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Presto, Change-o, Where'd the Credit Crisis Go?

Nobody likes to beat a dead horse, and by all accounts, MBIA (NYSE: MBI  ) qualifies as a dead horse. Nonetheless, its latest gimmick deserves as much finger wagging as any of its other recent results.

On Monday, when MBIA announced a $2.41 billion loss, management came up with a fascinating statistic. Its book value per share, despite shares trading below $10, might actually be as high as $42!

Not so fast
The $42 per share figure is peculiar, as anyone with a solid grasp of third-grade math would know. On its balance sheet, its real book value was clear as day: $8.70 per share, as of the end of March. Where did the $33.30 per share discrepancy come from? To put it lightly, management's rear end. 

MBIA has been the subject of colossal write-offs stemming from the value of credit derivatives designed to help the company insure debt safely. As the credit market surrounding residential real estate paddles through chaos, MBIA has been saddled with huge mark-to-market losses, as should be expected.  

They call it fair for a reason
But management seems to disagree with the market price of these securities. That price, in their minds, doesn't accurately represent "fair value." The market is an irrational beast, the thought goes, and no one should fall victim to its foul mood.

Their solution? When valuing the company, investors might want to exclude mark-to-market losses on derivatives as if they never happened. Just close your eyes and forget that this credit crunch ever occurred, throw in whatever number you choose for expected credit losses and future premium payments, and badabing-badaboom, book value per share mushrooms to almost five times its stated level! Wahoo!

Nice try
I understand MBIA's frustration in this unprecedented market mayhem -- Washington Mutual (NYSE: WM  ) tried to finagle a similarly shady move earlier this year -- but the imaginative accounting omits two points that have become crucial for financial companies: Market risk is real risk when you're leveraged to the moon, and why weren't similar adjustments imposed when prices were irrationally high?

While the mechanics are different, the outcome for derivatives often looks similar to when an investor employs leverage: Prices move a little in your favor, and you can make gobs of money; prices move a little out of your favor, and you can be taken to the cleaners. They're valued on the odds investors place on a specific event happening within a predefined timeframe, whether it's a default on a bond or a stock striking a price target.

Because leverage coupled with a finite timeframe equals wild volatility in exchange for possible higher returns, so-called market risk is as important in the calculation as anything else. You can't pretend it doesn't happen. Huge volatility is part of the game whether it works in your favor or not.

Now, MBIA's rebuttal proposes that the current market value of the derivatives doesn't portray the likelihood of loss -- and taken at face value, that's a sensible argument. You could believe them, the same ones who stated in their 2006 annual report, "We've had strong demand for insuring very low-risk tranches of many classes of CDOs," (emphasis mine) only to discover some of the same CDOs might as well have been filled with packing peanuts. Or you could acknowledge we're in the midst of one of the nastiest credit crises in modern history. Take it as you wish.

What goes around, comes around
The second part of the accounting bamboozlement is relevant to a slew of companies: If so many alarms of unfairness are going off amid irrationally low prices, why wasn't the same done when prices where irrationally high?

I can't recall any financial company begging the market to mark down securities and pleading for a lower book value when prices were obviously inflated, even when some knew beyond a shadow of a doubt prices would fall. Rather, companies like Citigroup (NYSE: C  ) , Merrill Lynch (NYSE: MER  ) , AIG (NYSE: AIG  ) , and Goldman Sachs (NYSE: GS  ) popped champagne and patted themselves on the back for a job well done.

When irrationality works in their favor, insane paydays are awarded. When it works against them, management stomps its feet in defiance, begging investors for mercy. It takes the concept of having your cake and eating it too to a whole new level.

Alas, even if MBIA's belief of the derivatives' value turns out to be correct, it still has to deal with surrendering business to more reputable players, like Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) . Let's see how it tries to sidestep that in its accounting.

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