11 October 2008 – The Aleph Blog

Recession or Depression?

Posted on 11 October 200812 October 2008 by David Merkel

Back to the crisis.? I want to be a bull, really.? I read what Barry wrote on 10 bullish signals, and I think, yes that’s what history teaches us.? I have used that for profit in the past.? I even have a few more.

Here’s my knockoff of S&P’s proprietary oscillator:

That’s the lowest reading ever, with statistics going back to 1990.? For more, consider the discounts on closed-end funds — they are lower than ever.? Or, consider that the IPO market is closed.? Or consider that every implied volatility measure under the sun is through the roof in ways that we haven’t seen since 1987.? The yield curve of the US is wide.? Fed policy is accommodative; don’t fight the Fed.? Consider that well-respected value investors like Marty Whitman are finally excited about the market.? Credit spreads are at record highs in the money markets and in the corporate bond markets.? Finally, consider that the lack of insider transactions indicates a potentially bullish situation:

I have a hard time accepting the bullish thesis at this point because of troubles in most of the major banks, and the disappearance of all of the major investment banks.? I have a saying that when you have a major market malfunction, there tend to be many things going screwy at the same time.? I don’t like to say that it is different this time, but rather, we have to be careful whenever there is a significant hint of depressionary conditions.? If that is the case, we should see many abnormalities:

The Treasury has shifted the TARP plan in order to recapitalize banks.? Good move, if late.
Similar things are afoot in the UK and Germany.
Many European banks are in trouble.

This is a global crisis, affecting most governments and firms.?? Our most severe crises, aside from the Great Depression, tended to be local, or limited to just a segment of the world.

Final notes: I warned about this disaster in advance, though I am not as prominent as a George Soros or Jeremy Grantham.?? I can dig up the references at RealMoney if necessary.? Last, as in the Great Depression, some moves by the government exacerbated the crisis, that may be true here as well.

With that, I conclude that we are back to the one key question: are we facing a recession or a depression?? If a recession, we should be buying with both hands, but if a depression, there will be better bargains later. At present, given the condition of the banks and the global scope of the problem, I lean toward the depression side of the argument, but I am not totally sold on the idea. There are bright people on both sides of the question. That said, I am not jumping to buy at present, even with many indicators that are favorable. The state of the financial system matters more.

IFRS: Incomparable Flexible Reporting Standards.

Posted on 11 October 200812 October 2008 by David Merkel

One housekeeping note before I start.? I made a small enhancement to the blog today.? I added a little link on the upper right, just below the banner that reads “Aleph Blog.”? If you click it, it brings you back to the home page.? I know that is how my banner is supposed to work, but I have not been able to get it to do that.

My first topic this evening is the SEC’s move to IFRS.? If you would like to protest this, the form is here.? Here is what I am submitting to the SEC:

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Sirs,

I strongly oppose adopting IFRS in place of US GAAP.? I am not an accountant, but something more important, a user of financial statements.? I am a life actuary and a financial analyst.? I have been on both the preparation and use sides of accounting statements over the last 20+ years.

My first critique is that there is nothing that is that big of an improvement over US GAAP in IFRS, and many areas that seem less accurate.? I will handle those later.? My point here is that in order to justify the costs of retraining accountants and financial analysts, what ever is put into place needs to be a large improvement over GAAP.? IFRS is not that.? It will impose big costs on US corporations to re-tool their accounting, and the small corporations will be disproportionately affected.? In the end, I don’t think we will have materially better financial statements.

Perhaps accounting consulting fees will rise in the short run from the conversion, but that it not a reason to put the rest of us through the wringer.? Just as laws are too important to be left to lawyers only, in the same way, accounting standards are too important to be left to accountants only.

Second, there have been a number of studies done that show that US GAAP confers an advantage of lower capital costs on companies that use it versus IFRS.? Why raise capital costs on US corporations?

Third, IFRS will not unify accounting standards around the world, because the national implementations of IFRS are significantly different.? Here’s an idea, though:? Call US GAAP an implementation of IFRS.? WHo knows, it might become the preferred IFRS because of its relative strictness.

Fourth, IFRS is more squishy than GAAP because it is “principles-based.”? We use rules-based systems in the US because they offer legal protection regarding fraud in securities laws.? I would argue that IFRS is actually rules-based also, but with a less-tested set of rules.? The rules of US GAAP are large because they have grown to meet the complexities of accounting in the modern economy.? More below.

Fifth, the additional squishiness/flexibility will make it more difficult to compare results across companies, making the job of securities analysts more difficult.

Sixth, US GAAP is more investor-focused than IFRS. That’s why it lowers capital costs.

Seventh, value investors will benefit from IFRS because the income statements and balance sheets will be less reliable, which will force more investors to the cash flow statement, which is harder to fuddle.? Average investors will have a harder time investing, to the extent that they look at financial statements.

Eighth, does Congress really want to give up its sovereignty over US accounting rules?? I think not; all it will take is one significant scandal, and Congress will move away from IFRS.? The pressure toward globalization is weaker than most think.

Ninth, IFRS is weaker when it comes to revenue recognition, joint ventures, and accounting for fixed assets and intangibles.? In general, the ability to revise asset valuations up should be limited or nonexistent.? The ability to be flexible in recognizing revenue should be similarly limited.

In the American context, where we have dispersed ownership, we need conservative accounting rules that are comparable across companies.? The proposed move from US GAAP to IFRS is a step backward.? Please do not sacrifice our relatively good accounting standards for something less accurate and applicable to the needs of our nation and its securities markets.

Sincerely,

David J. Merkel, CFA, FSA

Blame Game, Redux

Posted on 11 October 2008 by David Merkel

When I write, I don’t always know what will be popular, and what won’t.? Personally, I thought my article
Rethinking Insurable Interest was the more innovative of my two articles last night, but Blame Game made the splash.? Well, perhaps no surprise, the crisis has the attention of all of us.? I just have broader interests; I want to write about a wide number of things.

My readers took me up on my request, and gave me more targets to blame.? Let me expand on them:

21) The Rating Agencies — that was a popular choice.? Yes, the rating agencies messed up.? They always do.? Their job is an impossible one.? Should they be proactive or reactive?? Should they rate over the cycle, or be instantaneous?? Should they care about systemic risk issues?

Where they did err?? They competed for business, leading underwriting standards lower in structured finance.? They overrated the financial guarantors, who were their major clients.? Away from that, they made mistakes, but every firm offereing opinions makes mistakes.? I make mistakes regularly here.

22) Matt give me another party to blame, and I will let him speak for himself: I have one more to add – the Office of the Comptroller of the Currency. Not only did they fail to regulate the national banks, they also stone-walled State and local governments from bringing suit (claiming jurisdiction, but never following up on claims).

Add to that the divided regulatory structures that encouraged regulatory arbitrage.? That encouraged diminished underwriting standards.

23) Investment banks.? They asked the SEC to waive their leverage limts, and now none of the big guys are left as standalone publicly traded institutions.? They made a lot for a while, and then lost more.

24) Then there were the carry traders who have now gotten carried out on their shields. There were too many players trying to clip uncertain interest spreads, from hedge funds to Japanese housewives?

25) House flippers — whenever investors get to be more than 10% of a real estate market, beware.? Sad, but I heard an ad on the radio for buying residential real estate in order to rent it out.? It is not time for that yet.

26) The quants — they enabled models that gave a false sense of security.? They did not take into account decreased lending standards, and assumed that housing prices would continue to go up, albeit slowly.

They also assumed that various classes of risky business would be less correlated, but when hedge funds and fund-of-funds take many risks, returns become correlated because of investoors enter ing and exiting sectors.

27) The tax havens and hedge funds.? Hedge funds are weak holding structures for assets.? In a crisis they can be sellers, because they want to lower leverage.

28) Mainstream financial media — CNBC, etc.? They were relentless cheerleaders for the bull markets in stock and housing.? This isn’t a compliment, but financial radio makes CNBC sound cautious.? FInancial radio seems to be a home for hucksters.

And, that’s all for now.? If you have more parties to blame, feel free to respond.? One final note on my point 16, diversification, from the prior post: many quants did us wrong by focusing on correlations stemming from only boom periods.? There are many problems with correlation statistics in finance, but the big problem is that correlations are not stable even during boom times, much less between booms and busts.? In a bust, all risky assets become highly correlated with each other, invalidating ideas of risk control through diversification.

My view of diversification is holding safe assets and risky assets.? High quality short-term debt does wonders to reduce the volatility of results.? Other hedges are less certain.? Nothing beats cash, even when money market funds are open to question.