Accounting – Page 11 – The Aleph Blog

Eight Notes and Comments on the Current Crisis

Posted on 27 October 200827 October 2008 by David Merkel

1) Greenspan — what a waste.? A bright, engaging man becomes a slave to the Washington political establishment.? Now he gives us a lame apology, when he should be apologizing for his conduct of monetary policy, which encouraged parties to take on debt because of the Greenspan Put.? Now the debts are too big to be rescued by the Bernanke/Paulson Put, where the Government finances dodgy debts.

On a related note, Gretchen Morgenstern is right when she calls the apologies hypocritical.? I would only add that Congress also needs to apologize; they did not do oversight of the Administration properly.? Many members of the oversight committees are not economically literate enough to do their jobs; they can only score political points.

2) I found this post highly gratifying, because it points out the disconnect between macroeconomics and finance, which I have been writing about for years.? When I was an economics grad student, I felt economics had gone astray by trying to apply statistics/mathematics to areas that could not be precisely measured.? In this case, if your models of macroeconomics can’t accommodate the boom/bust cycle, you don’t deserve to be an economist.

3) You want accounting reform?? Start with accounting that disallows gains-on-sale in a financial context.? WIth modern life insurance products, gain from sale is not allowed under SFAS 97, and I would modify SFAS 60 to be the same way.? No profits at sale.? Profits are earned in a level way over the life of the business as risk decreases.? Let other financial firms use something akin to SFAS 97, and many business problems would be solved.

4) What freaks me out about this article is that Taiwan is refusing the full faith and credit of the US Government, which stands behind GNMA securities.? Don’t bite the hand that feeds you; who knows but that you might be traded for the elimination of Kim Jong Il.

5) It figures that the moment the PBGC buys the specious arguments of a pension consultant that the equity markets crash.? Whaat makes it worse is that the PBGC tended to buy long Treasury debt which has been one of the few securities rallying? recently.

Given all the furor over investing in long duration bonds for pensions versus equities, it is funny that the PBGC rejected the growing conventional wisdom that DB plans should invest in safe long bonds.? Once they reject their current pose, the equity market could rally.

6) Is the economy weak?? Well, look at the states.? If their tax receipts are going down, so is the economy.? We are in a recession, and maybe a depression, given the lack of strength in the banks.

7) Do we need a new system for managing the global economy?? The Chinese certainly think so.? They finance the US and don’t get much in return.? Perhaps China could host the new global reserve currency?? I don’t think so.? Their banking system isn’t real yet, and they still want to subsidize their exports.? The global reserve currency role will flow to the largest economy allowing free flow of capital.? Now, who is that?? Japan?? Too small, but the world now recognizes that their banks may be in better shape than many other countries.? Plus, they have been through this sort of crisis for a while, and may be closer to the end of it than the rest of us.? The alternative is that Japanese policymakers still don’t have the vaguest idea of what to do, much like the rest of the world now.

Thing is, we don’t have a logical alternative to the US Dollar as the global reserve currency.? The Euro is a creation of an alliance of nations untested by economic crisis.? Perhaps the rest of the world should consider the possibility of no global reserve currency, or keep the US Dollar, or, move to a commodity standard like gold or oil.

For now, though currencies will follow the path of panic, as carry trades unwind, as countries that had too much borrowing see loans repaid (Japan, Switzerland), and countries with high interest rates see a demand for liquidity, which perversely will push rates higher.? (Isn’t everything perverse in the bust phase, just as everything is virtuous in the boom phase?)

8 ) On the bright side, some boats are rising.? After seeming irrelevant, the IMF has found a reason to exist again with loans to Iceland, Hungary, and Ukraine, with more to come.? The small/emerging markets once again learn that they were at the end of the line in this economic game of “crack the whip.”? That said, the developed market banks financing them will get whipped too.? This is truly a global crisis.

And given that it is a global crisis, I wonder how willing the developed nations will be to add more funds into the IMF when they have crises at home to deal with?? I’m skeptical, as usual.? Perhaps the Treasury can send them a raft of T-bills.? The IMF can ask the Fed for contact info.

(more to come)

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:

=-=-==-=-=-=-=-=-=-=-=–=

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

Posted on 10 October 200810 October 2008 by David Merkel

Some people don’t like the concept of blame.? They view it as useless because it wastes time in looking for a solution.? I will tell you differently.? Blame is useful because it identifies offenders, which is the first step in eliminating the problem.? The trouble is that few have the stomach to get rid of the offenders.

So, as I traveled home from prayer meeting with my children last night, we listened to a radio show discussing the current credit crisis.? This was a good discussion, unlike many that I hear.? But the discussion (on NPR) eventually focused on “who should we blame?”? Okay, here is my incomplete version of who we should blame:

1) The Federal Reserve, especially Alan Greenspan.? For the past 20 years, we couldn’t let the economy have a severe, much less a moderate recession.? Rates were reduced before significant pain was felt by those who had borrowed too much.? The 1% Fed funds rate in 2003 was the pinnacle of that effort.? It created the ultimate bubble; there is nothing left to reflate in 2008 from easy monetary policy.

2) Congress and the Presidency — they encouraged undue leverage in a variety of ways:

a) Fannie, Freddie, the FHLB, and more: Everyone has gotta live in a single family home.? Gotta do that.? Thomas Jefferson’s ideal was that we should encumber future generations so that marginal buyers could live in houses beyond their means.? They compromised lending standards more and more, along with private lenders as the boom went on.

b) The SEC: in a fiat currency world, controlling the currency means controlling leverage of financial institutions.? The SEC waived leverage restrictions on the investment banks in 2004, leading to a boom, and a bust. Big bust.? Ginormous bust — how many large standalone investment banks are left?

c) Particularly the Democrats in Congress defended the GSEs as their own pet project.? I am not bashing the CRA here; I am bashing the goal of having everyone live in a house beyond their means.

d) We offered a tax deduction on mortgage interest, and a limited exemption on capital gains from selling a home.? There is no good reason for these measures.

e) And, the Republicans in Congress who favored deregulation in areas for which it was foolish to deregulate.? Much as I favor deregulation, you can’t do it if you have fiat money (unbacked paper money).? In that case you must restrain the growth of credit.

f) The Bush Jr. Administration — they did not enforce regulations over financial institutions the way that the law would demand on a fair reading.? Again, I’m not crazy about regulation, but unless you have a gold standard, or something like it, you have to regulate the issuance of credit.

g) Their unfunded programs with promises to the future; the states and Federal Government always promise today, and don’t fund it.? Hucksters.

3) Lenders steered borrowers to bad loans.? There was often implicit fraud, and in some cases, fraud.? The lenders paid their staff to do it.

4) Borrowers were lazy and greedy.? What? You’re going to enter into a transaction many times your income or net worth, and you haven’t engaged helpers or friends to advise you?? Regardless of the housing price mania, you should have gone slower, and done more homework.? Caveat emptor — you neglected that.

5) Appraisers were slaves of the lenders who wanted to originate and sell.

6) Those that originated MBS did not check the creditworthiness adequately.? They just sold it away.? Investment banks did not care where a profit was coming from in the short run.

7) Servicers did not demand a high price for their services, making it hard for them to service anything but solvent borrowers.

8) Realtors steered people into buying more than they could rationally afford; I’m not saying they did that on purpose, but their nature was to sell to get the highest commissions.

9) Mortgage insurers and financial guarantee insurers — because of the laxness of accounting rules, they were able to offer guarantees significantly in excess of what they could pay in the deepest crisis.

10) Hedge funds, investment banks and their investors — they demanded returns that were higher than what was sustainable.? They entered into businesses that would not survive difficult times.

11) Regulators let themselves be compromised by those following the profit motive.? Many hoped to make money after joining private industry later.

12) America.? We let ourselves become short-term as a culture, encouraging short-term prosperity, regardless of the cost.

13) Neomercantilists — they lent us money, because they wanted they export sectors to grow for political reasons.? This made our interest rates too low, encouraging overinvestment and overconsumption.

14) Average people who voted in Congress, and demanded perpetual prosperity — face it, we elect those that govern us, and there is the tendency in America to love the representative that brings home the pork, while hating Congress as a whole.? Also, we need to bear with recessions, and let them do their work, and not force our government to deal with them.

15) Auditors that did a cursory job auditing financial entities.? As the boom went on, standards got lower.

16) Academics who encouraged a naive view of diversification, and their followers who believe in uncorrelated returns.? In a bad economy, everything is correlated, and your statistics from a good economy don’t matter.

17) Pension and other funds that believed the academics.? It is amazing what institutional investors will fund, given the mistaken idea that correlation coefficients are stable.? Capitalistic economies are unstable by nature!? Why should we expect certain strategies to workallo the time?

18) Governmental entities that happily expanded government programs as the boom went on.? Now they are talking about increased taxes, rather than eliminating programs that are of marginal value to society.? Governments should not rely on increased taxes from capital gains, or real estate tax assessments.

19) Those that twitted “doom-and-gloomers,” and investors who only cared if markets went up.? It is hard to write about what could go wrong in the markets.? Many call you a wet blanket, spoiling their fun, and alleging that you are a short, or some sort of misanthrope.? The system is biased in favor of happy talk.? Just watch CNBC.

20) Me, and others who warned about the current crisis. Perhaps we weren’t clear enough.? Maybe our financial interests made us look like we were talking our books.? I know that I spent a lot of time on these issues, but in the short run, I was still an investor, trying to make money in the markets, hoping that what I feared would not occur.? Now I am getting my just desserts.

This is an incomplete list.? I invite you to add others to the list in your comments.

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…

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.

Let the Current Bailout Die

Posted on 26 September 2008 by David Merkel

I’m starting out tonight’s post with two stories, to try to help illustrate my position on the bailout. Recently I did some consulting for a financial institution that held the single-A tranches of several trust preferred CDOs that had CMBS, REIT debt, and a lot of junior debt from bank, mortgage, and housing related names. They wanted to know where I would market the bonds at year end 2007. I created a really complex simulation model with regime-switching for credit migration, to simulate how creditworthy the underlying bonds would be.

These bonds were on the cusp; the value of the bonds would vary a lot depending on the assumptions used. The bonds below the single-As in the securitization were all likely to eventually default. All they are worth is the value of interest they will get paid before the securitization shuts them off, plus the warrant value if things improved dramatically. The bonds above the single-As were very likely money good. Losses to the AA and AAA bonds were a remote possibility.

After estimating likely cash flow streams, I tried to estimate where a single-B bond would trade in that environment; that is, if it would trade. I estimated that it would need a 20% annualized return, leading to a dollar price around $35 on a par of $100. The bank pushed back in two ways, suggesting that my discount rate was too high, suggesting that I use 10% (price $65), and they trotted out another analysis from one of the subsidiaries of the rating agencies that was incredibly lightweight, suggesting a price of $85.

Now, did these beasties ever trade? Rarely. But they had traded two months earlier between $25-30, and at year end there was one unusual trade, for which I will give you a fictionalized version of how I think it happened:

Bond Owner: I need a bid for my bonds; you brought this deal to the market. Bid on my bonds.

Investment Banker: There is no market for those bonds; no one knows what they are worth. No one is bidding for them in this environment.

BO: You have a moral obligation to bid on my bonds; you brought the deal to market.

IB: So what, at this point almost no investment bank is willing to honor that.

BO: (begging) Look, I’ll take anything, anything, offer me a cruddy “back bid.” I just need to sell these to realize a tax loss.

IB: (long pause, feeling disgusted, and wanting to tell the guy to go away through a too low bid) Okay then, I’ll offer you $5.

BO: (Happy) Done. Sir, you have those bonds at $5!

IB: Done. (Ugh, what will the risk control desk say?…)

What did I tell my client? I said that I would tell them what my model yielded under their assumptions, but that my recommendation was that they mark them at $35.

Okay, so what’s the right price? $5, $35, $65, $85, $100. The bank marked them down to $75, average of the 10% discount rate and the rating agency’s view, because they could not take the full hit.

Now apply this lesson to the current bailout, and what do we learn?

The hold-to-maturity price mentioned by Bernanke is the $75, a value that has no basis in fact.? They don’t want to have the bank take losses.
The price that a clever investor would pay if he could buy-and-hold is below $35.? Where?? Not sure, thing have gotten worse since my analysis.
The security is worth at least $10, if it pays interest for three years (highly likely).
The investment bank that bought the bonds can’t re-sell them.
Most bond owners ignore the $5 trade, and ignore the $25-30 trades also.? They mark the bonds much higher, because they can’t take the losses.? They are eating an elephant.? How do you eat an elephant?? One bite at a time.? They can’t take a full loss this year, but will use flexible accounting rules to take those losses over the next three years.
A clever bailout would start sucking in these bonds in the teens, quietly.? We’re not doing that, but that is what Buffet would do, and maybe Bill Gross.
But these bonds are unique, as are most credit sensitive bonds.? The idea of holding reverse auctions is ridiculous, because I have given you one example, and there are hundreds of thousands, maybe a few million different bond tranches to evaluate.? Only the originally AAA-rated tranches have any size to them.? For any party, even PIMCO, to say that they can come up with the proper pricing for all of them is ludicrous, regardless of whether we go for the panic price, theoretical current “fair price,” or the price at which it is on the bank’s books.
This also discourages banks from taking writedowns.? Why write down, when the government will pay you book value?? Or at least, the lowest book value that is common….

Well, that’s one story.? Here’s one more: As a bond manager, I would occasionally come up with unsusal theses that would translate into inquiries after unusual assets.? in late 2002, I began buying floating rate trust preferred securities.? Junior debt — not as safe as senior debt, but because they were floating rate, they did not have the same call provisions as the fixed rate securities.? There could be a lot of profit if the credit market rallied.? So, I started buying slowly, because it is not a thick market, using three brokers to mask my actions.? By the time, I reached 90% of my goal, two things happened.? First, the chief investment officer called to ask what I was doing buying such low yielding securities.? My comment back was that I was earning more than a 5-year senior bank bond, and that it improved the asset-liability match for our insurance client.? He said that he didn’t want much more of them, and I said that I wanted $20 million more.? He agreed, and we were done.? Second, one of the three brokers, the one that I used the least, called me and said that their bank thought there was a buyer in the market, and that prices would rise from here.? I asked what they had left in inventory, and he named a few names that I did not have so much of.? I bought those bonds, and then (after a few weeks) the market repriced dramatically tighter, i.e., higher prices.? We never cleared less than a 10% gain on any of those bonds, which is a “home run” in bond terms.

Here’s my point: the Treasury, should it do the bailout, will find it hard to determine the proper prices for the bonds they want to buy. Why?

High prices bail out the banks.
Low prices protect taxpayers.
No one knows the correct price.
Anyone with a large amount of money to invest will artificially inflate the market, unless they are very careful.

The negotiations have broken down, and it is for a good reason.? There is little agreement over what costs the taxpayers should bear for matters that they had little say in creating.? I offer you the following articles that agree with my findings:

With respect to the central question, “Will the Bailout work?” my answer is no.? The assets are too fragmented, and the policy goals too uncertain to make the deal work.

We will see what happens tomorrow.? The Cantor plan may play some role in this, trying to restructure the bill as a reactive bill through an insurance mechanism, while making it sound proactive.? That is prefereable to me, because I think that the next administration whould take time to analyze the best options, rather than let an unaccountable lame duck President and Congress set the tone.? If bailouts are needed because of systemic risk before then, let them be done on a one-off basis.? We don’t need a systemic solution now.

What is the crisis at present?? It is mainly in the short-term lending markets.

That’s not good, because they are big markets, but on the other hand, the percentage losses aren’t large.? Again, I would call Congress to oppose the bailout, in order to let the next President and Congress consider the measure.? Until then, I would do one-off bailouts, like those done for AIG and Fannie, and Freddie.

That may not be optimal policy, and it might be messy, but it might minimize cost to the taxpayers, while causing those that would sell off liabilities to the government to think twice.? Bailouts shoud be painful.

Investing in Financial Stocks is Tough

Posted on 13 September 2008 by David Merkel

At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different.? In addition to many other things I mentioned there, I gave six ways that financials were different:

Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.

The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.

Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.

Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

In general, accruals are weaker than cash entries in accounting.? Not all accruals are created equal either.? Some are less certain to be collected/paid, and some are further out in the future than others.

Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others.? E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.

This is why management quality matters so much with financial stocks.? The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain.? Companies that grow too rapidly, or lack obvious risk control are to be avoided.

Looking at the Present Concerns

I own a bunch of insurance companies, but no banks or other financials.? Why?? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are.? Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc.? The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.

Now their valuations have been crunched, and their financing options are limited.? Fortunately there are the options of last resort:

Have you maxed out trust preferred obligations? Other subordinated debt?
Have you maxed out preferred stock?
Have you issued convertible debt to monetize volatility?
Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
Have you sounded out investors in your corporate bonds about debt-for equity swaps?
And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now.? I could also add another point: have you sold your most valuable liquid assets?

With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time.? Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.

In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent.? This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not.? Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.

Full disclosure: no positions in companies mentioned.? I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….

Accounting for Quality: the Quality of Accounting

Posted on 29 August 2008 by David Merkel

Accounting is esoteric.? :(? I say this as one who has never taken an accounting course in his life, but has written papers on accounting standards, and has had to implement them in the life insurance industry, which is possibly the industry with the most complex accounting of any industry.? (Okay, if we did the investment banks properly, they would be more complex.)

My post is prompted by Barry’s post.? I have known for a while, and commented here that the SEC is planning on abandoning GAAP for IFRS.? Why are they suggesting this?

IFRS is not that much different from GAAP.
They want to have every company in the developed world on a similar accounting basis, even if the basis is slightly worse than the existing standards.
Then perhaps, foreign companies will once again list their equities in the US.

You can get the same information in different ways from:

The latter two links do not directly address the issue, but they write intelligently about accounting.

This download is big, but it summarizes the differences between FAS and IFRS (in 77 pages).

My short take is this:

IFRS is a more liberal accounting standard.? Not by a lot, but significantly.
There will be a ton of retraining for accountants in the US, and financial analysts (ouch).
Earnings will rise, but P/E multiples will fall.? The intial net effect should be small.
Value investors will fare relatively better, as they spend more time on the balance sheet, income statement, and other earnings quality issues.
Exchanges in the US might get more foreign listings, if Sarbox were repealed.? Moving to IFRS is not enough.
If I were on the SEC, I would not care about global comparability, I would stick with GAAP, and stand alone if necessary, among the nations of the world.? Why move to a less informative, and more rubbery standard?? I don’t see a good reason.

IFRS is more flexible, which means that companies under it are less comparable.? I don’t see the advantage in our moving away from GAAP, which has its problems, but less than IFRS.? When I get the web address to post complaints, I will post it here, and I will be writing the SEC to stop this foolishness.

Analyzing Growth in Firm Value

Posted on 2 August 20082 August 2008 by David Merkel

We’re nearing the end of second quarter earnings season, and I have have had my share of hits and misses, compared to the estimates that the sell side publishes.? What is the sell side?? The sell side is the analysts working for broker-dealers who publish research on companies, often estimating what they think they should earn in a quarter or year.? There is a buy side as well, which are analysts working for mutual funds, asset managers, etc., who analyze companies for their employers.

As investors, we are pelted with terms for corporate performance:

Comprehensive income — increase in net worth (approximately)
EBITDA? (Earnings before interest, taxes, depreciation and amortization) — what monies are the assets of the company generating in cash terms
Operating income — Net income, excluding one-time charges.
Net income — An attempt to show the repeatable increase in the value of the business, excluding the adjustments that operating income makes.? It also excludes “temporary differences” that are expected to reverse, which go into Accumulated Other Comprehensive Income on the balance sheet, and not through income.? An example would be unrealized capital losses on unimpaired credit instruments.

Which of these measurements should an investor use?

In takeovers, EBITDA is the most relevant, because it shows the cash generating capacity of the assets.
Operating income is the most relevant each quarter for companies that are going concerns.? It excludes “one time” events.
Over the long haul, accumulated net or comprehensive income is the most relevant, because all of the “one time” adjustments are aggregated.

In the short run, the adjustments that come from one-time events (mostly negative) can be tolerated.? But managements are supposed to try to control the factors that generate one-time events in the long run.? That part of their job.? If you have enough track record on a management team, you can sit down and calculate accumulated operating income less accumulated net income.? For good managements, that number is negative to a small positive.? For bad managements, it is a big positive.? I’ve seen estimates over a long-ish period of time, and the average difference between the two is around +5% — +10%.? That much typically goes up in smoke from operating earnings, never to reappear.

Now, some have toyed with adjusted dividend yield formulas, where they add back buybacks, and they use that as a type of true earnings yield.? After all, that reflects cash out the door for the benefit of shareholders.? True as far as it goes, but other uses of retained earnings aside from buybacks are valuable as well.

Buy/create a new technology, plant or equipment
Buy/create a new product line
Buy a competitor, or, a new firm that offers synergies
Buy/create a new marketing channel

In the hands of a good management team, these actions have value.? In the hands of bad management teams, little value to negative value.? So, I prefer earnings to these new measures based off dividends and buybacks for good management teams.? With a bad management team you want them to not have much spare capital for bad decisions, but would you trust the safety of the dividend and commitment to the buyback to a bad management team?? So, in general I prefer earnings, or, if calculable, free cash flow, to dividend/buyback metrics.

What is free cash flow?? The free cash flow of a business is not the same as its earnings. Free cash flow is the amount of money that can be removed from a company at the end of an accounting period and still leave it as capable of generating profits as it was at the beginning of the accounting period. Sometimes this is approximated by cash flow from operations less maintenance capital expenditures, but maintenance capex is not a disclosed item, and changes in working capital can reflect a need to invest in inventories in order to grow the business, not merely maintain it.

Ideally, free cash flow generation is what we shoot for, but it is difficult to estimate in practice.? When I took the CFA exams, the accounting text suggested that the goal of earnings was to reflect free cash flow to the greatest extent possible.? I’m not holding my breath here; I don’t think that goal is achieved or achievable.? To do that, we would have to have managers expense maintenance capex, and we would have to reflect the capital requirements of financial regulators as a cost of doing business for financial companies, and there are many more adjustments like those.

So, I like accumulated net income in the long run and operating earnings in the short run for measuring financial performance.? I’ll give you one more measure to consider which might be better.? From a not-so-recent CC post (point 2, rest snipped for relevance sake):


		David Merkel
		Notes Before I Leave for ANother Series of Conferences
		11/9/04 5:44 PM?ET
1. Be sure and read Howard’s piece “Hurricanes and the Limits of Rebuilding .” He comments more extensively on something I touched on when Frances was threatening Florida. Recovery from disasters often makes GDP look better afterward, because the destruction is not captured in the GDP statistics as a loss, save for the reduction in insurance profits, whereas the work of rebuilding does get fully captured. 2. The same idea can be applied to equity investing. This is why I pay attention to growth in book value per share, ex accumulated other comprehensive income, plus dividends, rather than earnings. Nonrecurring writedowns, charges for changes in accounting principles, and other adjustments, if they happen often enough, it makes a statement about the way a company handles accounting. Companies that are liberal in their accounting may have good looking earnings, but growth in book value per share can be quite poor. I trust the latter measure.

Growth in fully diluted tangible book value (ex-AOCI) is a good measure of firm performance, if you add back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price. Why the current market price?? Some managements buy back stock indiscriminately, not caring about the price at purchase.? That’s rarely a good idea.? Good management teams wait until their shares are near or below their estimate of fair value before they buy back.

Good management teams are also sparing/judicious with share and option grants.? Measuring the cost of the issuance/grants/dilution at the current market price penalizes the financial performance appropriately for what they have given away from shareholders equity per share all too cheaply.

So, that’s my preferred measure for how much has the underlying value of the firm increased: growth in fully diluted tangible book value (ex-AOCI), adding back dividends, and subtract out net equity issuance/buyback measured not at cost, but at the current market price.

There are things that this measure does not capture, though.? Look for places where assets are misstated on the balance sheet. E.g., property may be worth more or less than the carrying value.? Plant and equipment may be worth more or less than the carrying value.? Having a feel for the appreciation/depreciation in value, however slow, can be an aid to estimating the true change in value for a firm.

Estimating the true value of a firm’s earnings is challenging.? There is no one good measure; it depends on the question that you are trying to answer.? But knowing the outlines of of the problem helps in analyzing the earnings releases as they pelt us each quarter.

PS — I know I have excluded EVA, NOPAT, and other measures here.? Perhaps another day…

On Management Books

Posted on 31 July 2008 by David Merkel

I get e-mails from PR flacks asking me to review books on economics and finance.? I tell them, “No guarantee of a review, and if reviewed, no guarantee of a favorable review.”? I give them my address, and they send me a review copy.

I recently received and read a book on how to manage companies better.? After reading it, I was nonplussed.? On the whole, the book was vague and filled with platitudes.? The author claimed to have been a successful CEO of three companies, but he never named the companies, and what digging I did could not turn that fact up.? So, I’m not doing a review or naming the book.? I do know that giving advice to management teams is a career for the writer in his retirement.

Was the advice in the book bad?? Most of it is common sense stuff like how to manage your time, the time of your employees, developing employees, thinking long-term, communicating a vision to employees, etc.? I am reminded of many firms that I have worked for where the management was less than stellar, but it was usually for a pretty basic reason, which varied across the companies.

1) The management team had no idea of how much risk they were taking.? This book would have no relevance to that company, which went bankrupt.

2) The company was seemingly successful, but pressure from a results-oriented management team seemed to lead to compromises in accounting standards.? This book would have no relevance to that company, which is having its share of troubles now.

3) Senior management was insecure about their abilities, and would not listen to their mid-level staffers as problems arose.? This company has merged out of existence.? This book could have been helpful, but as with so many business problems, it is not know what to do, but being willing to do it.

4) The CEO was managing the company to maximize his own pay at retirement.? He succeeded, but the company did badly after his exit, and has merged out of existence.? This book would not have helped, but what management book could convince a man to give up greed, and look out the good of others?? Oh, yeah, the Bible.? But getting someone to read that is harder still.

5) Another seemingly successful company realizes that it needs critical mass outside of its home country, so it starts buying US financial firms.? They buy bargain assets after inadequate due diligence, and end up paying double what they should have.? This book would have been no use to that firm.

6) A rapidly growing asset manager does not realize that they are getting so large that the informal way that they do things isn’t quite cutting it so well, and they need to become more corporate, and less informal/personal.? This book would have given modest help.

7) A business grown from scratch has a strong leader who limits the organization because he has to be involved in everything.? This book would be useful to the organization and him.

8) An organization that excels in design and manufacturing is mediocre in marketing, and poor in financial management.? This book would not help.

So, when I think of how many organizations that I have been closely involved with could have been helped by the book, it is not that many.

Most management book writers don’t have the erudition of the late Peter Drucker, who has long been my favorite writer in this area.? Consider another popular book Good to Great, which still sells quite well.? I usually find the Guy who wrote Freakonomics to be somewhat tedious, but I agree with him on this.? The firms that went from good to great have not been great investments.? If you want to find good investments, it would be better to invest in companies that go from bad to good.? That is where money is made.? The cost of going from bad to good is small, usually, and the reward is high.? The costs are higher going from good to great, and the incremental rewards are not as great.

So, being great is not so great, but being good is pretty good.? If you need to think about management, read books by Drucker; they are classic, and will teach you more than management, they will help you think better.? Look at Buffett and Munger — they are intelligent men who understand people, and are always learning.? They are atypical, but effective CEOs.

There is no one perfect management style, it varies by the individual and the industry.? I would only say this, build up your people skills, industry knowledge, general knowledge, and ability to understand basic finance, and you can do better as a manager.? Most important, is that you have to want to become a better manager, and from my experience, most managers don’t want to do it.

I do have some more book reviews coming up, one on energy, and another few on quantitative finance.

Full disclosure: if you buy books/things from Amazon please consider doing so by entering Amazon through the links on my leftbar.? It will not increase your costs at all, but I will get a small commission.? This is my version of the “tip jar” and the best part of it is it doesn’t cost you a dime.