2008 – Page 11 – The Aleph Blog

Industries Don’t Learn From Each Other on Credit Issues

Posted on 8 October 2008 by David Merkel

As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.? I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”? For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.? Why might a company do that?? Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.? Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.? As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.? The agents will write all that they can.? One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.? Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.? Credit triggers are designed to deal with small issues, not large ones.? Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.? But where have we seen this before?

Life Insurers with fixed rate GICs (early 90s)
Life Insurers with floating rate GICs (late 90s)
Utilities in the early 2000s (think Enron-like structures)
P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.? Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.? Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.? Normal companies stay away from the cliff.? Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.? Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.? Now we suffer for it, while bad debts get liquidated, or inflated away.

Entering the Endgame for Monetary Policy, Part II

Posted on 8 October 2008 by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

Inflation when the Fed monetizes the debt,
Depression from vastly increased taxes,
Debt repudiation (whether internal, external, or both), or
Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Setting a New Speed Record for Being Wrong

Posted on 7 October 2008 by David Merkel

Okay, so 16 minutes after my last post, Ben Bernanke says he will consider more rate cuts.? Nice, and toss in the commentary that sound like the Fed is taking signals from the TIPS market on inflation, as well as the commentary in the minutes that some members were leaning toward cuts in the Fed funds rate.

The key here is how much of the loosening they allow to work its way into the banking system, versus how much they put into the intervention programs.? So far, it hasn’t been much.

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

Posted on 7 October 2008 by David Merkel

These are the times that try my soul as a portfolio manager.? During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

Short-term: technical oversold/overbought-ness.
Intermediate-term: valuation levels.
Long-term: what industries benefit from economic change?

This is a difficult balancing act.? What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.? I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

As I note in the graph above, the changes are even larger than the change in the weekly average figures.? Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.? The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

The difficulty comes here: it’s easy to create these programs, but hard to shut them down.? Now the Fed will buy commercial paper.? Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.? jck at Alea rightly calls this not-so-wee beastie the Super-SIV.? As I commented there:

# 1 David Merkel Says:
October 7th, 2008 at 9:58 am I think you pegged it calling it the Super-SIV. As I commented in late 2007 as the Fed began this series of interventions in lending markets, it is easier to start these actions than to complete them. It is hard to estimate all of the consequences.Just as I think George Bush, Jr., started to go wrong when he concluded that he had found his mission (fight terrorism, without boundaries), Ben Bernanke faces a similar problem (do whatever it takes to stop the Second Great Depression, without boundaries).

History is being made here, and it will be volatile?

And jck responded:

# 2 jck Says:
October 7th, 2008 at 10:14 am one thing we know for sure, is that the policy of ?promoting? liquidity appears to have backfired, no reasonable person would claim that markets are functioning better now than when they started?in fact some people would say they are a lot worse.
as you say David, very hard to get out of this, I don?t expect to see a normal Fed balance sheet, i.e treasuries_t-bills in my lifetime.
I will pop in for a comment on your euro piece a bit later?busy???

The question is: what are the endgames for these programs… TAF, CPFF. PDCF, TSLF, TARP, the bailouts of Bear and AIG, etc?? Once a market gets a taste of cheap credit, it is difficult to get them to give it up; they begin to depend on it.

And there are more demands for use of the credit of the US Government.? Bill Gross wants Fed funds at 1%, and wants the Fed to guarantee that institutional transactions clear.? Sounds simple, but the devil is in the details.? The essentially means that the Fed takes short term risk of financial firms failing while securities are in the course of settlement.? The losses could be significant in a crisis, but so could the calming effect.

The Treasury/Fed hopes that if they can calm the markets, eliminating fear of cascading defaults, eventually the markets will regain a tolerance for risk, and they can slowly eliminate the new lending programs.? My sense is that is the Japanese solution, and we are still waiting after two decades to see if it works.? Other “solutions” include:

Inflating away the value of the promises made. (I.e., monetizing some of the T-securities that have been printed and given to the Fed.)
Increasing taxation to pay for the credit losses from the bailouts.
Creating a two-tier currency system, where foreign lenders get paid back in a cheaper currency, but domestic lenders don’t get so badly affected.
Or, a combination of the above four.? Like jazz, I think policymakers are making it up as they go along, and will use a wide variety of solutions.

And, all of this hinges on the willingness of those who buy Treasury and Agency securities to continue to do so.? On the bright side, the disarray in Europe is making the US Dollar and Japanese Yen more attractive, giving the US the opportunity to issue more debt at a time when it will be needed for the TARP.

I come down on the side of an eventual inflation, monetizing the debts of the US Treasury, though that is a minority opinion at present.? It certainly isn’t showing in the TIPS market.? Take a look at one of Greenspan’s favorite graphs, five year inflation, five years forward:

After six years of stability in this statistic, expected inflation has gone over Niagra in a barrel.? Call me a nut, but I like TIPS even more here.? Very cheap inflation insurance, which I think we will need when this comes into its endgame.

Most of the pressure is toward a lower Fed funds target rate, but given that the Fed has sterilized their prior cuts, I don’t see what great good it will do.? It just gets us closer to the zero bound, after which, Japanese quantitative easing exists, and the infamous helicopters of Friedman and Bernanke.? As it stands now, I don’t put much credibility in a Fed funds rate cut.? The Fed seems committed to using its balance sheet to intervene in lending markets, not the more traditional stimulus of the economy as done in the past.

Truth, I am not sure where this ends, but from my recent discussions with Ron Smith and Dr. Jeff Miller, the solutions aren’t easy or pretty.? The time to have acted was 5-15 years ago, and we don’t have a wayback machine.

You’re Owed Euros

Posted on 7 October 2008 by David Merkel

The Euro has been falling recently versus the Dollar.? Why?? There have been many theories proposed, but I want to offer my own theory this evening.? Fiat currencies are political creatures, and are only as strong as the political entity issuing the fiat currency (fiat — it’s currency because we say that it is).

The intersection of politics and economics is tricky.? Currencies, and confidence in currencies are ephemeral.? I look at the Eurozone and ask a simple question: who stands behind the Euro?? Who will lay out tax revenues to support it in a crisis?? Who will be the lender of last resort?

Much as I did not like the bailout plan because I think there were many better plans to pursue, nonetheless, the US has the benefit that the US Treasury and Federal Reserve are acting like one unit.? In the Eurozone, there is no central taxation, regulatory banking, or police authority; there is no lender of last resort.? Individual governments or “coalitions of the willing” may bail out financial companies, but there are no guarantees because the ECB and European Parliament are toothless.? If the same conditions existed in the US, regional Federal Reserve Banks would do the bailouts, and not the Central Bank.

When I was on “The Ron Smith Show” two weeks ago (sorry, no podcast), I commented that the credit crisis was a global phenomenon, and the European banks were more levered than US banks, though with less credit stress as a percentage of assets.? I pointed out that there is no lender of last resort, and that many countries have different goals for currency policy, and bank regulation.? I also noted that the criticisms of American finance were valid, but applied to Continental Europe as well.

At present, those Europeans that dissed Anglo-American finance have egg on their faces (including the lady who shares my surname).? With the competitive rush in Europe to guarantee bank deposits, even Germany switched its policy and guaranteed deposits.? That hasn’t happened in the US yet, but I wouldn’t rule it out.

It is possible that the current crisis could destroy the Euro, and possibly the EU.? I think of the Confederation, where the economic pressure became so great that an extra-constitutional coup took place to create the Constitution, and implicitly, the fiat Dollar that we live with to this day.? WIthout political unity, fiat currencies have short shelf-lives.? Alternatively, the crisis could create a Federal Europe where the central government has significant powers to the degree that France in the Eurozone would be similar to Texas in the US.? I don’t see that as likely; there is not the same degree of trust across the Eurozone as there is in the US.

What’s my upshot here?? Extreme volatility does not favor the Euro; it calls their system into question.? Better to be in the Dollar, or better yet, the Yen, Swiss Franc, or Norwegian Kronor.? Carry trades are play on low volatility; when volatility rises, the low interest rate currencies tend to do well because the ability to hedge bad currency outcomes is diminished, and carry trades collapse.

That’s where we are now.? Neither the US nor Europe should gloat over the other’s bad providence.? They have their own unique weaknesses.

A Proposal for Money Market Funds, and More

Posted on 4 October 20085 October 2008 by David Merkel

Unlike many, I have long felt that money market funds possess credit risk.? Does that mean that I don’t own money market funds?? I have a lot of money in money market funds, but I review the holdings of my funds to make sure that there are no “yield hogs” in the funds that might imply unreasonable risk.? I don’t go for the treasury only funds — I am willing to take ordinary high quality risk, so long as the managers aren’t doing anything to weird with structured products, ABCP, etc.

Money market funds break the buck when the market value of the instruments drops below 99.5% of par.? That rarely happens, though in this environment it is a risk, if a fund hasn’t availed itself of the cheap insurance offered by the US Treasury.

The real risk comes when a fund “breaks the buck” and allows withdrawals at par for a time, leading to a “run on the fund.”? My proposal says this: When a fund “breaks the buck,” it announces a credit event.? It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.

Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 100.25, and the number of shares reduced to the level that supports that NAV.? If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.

No one will like the concept of a credit event in money market funds.? That said, the idea would have many salutary effects on money market funds:

It would eliminate runs on the funds.
It would get people used to the idea that there is some risk in money market funds, though limited.
It would eliminate the need for the government to intervene and insure money market funds.
It would allow some money market funds to take more risk, and offer more return.
The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.

Now, my main application was money market funds, but there are two other areas to consider.? Area one: short-term income funds.? Here is my poster child.? Under my proposal, instead of freezing redemptions, units are eliminated for the capital losses to the degree that it is not in the interests of anyone to liquidate assets.? A run on the fund would increase the NAV relative to the price.

Here’s area two: stable value funds.? I’ve written about this before, but stable value funds possess more levers to continue operating, even when the NAV drops below 99.5% of par.? Stable Value funds don’t typically reveal the NAV, and when the NAV is lower than the price, they lower the credited rate relative to the earnings rate in order to bring the two back into balance.

But what if a Stable Value fund is in a deep hole?? What if the credited rate is nearing zero, and investors are fleeing, worsening the problem?? My view is that at some threshold for NAVs the Stable Value funds have to announce a credit event and reduce units.? That value might be 96-97% of par, with a revaluation of units around 101-102% of par.? Even if there is no fleeing, the excess would be amortized into the credited rate over time.

On the negative side, this could lead money market funds, short-term income funds, and stable value funds to be more aggressive.? That said, it would encourage invest to analyze these funds that are not riskless, because they could undergo devaluations.

For those who hold pseudo-cash through money market funds, short-term income funds, or stable value funds, you need to be aware that they are not riskless, and that in their present form they may deliver capital losses, and more so if withdrawals are not limited.? My proposal provides an orderly way for recognizing and dealing with those losses in a way that does not require the government to step in with guarantees.

Begin the Fourth Quarter Reshaping

Posted on 4 October 2008 by David Merkel

Here we go again.? Once a quarter, I gether together the ideas that I have gathered from the last three months, so that I can consider them as replacements for companies in my current portfolio.? Here are the initial candidates:

AAUK??? ABC??? AE??? AGNC??? AHS??? AIB??? AIMC??? AIQ??? AKLE??? AKO.B??? ALJ??? ALV??? AMAT??? AMN??? AMOT??? AMX??? APA??? APD??? ARG??? ATPG??? AUO??? AXP??? AZZ??? BBSI??? BHE??? BRNC??? BTM??? BWS??? CIG??? CNH??? CNMD??? COMS??? COP??? CPOG??? CPX??? CRESY??? CTGX??? CVI??? DAC??? DAI??? DAN??? DCM??? DDS??? DE??? DIT??? DPS??? DVR??? EROC??? ETH??? EXH??? FCS??? FLR??? FRZ??? FWLT??? GD??? GIB??? GIGM??? GIII??? GLT??? GNW??? GRMN??? GSK??? GT??? GVA??? HANS??? HAWK??? HD??? HDNG??? HES??? HOC??? HRZ??? HURC??? IAR??? IP??? IPAS??? ISYS??? JAH??? JMHLY??? JOS\B??? JOYG??? KHD??? KLAYN??? LCRY??? LII??? LINC??? LINE??? LOGI??? LONG??? LOW??? LSR??? LWSN??? LYTS??? MC??? MDR??? MF??? MIDD??? MLM??? MOV??? MRO??? MRX??? MWA??? N??? NCS??? NFX??? NGLS??? NLC??? NOK??? NOV??? NSRGY??? NTGR??? NTL??? NTT??? NUE??? NYX??? OME??? OMI??? ORBK??? OTEX??? PARL??? PBR??? PCP??? PCR??? PDLI??? PHG??? PII??? PKX??? PLCM??? PLUS??? PNX??? PQ??? PRDT??? PRE??? PRU??? PTP??? PWR??? PX??? RAME??? RDS.A??? RE??? RHD??? RIG??? RIO??? SB??? SCHN??? SCL??? SCX??? SDXC??? SGY??? SHLO??? SHS??? SM??? SMCI??? SNX??? SNY??? STX??? SU??? SUN??? SYNL??? TAR??? TEL??? TEO??? TEVA??? TEX??? TFCO??? THRX??? TKTM??? TMB??? TNE??? TOT??? TRID??? TRMA??? TRS??? TRV??? TSO??? TTM??? UFCS??? UFS??? UPL??? USAK??? VMC??? VMW??? VQ??? VRS??? WERN??? WES??? WEYS??? WINN??? WMW??? WNI??? WRB??? WST??? WTS??? ZNT??? ZZ

Now, what have I done in the recent past, aside from losing more money than the S&P 500?? The following transactions:

Rebalancing Buys: ESV DVN IBA KPPC MGA VLO HIG (twice) LNC XEC SFD AVT NTE YRCW CHIC GMK HMC (twice) SBS OMX TNP

Rebalancing Sales: RGA/A YRCW GPI NTE CHIC

Complete Sales: GPI SFD MET RGA/A IRF

New Buy: RGA/B

I sold International Rectifier because of the bid from Vishay.? I would buy more Vishay, except that I fear their bid could succeed, and financing a cash deal in this environment, so large for them, would be a disaster.? I sold Group One and Smithfield for balance sheet reasons.? Metlife I sold because I needed to lighten up in asset sensitive life insurance; I sold the one that I felt could get hurt the worst in a prolonged slump.? FInally, I swapped RGA/A for RGA/B, getting the lesser voting shares at a decent discount.?? It is possible that the two classes will be unified at some point, or, that RGA could be bought out, and the B shares would do better than the A shares in such a situation.

THe next article n this series will be on my industry model and ideas for there, but if you have ideas that I should consider, add a comment, and I will throw the idea into the hopper.

Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

Posted on 3 October 2008 by David Merkel

I have been overloaded the past few days.? I took the FINRA series seven exam today and passed (88%, no section below 75%).? I may have my first client.? A dear friend of mine died.? The market has been lousy, and I have done worse than that.? Reporters have been regularly calling to talk about the markets.

When I thought I needed to reposition my portfolio a week ago, it was after the last H.4.1 report.? Well, the next one has come out and it is worse.? The Fed is stretching itself thin, with the aid of the Treasury.? I’ll post on that tomorrow.

I was a little surprised about some of the responses to my article on accounting rules not affecting cash flows.? Uh, that should be obvious.? But those that disagree point to arrangements where perceived reductions in credit quality lead to a need for more capital.

Let me first say that that is not a problem with the accounting rules.? It is a problem with liability stability.? What is the possibility of a run on the bank/company/fund?? Even if it is remote, have you guarded against it?

Runs occur in unusual ways.? Derivative agreements that require more collateral on a downgrade?? Enron-like structures that issue preferred to redeem senior debt, after some triggers are hit?? Uncertainty about ability to roll over short-term financing lines?? Ratings triggers on floating rate GICs?? Ratings triggers on regular GICs (a separate event)?? Ratings triggers on property-catastrophe reinsurance?? Over-reliance on factors to finance inventory?? Dare we mention the S&Ls in the late 80s/early 90s) Visiting the local loan shark each evening? 😉

Most insolvencies occur because assets are considerably less liquid than liabilities, and the margin of assets over liabilities on? a “fair value” basis is thin to negative.? The company is playing near the cliff, and is relying on the kindness of strangers not to push them over.

What I have been arguing for the last five years, whether here or at RealMoney, is that companies of all sorts need to play at a lower level of leverage.? FInancial slack is valuable, especially in a bear market.? Just ask Warren Buffett.

Almost any company that goes bankrupt, does so because the need to cash out liabilities runs ahead of their ability to cash out assets, without having fire sales where the total value of assets drops below that of liabilities.? I.e., they run out of cash!

That is why I don’t buy arguments that mark-to-market accounting is doing firms in.? First for financial firms, SFASs 133 and 157 don’t affect solvency, only the views of shareholders.? The regulatory/statutory accounting matters.? Also, private agreements, whether margin or derivative agreements, matter even more, because they can result in a call on cash during a crisis.? To eliminate MTM accounting is to eliminate doing business.? (Can you get a brokerage to look at your margin account only once a year, or less often?)

The problems for financial firms arise from too much debt that is too short term in order to finance longer dated assets.? They run the risk that they will hit a cash crunch.? Sorry, but that’s the way that it goes, and it doesn’t matter what the accounting rule is if you don’t leave sufficient margin to survive the worst case scenario.

The crises today boil down to an asset-liability mismatch in both time and liquidity, which are correlated.? It points toward a cash flow crunch, over which accounting rules have no control.? This is endemic to the market during crises.

Aside from all of the scholarly articles indicating that accounting rule changes have little impact on valuations, this line of argumentation explains why accounting changes have little effect on the prices of stocks.? If it doesn’t happen broadly, it is unlikely to happen narrowly.

Under the wrong circumstances, and we are living in wrong times now, almost any security can be equity-like, having an uncertain outcome.? Even T-bills face that uncertainty in purchasing power terms.? (Should we bring back the debates of adjusting accounting for inflation?? Dead issue for 20 years, could it live again?)? Equity-like instruments should be marked to the best current estimate of value, which does not mean last trade if the markets are thin.? Instead, if reliable markets don’t exist, and the calculation of market inputs is uncertain, then go back to a cash flow model with a “reasonable” discount rate.

If a thinly traded security is genuinely “money good” SFAS 157 offers enough flexibility to not mark it down heavily.? Granted, you might have an argument with your auditors and consultants, but SFAS 157 is not the ogre that everyone makes it out to be.? (The rating agencies, regulators and margin clerks may disagree though… and that means companies need a greater than normal provision against bad times.)

Nor is it freedom for a management to ignore the trading values of illiquid assets, because rating agencies and counterparties will still watch those factors, and a run on the company is as likely in a fog as on a sunny day.

The only way to avoid runs on the company is to hold enough slack assets that you know you will be alright in the worst of times, meaning a depression scenario, or, scenarios where nothing trades.? Does your company/strategy possess bicycle stability or table stability?? Is there a chair to sit on if the music stops?

What’s that you say?? Holding that much capital would kill our ROE?? That’s the thinking that got us into this mess, and is what makes risk management so tough, because the short run need for profits always leads to a diminution of risk control.? Now we are not only paying the price for it with individual companies, but across our corporate sector as a whole.

Deleveraging is painful.? There are almost always defaults and reductions of future profitability involved.? And, bailouts of the sort that our government that out government is pursuing have a low probability of success.? So, analyze your own investments for survivability this weekend.? Who can survive for two years without financing at any reasonable rate?? That’s an acid test.? I just wish that when I reviewed the recent actions of the Fed, I had acted more quickly.? Alas, perhaps my next post should be what do you do when you find yourself behind the curve…

Oppose the Current Bailout Plan, Redux

Posted on 1 October 2008 by David Merkel

Perhaps the tide is turning.? Congress is now receiving more calls in favor of the bailout? Ugh.? People are so attuned to short term market moves defining what is right or wrong.? They would surrender their liberties just to make the markets rise.? Well, the Senate votes on Wednesday evening, and the House probably on Thursday, so I urge my readers, and the rest of the blogosphere to call Congress to oppose the Bailout.

Now, the current plan is better than the original one, having more oversight, and requiring equity stakes.? I still don’t like the proposal, because it won’t work on the areas of our economy that need help now, mainly the short term lending markets between banks.

As it is, the pressure in those markets is high, and the Fed is stretching its balance sheet to cope.? Other nations and central banks are acting to stem the panic, and are moving to support the short-term lending markets.

This is a global crisis, with rates rising in Asia, with failing banks in Europe, and the rescue of AIG protecting the interests of European banks, as well as domestic institutions.? The other nations of the world should step up to their responsibilities; we are all in this together.? If not, we will probably experience a global recession lasting two or more years.

Not that anything is certain in economics; the global economy has been straining over the last few years to goose growth in ways that seem foolish to me.? We know the lessons of mercantilism.? Why force exports when the returns may prove to be far less than advertised?? China may laugh over a growing economy where they sell an increasing amount to the US, but what are they receiving in return but devaluing US T-notes?

Look, there is a better bailout available.? Aim at the short term lending markets; use the $700 billion to recapitalize the Fed, and let them provide liquidity until the short-term lending markets calm down.

Or, use the money to take super-senior convertible stakes in financial institutions that are in trouble.? If the government is bailing institutions out, let them do it in a way that minimizes loss, that they would have a senior creditor position if there is loss, and significant ownership if there is a recovery.

With that, I close by saying don’t listen to foolish people who say that we can make money off of the bailout.? The objective of a bailout is to lose less money than you expected.? There are rare cases where money is made, but as we would expect with government intervention in tough times, the incentives are perverse.

Accounting Rules Do Not Affect Cash Flows

Posted on 1 October 2008 by David Merkel

At my congregation, I have a friend who is a lawyer at the Justice Department.? (Such is life for a congregation located near DC.? I am one of the few that does not derive his income from the government.)? He has asked me a couple of times about SFAS 157, and the effect it is having on the current crisis.? My recent comment to him was:

Accounting is a way of portioning economic results by time periods.? It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk.? If we were back in an era where the financial instruments were simple, then the old rules would work.? But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.

Equity instruments have always been marked to market, because of their volatility.? Similarly volatile debt instruments should be marked-to market.? Even the the old-style “hold-to-maturity” bonds would get marked down if there was a “permanent impairment of capital.”? Even today, the same rules apply, the companies could specify certain volatile bonds as hold-to-matutrity or available-for-sale.? But when the auditors look at the bonds, and ask what the market price is, the challenge is to explain why there is no permanent impairment of capital.

Those that are complaining about SFAS 157 and SFAS 133 are barking up the wrong tree.? They wouldn’t be complaining if the companies in question had not bought inherently volatile assets.? These accounting rules reveal the results of their actions.? The regulators could ignore the rules of FASB, and allow the financial institutions to balue them otherwise. The regulators have a different attiuude; they don’t care about profitability, but they do care about solvency, and avoiding “runs on the bank.”

A very well-established rule in academic finance is that changes in accounting rules do not have much impact on stock prices on average, because they don’t affect cash flows, and free cash flows are the major basis for evaluating stock prices.? If a financial company holds an impaired security, eventually that will factor into the cash flows regardless of what the accounting rules are.

There are a number of articles today on this issue:

FASB has offered a little more room to interpret the mark-to-market rules, but only a little.? Congress could mandate more latitude, though I think it would be a mistake.

Mark-to-market accounting should pay a role in valuating volatile financial instruments.? Now that financial institutions have bought financial instruments more volatile than tha buy-and-hold attitude of the old days would have done, ther rules must adjust to present a fair value.

I don’t see any way that lets the markets gain from the suspension of the rules.? The rating agencies will still do calculations of risk based liquidity on financial firms to set ratings.? Here’s a way to test though.? Go back to my old proposal that we have two income statements and two balance sheets.? Let the market see both a fair value and an amortized cost appproach.? If fair value is distorting, then investors will welcome and use the amortized cost figures in their calculations.? More information is better than less, and it is trivial to add back an amortized cost balance sheet and income statement.

For complex balance sheets in volatile times, I know which one that investors will prefer — fair value.? Let the advocates of eliminating fair value explain why reducing information to investors is such a great benefit.? In the end the cash flows will be the same, and maybe it will take a little longer, but the results of bad investment decisions will be revealed, and the same firms will fail — perhaps in yet more ugly ways, as their shenanigans will go on longer, with less to recover for the bondholders, and wiping out the equity entirely.

In the absence of fair value, suscpicion will take the place of information, and companies will still get marked down as failure takes place in fixed income assets classes.? The same things will happen, just in a messier way.? You can’t fight the cash flows arising from bad investment decisions, and too much leverage.