Pandora and the Fair Value Accounting Rules

Pandora and the Fair Value Accounting Rules

Posted on by David Merkel

I’ve been involved in financial reporting for a large amount of my career, so even though I’ve never had an accounting course in my life, I’ve had to work with some of the most arcane accounting rules out there as an actuary, and later as an investor.? Over the years, the direction that the FASB and IASB have gone is in the direction of presenting the statement of financial position (balance sheet) on more and more of a fair market value basis.? (Please ignore the treatment of goodwill, advertising,? R&D, you get the idea though…)? To soften the blow on the income statement, changes in the value of many balance sheet items don’t get run through net income, but through accumulated other comprehensive income, so that income can reflect sustainable earnings power, in theory.? Now, I agree with Marty Whitman’s critique on these accounting issues.? We may be getting more accurate on individual companies (if the accounting is done by angels, for humans we are granting too much freedom), but we are losing comparability across companies.? What an item means on the balance sheet of one company may be considerably different than the value at another company.
The hot topic today is SFAS 157 and 159.? I would point you to Dr. Jeff’s article this evening on the topic.? I would like to give my perspective on this, becaue I have had to work with these accounting rules, and ones like them.

At one company that I managed money for, I originated a bunch of long duration high quality assets that did not trade.? At year end, our incentive payment was based on the total return that we generated.? Interest rates had fallen through the year, and so my high quality illiquid assets had yields well in excess of where new money could be deployed.? What were those assets worth?? Historic cost?? The cash flow streams were fixed.? As a conservative measure, though spreads over Treasury yields had fallen for those instruments, we kept the spreads from the issue, and accounted for the price change due to the move in Treasury yields.? (If spreads had risen, I would have argued that we move the spreads up as a conservative gesture.)? Now this was prior to SFAS 157, but it illustrates the point.? How do you calculate the value of illiquid instruments?? Worse, under SFAS 157, you can’t be conservative; you have to try to be realistic.

Now, that was a simple example.? Almost every moderate-to-large life insurance company has a variety of illiquid privately placed bonds for which there is no market.? What is the fair value?? Who can tell you?? Well, the broker(s) that brought the deal are supposed to provide continuing “color” on the bonds, and what few trades might transpire.? Typically, they don’t move the prices much as the interest rate and spread environments change, and third party pricing services are loath to opine on anything too illiquid.? Though the rating agencies night give a rating at issue, they might not update it for some time.? What’s the fair value?? The life insurer has a hard time determining that for that small minority of assets.

Now let’s take it to a yet more difficult level.? If we are talking about many asset-backed securities, they are generic enough that pricing models can determine a spread to Treasury or Swap yields for tranches with a given vintage, maturity, originator, and rating.? Yes, there will be many assets that “trade special,” but those are deviations from the model that the traders feel out.

With CDOs, things get more difficult, because aside from indexed CDOs, there is no generic structure.? The various tranches are bought and held.? They rarely trade.? Projecting the cash flows is a difficult talk, because there are many different bonds in the trust, with many different scenarios for how many will default, and what recoveries will be obtained.? The best a good simulation model can do is to illustrate what a wide variety of possibilities could be, and look at the average of those possibilities.? Even then, the modeler has an expected cash flow stream.? What’s the right discount rate to use?

There is no good answer here.? One can try to infer a rate from what few trades have happened in the market with similar instruments, but that can be unreliable as well.? During a bear market, the sellers will be more incented than the buyers, particularly if they are trying to realize tax losses.? One can try to look at the scenarios across the tranches, and see which tranches have cash flows that behave like bonds, equities, and warrants, and apply appropriate discount rates like 6%, 20%, and 40% respectively.? Some explanation:

  • Bonds: pays interest regularly, and principal within a narrow window.? Few deferrals of interest.
  • Equities: high variability of payoffs.? Pays something in almost all scenarios, but the amounts vary a lot.? Timing and existence of principal repayment varies considerably.? Interest deferrals are common, but rarely last long.
  • Warrants: many scenarios have very low or zero payoffs.? Some scenarios have significant payoffs.? Interest deferrals last a long time, many never end.? Principal payments are rare.

Estimating fair value in a case like this is tough, if not impossible.? But a fair value must be estimated anyway.? Management teams may try to make the third party estimator come to a certain value that fits their accounting goals.? Given the squishiness of what the discount rate ought to be, management teams could say that once the market normalizes a low discount rate will prevail, and our models should reflect normalized, not panic conditions.

Well, good, maybe.? The thing is, once we open Pandora’s box, and allow for flexibility in valuation methods, subject to auditor sign-off (now, who is paying them?), our ability as third party investors to evaluate the value of illiquid assets and liabilities declines considerably.? There’s a great argument here for avoiding companies that own/buy complex assets in an era where fair value accounting reigns.? There is too much room for error, and human nature tells us that the errors are not likely to yield positive earnings surprises for investors.

“How About Tomorrow?”

“How About Tomorrow?”

Posted on by David Merkel

Yesterday I called my auto dealership for regular service on my van, and they said, “When can you come in?”? I said that I could come in any time over the next seven days.? “How about tomorrow?” was the reply.? I agreed, and then I thought about how I normally have to schedule a week or so in advance to get service, which made me wonder whether things have slowed up that much in the economy.

Almost makes me want to test the waters, and call a contractor to do some deferred maintenance on our humble hovel.

I’ll put it to the rest of you.? How much do you think business conditions have slowed down?? How anxious are sellers to get your business?

I’m Not Afraid Of Derivatives

I’m Not Afraid Of Derivatives

Posted on by David Merkel

In one state that I worked in, I managed to push a bill through the legislature that modernized that life insurance investment code, bringing it from the mid-50s to the late ’90s.? The bill had the D-word in it, and prominently: derivatives.? I had structured the bill so that derivatives could only be used for the purposes of risk reduction.? We had two investors and two lawyers on our team, and I was the “quant” who happened to have a good handle on economic history.? When testifying before the Senate, they asked us three questions:

  • How can you make sure that Procter & Gamble doesn’t occur?
  • How can you make sure that LTCM doesn’t occur?
  • How can you make sure that Orange County doesn’t occur?

Three derivative disasters.? I pointed to the protections embedded into the proposed law prohibiting speculation, and the detailed reports that the valuation actuary must submit on interest rate and investment risks, and that all transactions had to be reported to the insurance department, which could disallow transactions.

The bill passed unanimously.? Eight years later — no disaster yet.

This brings me to a piece by Bill Gross, and a critique by Felix Salmon.? As I have commented before, I am not horribly worried about counterparty risks at the investment banks.? Past history shows that they are very good at preserving their own hides while kicking their overleveraged customers over the edge.? Unless there are significant losses from counterparty risks, it is difficult to have large systemwide losses, because with derivatives, for every loser, there is a gainer.? It’s a zero-sum game.? I think Felix has the better part of the argument by a wide margin.? Also, PIMCO is a large user of derivatives; they write significant exposures that are the equivalent of out-of-the-money calls to enhance their returns.? If large losses are coming, what is PIMCO doing to limit losses, or better yet, profit?

That’s not to say that those that have taken risky positions won’t lose.? They very well might lose, but someone else will win.? That doesn’t make the analysis easy, because derivatives and securitization obscure what is going on with any one entity, even if the system as a whole is unchanged.? Even Moody’s is scratching their heads on the matter.? If the rating agencies which have inside information, are puzzled, the rest of us can feel better about being puzzled as well.

Two last notes: CDOs are ugly beasts, and there are really only two places to invest in them: at the most senior level, and at the most junior level.? At the senior level, you have some protection, and can control the deal in a crisis.? The most junior investors can make a lot of money if everything goes right.? Not generally true now, but in the right environment, it can be a winner.

Second, I don’t think CMBS market is as bad off as the CMBX indexes would indicate.? CMBS are more carefully underwritten and serviced than other securitized asset classes.? The only thing that gives me worry is that recent vintages have relied on rising rental rates, and property values that may temporarily have overshot.? Things aren’t great in CMBS-land, but there are other places more worthy of scrutiny.? Again, my comments about being senior or being junior (equity) apply here as well.

Securitization and derivatives are tools, and they can be used wisely or foolishly.? They can destroy individual companies, but not whole economies.

Personal Finance, Part 9 ? Property & Liability Coverage

Personal Finance, Part 9 ? Property & Liability Coverage

Posted on by David Merkel

In this irregular series on personal finance, my next topic is protecting yourself against disaster.? Now there are a few main aspects to this:

  • Have adequate vehicle and dwelling coverages.
  • If you are worth suing, have an umbrella policy as well
  • Use insurance for big disasters only.? Don’t use the insurance company to pay small claims.
  • Adequate business coverages if you need them.
  • Buying insurance from a company that pays claims without too much argument.
  • Keep your credit rating good, it reduces all insurance premiums, because a credit rating is a measure of moral tendency; people who are careful with their money tend to be careful with everything else.
  • Avoid minor coverages; they aren’t worth it.

The first thing to note is that the lowest premium may not be the best option.? Companies that sell policies touting their low cost are typically selling minimal coverages, which may not be adequate to fund all claims in a real tragedy.? Other companies make it tough on claimants.? It can be worth it to review the complaint records per 1000 policyholders at your state insurance department website.? As the story goes, and I won’t name names, a wealthy guy got a policy from XYZ Insurance, and was bragging about the low premium to a friend.? The friend, who had a policy from Chubb, said, “You don’t have an insurance policy!? You only have the right to sue XYZ Insurance when you have a claim!”? (I like Chubb; no, they don’t insure me, and I don’t own shares…)

Make sure your dwelling protection is adequate to rebuild and replace possessions.? With inflation, and housing has had a big dose of that, policies can quickly become inadequate.? If the premium gets too high, better to raise the coverage and the deductible, leaving the premium even, than to leave the policy alone.

An umbrella policy can be a cheap add-on; I left GEICO because they would not underwrite an umbrella on me; too much risk from my writings on the internet (and I was on the board of a small college at the time).? It is definitely worth looking into if you want to protect yourself from liability.

If you are well enough off, with your own business, and you have a lot to protect, a good insurance broker can be an aid in all of this.? He is a professional who will proactively look for the risks you might be missing, and will find adequate companies to cover you at a reasonable price.

This would dovetail into another piece,? “Keep your credit rating good, it reduces all insurance premiums, because a credit rating is a measure of moral tendency; people who are careful with their money tend to be careful with everything else.”? This applies to personal coverages and small business coverages.? Insurers use this data to greatest extent they can, not to be unfair, but because it correlates so highly with low losses.

Finally, avoid little add-on coverages like warranties, and use your main coverages for large losses only.? Have money set aside for the vicissitudes of life.? A large deductible reduces your costs considerably, and signals to the insurance company that you regard yourself as a better class of risk than the average guy.? They will offer you better rates as a result.

Make Money While You Sleep — II

Make Money While You Sleep — II

Posted on by David Merkel

Thanks to Eddy Elfenbein for sending over the data on how the market does over multiple nights when the market is closed.? Unfortunately, the data is skewed because of 9/11, where the market was closed for seven days, and the change from the close to the open was -4.59%.? What should be done with that data point?? When the market closed on Monday 9/10/01, traders expected that the market would reopen as normal on Tuesday, but it didn’t.? The seven day hiatus was not planned, so traders treated it as a one night gap on Monday, but it opened as a seven night gap the next Monday, with negative results.

Now, if you throw out the 9/11 data point, the average price return over a one night gap is 0.005% over the last eight years.? For a multiple night gap, the return is higher — 0.012%.? If you include in 9/11, it is lower — 0.002%.

But what of dividends?? Where do they belong?? They belong to the nighttime returns, because on the morning that a stock goes ex-dividend, on average the price drops at the open to reflect that.? Now, assume a 1.5%/year dividend rate (rounding, the actual is a little higher).? Now the returns for a one night gap are 0.010%, and for a multiple night gap it is 0.024%.? Even counting in 9/11, the result is 0.014%, higher than the single night gap.

One commenter on last night’s post commented that it might not be the risk of holding stock overnight as much as the possibility or occurrence of news flow.? Before the fact, risk and potential news flow are similar concepts.? After all, how does risk shift, but often through news flow changing the opinions that people hold regarding assets?

For a long term investor like me, this all doesn’t matter much.? I’m not going to buy a bunch of futures contracts or ETFs near the close and sell them into the open.? Still, this could be another example of a market anomaly that stems from the perception of a risk which does not occur on average.

Why Do I Follow M3?

Why Do I Follow M3?

Posted on by David Merkel

I like the no-nonsense attitudes of some bloggers. Dr. Jeff would be one of them. In response to my piece Looking Beyond the Three Percent Horizon he posed the following question:

David –
I understand that the Fed discontinued M3 and that you have a good proxy. My question is, ?Why??

In my research on money supply measures, I have been asking economists what they are trying to measure and why. So far, none has had any reason to track M3. I?ll get around to my reasons for this in a future post, but before doing so, I am curious about why you think this is important. The same question might be asked of MZM.

Thanks,

Jeff

I do have a reason to track M3, so maybe this will help Dr. Jeff.? At RealMoney, as M3 was eliminated, I made the following post:


 David Merkel
Taking a Substitute for Vitamin M3
3/14/2006 3:26 PM EST

If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.

But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.

Position: none

My reason for wanting an M3 measure is that the process of intermediated credit creation is important.? As we go down the monetary aggregates, from cash, to the monetary base,? to M1, M2, and MZM, we get further away from cash, and closer to credit.? At one point in time, the Fed had a measure called L for total liquidity, which was broader than M3.? In a credit-driven economy like ours, measuring the differences between various types of credit creation can give signals as to how the banks are faring, and how well aggregate demand will do in the intermediate term.? That’s why I look at M3; it helps me to see how much the banks are stretching their balance sheets compared to how much the Fed is stretching its balance sheet.? There are limits to how much independent stretching the banks can do, in the absence of aid from the Fed.

Perhaps I’m just a wonk here, but the willingness of banks to extend credit in our economy is important, and M3 was better correlated with that than most other monetary measures.? That’s why I went in search of an M3 proxy.

Fifteen Points on Credit Where Credit Ain’t Due

Fifteen Points on Credit Where Credit Ain’t Due

Posted on by David Merkel

I’ve wanted to do a post on credit for a while, but I’ve just had too many things to think about. Well, here goes:

1) From the “We Keep Him in a Bubble” file there is James Glassman with his prediction that Spring 2008 would bring the end of the housing troubles. Why does this guy still get air time? Why wasn’t Dow 36,000 enough? There are too many vacant homes to reconcile, there is no way for Spring 2008 to be it….

2) For an excellent summary of where we are in housing, Calculated Risk has this review piece.

3) Not all defaults are subprime. They are happening with Option ARMs, and even prime loans where they had to get Private Mortgage Insurance.

4) Is the subprime mortgage bust bigger or smaller, or similar to the size of the the S&L crisis? I’ll go with bigger. I don’t buy DeKaser’s smaller argument because securitization has provided more credit to small and medium sized businesses. I do think Portfolio.com is on the right track by looking at the amount of the housing price rise that has happened.

5) Personally, I find it delicious that the banks get stuck footing the bill in particularly bad foreclosure situations. So much for structural complexity in lending.

6) Americans are the most overhoused people in the world. No one else gets as much space, or stores as much stuff, broadly speaking. This book review of “House Lust,” will take you through the whole matter, in probably too much detail. (And yes, my house is large also, but I have ten people here… Americans can be unusual in other ways too; as a culture, we are more optimistic about children.)
7) From Calculated Risk, a tale of why lenders tend to forbear with marginal borrowers that are having difficulties with their current loans. One thing they don’t mention, the Residential MBS market does not have special servicers like the Commercial MBS does. When a loan gets into trouble, the CMBS special servicer gets paid adequately, but the ordinary RMBS servicer does not, particularly when lots of loans are in trouble. It is a weakness in the RMBS system.

8 ) As the TED spread declines, market players begin to relax about liquidity. But what of solvency? As losses are realized by banks, some will have to shore up their capital positions, and to do that, they will have to ratchet back lending.

9) How similar is the US today to Japan back in the early ’90s? There are some similarities, given the property bubbles in both places, and the interest rates that get lower and lower, but there are differences — a healthier banking system in the US, and a more market-oriented economy here as well. A depression is possible in the US, but I would not assume it at present.

10) Is the US consumer spent-up? Could be. Consider this article on auto loans as well. Personally, I am surprised at the degree to which lenders will make consumer loans with inadequate security, but that is just a normal aspect of American life today. For now.

11) What of corporate bonds? It certainly seems like junk bonds will be seeing more defaults in 2008. (Here also.) This shouldn’t surprise us, because the credit quality was low and the volume of high yield bond issues was high 2004-2006. It takes a little while for bad debt to season, and we should see the results in 2008.

12) When I did my “Fed model” I used BBB corporate yields as my comparison to earnings yields on equities. Given the backup in credit spreads, my Fed model is not nearly as favorable as those using Treasuries. But those looking only at credit spreads get the wrong result also. With Treasury yields so low, most high quality bonds are not attractive now.

13) On the bleak side, I tend to agree with Naked Capitalism and the FT that there is a transfer of power going on in the world, away from the US, and toward China and the Middle East. Power follows capital flows, and they are funding the US at present. They will own more and more of US businesses over time. They increasingly won’t be satisfied by owning our debts.

14) I found this piece from Credit Slips to be educational. There are certain types of income that can’t be garnished; nonetheless, garnishing happens. The only way to protect yourself is to fight back, and that article highlights how it is done.

15) Finally, credit at its most basic level. Credit is trust; trust that repayment plus interest will occur. Who do you trust? Personally, I found the discussion following Barry’s post to be depressing, because so many commenters were cynical. here was my comment:

Capitalism is based on trust. Without trust, capitalism will slowly cease to exist. Yes, there will be barter-type transactions, but any complex long-term transaction or relationship is based on trust. Any multi-party transaction requires trust, because multiple parties can gang up on the weak one.

Even representative government requires trust. Now, that trust is often abused, but who wants to get rid of representative government?

There is a lot more trust within our society than most of us imagine. Woe betide us if trust drops to a minimum level.

Estragon (thank you) agreed with me at the end, but it is fascinating to consider the implications of a society where trust is declining. Ultimately, it means that credit will be declining.

Make Money While You Sleep

Make Money While You Sleep

Posted on by David Merkel

Eddy Elfenbein often comes up with cute ideas on how the market works, and this article is no exception.? Someone holding the stock market overnight, at least over the past decade, does better than someone owning stocks during the day.? (I assume that? Eddy has made the proper corrections for dividends, and things like that.)? Now, why might this be?? This is my theory: though daytraders are a part of this, it is not that we are all a bunch of daytraders, but that enough players in the market view the daylight hours as less risky than the night, because they can’t trade then.? Newsflow happens more often while the market is closed.? Thus, there is a tendency to clear out positions before the session closes.? (Now, no net position clearing occurs.? Someone has to hold the stock overnight; they receive a slight discount in the price to do it.)

Another way to think about it is that people get paid to take risk, and there is risk in holding stock overnight.? Now, if we wanted to test this hypothesis, there is even more risk holding stock over the weekend.? How do the overnight returns vary overnight, versus over multiple nights?? Perhaps Mr. Elfenbein can run that calculation as well.

Momentum, Schmomentum

Momentum, Schmomentum

Posted on by David Merkel

My biggest insecurity when it comes to my investing comes from the concept of momentum.? For the past 7+ years, I’ve been leaning against the wind, buying companies with bad momentum, and for the most part, it worked.? In general, falling stocks have bounced back.? Over the last six months it has not seemed to work so well.? Now, I had a period that was much worse in the middle of 2002.? I even scraped excess money together to invest in late September of 2002.? I am less confident here.

I have a number of ideas that work with respect to momentum:

  • In the short run, momentum persists.
  • In the intermediate-term, momentum reverts.
  • Sharp moves tend to mean revert, slow moves tend to persist.

My own proprietary oscillator indicates that we are very close to a short-term bounce point.? The recent move down has been too rapid, and sellers should be tired.? One more hard down day, and a bounce should occur.

Back to my own portfolio management.? Since I am a value investor, I have leaned toward longer holding periods, which implies to me that I should be playing for the intermediate-term reversal of momentum phenomenon.? But the short-term momentum anomaly is probably stronger.? Consider these two pieces from Crossing Wall Street.? Eddy illustrates the point well.

So, as I head into my next portfolio reshaping, I am scratching my head, and wondering how I should use momentum in my investing.? Suggestions are welcome.

Random Notes

Random Notes

Posted on by David Merkel

A few random notes:

  1. When I left my prior employer, one of the first things I did was buy a new laptop from Dell. It was much slower than I expected, and I began experimenting to see if I couldn’t speed it up. Now, here are a few tips: a) install sysinternals process explorer — it gives you much more information than task manager, and will show you what programs are hogging system resources. b) shut off or cripple the many little programs that lurk in the background, many of which occupy a decent amount of resources while waiting for program updates to be released over the internet. Do the updates manually, say, once a quarter. c) Reduce the number of programs that load at startup. d) I turned off the advanced graphics that were kind of pretty from Windows Vista. e) all of these helped, but the big bopper was removing McAfee and replacing it with ZoneAlarm Security Suite. McAfee was a real resource hog, and after removing it and installing ZoneAlarm, everything is faster. Everything. There is a limit to security systems; if they are pressed too far, they kill productivity. Productivity and security must be balanced.
  2. QBE’s gain is the Nasdaq’s loss. North Pointe, a not-all-that-well-known property-casualty insurer has sold out to QBE of Australia. Personally, I really liked NPTE’s management team, and thought they were on the right track. I appreciate insurance management teams that can focus on profitable niches, and are willing to let business go if they can’t make an underwriting profit. If QBE is smart, they will give prominent positions in their US operations to James Petcoff (the CEO) and Brian Roney (the CFO).
  3. Just as an aside, I felt like republishing this off topic post from RealMoney:

 David Merkel
How to Sell More Popcorn
11/3/2006 2:07 PM EST

When I was in college, I needed to make money, so I got a job working at a convenience store. The young lady who trained me showed me how to operate the popcorn maker. After adding the oil and the popcorn, she reached for the flavoring container and dumped the lot in. Her comment, “Just watch, the extra flavoring really creates sales.” She was right. As people walked in the door, a larger number than I would have expected bought popcorn. But there was a problem. The popcorn didn’t taste good. Too much salt and fake butter flavor. It led to few, if any repeat customers.

About a month later, when I was on the night shift, I tried an experiment where I cleaned out the popcorn maker, cleared out the old popcorn, and the popped a fresh batch using a little less than the instructions would indicate, much less the young lady who trained me. The smell was there, but it wasn’t overpowering. Since popcorn wasn’t usually done on the night shift, though, it would be noticeable.

The surprise: repeat customers for popcorn in the graveyard shift because it tasted good. Word of mouth spread, so I made popcorn regularly.

I believe in UPOD (underpromise, overdeliver) as Jim Cramer often points out. It applies to investing in two ways: first, buy companies whose managements do UPOD, and not OPUD. Positive surprises drive stocks higher, negative ones drive them lower.

That said, there is a second way that UPOD plays into investing. It’s what you tell your investing clients or readers. No strategy works all the time. No strategy is perfect even in the long run. No analyst is always right. Underselling your investment abilities, and demonstrating humility, may not attract as many clients in the short run, but it keeps them in the longer run, with continued diligent work.

And with that, I have to grab lunch; writing about the popcorn has made me hungry.

Position: None

Tickers mentioned: NPTE DELL

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