as for so many aspects of speaking/writing on investments, it is mostly theater, and shouldn’t be taken too seriously by serious investors.

A few readers asked me if I would review some books dealing with accounting issues. I’m happy to do that. I am not an accounting expert, and certainly not a forensic accountant, but my investing has benefited from being willing to look at the weaknesses in financial statements, and avoid companies where the economic results are likely worse than the accounting statements.

Howard Schilit, in his book, Financial Shenanigans, highlights seven areas where accounting can be fuddled:

1. Recording revenue too soon.
2. Recording bogus revenues.
3. Boosting income with one-time gains.
4. Shifting current expenses to a later period.
5. Failing to record or disclose all liabilities.
6. Shifting current income to a later period.
7. Shifting future expenses to the current period.

There are several common factors at play here.

• Beware of companies where earnings exceed operating cash flows by a wide margin. (1-4)
• Watch revenue recognition policies closely. It is the largest area of financial misstatement.  (1-2)
• Look for assets and liabilities that aren’t on the balance sheet, and avoid companies with hidden liabilities. (5)
• When companies do well, they often hide some of the profitability, and build up a reserve for bad times. This will show up in an excess of cash flows over earnings, so look for companies with strong cash flow.  (6,7)

The book liberally furnishes historical examples of each of the seven main categories for accounting machinations, showing how the troubles could have been seen from documents filed with the SEC in advance of  the accounting troubles that occurred.  Now, aside from point 5, the other six points boil down to a simple rule: watch operating cash flow versus earnings.  I wouldn’t say that the cash flow statement never lies, but investors pay more attention to the income statement and balance sheet.  Aside from outright fraud, ordinary deceivers can manipulate one statement, and clever deceivers can manipulate two.  To do three, it takes fraud.

Now, suppose you have found a company where the operating cash flows are weak relative to reported earnings.  That is where this book can help, because it will give you ways to analyze whether the difference is accounting distortion or not.  For those of us who use quantitative methods to aid our investing, this is particularly important, because many companies are seemingly cheap on GAAP book and earnings, but a review of the cash flow statement will often highlight the troubles.

The book is an easy read, and does not require detailed knowledge of accounting in order to get value out of it.  For fundamental investors, I recommend this book, with the proviso that it only works with non-financial companies.  Financial companies are more complex (they are all accruals — the cash flow statement is not very useful), and can’t easily be analyzed for earnings quality from looking at the financial statements alone.

Full disclosure: I get a pittance from each book sold through the link listed above.