Accounting – Page 12 – The Aleph Blog

Fannie, Freddie, and the Financing Methods of Last Resort

Posted on 8 July 2008 by David Merkel

Ugh.? I’m still not home yet, but after my recent 48-hour news blackout, the news on Fannie and Freddie is pretty amazing.? Now, I would not be so certain that an interpretation of SFAS 140 would force Fannie or Freddie to raise capital — GAAP accounting often has little to do with regulatory capital rules.? Only if OFHEO decides to mimic the treatment in GAAP would it force capital-raising, absent any net worth covenants on their debt that might be poorly written.

All that said, the problems with Fannie and Freddie are not primarily accounting-driven, but are being driven by diminishing housing prices, which erodes their margin of safety on their lending and loan guarantees, and diminishes the value of the mortgage insurance that they rely on for some of their business.? Writedowns from these items are what hurt.? It is likely that Fannie and Freddie need to raise capital, but the great questions are how much is needed, and how much can the market stomach?

At times like this, I run through my pecking order of the “financing methods 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?

All of these financing methods carry a cost.? (And, as with most situations like this — if it were done, best it should be done quickly.? Delay usually means that cost of financing rises.)? Most of the cost is dilution to existing shareholders, whether common or preferred.? The debt guarantee, or investment by the government has costs for the US taxpayer, which I would rather not see.

Clearly, Fannie and Freddie have room to raise more capital, but the room is not unlimited.? As the Financial Guarantors found, when your stock price gets too low, the jig is up.? You can only raise so much capital relative to the size of your current market capitalization before the market chokes.? After all, most capital raising requires a discount to current price levels, and somehow the diluted value of the equity needs to represent a premium price where new capital gets put in.

In short: it’s tough to get new investors to pay for past losses.? Capitalize a new company?? Could be done, and has already happened with the Financial Guarantors, which has largely sealed the fate of the tarnished incumbents.? That said, why would the US government want a competitor to Fannie or Freddie, aside from GNMA?

As for the US Government, perhaps this all waits for a new President and Congress to act.? Personally, I think that any help extended to Fannie or Freddie should have strings attached.? Investments, or debt guarantees should allow the US government to profit if things turn around.? Other things to explore: only guaranteeing new liabilities, or, expanding the role of GNMA, which is a full-faith-and-credit of the US Government lender.

The one thing I don’t want to see is a bailout that benefits the shareholders of Fannie or Freddie.? They have long had private profits with many public subsidies for years.? Now it is time for the shareholders to bear the losses; let public money only step in to keep senior obligations whole, if it steps in at all.

(Note: these are my private opinions, and not those of my employer.)

A New CEO at AIG

Posted on 17 June 200817 June 2008 by David Merkel

Before I start this evening, I just want to say to new readers who are reading me because my piece, Ten Notes on Crude Oil: The Fixation made an unexpected splash, that my blog is a hodgepodge. I write about a wide variety of topics, but mostly it boils down to macroeconomics, stocks, bonds, portfolio management, value investing, insurance, speculation, real estate and mortgages, and structured products and derivatives. When I wrote more actively for RealMoney, I realized that I was probably the columnist with the widest field, including Cramer. I like to think that I am a good generalist, but I try not to push my expertise beyond its limits. Writing about energy fits into many of my posts, but it is not what I write about most of the time.

On to AIG. I write about AIG this evening, because businessweek.com cites my blog post as the source of “buzz” for breaking up AIG. (I like what I do in blogging, but my voice isn’t that big.)

Well, the dissident shareholders won. Martin Sullivan is out, Robert Willumstad is in. Whether having been part of Citigroup when it grew into a behemoth is an advantage here is questionable. He is clearly a bright guy, but so is Martin Sullivan. One thing is certain, and I wrote about it when Greenberg was shown the door in 2005, no one can replace Greenberg. He built AIG, and he is a bright guy who had his fingers on the pulse of a very complex operation. No one else can match his institutional knowledge, or the culture of fear that he ran.

This brings me to my controversial point for the evening: what if AIG did so well for so long by shading/shaving their reserves? A new CEO coming in to clean up would find a continual stream of assets marked too high, and liabilities markets too low. Martin Sullivan found that out the hard way. What then for Robert Willumstad?

If there are large holes on the balance sheet, the old mantra about eating elephants applies. How do you eat an elephant? One bite at a time. Much as the credit rating has fallen, AIG would not want to see it fall further. If I were in Mr Willumstad’s shoes, I would do a thorough scrubbing of every asset and liability on the balance sheet, and then do the following exercise:

If the restatement is small, take it all at once, declare victory, and make a splash to the media.
If the restatement is moderate, such that it would wipe out a year of earnings or so, take some writeoffs quarter by quarter, until the hole is filled.
If the restatement is large, such that it would wipe out 3-5 years of earnings, or wipe out a large amount of book value, I would create a plan for a turnaround, and then sit down with the rating agencies and the regulators. That would minimize the ultimate damage. The stock price would get killed when the problems are revealed, though.

I have a few other thoughts if the loss is larger still, but I will leave those to the side, because they would be too sensational. Now as to breaking up AIG, this WSJ article suggests that some units could be sold. That’s a good idea; as companies get huge, diseconomies of scale set in. It becomes more and more difficult to manage behemoth firms.

Perhaps AIG can get back to areas where they had a true sustainable competitive advantage: serving foreign markets where there is little/less competition. Maybe ILFC [International Lease Finance Corp]. Beyond that, what is truly distinctive about AIG? In my opinion, not that much.

The Bottom for the Banks

Posted on 14 June 200815 June 2008 by David Merkel

There are many people calling for a bottom to banking stocks, and I must admit, it is a tempting place to play. I never thought Fifth Third would trade so low. Or Keycorp. Royal Bank of Scotland, sorry, I sold you early in 2008; yes, I thought you would fall. When does the excessive leverage finally eliminate the CEO?

Here’s the challenge for investors: on the one hand, you have declining earnings per share in the near term, from losses and capital raises. But when have equity prices fallen enough to discount the future losses?

I am being cautious here. I own no banks.

Here’s another way to think about it — after all of the bad debts are written off, and bad banks eliminated, what kind of earnings stream will be attractive?

I’ll use the homebuilders as an example here — at troughs, they sometimes trade for half of written-down book value, The question becomes the final side of the book value after the writedowns.

I would still be cautious here, but markets are discounting mechanisms — we are getting closer to a bottom in the banks; we are not there yet.

The rating agencies have been dragged. When will the kicking and screaming stop?

Posted on 5 June 2008 by David Merkel

First, an old RealMoney Columnist Conversation post:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Position: none

And this comment that I left at WSJ MarketBeat on their article Ambac Falls on S&P 500 Deletion.

Can we get the equity side of S&P to chat with the debt ratings side? Debt ratings always have a bias toward bigger firms, and Ambac is no longer big enough to rate being in the S&P 500.

Quick, name another corporation that is AAA that is not in the S&P 500. Berkshire Hathaway, but that is because the float is small? but wait, Ambac the holding company is only AA, their regulated subsidiaries are AAA.

Are there any AA- or better US publicly traded corporations not in the S&P 500? One AA ? Genentech. Three AA-: MGE Energy, WGL Holdings, and Northwestern Natural Gas? two utilities and a gas pipeline. Decidedly more stable businesses than Ambac.

So, S&P debt ratings, take the hint from your corporate brother, and downgrade Ambac.

Comment by David Merkel – June 4, 2008 at 11:07 am

Now, consider this article from the AP, where they say: “Despite raising $1.5 billion in new capital in March, Ambac’s financial flexibility has deteriorated, Moody’s said. A decline in the firm’s market capitalization and high spreads on its debt securities makes it difficult for the company to address potential capital shortfalls.”

Also quoting from the post at Accrued Interest, quoting from the Moody’s report, “Moody’s stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK’s financial flexibility since the company’s $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm’s market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company’s capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac’s ability to regain market acceptance and underwriting traction within its target markets.”

Now, maybe I’m nuts, but when I think of debt ratings, I don’t want to directly consider the ability to raise new equity capital as a significant factor in my rating decisions.? Why?? Because deterioration can happen slowly, but it doesn’t have to.? Companies the are AAA or AA should be beyond the possibility of having to do a forced equity raise in anything short of a depression.? Aside from that, the decision to raise equity capital is discretionary, and managements rarely do it at the right time — when things are going well.

Naked Capitalism calls it the Monoline Death Watch, and Yves is spot-on.? For financial guarantors, ratings are a slippery slope.? You can go down, but you can’t easily go up.? MBIA and Ambac are close to being in runoff now.? Losing the AAA from either agency will seal that.? Also, once one agency downgrades, the other will quickly follow.? There will be new start-ups, but for now Berky, Dexia, and Assured Guaranty will make hay while the sun shines — they are the new oligopoly, and won’t do structured finance, for now.

PS — If indeed FASB eliminates QSPEs by modifying SFAS 140, and if there are no financial guarantors willing to do structured finance, then what happens to securitization?? It is too useful of an idea to disappear.? I don’t think it will disappear; I just don’t know the form in which it will reappear.? I’ll toss out this idea: Wall Street creates a bunch of small cap companies to own the assets, and the tranches, are simply different levels of subordinated debt.

A Comment on SFAS 159

Posted on 3 June 2008 by David Merkel

I am ambivalent about fair value accounting standards because they ruin comparability of financial statements across companies.? Recently, SFAS 159 has come into the news because some securities firms used it to book gains because the market value of debt that they issued had fallen.? Four notes:

1) They had no choice, they had to do it.? Their debt has liquid markets — those are level 1 and at worst level 2? liabilities.

2) Many of the assets that they carry have credit risk also.? The pressures that are leading the prices of their debt to fall, are also causing the carrying value of some of their assets to fall as well.

3) If credit markets for their debt improve, they will have to write those liabilities up to higher values.? Even if creditworthiness stays the same, the passage of time will make the liabilities rises in value as they get closer to the ultimate payoff.

4) In bankruptcy, their obligation to pay par does not change.? It is not as if they can pay the reduced market? value to pay off their debt, except through a deal agreed to by the court and plaintiffs.

Look, I don’t like the confusion SFAS 159 creates at this point any more than the next guy, but the gains here will likely reverse over time, absent bankruptcy.? As an analyst, I strip those gains out of income, and I should strip out losses on the asset side that I think will reverse as well.

We can change the way that gains and losses are reported — book, market, model, hybrid… but we can’t change the ultimate cash flows from the business, which is what will ultimately drive the value of the firm.? Be careful and conservative here, as accrual entries get more subjective, they become less trustworthy, and managements on average release more into income from accrual entries than they ought to.

Ten Things Not To Worry About

Posted on 16 April 2008 by David Merkel

There are many that cover the markets that try to get you to worry about things that aren’t real problems.? Here’s a sampling for the evening:

1) Changes in accounting standards, or ineffective/opaque accounting standards.? Take Goldman Sachs and level 3 assets as an example.? The accounting standard is fine, so long as you understand it.? In general, the higher the level of level 3 assets, the more opaque the valuation of assets is, and a valuation haircut gets assigned to the stock.? This is proper, because it happens to all companies with high or cloudy accrual figures.? It makes it hard to estimate free cash flow.

Should we move from US GAAP to IFRS, it should not affect the valuations of stocks on average, though it will make it a little harder to do financial analysis.? What does not change is free cash flow, which is not subject to accounting rules.? The money that can be withdrawn from a business without harming its current prospects (free cash flow) is the key metric for understanding business value.

2) Counterparty risk.? In derivatives, for every loser, there is a winner.? So long as the appropriate margin levels are maintained at the main brokerages, and the main brokers don’t experience conditions that dramatically change their credit quality, counterparty risk is not a problem.? (Or maybe, I should say, worry about the brokers, not the other counterparties.)

3)? Investors moving to cash.? Money rarely leaves the market.? When funds raise cash (and here), others buy their shares at a discount.? Typically, they are stronger holders than those that sold.? I wouldn’t be too bullish over stories of investors moving to cash, but I certainly would not be bearish.

4)? Rating agency downgrades, unless they trigger a debt covenant.? For the most part, market spreads and yields are set independently of debt ratings.? Sophisticated investors dominate the market, not the rating agencies.? As an example, suppose the US were downgraded to Aa1/AA+/AA+.? After a week, I doubt yields would change much at all, because the fundamental view of the US would not be changed by a change in its rating.

5) High credit spreads.? Those are a reason to be optimistic, because it means pain has been taken already.? Spreads can’t get higher than a certain level, or companies start delevering, because it is profitable to do so.? So when you see spreads near record highs, that is a buying signal, at least for the debt.

6) Retailers in trouble.? Some retailers are always in trouble during hard economic times.? It’s a tough business model, so expect some defaults; it is normal and healthy for the economy as a whole.

7) Collapse of a large portion of the auction rate securities market. ? Most borrowers will refinance.? In the interim, speculators are driving down the rates that get paid.

8) Downgrades of the major financial guarantors.? The market has priced it in, and perhaps we just run off MBIA and Ambac.

9) Tranche warfare in CDOs.? Read your prospectus with care, but when the seniors grab hold of a deal after and event of default, that is a step toward normalizing the market, though the mezzanine holders may ineffectively object as they end up getting nothing.

10) The ABX indexes, etc.? I’ve written about this before, but the various synthetic indexes — ABX, CMBX, LCDX, etc., are very hard to arbitrage against the cash market bonds that they represent.? The indexes should not be used for pricing as a result.? Whenever the synthetic market gets too much bigger than the cash market, it becomes a bettors market, and becomes incapable of delivering pricing signals to the underlying cash markets.

There are enough real things to worry about.? Perhaps I will write about those tomorrow.

The Economics of SFAS 157

Posted on 2 April 20082 April 2008 by David Merkel

I’m not crazy about flexible accounting standards because they destroy comparability across companies, with perhaps a gain in accuracy within companies. We’ve had a lot of noise in the blogosphere recently regarding the SEC allowing companies to ignore prices if they are the result of forced sales or tax-loss selling. You might expect me to say that the SEC is nuts again. You would be wrong.

I am aware of reasons there are economic for one party to sell, that do not appeal to the bulk of investors, and I have seen forced sales for tax and other reasons. Even with those sales, the market is thin. Almost every transaction is special; trades are by appointment only, unless someone offers a humongous bargain for immediate liquidity. I have seen this in the market myself, and seen management teams struggle with how to price an illiquid bond when tax loss sellers bomb the market at the end of a year

So, when I read facile pieces suggesting that FAS 157 has been gutted, (and here) I just groan. With level 3 assets, the markets must be very thin, not nonexistent. Prices in a thin market rarely represent the net present value of the future cash flows to the average market participant.

Also, one should realize that SFAS 157 merely cleans up the rules for how assets are to be valued under SFAS 133. Calculating “fair value” is often hard, though unscrupulous managements will take advantage of that flexibility. At least we have rules to determine when we use market prices, figures that derive directly from other market prices, and figures where a discounted cash flow analysis, or something like it must be employed.

Was the move of the SEC a big help? A help, yes, but a wee one. Companies could already under SFAS 157 make the argument that the SEC blessed. The SEC simply makes that argument easier.

All that said, I don’t think that SFAS 157 has that much economic impact, compared to the way firms finance themselves. A loss of liquidity does far more damage than volatility in earnings results, unless there are debt covenant violations.

In the end, I am saying that there is an issue here, but it is not a big one. Better that companies in trouble would lower their leverage, and finance long-term, which costs more in the short run but preserves the company to fight another day.

Mark-to-Market Accounting Is not the Major Problem

Posted on 21 March 200823 May 2013 by David Merkel

I?m not a fan of mark-to-market accounting, partially due to the loss of comparability across firms. It introduces a level of flexibility that can be gamed by the unscrupulous. That said, any accounting method can be gamed. Accounting attempts to assign the value of economic activity at and across points in time.

Now, with financial firms, there are typically several accounting bases going on at the same time. There?s GAAP, Regulatory, Tax, and then the accounting for special agreements, which may be different than any of the three major accounting bases.

Why has mark-to-market come up as an issue recently? Because it has seemingly created downside volatility in the financial statements, leading investors to panic, which pushes down security prices.

In my opinion, the greater problems are how a firm finances itself, how it is regulated, and negative optionality in its assets and positive optionality in its liabilities. I?ll give some examples to illustrate:

With Thornburg, the problem was over-reliance on short-term lending to finance long term assets. It doesn?t matter how you do the GAAP accounting here. The brokers will look at the day-to-day market value of the positions versus the capital supporting them. If the capital becomes insufficient to carry the position, the positions will be liquidated. Given that there were a lot of players with similar trades, and funding in the repo market, that created an ideal setup for the most levered to lose a lot as financing dried up.

Bear Stearns also relied on short-term financing. Bear ran with high leverage that made them vulnerable to attacks from those that bought credit protection in the credit default swap market? as those spreads went up, the willingness to extend credit went down. Ratings downgrades pushed up, and in some cases eliminated the willingness of lenders to extend short term credit. (Bear also lacked friends to help them in their time of need, a payoff for not helping on LTCM. Lehman had similar leverage, but the Street supports it.) Also, derivative agreements often specify a need for more collateral if downgrades occur, which is exactly the wrong time to have to provide more collateral. Again, this has nothing to do with GAAP accounting, but it has a lot to do with positive optionality in the liabilities of the firm. (I.e., the liability can get more onerous under conditions of stress.)

Consider PXRE, which recently merged with Argonaut Group. When the storms of 2005 hit, they claims against them were bad enough, but many of their reinsurance agreements had downgrade clauses, saying they would have to post collateral. Though it didn?t bankrupt them, it could have, and they had to find a buyer. Nothing to do with GAAP accounting.

General American wrote a bunch of floating rate Guaranteed Investment Contracts that had 7-day put provisions after a ratings downgrade. They wrote so much of them, that they comprised 25% of their liability structure. When they got downgraded, they could not meet the call on liquidity. They wen insolvent. Nothing to do with GAAP accounting.

CIT got downgraded and drew down their revolver because of a liquidity shortfall. The stock has fallen more then 80% in the past year. Mark-to-market accounting to blame? No, deteriorating assets and too much short-term financing.

I could go on. Regulators are under no obligation to use mark-to-market accounting, and they can set capital levels as they please. Optimally, regulators should look at risk based liquidity. How likely is it that a financial firm will have adequate liquidity in all circumstances? How safe and liquid are the assets? Is the liability structure long enough to support them? Can the liability structure dramatically shorten? (I.e., a run on the bank.)

Deterioration in the value of assets has to be addressed by accounting somehow. But regardless of the method, those that finance the company will look beyond the published GAAP financials, and will look at the cash generation capacity of the firm over the life of the loan, and how prone to change that could be. Even if a firm could take an asset worth 80 cents and mark it at $1.00, the sophisticated lenders would only assign 80 cents of value.

Along with The Analyst?s Accounting Observer, I don?t see mark-to-market accounting as a major threat to the solvency of firms. The companies that have gotten into trouble recently have held assets of dubious quality, and have financed themselves with too much leverage, borrowing short-term, and/or implicitly sold short options against their firms that weakened themselves during a crisis. Dodgy assets and liquid liabilities are poisonous to any firm, regardless of the accounting method.

The Value of a Balance Sheet

Posted on 11 March 2008 by David Merkel

Monday, at about 10AM, I sold my holdings in Deerfield, Deutsche Bank, and Royal Bank of Scotland.? I did it bloodlessly, realizing that Deerfield is the largest loss I have ever taken.? With the proceeds, I bought two placeholder assets that I will hold until the next reshaping (coming in a month), the Industrial (XLI) and Technology (XLK) Spiders.? By doing that, I cut the majority of the links that I had to the leveraged lending economy, which is collapsing at present.? When I saw that haircuts on repo for prime agency collateral had been raised for the second time, I threw in the towel, because too many things have broken that even I did not expect would break. (Even the haircuts on Treasuries have risen.)

With Deerfield, I made the error that if the collateral was very high quality, it could survive, even at high levels of leverage.? In a true panic, that does not matter.? All that matters is whether your leverage is low enough to allow you to survive the credit bust, and that you can do that over your financing horizon.

Financing horizon?? By that I mean how often your solvency gets measured.? For many mortgage REITs, that is a daily, weekly, or monthly phenomenon.? The longer the period, the better the odds of survival.? Short repo financing is by its nature is a weak financing method in a crisis.? The day you cross the line (margin inadequate) the brokers move to liquidate.? Given that some other managers may have been more aggressive, your excess capital can disappear, as more aggressive mangers miss margin calls, and the pressure of their liquidations, forces your more conservative positions down, and you have to liquidate also.

Now, think of a life insurance company, a long-tailed casualty insurer or a defined benefit pension plan.? If they buy AAA whole loans, or prime mortgage collateral, they can hold that position for 3+ years without worry.? Their liabilities aren’t going anywhere.? They know what they will be able to hold the investment through the panic period.? There are still questions over what the best time to buy is, but with many large companies or plans, the optimal thing to do is to suck in a little bit each day, quietly, when the bonds are cheap.? You won’t get the exact bottom; no one does, but you will do well.? My own example is buying floating rate trust preferreds back in late 2002.? Bought a 2% position over two months for my life insurance client without disturbing the markets.? My client cleared a minimum of 10% on those investment grade bonds within a year as the panic lifted.

Accounting vs. Financing

Now, there’s a lot of talk about fair value accounting standards, and how they are adding to the volatility at present.? They are adding to the volatility, but they have less effect than the way things get financed.? Unless the fair value accounting leads a company to violate a debt covenant, typically it does not have that much effect, because it does not change the pattern of cash flows that the company will generate.? Short term financing, where the portfolio’s “market value” gets measured on a daily basis has a much bigger impact, because as prices fall, liquidation of assets can feed a collapse of prices.? Or consider this article from Going Private, which cites an article from Financial Crookery, which highlights an attempt by Merrill Lynch to avoid having to pay out cash on a putable bond.? In order to do that, they make the bond more valuable, so that it won’t be put.? But this isn’t an accounting issue.? It is a financing issue.? Merrill doesn’t want to part with cash now, so it makes its future financing schedule more difficult.? It is a complex way of selling off a bit of the future in order to bail out the present.

Now, I disagree with The Economist article that spawned those posts as well.? There is a better way.? In place of the four common financial statements (Income Statement, Balance Sheet, Cash Flow Statement, and Shareholders Equity), have six.? The two additional statements would come from having a amortized cost income statement, and a fair value statement, and then, the same for the balance sheet.? It would not be a lot of extra work, because all of that data has to be gathered now already.? It would just create two different ways of looking at a financial entity.? One views it as a buy-and-hold investor (amortized cost), and the other as a trader (fair value).? The interpreter of those statements could decide which is more relevant.

I proposed this to an IASB commissioner 2-3 years ago, and she was horrified at the idea.? Two income statements?? Two balance sheets?? What confusion.? I pointed out to her that every financial statement is designed to answer one question.? Bond investors have to rearrange the data to do their analyses; we could create an EBITDA statement to make life easier for them, but we don’t.? The two statements types define two different ways of looking at a firm.? Each is more valid in different situations.

Now, for utility and industrial firms, these distinctions usually don’t matter much, but they do matter for financial firms.? There could be a seventh statement added there, which life insurance companies calculate for their regulators.? All financial companies should have cash flow testing done over the greater of the life of their assets and liabilities, over a wide number of interest rate and credit scenarios, calculating the present value of distributable earnings, to show where they are vulnerable.? They should publish the assumptions and results, and then let the market stew over them.

Now, for my actuarial friends, this would be the “Actuarial Full Employment Act.” Life Insurers control risk not by looking at short term movements in market prices, but through long-term stress testing.? It is no surprise that the insurers are doing much better than the banks in this environment.

Berkshire Hathaway — The Anti-Volatility Fortress

Posted on 1 March 2008 by David Merkel

I?ve commented on Buffett?s Shareholder letter now for the past five years.? Those who know me well know that I admire Buffett and Berky, but not uncritically.?? Also, I view Berky as primarily an insurance company, secondarily as an industrial conglomerate, and thirdly as an investment company.

Onto the letter:

From page 3:

You may recall a 2003 Silicon Valley bumper sticker that implored, ?Please, God, Just One More Bubble.? Unfortunately, this wish was promptly granted, as just about all Americans came to believe that house prices would forever rise. That conviction made a borrower?s income and cash equity seem unimportant to lenders, who shoveled out money, confident that HPA ? house price appreciation ? would cure all problems. Today, our country is experiencing widespread pain because of that erroneous belief. As house prices fall, a huge amount of financial folly is being exposed. You only learn who has been swimming naked when the tide goes out ? and what we are witnessing at some of our largest financial institutions is an ugly sight.

Buffett starts out with the cause behind most of our current problems in financial companies.?? There are too many houses chasing too few people, and inadequate underwriting of the financing, because of a misplaced trust in the rise of housing prices.

From page 4:

Though these tables may help you gain historical perspective and be useful in valuation, they are completely misleading in predicting future possibilities. Berkshire?s past record can?t be duplicated or even approached. Our base of assets and earnings is now far too large for us to make outsized gains in the future.? (emphasis his)

Buffett has been honest on this point for years.? As the business grows, it is unlikely to find opportunities as good in percentage terms as it did when it was smaller.? That?s normal, even for the best investors.

In our efforts, we will be aided enormously by the managers who have joined Berkshire. This is an unusual group in several ways. First, most of them have no financial need to work. Many sold us their businesses for large sums and run them because they love doing so, not because they need the money. Naturally they wish to be paid fairly, but money alone is not the reason they work hard and productively.

Buffett hits on what I think is one of the great secrets of good capitalism.? The best capitalists are not purely money-motivated, but are idealists, aiming for excellence as they serve others though their businesses.? In the best businesses that I have worked in, we did it because we loved what we did.? That?s a key for all good businesses, from the CEO down to the clerk.

From page 7:

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There?s no rule that you have to invest money where you?ve earned it. Indeed, it?s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can?t for any extended period reinvest a large portion of their earnings internally at high rates of return.

This is the core of Buffett the businessman.? He understands the need to redirect free cash flow to the opportunities that offer the best returns.? He knows that certain businesses will never be more than niches, and like a good farmer would, harvests his specialty crop each year, but doesn?t plant much more the next year.

He goes on for two pages on how he distinguishes between businesses, considering their long-term competitive advantage, return on investment, and capital intensiveness.??? It?s a good read, and very basic.? If it weren?t for the fact that many companies operate more for the good of management than shareholders, you might see this in operation more broadly.? (And you would see opportunities diminish for private equity as far as big deals go.? Private equity keeps public management teams on their toes, for the bigger deals.)

From pages 9-11, Buffett discusses his insurance businesses, and spends much less time on them than in prior years.? It is not as if there isn?t a good story to tell.? Are underwriting profits down?? Yes, but only by 10%.? The rest of the P&C insurance industry is struggling with the same problems, and is likely doing worse in aggregate.? I think that some major disasters will have to happen to re-energize earnings here.? Berky is an anti-volatility asset, and always does relatively better when the rest of the insurance industry is hurting.

On page 11, Buffett comments on his utility businesses.? Earnings are up in this line.? These are a natural fit for Berky, with their earnings yield considerably above Berky?s cost of float, and earnings that tend to do well when inflation is higher.? Expect Buffett to buy more here, but only during some significant pullback in utility stock prices.

From that page:

Somewhat incongruously, MidAmerican also owns the second largest real estate brokerage firm in the U.S., HomeServices of America. This company operates through 20 locally-branded firms with 18,800 agents. Last year was a slow year for residential sales, and 2008 will probably be slower. We will continue, however, to acquire quality brokerage operations when they are available at sensible prices.

From page 13:

Last year, Shaw, MiTek and Acme contracted for tuck-in acquisitions that will help future earnings. You can be sure they will be looking for more of these.

and

At Borsheims, sales increased 15.1%, helped by a 27% gain during Shareholder Weekend. Two years ago, Susan Jacques suggested that we remodel and expand the store. I was skeptical, but Susan was right.

From page 15:

Clayton, XTRA and CORT are all good businesses, very ably run by Kevin Clayton, Bill Franz and Paul Arnold. Each has made tuck-in acquisitions during Berkshire?s ownership. More will come.

Buffett understands that most good acquisitions are little ones that can be used to increase organic growth of the subsidiary. ?Same thing for intelligent capital spending, as at Borsheim?s.? He may keep a tight hold on free cash flow, but he listens to his subsidiary CEOs, and usually gives them enough to invest to improve the businesses.

Also look at the countercyclical nature of Buffett?s acquisitions.? He is willing to buy real estate sales franchises in this environment, if they come at the right price.? Much as I am a bear on housing, this is the right strategy, if you have a strong enough balance sheet behind it.

On pages 12 and 14, net operating income improved in Manufacturing, Service, and Retailing Operations, and fell in Finance and Finance Products.? He doesn?t discuss it, but there was a loss in life and annuity.? Berky mainly does life settlements there, a business I regard as somewhat malodorous because it undermines the life insurance industry, by weakening the concept of insurable interest.? Also, leasing didn?t do that well, as Buffett points out.

On page 15, I don?t have a strong opinion on his stock positions? they are a little more expensive than I like to buy, but he has to deploy a lot more money than I do, and has a longer time horizon.? His focus on long term competitive advantage is exactly right for his position in the market.

On page 16, Buffett discusses his derivative book:

Last year I told you that Berkshire had 62 derivative contracts that I manage. (We also have a few left in the General Re runoff book.) Today, we have 94 of these, and they fall into two categories. First, we have written 54 contracts that require us to make payments if certain bonds that are included in various high-yield indices default. These contracts expire at various times from 2009 to 2013. At yearend we had received $3.2 billion in premiums on these contracts; had paid $472 million in losses; and in the worst case (though it is extremely unlikely to occur) could be required to pay an additional $4.7 billion.

We are certain to make many more payments. But I believe that on premium revenues alone, these contracts will prove profitable, leaving aside what we can earn on the large sums we hold. Our yearend liability for this exposure was recorded at $1.8 billion and is included in ?Derivative Contract Liabilities? on our balance sheet.

The second category of contracts involves various put options we have sold on four stock indices (the S&P 500 plus three foreign indices). These puts had original terms of either 15 or 20 years and were struck at the market. We have received premiums of $4.5 billion, and we recorded a liability at yearend of $4.6 billion. The puts in these contracts are exercisable only at their expiration dates, which occur between 2019 and 2027, and Berkshire will then need to make a payment only if the index in question is quoted at a level below that existing on the day that the put was written. Again, I believe these contracts, in aggregate, will be profitable and that we will, in addition, receive substantial income from our investment of the premiums we hold during the 15- or 20-year period.

Two aspects of our derivative contracts are particularly important. First, in all cases we hold the money, which means that we have no counterparty risk.

Second, accounting rules for our derivative contracts differ from those applying to our investment portfolio. In that portfolio, changes in value are applied to the net worth shown on Berkshire?s balance sheet, but do not affect earnings unless we sell (or write down) a holding. Changes in the value of a derivative contract, however, must be applied each quarter to earnings.

Thus, our derivative positions will sometimes cause large swings in reported earnings, even though Charlie and I might believe the intrinsic value of these positions has changed little. He and I will not be bothered by these swings ? even though they could easily amount to $1 billion or more in a quarter ? and we hope you won?t be either. You will recall that in our catastrophe insurance business, we are always ready to trade increased volatility in reported earnings in the short run for greater gains in net worth in the long run. That is our philosophy in derivatives as well.

Okay, so Buffett is long high yield credit, and seemingly receiving a pretty reward for it (the numbers seem too good, what is he doing?), and is long the US and other equity markets by writing long-dated European puts.? Sounds pretty good to me on both, though I?d love to see the details on the high yield, and on the equity index puts, Berky will be vulnerable in a depression scenario (it would be interesting to know the details there also).

Buffett is behaving like a long-tail P&C insurer, and he is willing to take on volatility if it offers better returns.? Berky is almost always willing to take on catastrophe risks, if they are more than adequately compensated.? If you are uncertain about this, ask the financial guarantors, they will tell you.

On page 17:

There?s been much talk recently of sovereign wealth funds and how they are buying large pieces of American businesses. This is our doing, not some nefarious plot by foreign governments. Our trade equation guarantees massive foreign investment in the U.S. When we force-feed $2 billion daily to the rest of the world, they must invest in something here. Why should we complain when they choose stocks over bonds?

Indeed, what?s sauce for the goose is sauce for the gander.? Why should the rest of the world buy our depreciating bonds, when they can buy our companies, which in my opinion, often offer much better prospects?? As Buffett puts it later, we are force-feeding dollars to the rest of the world? the decline in value is to be expected.

Also on page 17:

At Berkshire we held only one direct currency position during 2007. That was in ? hold your breath ? the Brazilian real. Not long ago, swapping dollars for reals would have been unthinkable. After all, during the past century five versions of Brazilian currency have, in effect, turned into confetti. As has been true in many countries whose currencies have periodically withered and died, wealthy Brazilians sometimes stashed large sums in the U.S. to preserve their wealth.

Clever move, and emblematic of the shift happening in our world where resource- and cheap labor-driven nations grow rapidly, and build up trade surpluses against the developed world.? Their currencies have appreciated.

Also on page 17:

Our direct currency positions have yielded $2.3 billion of pre-tax profits over the past five years, and in addition we have profited by holding bonds of U.S. companies that are denominated in other currencies. For example, in 2001 and 2002 we purchased ?310 million Amazon.com, Inc. 6 7/8 of 2010 at 57% of par. At the time, Amazon bonds were priced as ?junk? credits, though they were anything but. (Yes, Virginia, you can occasionally find markets that are ridiculously inefficient ? or at least you can find them anywhere except at the finance departments of some leading business schools.)

The Euro denomination of the Amazon bonds was a further, and important, attraction for us. The Euro was at 95? when we bought in 2002. Therefore, our cost in dollars came to only $169 million. Now the bonds sell at 102% of par and the Euro is worth $1.47. In 2005 and 2006 some of our bonds were called and we received $253 million for them. Our remaining bonds were valued at $162 million at yearend. Of our $246 million of realized and unrealized gain, about $118 million is attributable to the fall in the dollar. Currencies do matter.

Though Buffett got scared out of many of his foreign currency positions over the last few years, intellectually he was right about the direction of the US dollar, and made decent money off it.? The Amazon position was a home run in bond terms.? Bill Miller benefited from that one as well.? (I also endorse the comment on occasional inefficient markets.)

On page 18:

At Berkshire, we will attempt to further increase our stream of direct and indirect foreign earnings. Even if we are successful, however, our assets and earnings will always be concentrated in the U.S. Despite our country?s many imperfections and unrelenting problems of one sort or another, America?s rule of law, market-responsive economic system, and belief in meritocracy are almost certain to produce ever-growing prosperity for its citizens.

This is one of America?s greatest sustainable competitive advantages.? We allow more flexibility and failure than anywhere else in the world.? We have a relatively open and free system of markets and government.? Woe betide us if we change this.

On pages 18-20, Buffett takes on employee stock option accounting and pension accounting.? He believes options should be expensed, and that companies should bring down their assumptions for investment earnings, because they are unrealistically high.? I agree on the latter, and on the former, I think full disclosure is good enough.? Accounting rules are important, but investors (like Buffett) look for long-term free cash flows, which are largely unaffected by accounting rules.

I don?t think the market is fooled in either case.? Companies with large stock option grants and high assumed earning on pension plans both tend to trade cheap.? Their earnings quality is light.

Finally, on page 20:

Whatever pension-cost surprises are in store for shareholders down the road, these jolts will be surpassed many times over by those experienced by taxpayers. Public pension promises are huge and, in many cases, funding is woefully inadequate. Because the fuse on this time bomb is long, politicians flinch from inflicting tax pain, given that problems will only become apparent long after these officials have departed. Promises involving very early retirement ? sometimes to those in their low 40s ? and generous cost-of-living adjustments are easy for these officials to make. In a world where people are living longer and inflation is certain, those promises will be anything but easy to keep.

Ummm? say it again, Warren.? I?ve been saying this for years.? Hey, throw in multiple employer trusts as well.

With that, I would offer two observations about this letter from Warren.? First, it is shorter, and contains less data on the businesses, particularly the insurance businesses, but then, it was a quiet year.? Second, he had less in the way of ?soap box? issues this year.

In closing, Berky had a good year, and I have little to quibble with in this letter.? Another good job, Warren.