Accounting – Page 7 – The Aleph Blog

Portfolio Rule Five

Posted on 16 October 201017 October 2010 by David Merkel

News: I’m planning to submit my paperwork to Maryland on Monday for registering my investment advisory.? Aside from that, I am giving a talk on the Efficient Markets Hypothesis in New York City on Wednesday to the Society of Actuaries.? Onto tonight’s topic:

Analyze financial statements to avoid companies that misuse generally accepted accounting principles and overstate earnings.

Maybe I should rephrase that to be “avoid companies that abuse their accounting, overstating earnings,” because it is perfectly possible to overreport earnings, while staying within the boundaries of GAAP accounting.? Over time, I have developed four broadbrush rules that help me detect overstated earnings. Here they are:

For nonfinancials, review the difference between cash flow from operations and earnings.? Companies where cash flow from operations does not grow and? earnings grows are red flags.? Also review cash flow from financing, if it is growing more rapidly than earnings, that is a red flag.? The latter portion of that rule can be applied to financials.
For nonfinancials, review net operating accruals.? Net operating accruals measures the total amount of asset accrual items on the balance sheet, net of debt and equity.??? The values of assets on the balance sheet are squishier than most believe.? The accruals there are not entirely trustworthy in general.
Review taxable income versus GAAP income.? Taxable income being less than GAAP income can mean two possible things: a) management is clever in managing their tax liabilities.? b) management is clever in manipulating GAAP earnings.? It is the job of the analyst to figure out which it is.
Review my article “Cram and Jam.”? Does management show greater earnings than the increase in book value plus dividends?? Bad sign, usually.? Also, does management buy back stock aggressively — again, that’s a bad sign.

The idea is to see how honest and focused on the long term the management team is.? Management teams that cut corners in financial reporting will cut corners elsewhere, and deliver negative surprises to you.? That’s what I aim to avoid.

Financial Statements Have One Major Purpose Each

Posted on 8 October 2010 by David Merkel

Financial statements encourage us to look at the bottom line.? The bottom line indicates the purpose of financial statement.? With an income statement, the purpose is to show us how much the company has profited.? With a balance sheet, the purpose is to show us how much the company is worth on a book value basis.? Now, book value is nowhere near perfect, but neither is it to be neglected, so neglect book value, particularly tangible book value at your peril.

Then there is the cash flow statement.? The main idea that there is to look at the change in net cash of the corporation.? But the subordinate goals of the cash flow statement are to show us how much cash has been generated from operations, how much has been used in investing, and how much has been acquired through financing.? There are many scams with the cash flow statement most of which try to recharacterize cash flows from financing or investing into operations if they are positive.

Finally, there’s the statement of shareholder equity.? This forgotten statement helps to clarify who owns what and clarify where book value comes from.? What is the effect on book value from new shares and their equivalents?? How was book value increased or decreased various corporate actions and why?

That said, the financial statements each have one major purpose, unless they can be adjusted for other purposes.? A stock investor will want to understand earnings per share and how it is changing.? But a bond investor will want to look at EBITDA, which shows how much cash is available to service debt.? To the stock investor, EBITDA is not very useful, except in the situation where the company might be a takeover target.? In that case, the acquirers may be looking at EBITDA because they will be financing the acquisition with a large slug of debt.

Someone doing an analysis of the industry on the whole is going to abstract from interest, taxes, depreciation, amortization, and will focus on gross revenues or maybe even revenues.? It all depends on the type of analysis that you are doing.? In one sense, every analyst must adjust the statements that they look at in order to reflect the claim priority of the investor for which they are analyzing.

Common stockholders should view statements differently than preferred stockholders who should view statements differently than junior debtholders who should view statements differently than senior debtholders. (Need I mention the bank debt holders or trade claimants? Nah, but they have different goals as well, and use the statements differently.)

Existing income statements and balance sheets and cash flow statements are designed for equity investors, because they run the calculations for the residual income claimant, the equity investor.? Bond investors, bank debt investors, have to think in these terms: what type of revenue or operating income is necessary for me to get paid dollar one, and for me to get paid in full?? And how likely are each of those events?? The same set of questions can be applied to the balance sheet where the debt investor asks what it would take for his claim to be impaired in bankruptcy, or wiped out in full.? And then the debt investor can ask how likely those events could be.

The boundary line answers for these questions may be easily calculated, but the probabilities will be more subjective, and depend on estimates of the likelihood of future revenue or operating earnings.

I don’t have a lot more to say here.? Just be aware of what question you’re trying to ask of financial statements, and if you’re other than the equity investor, make the necessary adjustments so that you get the answer that is tailored to your questions.

Earnings Estimates as a Control Mechanism, Flawed as they are, Redux

Posted on 6 October 2010 by David Merkel

One of my favorite topics to write about is portfolio management.? That’s because I love my methods for managing equities and bonds.? The methods work, but they aren’t a lot of work.? So, I enjoyed writing my piece last night, Earnings Estimates as a Control Mechanism, Flawed as they are.? And I got two good comments that I would like to develop here.? Here?s the first comment:

Actually, David, I think you have left out the more pressing issue with earnings estimates.

The system, such as it is, has evolved as a collaboration between the companies and analysts to promulgate estimates that are deliberately LOWER than is realistic. Both parties know that stock prices do well when they beat estimates, and it is a lot easier to set the bar really low than to actually outperform realistic expectations. I think many small investors don?t realize how the analysts are linked at the hip to the companies they supposedly cover objectively?when the stocks do well, the analysts do well!

This of course is the data shows that 60-70% of companies beat estimates every quarter, even in lousy years, and why you see stocks almost always beat the bottom line estimates even when they fall short of revenue estimates.

Just another way in which the integrity of the markets is in an utter shambles.

I appreciate what you have to say, but it is not something that I did not consider.? I omitted it for reasons of brevity, and I will explain why here.? If management team lowballs earnings estimates, they raise their forward P/E, which is a drag on their stock price.? There is no free lunch here; stock prices converge on the market?s view of future earnings power.? A management team can set their estimate of future earnings wherever they like.? A high estimate may goose stock prices in the short run, and low estimates may cause stock prices to fall in the short run.? But in the intermediate term, actual earnings will mean more to stock prices than any games played with earnings estimates.? Managements that cheat eventually get punished.

Here is the second comment:

A comment that reinforces the caveats on forward earnings: Lombard Odier has shown that there is NO correlation between forward P/E and actual returns over the following 12 months (http://media.ft.com/cms/965cca10-b5d7-11df-a65e-00144feabdc0.pdf).

And a question. All measures like the growth in tangible book value per share become considerably more complicated to evaluate when a company grows via a series of mergers. In theory one can do the analysis on each tributary. In practice, getting to know the peculiarities of the accounting in each company involved becomes very time consuming. I wonder how you approach such a case?

On the forward earnings piece, that may apply to the market as a whole but that may not work with individual stocks.

On your question: yes, when we are dealing with M&A the calculations become more complex.? Using the measure of tangible book value per share penalizes acquisitive companies, unless they can buy companies for less than their tangible book value per share.? There are other issues, in that one must give companies credit for spinoffs and such.? I covered that my piece Cram and Jam.? The main question that investors should be asking is: are management teams growing net worth per share for investors on a fair market value basis?

Many do not do that.? Instead, they choose a shortcut.? The most common shortcut is maximizing operating earnings per share.? That measure does not take to account the losses that occur from one-time events and chicanery that comes from buying back stock at prices that are too high.

One more note: I usually avoid companies that do a lot of acquisitions relative to their size, because they tend to underperform.

Final comment

I appreciate all the blogs that quoted my piece yesterday, or linked to it.? But there is a misunderstanding.? Though I am not crazy about sell side earnings estimates, I still see them as necessary.? Why?? We need them to allow us to evaluate progress of the company quarter by quarter.? To use a gambling term, earnings estimates are “the line.”

We could argue that we don’t need to evaluate companies quarter to quarter, and I’m fine with that.? Let’s be like Buffett and say that we would be happy if the stock market were closed most of the time.? I could live with that, but most players the stock market could not.? So, if we’re going to allow the market to be open every day, then we need a control function to allow us to estimate the change in value of a corporation when its earnings are released.

Earnings estimates are a necessary evil.? Please remember that as the earnings season begins.

Earnings Estimates as a Control Mechanism, Flawed as they are

Posted on 6 October 2010 by David Merkel

Why does the stock market pay so much attention to earnings estimates?? Don’t earnings estimates embody the worst type of analysis of stocks on Wall Street?

There is some truth to the thought above.? After all, earnings estimates eliminate all one-time charges.? Now, that makes sense in the short run, but not in the long run.? In the short run we want to estimate the growth in value of the business on a continuing basis.? Thus, we eliminate one-time events.? In the long run we must see how a management team has grown the total value of the Corporation.? To do that, we must factor in all of the one-time events as well as the regular earnings in order to see how they have managed Corporation over time.? Would that one-time events were really one-time events.? And, would that one-time events averaged out to zero.? But truth, one-time events are on average highly negative.? And so, companies with a lot of one-time events typically have lousy earnings quality, and deserve a lower price earnings multiple as a result.

So if there is that much trouble with how we measure earnings as far as earnings estimates go, why do we use earnings estimates?? Most of the value of a Corporation on a going concern basis stems from the future earnings of the company.? Investors want to have an estimate of forward earnings so that they can gauge whether the company is growing at an appropriate rate.

Now, it wouldn’t matter if the system were set up by third-party sell side analysts, by buyside analysts, by companies themselves, or by a combination thereof.? The thing is investors are forward-looking, and they want a forward-looking estimate to allow them to estimate whether the companies are doing well with their current earnings or not.

So long as the earnings estimates are relied on a fair measure of likely future earnings of the company, they become an influence on the current price stock.? For example:

If earnings estimates rise rapidly, so will stock prices.
If actual earnings comes in above estimates the stock price will have one-time rise.
And vice versa for when estimates fall , and when actual earnings are less than the estimate.

Now if earnings estimates were done right, together with growth estimates, by angels did not men, they would serve as cornerstones for estimating the value of corporations.? But our ability to see the future even collectively is poor.? Many things happen that we do not expect, whether from the government or the central bank or wars, you name it.

But even with all those flaws, earnings estimates provided useful function in being a feedback mechanism so that the market knows how to react in general, when earnings are released.

New Problem

But when beating earnings estimates become the be all and end all of the corporate management, we run into trouble.? Knowing that the estimate drives the stock price, makes some corporations fuddle the accounting.? They adjust revenue recognition, they differ recognition of expenses, enter into useless mergers and acquisitions, etc. Most accounting chicanery problems would not exist if beating the earnings estimates was not so important.

So what do we as investors do?? We look at the release of actual earnings with skepticism.? We carefully consider the adjustment of net earnings to operating earnings and asked whether the adjustments are truly reasonable or not.? We also don’t give full credibility to earnings estimates as if they were a sure thing.? Further, we review revenue recognition policies, and all other means to easily adjust operating earnings so we are not deceived by corporate managements.

And, if I can be so radical, we begin ignoring earnings and focus on growth tangible book value per share.? We look at growth cash flow per share net of maintenance capital expenditure.? We do all we can estimate free cash flow, and yet, take a step back and ask how the free cash flow is being used.

Free cash flow is not valuable if it’s being used to buy back stock at a high multiple.? It’s not valuable if it’s being used to do a scale acquisition.? Both of these are forms of dilution to common shareholders.

The key question is this: is the management building the net worth per share of the company?? That’s a lot harder question asking if the current earnings beat the estimate, but if this were easy, they would’ve brought someone else in to do it, not you or me.

PS ? I leave aside the issue of intangibles here.? Usually intangibles are worthless.? But some are quite valuable, like the name Coca-Cola, or distribution network that is not easily replicated, or research and development is unique to the Corporation has not yet developed into a product.? All that said, for an intangible to have value, it must produce additional cash flow in the cash flow statement under operations, that do not reflect in the earnings statement.

Portfolio Rule Two

Posted on 25 September 201026 September 2010 by David Merkel

For those that have e-mailed me about equity management, I will get back to you soon; I have been tied up in details of getting my assets management business going recently.

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If you have read me for a while, you have heard of my eight rules of stock investing.? Recently some people have been e-mailing me regarding my plans to start Aleph Investments, and one asked if I could write a series of pieces to explain how I manage stocks.? I thought it was a good idea, so this is the second of what is likely to be eight episodes.? Here?s portfolio rule two:

Purchase equities that are cheap relative to other names in the industry. Depending on the industry, this can mean low P/E, low P/B, low P/S, low P/CFO, low P/FCF, or low EV/EBITDA.

The first principle of value investing is having an adequate margin of safety.? Make sure that your downside is clipped, if things go wrong.? But that’s not today’s topic, I will cover it later in this series.

The second principle of value investing is buying the investment cheap to its intrinsic value.? That is an easy phrase to utter, but complicated to implement.? There is no one single simple metric that serves as a guideline for evaluating cheapness as a value investor.

Ideally, one would create an integrated free cash flow and cost of capital model, one like Michael Mauboussin did in his book Expectations Investing.? That is the correct general model to use; the only problem is that it is impossible for individuals or even small investment shops to implement.

So, when evaluating companies, rather than using a complex model for free cash flow and cost of capital, it makes more sense given limited time, to look at the most critical partial sensitivities of the true model.? What do I mean there?

I go back to what the best boss I ever had sent me regarding modeling: “80 to 90% of the valuable model can be encapsulated in the top 2-3 factors of the model.? What that implies to me regarding analysis of valuation is that simple ratios do still have punch.? But the challenge is selecting the ratios that are the most appropriate for companies in a given industry.

Here is the most basic thing I have learned so far about what valuation ratios to use: with financial companies use price-to-book, and with all other companies use price-to-sales.? How did I come up with this insight?? I spent a lot of time using one of Bloomberg’s functions [GE] and I found the tightest correlation of price movement to each of those variables.

But the intuition that I have received from that is not the end of the story.? Let’s stop for a moment and think about what various valuation ratios mean.

The classic ratio is the price to earnings multiple.? It makes a lot of intuitive sense because we want to know how much we are earning per dollar spent on the stock.? Earnings, and its cousin operating earnings, are the lowest figures on the income statement.? They are also the most manipulated numbers on the income statement.? But there are other ratios on the income statement, less manipulated, that exist higher up on the income statement, or over on the cash flow statement.

Operating income/earnings is a means of trying to look at the profitability the business before interest, taxes and nonrecurring elements.? Many analysts think that this is a better measure of earnings on a continuing basis than ordinary earnings, because it eliminates a lot of noise.? But you can go higher up on the income statement and move to price to sales.? Particularly in an environment like this where sales growth is so scarce, the price to sales ratio plays a larger role.? Exactly how cheap can a stock get on price to sales ratio basis?? Where would its valuation be stretched?

Away from that, on the cash flow statement, we have EBITDA, cash from operations and free cash flow.? EBITDA is earnings before interest, taxation, depreciation and amortization.? Cash from operations is simple to understand.? How much cash is the business generating?? So long as that does not involve the buildup of additional liabilities, or need for additional capital expenditure, that can be a useful figure for analysis.? The same is true of EBITDA.? Free cash flow goes further and subtracts maintenance capital expenditure.

Operating earnings and free cash flow are proxies for trying to understand what the income generating capacity of the business is on a normalized basis.

But then there are balance sheet measures like price-to-book and price to tangible book.? The idea is to ask how much assets are allocable to the equity investors.? In financial companies, where the cash flow statement is pretty meaningless, attempting to estimate the value of the firm, using book or tangible book has some power.? Why?? Because financial firms are in the business of shepherding scarce capital in order to produce returns.? Since capital is typically a constraint for earnings price-to-book is a useful measure for analyzing the valuation of the financial company.

The same is largely true of sales for industrial companies, sales are relatively hard to fake.? Now don’t get me wrong here, sales have been faked in many companies.? It helps to study revenue recognition policies, and it also helps to consider the buildup in accruals for accounts receivable.? Yes, sales can be faked, but cash from sales is very hard to fake.

One more metric worthy of consideration is enterprise value to EBITDA.? This metric is useful during times when there are a lot of mergers and acquisitions going on.? This metric measures in a crude way the amount of free cash flow that the assets of the business throw off.? It is the way many acquirers would look at a business.

Another way to think of it is, is the business more valuable in the hands of the current management, or the hands of new management?? If it is more valuable in the hands of new management, enterprise value to EBITDA is the better metric.? If the current management makes it more valuable, then price to sales is the better measure.

Now there are two more ideas that must be considered here: cost of capital, and reversion to mean.? In one sense we want to look at earnings, or free cash flow in excess of the cost capital employed.? The way I handled this is not to estimate the cost of capital but to look at the credit ratings, leverage on the balance sheet, volatility of the stock price, and volatility of earnings in order to get a feel for the riskiness of the company.

Mean-reversion is involved in value investing, in the sense that return on equity for firms tends to mean-revert over time.? What that implies is that it makes sense to pay attention to valuation, because firms in bad shape often clean up their act and get better, and firms in exceptionally good shape find their excess earnings competed away by other firms.? And that’s why value investing tends to work: companies with cheap valuations improve, and multiples expand.? Companies with high multiples tend to contract, because it is difficult to maintain superior growth over the long haul.

Of Investment Earnings Assumptions and Century Bonds

Posted on 23 September 2010 by David Merkel

Recently I got an e-mail from my friend Kid Dynamite.? He asked me an interesting question about pensions and long-duration bonds:

?back to the concept of century bonds.? I’m not sure if you read my recent pension post (http://fridayinvegas.blogspot.com/2010/09/problem-with-pensions.html) , but I’m having trouble with the concept of pensions investing in 100 year bonds at 6% while using an 8% portfolio return assumption. Does not compute…(and you can even pretend that pensions have 100 year obligations)

I just don’t get the concept of locking in long duration returns below your long term bogey. That just means that you have to do even better on the balance of your portfolio…which is nice to pretend about, but in reality, if you can do better on the balance, why bother with the 6% fixed income???

It’s a great question and one that deserves more thought.? To do that, we have to separate the accounting from the economics.

When I was a young actuary, I was preparing to take the old Society of Actuaries test eight, which was the Investments exam.? An older British actuary made a comment in one of the study notes that I had to think about several times before I understood it: “Risk premiums must be taken as earned, and never capitalized.”

Sadly, the pension profession never got the memo on that idea.? The setting of investment assumptions accepts as a rule that risk margins will be earned without fail.? Therefore, when looking at a portfolio of common stocks in a pension trust, the actuary will assume that the equity premium will be earned over the long haul and build that into his discount rate assumptions and earned rate assumptions.? The same is true of bonds in the pension trust.? They may haircut the yield for potential default losses, but they will assume that much of the spread over Treasuries will be earned without fail and thus they capitalize the excess returns.

Let’s pretend that the 6% century bond that Kid Dynamite told me about is risk free.? Also, let’s pretend that the pension actually needs bonds as long as a century bond.? Defined benefit pension plans, if trying to match cash flows, need bonds longer than 30 years, but probably don’t need bonds longer than 75 years.? That said, given the lack of bonds that are longer than 30 years, a century bond will still prove useful in trying to immunize the tail cash flows of the defined benefit pension plan.

What that 6% century bond tells us is that the investment return assumption on an economic basis is too high.? And, given that the yields on safe debt shorter than a century is much less than 6%, it probably means that the investment earnings assumption rate is way too high at 8%, and should definitely be lower than 6%.

I know that’s not what GAAP accounting requires.? GAAP accounting allows you to choose whatever investment earnings rate you can justify using statistics.? That’s not the way GAAP accounting should work though.? GAAP accounting should work with discount rates derived from low risk fixed income securities, and use those to develop the investment earnings assumption.

If you earn more than the risk free investment earnings assumption, good.? Those excess earnings will reduce the pension plan deficit or increase its surplus.

Okay, then suppose we reset the investment earnings assumption at 4%, because that’s closer to where it should be economically.? My, what large pension deficits we see.? But now, all of a sudden, that 6% century bond looks pretty good, because it brings the cash flows of the plan into better balance, and earns a decent return in excess of the earnings assumption.

So, the problem isn’t with the century bond, it’s with the earnings assumption.? Now why does that earnings assumption exist?

The US government wanted to encourage the creation of defined benefit pension plans, and so informally encouraged loose standards with respect to the earnings assumption.
For years, it worked well, while we had bull markets going on, and interest rates were high, which decreased the value of the pension liabilities.
The IRS took actions to prevent defined benefit plans from building up large surpluses, because it decreased their tax take.? Had companies been allowed to build up large surpluses, we wouldn’t be in the mess that we?re in today.
There is the lazy acceptance of long-term historical figures in setting earnings assumptions, instead of building them from the ground up using a low risk yield curve, and conservative assumptions on how much risky assets can earn over the low risk yield curve.

So in an environment like this, where interest rates are low, and surpluses could not be built up in the past, pension funds are hurting.? The truth is, they are worse off than their stated deficits imply.? For economic and political reasons, the likely outcome resembles the riddle of how one eats an elephant: one bite at a time.

So we will see investment earnings assumptions and discount rates fall slowly, far too slowly to be the economic truth, but slowly recognizing funding gaps as corporations eat the loss one bite at a time, as they can afford to.

The investing implication is this: for any stock you own that sponsors the defined benefit pension plan, take a look at the earnings assumption and raise the value of the liabilities.? Also recognize that earnings will be lower than expected if the deficit is large and they need to make cash contributions in order to fund the pension plan.? That said, they could terminate the plan, and I suspect many current defined benefit plan sponsors will do so.

And given that, there is one more implication: if you are employed by, or are a beneficiary of a defined benefit pension plan, take a look at the form 5500, or at the company’s financial statements and look at the size of the deficit.? Take a look at what the PBGC will guarantee for you, and adjust your plans so that you are not relying on the continued well-being of the defined benefit pension plan.

I wish I could be the bearer of better news than this, but it is better to be aware of problems, then to learn that what you don’t know can hurt you.

Book Review: Early Warning and Quick Response

Posted on 16 September 201016 September 2010 by David Merkel

If you are not into accounting, you can skip this review.? Before you skip it, though, ask yourself a question.? Do you rely on financial statements?

Most of us do whether we admit it or not, but accounting rules for most of us are like plumbing.? We need to use bathrooms, and sinks in our kitchens, but that doesn’t mean we would know how to set up the plumbing in a kitchen or a bathroom.

In the same way, most users of financial statements don’t have the vaguest idea of all the assumptions underlying financial statements.? Modern financial reporting today is a hodgepodge of rules straddling two eras: the Renaissance/Reformation era, and the modern era.

In the R/R era, accruals were almost always short, liquidating within the next few accounting periods.? Few items on the balance sheet were traded, or would have prices that would adjust materially before they would be used or sold.

In the modern era, accruals are frequently longer and less certain.? Many items on the balance sheet are tradable, and prices often move materially before the items are used or sold.? What is more, there are often hybrid financing instruments that make the estimation of equity versus liabilities difficult.

David Mosso grasps the nettle, and says that modern accounting must move entirely to a fair value basis.? Net worth is the difference between the fair value of assets and liabilities.? Net Income is the change net worth.? No more obfuscation.? No more AOCI.? No more goodwill.? The values of assets and liabilities derive from the future cash flows they will generate.? Even claims against equity must be done on a fair value basis, where hybrid instruments get decomposed into an equity claim and a debt claim, and the split gets re-evaluated each period as market prices change.

All measurable assets and liabilities must go on the balance sheet, and all nonmeasurable assets and liabilities must be disclosed.? Beyond that, financials should be segmented by major lines of business or marketing channel or geography in order to give users a greater sense of what is going on.

Measuring wealth, and the increase in wealth is the main metric.? This would apply to all entities — nonprofits, governments, etc.? No longer could we do a monstrosity like “cash for clunkers,” where we destroy autos and do not record the loss in GDP, but we add to GDP the sales of autos generated.? I can think of many transactions at a usually scrupulous company that I worked at, where the new and unscrupulous CEO and CFO found ways to convert capital losses into operating income, giving ROE a big boost –> R up, E down, and letting management take home large bonuses as a result.? That said, the only real loser was another mutual life insurer that bought the company after insufficient due diligence.

The book has much more to it than this.? It delves into how to set accounting standards better, and spends time more closely defining fair value with respect to assets, liabilities, and equity claims.

The changes would be sweeping, and widely opposed by much of industry, as well as utility and financial businesses.? The government would never let such standards be applied to them; honesty is alien to them.

I have a hybrid proposal, which I would view as transitional, that I proposed to a commissioner of IASB at a Society of Actuaries meeting five years ago.

I said, “I am a user of financial statements, and we need an upgrade in the quality of data that we receive from accounting.? What we need are five main financial statements.? Book value balance sheet and income statements, supplemented by Fair value balance sheet and income statements, with a cash flow statement to round them out.? This would give us the flexibility to chose our own accounting basis.”

The lady had a horrified look on her face, and said “But that would be so costly to do.”

I replied, “Most of these estimates are being done already by companies.? This would formalize it.? Besides, to my friends here (turning around to the back of the room, catching grins, and then looking at her) this is the actuarial full employment act, because the work of estimating long-dated accruals is something that needs professionals like actuaries.”

No comment, and they went to the next question.

Quibbles

The devil is in the details here.? Anyone who has read me closely for a long time knows that I am of two minds when it comes to Fair Market Value accounting.? My experience is that managements, when given freedom to estimate the value of assets, tend to estimate them too high, and liabilities too low.? Historical cost accounting may be wrong, but it is relatively determinate.? There is comparability when managements don’t have a lot of latitude to change values.? After that, it is the job of investors to figure out how good the accruals are.

But on the plus side, fair value accounting does give the snapshot view of net worth, which managements resist in a crisis.? They want book value accounting that presumes the likelihood of reversion to all claims being paid.? Sorry that doesn’t always happen, and accounting should probably reflect it, even if it ruins comparability across firms.

Who would benefit from this book

Users of financial statements that want to think a little more broadly about accounting should buy this book.? Note that the sticker price of this book is stiff, at roughly $1 per page.? Accounting mavens, whether they like the ideas should buy the book so that they can understand the issues involved.? Even if they never become the standards, the ideas are the exemplar for fair value, and represent the opposition view in accounting.

If you want to, you can buy it here: Early Warning and Quick Response: Accounting in the 21st Century (Studies in the Development of Accounting Thought).

Full disclosure: The publisher sent two copies, after I asked to receive a review copy.

If you enter Amazon through my site, and you buy anything, I get a small commission.? This is my main source of blog revenue.? I prefer this to a ?tip jar? because I want you to get something you want, rather than merely giving me a tip.? Book reviews take time, particularly with the reading, which most book reviewers don?t do in full, and I typically do. (When I don?t, I mention that I scanned the book.? Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.? Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.? Whether you buy at Amazon directly or enter via my site, your prices don?t change.

PS — The book looks mush nicer than the cover that I scanned, with the abuse that I gave the book.

Why Are We The Lucky Ones?

Posted on 2 July 20102 July 2010 by David Merkel

Working as the only analyst in a small broker dealer means you occasionally get some interesting projects.? There are many hucksters out there, and if they drop by your bitty broker-dealer to run their deal, skepticism, not hope, is the proper reaction.? ?Why are we the lucky ones?? should be the skeptical question.

Anyway, here are three responses that I gave to my bosses over a four month period on deals that were brought to them.? Names have been obscured where possible.

Project 1

This was a deal that attempted to securitize life settlements, i.e. life insurance policies where the owner has sold off his interests to a third party.? The biggest problem was all of the money sucked out of the deal that would not be invested to earn a return.? Here is what I wrote:

Dear Boss,

Notes on the deal

I have read the Overview and the Private Placement Memorandum [PPM], and have scanned everything else.? Here are the main points:

1. The key page of the entire document is page 18 of the PPM.? In it we learn: the zeros get a 4.07% return, but the collateral has to earn 11.72% net of fees in order to make this deal pay off.? Also, 65.52% of the proceeds go to other than investment purposes.? Why so large?? (As an aside, this yield is at a discount to Treasuries.? An equivalent length treasury zero yields 4.55%, AAA Aid to Israel – ~5%.)
2. The continuing fees are hefty – Servicing 1%/year of Face?? Origination – 1%/month of the Matured Policy Increase Amount [MPIA – essentially a measure of cash flow profitability]?? Administrative expenses as well to third parties.? I can’t tell how big those are, or how much the collateral would have to earn to make the bond pay off.
3. The residual value guarantor, AAACO, is not in good shape.? The central bank of CN has taken over the assets and liabilities for now, but it does not seem that they have guaranteed the liabilities permanently. They are rated “B” by AM Best – not a sound rating.? On taking over the group that owned AAACO, S&P said that it was a big enough rescue that they might have to downgrade CN from its A rating.? They have since reaffirmed the rating as stable, but Moody’s now rates CN as Baa1.
4. The residual value policy doesn’t do much if there is a modest deviation from perfect performance by the originator or servicer, the policy won’t pay.
5. We don’t have all of the documents, such as the Blocked Account Control Agreement.? But beyond documents, we don’t have any sort of cash flow analysis.? How are they going to earn so much on so little invested capital?
6. We don’t have any data on the life policies, insurers, etc.? Some insurers fight life settlements.
7. The Overview dramatically oversells the virtues of the deal.? Many of the things it lists as protections are weak.? Points 3 and 5 are the same points, but it makes them sound different.? Further, CN do not own AAACO, they have it in a form of semi-receivership.? If they did own it, AM Best would give it a better rating.
8. BBB is the actuary, but she owns the originator and the servicer. [Origco & Servco]? She is not bound to continue with the deal till maturity if it gets originated (she will be 75 herself then).
9. Servco and Origco have defaulted on prior deals, and they weren’t able to get enough interest on the first deal to make it work.
10. Origco is basically broke.? They have assets of $500K, and liabilities of $2 million.? The assets are receivables from Servco.? Servco owes $16 million that it can’t pay off either.
11. Origco and Servco do not use accrual accounting.? They could not pass a GAAP audit.? Even with accrual accounting, they would not be a going concern.
12. Origco and Servco have existing default judgments against them, and no way to pay them.
13. If Servco or Origco default, the residual value policy does not pay.
14. Servco and Origco have no significant staff.? If this gets originated, there will be a significant risk as they staff up.?? They also don’t have licenses.? This is not a bond, it is seed stage venture capital.
15. They have had run-ins with the SEC, Texas Securities Commission, and Securities Division of North Carolina.
16. The notes are deemed equity for tax purposes, which seems aggressive to me.

If you want, read page 18, and scan the risk factors section of the PPM (pages 19-57).? It is my belief that this is something that we don’t want to get mixed up with, at any price.? I can understand why no underwriter wants to take this on, and why they are looking to smaller broker-dealers.? But if you want to look into this further, have them forward to me their cash flow analyses.? I can’t imagine how they get this to work.

I have this phrase that I use sometimes, “Holding my nose as I hit the delete key.”? That is when something smells so bad, the odor can even travel over the Internet.? This feels like the attempt of some desperate people who are deeply in debt, and need one “grand slam” to bail themselves out of debt
and have a happy retirement.

Postscript: this deal not only did not get done, but the boss apologized for bringing it to me.

Project 2

This was a case where someone was willing to offer us $5 million in capital if we gave them $1 million.? What an altruist!? Not.? Yes, the value of shares if you could sell them all at the ?last trade? was worth $5 million, but the company was basically a warrant on the success of a technology, and the balance sheet was horrendous.? This is what I wrote:

Dear Boss,

This doesn’t smell good.? Here’s my commentary, together with excerpts from their recent 10-K and 10-Q:

$6250 Stock Trading Volume per day

Negative earnings, cash flow, and net worth.? Little to no liquidity ? huge negative net working capital.

1-100 reverse split

Auditors comment for 2008 10K: The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 11 to the consolidated financial statements, the Company has a significant working capital deficit, has recognized significant operating losses in each of the years in the three year period ended December 31, 2008, and will need significant amounts of investment funds to fully develop its oil and gas leases. Management’s plans in regard to these matters are described in Note 11. The financial statements do not include any adjustments that might result from the outcome of this uncertainty.

The Company currently has three full-time employees.

Risk factor: The Company has incurred net operating losses since 1997. However, the Company currently has operations that provide working capital. The Company is also seeking further project based financing to develop its existing projects. There is no assurance that the Company will be able to secure adequate financing to fund those operations.

High compensation to management for not much of a company.? $5 million in 2008.

The Company failed to timely file a current report on Form 8-K upon the occurrence of the Default Notice and Acceleration Notice under the Credit Agreement with CCC, and the July 22, 2008 Limited Forbearance Agreement pursuant to which Gas Rock agreed to refrain from pursuing remedies for a limited time.

NOTE 7 – Note Payable – CCC CAPITAL LLC

The Company entered into an advancing term credit agreement for $30,000,000 on April 13, 2006 through its subsidiary DDDa, LLC with CCC Capital, LLC to fund the purchase of the EEE Field in GGG Oklahoma. This agreement was increased to $50,000,000 on April 2, 2007. The balance at December 31, 2008 was $13,423,221, net of debt discount of $41,077, and the Company paid interest of $1,957,294 for the year ended December 31, 2008. The note is secured by all of DDDa’s assets and certain personal assets owned by EEE, CEO of the Company. DDDa’s assets are cross-collateralized on a $3,469,000 loan made by CCC Capital, LLC to FFF, a related party. This loan is currently in default, with interest only payments being made.

On April 9, 2008, CCC delivered to the Company a Notice of Events of Default and Unmatured Events of Default (“Default Notice”) under the Credit Agreement. Due to these claimed Events of Default, interest under the Credit Agreement began accruing at the Default Rate of 15% and 100% of DDD’s Net Revenues were applied to Debt Service and other Obligations as of April 9, 2008. On April 16, 2008, CCC delivered to the Company a Notice of Acceleration (“Acceleration Notice”) under the Notes due to the continuing claimed Events of Default under the Credit Agreement. The Acceleration Notice declared the amounts due under the Note to be accelerated and due and owing in full as of April 16, 2008.

On July 22, 2008, CCC, DDDa and FFF (“FFF”, and together with DDDa, the “Borrowers”), entered into that certain Limited Forbearance Agreement, pursuant to which CCC agreed, subject to the terms thereof, to forbear from pursuing remedies under the Credit Agreement and Notes in respect of the Events of Default claimed as of that same date until the earlier of (i) November 15, 2008 and (ii) the date that CCC gives DDDa notice of any additional payment default under the Credit Agreement. FFF is controlled by the Company’s CEO and is a guarantor of the DDDa Obligations under the Credit Agreement. CCC is also a lender to FFF under an Advancing Term Credit Agreement (the “FFF Credit Agreement”, and together with the Credit Agreement, the “Credit Agreements”.

The Forbearance is subject to the following conditions to be fulfilled:

1) On or before November 15, 2008, (i) the Borrowers must repay all Obligations (as defined in the Credit Agreements) or (ii) DDD must have entered an agreement for the full or partial sale of the EEE Field, the proceeds of which would fully repay the Obligations owing under the Credit Agreements, and such sale shall close and repayment of the Obligations shall be made by December 31, 2008;

2) If the Obligations are not repaid by November 15, 2008, DDD must assign a 5.0% net profits interest in the EEE Field to CCC, effective as of November 1, 2008. The form of this assignment and the potential assignments discussed in paragraph 3, below, will be substantially in the form of the Conveyance of Net Profits Overriding Royalty Interests, attached as Exhibit A to the Forbearance Agreement;

3) If the Obligations are not repaid by December 15, 2008, DDD must assign an additional 1.0% net profits interest in the EEE Field to CCC, effective as of December 1, 2008, and will assign to CCC an additional 1.0% net profits interest each subsequent month if the Obligations are not repaid by the 15th of such month;

4) DDD shall escrow one 5% net profits interest conveyance and five 1% net profits interest conveyances to ensure it’s delivery of any potential obligations under paragraphs 2 and 3, above;

5) Any and all Net Proceeds (as defined in the Forbearance Agreement) from any equity issuance, refinancing, or asset sale will be applied first to outstanding fees and expenses of CCC, second to the accrued and unpaid interest on the Notes, and third to the outstanding principal balances on the Notes; and

6) The Borrowers must ensure that its hydrocarbon purchasers make payments relating to any of CCC’s overriding royalty interests in the EEE Field directly to CCC.

NOTE 11 – Going Concern

The Company has reported operating losses aggregating $9,877,016 for the two (2) year period ended December 31, 2008. At December 31, 2008, the consolidated balance sheet reported a working capital deficit of $23,887,172. The Company must raise significant amounts of cash to pay its current liabilities and to provide investment funds to continue development of its oil and gas leases. There can be no assurance the Company’s management will be able to secure funding.

David here: There is little assurance that an immature development stage company like this will ever be worth anything.? I am no expert on hydrocarbons but this company is overindebted, and it is likely that debtholders will own the assets within a year or two, and equityholders get nothing.

DDD shares would not, not, not be an asset to our firm.

Postscript: 6 months later, the stock worth $5 million is worth $300,000.? And will be worth zero soon.

Project 3

Another life settlements securitization.? The originator seems to be honest, but is using the securitization to get a cheap commercial mortgage loan.? What I wrote:

Dear Boss,

I’ve read through the whole document.? Here are my thoughts:

Summary Notes

The officers of the company have no experience at all with life settlements.? They do have some experience with multifamily housing.? They are using a life settlements securitization to facilitate loans for their multifaqmily housing expansion plans.? To me, that is pretty convoluted.? Why not simply go out and borrow the money?

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

Need to see the financials of the GGG enterprises
Correct address for their website.
Who is HHH Capital Management?? Can’t find them –?the portfolio managers.
Need fees, policy data, and expected cash flows
What are they doing to source portfolio 2?
Need actuarial projections
Exactly what are the trusts receiving as collateral for the loans?? I need pro-forma financials on the property(ies) to be developed?
Where are the related party transactions?
If this deal is 3x overcollateralized, where does the excess money come from?? Who is the equity, and what are their motives?

That’s all for now.? Looking forward to more data.

After the response, I wrote:

Dear Boss,

I realize the offering memorandum is preliminary, but there are several things that need to be clarified:

I have three tentative conclusions (with questions):

1.????? The largest asset is a 9 year fully amortizing 2.7% loan on the $40,000,000 to the sponsoring company.? It is a hidden source of profit to them, but the full amortization makes the loan more secure, it they can make the first few payments.? That said, they would need 12% cash flow on the loan to make the payment, and where will they get that?

2.????? The deal would need a 6.1% return on the Life policies to get a Treasury yield on the certificates.? 8.0% return to get T+100.? 15.75% to get T+500.? What would it take to sell these notes?

3.????? There is a low probability of full payment of principal.? A margin of $25 million on a $250 million principal payment is skimpy, and in my opinion, decidedly not investment grade.? I assume these aren?t going to be rated, right?

And I have additional data needs:

4.????? Who is HHH Capital Management?? It looks like a new firm ? do they have the ability to do their part?

5.????? I need fees, policy data, and more detailed expected cash flows. Where is Appendix B?

6.????? How were the life expectancies calculated?? That?s hard to do right.? Second opinions?

7.????? I need actuarial projections, with considerable detail. That would mean a copy of the JJJ review.

8.????? Exactly what are the trusts receiving as collateral for the $40 million loan?? Pro-forma financials on the property(ies) to be developed? And, I would need to see the financials of the GGG enterprises.

I think this deal will prove hard to complete.

Postscript: we went further with this group than the other two, but when faced with my data requests, the originator gave up.

After this happened to me, I talked with an investment banker who is local, and has many contacts like mine.? He commented on how small broker dealers get hit up with slick pitches, any one of which if accepted, could destroy the broker-dealer.? The trafficking of blocks of life settlements is endemic, and is a search for what lemming has the lowest discount rate — has mis-estimated the risks.

He also mentioned how these groups toss around big names as those that will buy the senior certificates.? I experienced that myself.? Kuwaiti Investment Authority, indeed.

So, in four months time, I kept my firm from making dumb decisions three times, any one of which might have severely damaged or destroyed the firm.? What did I get get for my efforts?? The best thing of all: gratitude from my bosses, and knowing that I did my best for those that hired me, protecting the interests of all stakeholders of the firm.

Skepticism is a necessary aspect of investing, particularly as the complexity level rises.? Aim for simplicity, and put safety first in your investing.? It is easier to protect value than to try to earn back losses from mistakes.

To phrase it another way — in order to work through these deals, I had to read through over 1000 pages of data.? Don’t let the multiplicity of words dull you to the risks that exist.? Even for small investors I would say avoid complexity.?? Where there is complexity, there is a much higher risk of loss, almost always.? Stick to simple investments, and let the complex stuff be bought by experts, who will turn away most of the charlatans.

Was AIG Chronically Underreserved in its P&C Lines? (Part II)

Posted on 30 May 201025 December 2010 by David Merkel

I read every email sent to me, and every comment? written at my blog.? But much as I would like to, I can’t answer them all.? One comment to my last piece on this topic questioned the validity of accrual entries in insurance accounting.? I would like to say that the standards for GAAP reserve accounting are pretty good.? They need some tweaks here and there, but they do the job fairly well.

One of the things you learn as a fundamental investor is that the quality of accounting derived from accrual entries is always lower than that for cash entries.? There is an implicit assumption behind every accrual entry that someone will make good in the future to pay cash, whether the amount is fixed or estimated.

Accruals vary in quality.? Accounts Receivable are more reliable than inventories.? Who knows what fixed assets, property, plant and equipment are worth?? Pension obligations are squishy, the assumptions can be manipulated within reason.? Deferred tax assets rely on the ability to earn more money, but most companies with the deferred tax assets have lost significant money in the past.? Will the company bounce back?

And there are intangibles.? Goodwill is only worth something if a company earns cash from operations in excess of net income over the long run.? Capitalized R&D, software costs, must produce cash flows that justify capitalizing the expenses, otherwise capitalizing is merely deferring losses.

So there are tests such as normalized operating accruals that for industrial companies and utilities can flag many companies that look cheap, but may not be, because too much of their income comes from accrual entries.

With financial companies, the problem is worse, because financial companies are a bag of accruals.? What are the loans worth?? What are those weird structured securities worth?? And with insurance it gets tougher.? What level of claims do you expect to pay out and when?? Will you recover the amounts that you invested in acquiring the policies that have been written?

Tough questions, but they are what accounting rules have been designed to try to answer.? Because there is complexity, unscrupulous management teams can take advantage of the flexibility.? That does not mean the rules are wrong, though.? No human system can be both consistent and comprehensive.? There are tradeoffs between modeling the details of a company’s financials accurately, and doing the accounting consistently across corporations.? To what degree do you make accounting “cookie cutter” versus tailored?? That is the tough question that vexes those that set the accounting standards.

I would add that insurance accrual quality is subject to three factors:

Length of the accrual — longer is worse.
Uncertainty of the contingency in question — uncertainty of amount and timing?
Does the law of large numbers apply?? What is uncertain in specific, may be more predictable in aggregate.

I received another comment, and initially I said, “I can’t get that done.? Yes that would be good but….”? Here is the comment:

Doug Says:

May 24th, 20109:10 am at Edit

It would be interesting to normalize the reserve charges two ways:

1) Adverse reserve development as a % of beginning reserves.
2) The ratio in #1 above compared with the industry.

While these reserve charges were bad, long-tailed P&C insurers were taking similar reserve charges ? even the more ?responsible? ones.

Look at the results of one of AIG?s smaller competitors ? W.R. Berkley. Similar business mix and a charismatic CEO to boot. Same string of reserve charges, but the CEO is still there, and investors got a nice 20% annual rate of return from 2000. The difference? AIG was trading at 4x book value in 1999, while Berkley was trading below book.

So I went and did it, choosing eleven peer companies that were large, having long tailed liabilities.? This was the peer group:

ACE — ACE Limited
BRK — Berkshire Hathaway
CB — Chubb
CINF — Cincinnati Financial
CNA — CNA Financial
MKL — Markel
PRE — PartnerRe
TRV — Travelers
WRB — W. R. Berkley
WTM — White Mountains Insurance
XL — XL Capital Limited

I could have chosen more, but I thought these were representative of stockholder-owned insurers and reinsurers that write long-tailed P&C business.

So what did I find?? I found that AIG was among the worst of major P&C insurance companies in terms of having to strengthen reserves from 1993 to the present.? AIG had to strengthen its reserves 2.1%/yr versus my peer group average of 0.6%/year.? CNA did worse, and White Mountains (a company that talks a lot about conservative accounting) was slightly behind.

Note that the four companies that did not stretch all the way back to 1993 in terms of reported numbers likely would have looked better, because they missed some favorable underwriting years.

Here is the graph of the twelve companies, and the average:

And here is the graph of the companies that were not as good as the average:

The clear conclusion is that AIG was among a group of P&C insurers that were less conservative in reserving than most of their large competitors. CNA and White Mountains were much smaller companies — AIG was dropping a boulder into the pond.

Among all the other difficulties that AIG had, from a yield-seeking derivatives subsidiary, to life and mortgage insurance subsidiaries in trouble, this was just another facet of a company that played it fast and loose.? They under-reserved their P&C divisions, and there can be no reasonable defense on that topic.

PS — I like investing in P&C insurers and reinsurers that regularly release reserves for the business of prior years.? Conservative companies have high earnings quality, and are reasonable investments, despite all of the uncertainty.

Full disclosure: long PRE, CB

Dumb Regulation is Good Regulation — How to Regulate the Banks

Posted on 16 March 2010 by David Merkel

Should regulation be dumb?? In one sense yes, in others, no.? It really depends on how well the regulators understand the risks involved, and how much they can encourage professionalism among profit center heads and risk managers.? As those two increase, regulation can be smart.? ?Follow these detailed rules to calculate the capital you need to be solvent 99% of the time.?

But when either of those two aren?t true, dumb regulation may be in order:

Strict leverage limits, reflecting the worst outcome from underwriting poor quality loans.
Disallowing risky types of lending, regardless of capital level.
Disallowing liabilities that can run easily.
Disallowing products that commonly deceive buyers.
Disallowing certain types of contracts that fuddle accounting.
Those regulated may not choose their regulator.? The highest regulator assigns a regulator to you.? The highest regulator must evaluate the jobs that lower regulators are doing, and eliminate/lessen regulators that do not use the powers they have been granted, and get co-opted by those that they regulate.

If everyone were smart, things could be different.? Deceiving people would not take place, and managements would not take undue risks.? Limits could be looser, and products would be designed for discriminating buyers.

But, face it, we are dumber than we think, myself included.? Consumer choice is a good thing, though it implies that some will be deceived, no matter where one places the line of demarcation.? Along with that, some bank will not fit the rules and go insolvent, though it previously passed the solvency tests.

Dumb Regulation: Insurance in the US

My poster child for relatively good dumb regulation is the insurance industry in the US.? The industry is far less free-wheeling than the banking industry, and under most circumstances, the solvency margins are set high enough to have few insolvencies.? There is room for improvement, though:

Make risk based capital charges countercyclical.? Perhaps tinkering with the Asset Valuation Reserve would do that.
Have some sort of rigorous testing for capital relief from reinsurance treaties.
Ban surplus notes in related party transactions.
Ban all forms of capital stacking, especially where the transactions go both ways.? I.e., subsidiaries can?t own securities of any companies?in their corporate family.? All subsidiaries must be owned by the holding company.
More rigorous testing for deferred tax assets.
Assets as risky as equities, including limited partnerships, should be a deduction from capital.
Securitized bonds that are not ?last loss? should have higher RBC charges than comparable rated corporates, because loss severities are potentially higher, and assets that are originated to securitize are always lower quality than those held on balance sheet.
A standardized summary of cash flow testing results should be revealed.

As for the banks, they need to do that and more:

Insurance companies list all of their assets.? Banks should as well.
Intangible assets should be written to zero for regulatory capital purposes.
Risk-based capital standards need to be tightened to at least the level of insurance companies, if not tighter.
Some sorts of lending to consumers should be banned.? I am talking about complex agreements, that individuals with IQs less than 120 can?t understand.? Insurance policies have to be Flesch-tested.? Bank lending agreements should be the same.? If some argue that the poor need access to credit, I will say this: the poor need to get off of credit.? Credit is for the upper-middle-class and rich.? Poor people should not go into debt.
Standardized summaries of terms and fees must be created for consumer lending, with large, friendly letters, and simple language that all can read.

What I am saying is that accounting has to be more conservative, and that regulators have to require larger amounts of capital to support their business, particularly at the banks.? Financial products must be made simpler for consumers to understand.? More transparency is needed everywhere, and if the financial companies complain, tell them that they will all be in the same goldfish bowl, so no one will gain an unfair advantage.

Preventing Too Big to Fail

As part of preventing too big to fail, the Risk based capital [RBC] percentage should rise with the amount of risk-based capital.? Say, when RBC gets over $10 billion, the percentage of capital needed for RBC grades up to 50% higher than the level needed at $10 billion by the time RBC gets up to $50 billion.

Here is my example of how it would work:

Equity [RBC]	Assets	E/A Ratio	Marginal E/A Ratio	Marginal Income	Income	ROE	Marginal ROE
10.00	100.00	10.00%	10.00%	2.00	2.00	20.00%	20.00%
26.25	200.00	13.13%	16.25%	1.90	3.90	14.86%	11.69%
42.50	300.00	14.17%	16.25%	1.80	5.70	13.41%	11.08%
58.75	400.00	14.69%	16.25%	1.70	7.40	12.60%	10.46%
75.00	500.00	15.00%	16.25%	1.60	9.00	12.00%	9.85%

I have assumed that firms undertake their highest ROE projects first, and do progressively lower ROE projects later.? Now, by raising capital requirements on bigger firms, a common response is, ?Well, then they will just take on riskier loans to compensate.?? Sorry, but that dog don?t hunt.? If they take on riskier loans, their RBC goes up even more rapidly, because loan quality is reflected (or, should be reflected) in RBC formulas prior to adjustment for bank size.

More Dumb Regulation

Dumb regulation bars certain lending practices, and raises capital levels higher than is needed over the long run.? So be it.? Smart regulation is far more flexible, and trusting that companies and consumers know what they are doing.? Unfortunately, when financial firms fail, there are often larger repercussions.? It is better to limit regulated financial companies to businesses where the risks are well-understood.? Let the less understood risks be borne by those outside the safety net, and bar those inside the safety net from holding any assets in those companies.

That brings me to the Volcker Rule, which is a good example of dumb regulation.? My preferred way would be to do something similar through adjusting the risk-based capital formulas ? Equity-like risks should be funded through a 100% allocation of equity. Few banks would take on that level of speculation at that level of capital used.

If you need proof, look at the life insurance industry. Companies used to hold a lot more equities prior to the tightening of RBC rules. Now they hold little, except at a few mutual companies that are flush with capital.

That also has preserved the insurance business in this crisis, leaving aside mortgage and financial risks, where the state regulators still have no idea what they are doing ? that a proper reserve level would leave most of the companies insolvent today, but had it been implemented ten years ago, would have preserved the companies, but eliminated much of their profits.

At the Treasury meeting with bloggers in November 2009, I commented that the insurers were better regulated for solvency than the banks.? One of the reasons for that is that they do harder stress tests, and they look longer-term. Life and P&C insurers survive the process because of better RBC standards, and ?scaredy cat? state regulators. What a great system, which prior to the crisis, was criticized as behind the times.? (I suspect that if we ever get a national regulator of insurance, there will be a big boom and bust, much as in banking at present. It is easier to corrupt one regulator than fifty.)? The more state involvement in bank regulation, the dumber (better) bank regulation will be.

What to Do

So, if one is trying to regulate banks for solvency, there are seven things to do:

Set risk-based capital formulas so that few institutions fail.
Make it even less likely that larger institutions fail.
Limit the ability of financial institutions to invest in other financial institutions.
Regulators must benchmark the underwriting culture, and raise red flags when underwriting is poor.
Insure that equity is truly equity.
Institute a code of ethics for risk managers.
Make sure that balance sheets fairly reflect derivatives.

It is almost always initially profitable to borrow short and lend long.? That said, it is a noisy trade.? Who can be sure that short rates will remain below the rates at which one invested long?? Another component of a good risk-based capital formula is that there is no investing in assets that are longer than the liabilities that fund the financial institution.? (For wonks only: regulated financial institutions should be matching assets versus liabilities as their most aggressive posture.? Unregulated financials can do what they want.? And no investing in unregulated financials by regulated financials.)

One of the great subsidies banks get is the cheap source of funds through deposits.? It is only cheap because depositors know the FDIC is there.? The FDIC should raise its fees to absorb that subsidy back to the taxpayer.? Keep raising it until you see banks begin to shift to repo and other short-term sources of funding.

As a clever old boss of mine once said, ?A banks liabilities are its assets, and its assets are its liabilities.?? The idea is this ? banks that focus on their deposit franchises have something of real value ? that is hard to replicate.? But any bank can invest their funds aggressively, which will lead to defaults with higher frequency.? It is true of insurers as well, most financials die from bad investing policies, and short-term liabilities that require complacent funding markets.

That?s why there has to be a focus on liabilities in regulating solvency.? Financial institutions, even simple ones, are opaque.? Most die from the deadly combo of illiquid assets and liquid liabilities.? Those that have funded the bank in the short run refuse to roll over the loans at any price.? Assets can?t be liquidated to meet the call on cash, and insolvency ensues.? Those that have read me for a long time know that I don?t buy the malarkey that some managements will trot out, ?We?re not insolvent; we merely have a liquidity crisis.?? Hogwash.? You took too much risk, because the first priority of risk control is liquidity management.? Assets are only worth what you can sell them for, or, what cash flows they can generate.? If assets can?t generate cash flows or sale proceeds adequate to service liabilities, then you are insolvent, not merely illiquid.

Cash flow testing for banks should focus on the ability of the bank to finance itself without recourse to selling assets.? To the extent that selling assets is allowed in modeling, they must be Treasury quality assets.

The essence of a good risk-based capital formula is that it forces intelligent diversification, and forces adequate liquidity.? No assets should be bought that the liability structure of the bank cannot hold until maturity.? There should be no concentration of assets by class, subclass, or credit, that would be adequate to lead to failure.

My view is that a proper risk-based capital regime would start with asset subclasses, and double the capital held on the largest subclass, and 1.5X the capital on the second largest subclass.? After that, within each subclass, the top 10 credits get twice the level of capital, the next 10 1.5x the level of capital.? Having managed assets in a framework like this, I can tell you that it creates diversification.

Beyond that, no modeling of asset correlations would be brought into the modeling because risky asset correlations go to one in a crisis. Any advantage derived from diversification should be accepted as earned, and not capitalized as planned for.

Securitization deserves special treatment: risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities, and assets that are originated to securitize are always lower quality than those held on balance sheet.? Capital charges should be raised until banks don?t want to securitize as a matter of common practice.

Eliminating Contagion

In order to avoid systemic risk and contagion, banks should not lend to or own other financial firms.? That would end contagion.? At least that should be limited to a percentage of assets, or through the RBC formula. Think of it this way, financials owning financials is a form of capital stacking across the country as a whole.? In a stress situation it raises the odds of a deep crisis.? Setting a limit on the ability of financials to own the assets of financials is the single most important step to avoid contagion.? I would set the limit at 5% for equity, and 20% for debt.

Regulating Underwriting

Most of the real risks came from badly underwritten home mortgage debt, whether conventional, Alt-A and Jumbo, or subprime.? Underwriting standards slipped everywhere.? Commercial mortgage lending hasn?t yet left its marks ? there is a lot of hope that banks can extend maturing loans rather than foreclose and take losses.

For much but not all of this crisis, it was not a failure of laws but a failure of regulators to do their jobs faithfully. ?Regulators should have looked at indicators of loan quality, and raised red flags when they saw standards deteriorating.? Where I worked, 2003-2007, we saw the deterioration, and were amazed that the regulators had been neutered.

Let Equity Be Equity

Beyond that, there was a dearth of true equity, and a surfeit of preferred stock, junior debt, trust preferreds, and particularly, goodwill. ?Equity has to reflect assets that are high quality and that are not needed to support short-term obligations from the cash flow tests.

Code of Ethics for Risk Managers

One reason the banking industry is worse off than insurance, is that they don?t have many actuaries.? Actuaries have a code of ethics.? They tend to be ?straight arrows? telling it like it is.? Bank risk managers need the same thing, together with the rigorous education that actuaries receive.? Accept no substitutes: CFAs and CERAs are no match for FSAs.

Reflect Derivatives Properly

Derivatives must come onto the balance sheet for regulatory purposes, revealing leverage increases/decreases, counterparty risk, overall sensitivity to the factors underlying the contracts.? Any instrument that can cause cash to flow at the regulated entity should be on the regulatory balance sheet.

Other Issues

I would not create a prospective guarantee fund. The insurance industry has a retrospective fund that has worked fairly well.? ?Do you really know what it would take to create a macro-FDIC, big enough to deal with a large systemic risk crisis like this one?? (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)? It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.? Also, there would be moral hazard implications ? insured behavior is almost always more risky than uninsured behavior.

Though it is not bank reform, we need to end the Greenspan/Bernanke Put.? The Fed encouraged risk-taking by the banks by not allowing recessions to damage them.? They tightened too late, and loosened too early, and that pushed us into a liquidity trap. Monetary policy that is too loose creates perverse incentives for the solvency of financial institutions in the long run.

Bonuses to executives skew incentives.? Bonusing a financial executive on current earnings creates perverse incentives.? It is a form of asset/liability mismanagement, because cash flows in the short run, while the value of the institution is a long-run issue. Far better to incent using long dated restricted common stock.? The only trouble is, it doesn?t incent as well as cash.? Tough, sorry, but that is a loss that must be accepted for the good of the system as a whole.

Summary

Dumb regulation is good regulation.? Regulators should be risk-averse, and take actions that limit ROEs for banks in order to promote solvency, and reduce the likelihood of liquidity crises.? The remedies that I have proposed here will do just that.? May we use them to regulate our financial sector better, for the good of all in our nation.