Category: Speculation

The Sea Change in Bonds

The Sea Change in Bonds

Posted on by David Merkel

The bond market has had quite a shift since the last Fed meeting. What are the common themes?

  • Outperformance of credit, especially high yield.
  • Return of the carry trade.
  • Tax-free Munis have run.
  • Underperformance of Treasuries (longer= worse), and foreign bonds, particularly carry trade currencies like the Yen and Swiss Franc.

The willingness to take risks in fixed income has returned, particularly in the last two weeks. I don’t want to tell you that this is a trend that won’t reverse… it might reverse. Remember that bear market rallies tend to be short and sharp, and that the credit bear market in 2000-2002 had several legs. Leg one may be over for this credit bear market, but that doesn’t mean the credit bear market is over; there are still too many unresolved credit issues in housing, builders and investment banks.

Now, to flesh out the changes, I looked at the total returns on 15 major ETFs in different sectors of the bond market. Here are the returns since 3/19:

  • HYG — High yield Corporates + 4.47%
  • DBV — Carry trade fund +2.83%
  • MUB — National Municipals +1.10%
  • LQD — Investment Grade Corporates +0.99%
  • FXE — Euro currency Trust +0.29%
  • BIL — Treasury Bills -.06% (Negative on T-bills?!)
  • AGG — Lehman Aggregate -1.03%
  • SHY — Short Treasuries -1.18%
  • TIP — TIPS ETF -2.85%
  • IEI — 3-7 yr Treasuries -3.41%
  • FXF — Swiss Franc Currency Trust -3.44%
  • BWX — Intl. Gov’t Bond Fund -3.49%
  • IEF — 7-10 yr Treasuries -3.74%
  • TLT — 20+ Treasuries – 4.87%
  • FXY — Yen Currency Trust -5.30%

What a whipping for safe assets. Perhaps the Fed will be happy that they helped engineer the whacking. Then again, the TED spread is still high, and the change might just be a normal shift in sentiment after the panic leading up to the last FOMC meeting. Interesting to see both the return of the carry trade and credit spreads outperforming the move in Treasuries.

For those that follow my sector recommendations, I would be lightening, but not exiting credit positions in the near term. I’m in the midst of considering my other sector recommendations, and will report on this soon. For more on this topic, refer to:

Before I close, one large negative area where there is excess supply: preferred stock of financial companies.? There is a lot floating around from balance sheet repair efforts where they didn’t want to dilute the common.? (That’s the next act.)? I would stay away for now, but keep my eyes on selected floating rate trust preferreds, to leg into on the next leg down.

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Book Reviews: Manias, Panics, and Crashes, and Devil Take the Hindmost

Posted on by David Merkel


Sometimes we forget how bad it can be, and then we howl over minor bad times in the markets. We may be past a mania in residential housing, but we have not really experienced a panic or crash yet. People squeal over how bad the equity market is, but recently we haven’t had anything like the 2000-2002 experience, much less the 1973-1974 or 1929-1932 experience.

Two books come to mind when I think about disaster in a non-fear-mongering way: Manias, Panics, and Crashes, by Charles Kindleberger, and Devil Take the Hindmost, by Edward Chancellor. They take two different approaches to the topic, and those approaches complement each othe, giving a fuller picture. Chancellor takes a historical approach, while Kindleberger deals with the structures of financial crises.

From Chancellor, you will see that manias and their subsequent fallout are endemic to Western culture. Someone living a full life over the last 300+ years would see one or two big ones, and numerous small ones. Relatively free societies give people freedom to make mistakes. Given the way that people chase performance, we can all make mistakes as a group, with large booms and busts. Much as the regulators might want to tame it, they can pretty much only affect what kind of crisis we get, and not whether we get one. He is somewhat prescient in suggesting that the leverage inherent in derivatives post-LTCM could be the next crisis. This book is a better one if you like the stories, and don’t want to dig into the theories.

But if you like trying to place the manias, panics, and crashes on a common grid, to see their similarities, Kindleberger has written the book for you. In it he draws on a number of common factors:

  • Loose monetary policy
  • People chase the performance of the speculative asset
  • Speculators make fixed commitments buying the speculative asset
  • The speculative asset’s price gets bid up to the point where it costs money to hold the positions
  • A shock hits the system, a default occurs, or monetary policy starts contracting
  • The system unwinds, and the price of the speculative asset falls leading to
  • Insolvencies with those that borrowed to finance the assets
  • A lender of last resort appears to end the cycle

I liked them both, but I am an economic history buff, and a bit of a wonk. The benefit of both books is that they will make you more aware of how financial crises come to be, and what the qualitative signs tend to manifest during the boom and bust phases of the overall speculation cycle.


Full disclosure: if you buy anything through Amazon after entering their site by clicking on one of the links here, I get a small commission. That’s my version of the tip jar.

Nerds and Barbarians

Nerds and Barbarians

Posted on by David Merkel

There have been a lot of bits and bytes spilled recently over whether hedge funds like volatility or not. Here’s a sampling:

Here’s the truth, the answer isn’t a simple yes or no.? Hedge funds are limited partnerships that do a wide variety of things in the markets.? Some aim for easily modeled consistent gains through arbitrage.? Others aim for maximum advantage, no matter what.? I call the first group the “nerds” and the second group the “barbarians.”? Neither of these terms are meant to be insulting — I consider myself to be a nerdy barbarian.

Nerds are yield-seekers.? They are attempting to achieve high smooth yields well in excess of the nominal risk-free rate on a constant basis.? They tend to get funded by fund-of-funds who attempt to diversify nerds, and maybe a barbarian or two, who have clients looking for smooth yields in excess of their hurdle rates.

When volatility rises, nerds get hurt.? In the same way that junk bond investors get hurt in volatile times, so do hedge fund nerds.? Almost all simple arbitrages rely on calm markets, where there is enough liquidity to finance every project imaginable, and a few that aren’t imaginable.? Volatility alerts investors to the concept that maybe there will not be enough cash flow to complete the transaction at a positive net present value.

Barbarians are another matter.? They swing for the fences, and are looking for maximum advantage.? They look to earn the returns from big bets that could be right or wrong.? They like increased volatility, because it enables them to take positions when they are despised or enraptured.? They play for the mean reversion, something that the nerds can’t do.

To make matters more complex, some hedge fund groups blend the two attitudes.? Good idea, if you can maintain your competitive advantages.

To close this, there is no simple answer to whether hedge funds like volatility or not.? Some benefit,? some get hurt. In my opinion, because of hedge fund-of-funds, which like nerds, volatility tends to hurt hedge funds in aggregate, but not by much.

With credit spreads wide, and disarray among the nerds, it is probably time to favor high yield investing and nerds in hedge funds.??? Don’t jump in with both feet though, I would only allocate 50% of a full position at present.? There is a lot more volatility to be worked out of the system.

The Global View — Six Themes

The Global View — Six Themes

Posted on by David Merkel

Though I write mainly about US economic and investment issues, I try to be think globally as I consider macroeconomics. I think that many economists are hobbled because they think about the US economy in a closed framework, neglecting the effects that the rest of the world has on the US. Prior to the end of the cold war, that was a useful shortcut, but now many aspects of the US economy depend on global, and less on local factors. (Some articles cited here will be dated, but are still relevant in my mind.)

This article is meant to take you through six themes affecting the global economy. Here goes:

China

I’ve been writing about neomercantilism and China now for almost five years. The negative effects are now obvious. Inflation has been rising in China, because too much credit is chasing too few goods. That inflation is funneling into US goods prices as well. China exports too much, and imports too little, which forces them to import US credit. This is getting tired, and the Chinese and Middle Eastern savings gluts need a new place to invest, or better, new goods to buy. Absent these adjustments, in order to cool the economy, the PBOC keeps raising reserve requirements again and again. Better they should revalue the yuan up 20%, or they will continue to import inflation from the US.

China has its growing pains amid this. Pollution is rampant, and standards for product safety are low. Beyond that, China now competes with the US and Europe for economic alliances in Africa. Given past bad blood there, the Chinese may at many points be better received, that is, until they abuse their welcome.

Currencies

The main question here is the demise of “Bretton Woods II” where the rest of the world uses the US Dollar as the main reserve currency, while the US continues to debase the dollar through the issuance of more dollar claims. You can read about it in any of the following articles:

Now, Ken Fisher told us not to worry about the declining dollar, but the euro-yen exchange rate. It’s too early to say, but that exchange rate is flat, while the S&P 500 is off 7% or so. Perhaps the overall carry trade is weakening, but not with the euro as a currency to purchase, yet.

Finally, not only is the weak dollar good for exports, but for tourism as well. Now maybe they buy some of our slack houses as well…. please?

Inflation, Especially Food Prices

All the buzz is over rice, which has risen fivefold in six years. You can read about it here:

Now, that inflation is feeding back to the US, but slowly.? You would think that this would be a great time to eliminate US farm subsidies, but no, they are too effective at buying votes insuring economic stability in the Midwest.

Now, in the face of these inflationary pressures, the ECB is not mimicking the Fed.? They see the inflationary pressures, and aren’t loosening, at least not much.? Australia is even tightening.

Recession Fears in the Developed World

Now there are similar stresses in housing in some places of Europe, as compared to the US.? Consider Spain (and here), and the UK.? Low-ish interest rates can lead to overbuilding anywhere, if the regulators look the other way.? Japan may not have housing worries, but their growth is slowing, and they worry about the next recessionary leg of a what is proving to be a long recessionary era (since 1990).

Energy

It doesn’t matter how you slice it, Chavez has mismanaged the Venezuelan economy, and particularly the oil industry.? Now he is trying to do the same thing to cement.? Venezuelans are experiencing shortages and high inflation, as Chavez directs resources that he has stolen nationalized to his cronies and his foreign interests that he funds in order to make life difficult for US foreign policy in Latin America (not that I am a great fan of US policy there — I only recognize the conflict).

The Middle East has lots of new oil fields to tap at the right price, yes?? Well, I’m not so sure.? It is interesting to see the UAE develop a nuclear program.? Perhaps they are looking to a day when oil will not be so plentiful?? Then again, maybe we will have a big energy find in Greenland (an island that may once again be green, now that temperatures are rising to levels last seen in the middle ages).

Emerging Markets

Coming back to the beginning of the article, emerging markets (like China), are going through an adjustment period.? Since these two articles were written, emerging market equities have fallen significantly.? They may fall further; many of those nations are geared to global growth, and when it slows, it slows even more for them.? Many of them are absorbing US inflation as well, and need to raise their exchange rates.? That will hurt exports in the short run, but will aid in bringing economic stability.

The Financings of Last Resort

The Financings of Last Resort

Posted on by David Merkel

After seeing the amazing “refinancings” done by entities like MBIA, Thornburg, WaMu, and Rescap, I felt it was right to comment on last-ditch financing methods, so that you can recognize desperation (if it’s not obvious already).? Here are some methods:

  • Borrow money using a healthy subsidiary while limiting capital flows up to the less than healthy holding company (e.g., MBIA) .
  • Do a rights offering at a significant discount, diluting existing shareholders if they don’t participate.
  • Offer common stock at a significant discount to a private buyer (perhaps with warrants), diluting existing shareholders, but perhaps allowing the company a chance to play again another day. (e.g. WaMu, Thornburg).
  • Offer a convertible bond/preferred to monetize the volatility of the stock price, contingently diluting existing shareholders. (e.g. Lehman, Citigroup, Merrill)

With the exception of the first one, all of these dilute existing shareholders, usually driving the stock price down in the short run, unless the removal of fear of bankruptcy is the dominant factor.? With the first one, it is an example of structurally subordinating lenders to the holding company, who now lose “first dibs” on the value of the healthy subsidiary.

I try to avoid companies that do financings like these, or are likely to do them.? They have a high default rate.? And what goes for the stock here, goes triple for the corporate bonds, where you have all of the downside of the stock, and little of the upside, if the company should manage to survive.

Uptight on Uptick

Uptight on Uptick

Posted on by David Merkel

There have been many writing about the impact of the lack of an uptick rule in the present market.? In the past, before a player could sell short, the stock had to trade up from the last trade — an uptick.? This made it hard to short a stock too heavily, forcing the price down.

Well, maybe.? I still think shorting is a pretty tough business.? First, the long community is much larger than the short community.? Second, the longs can always move their positions to the cash account if they don’t like other players borrowing their shares.? (Move to the cash account, squeeze the shorts.? Wait.? You don’t want to lose the securities lending income?? Shame on you; you should put client interests first.)

The thing is the uptick rule is not the real problem.? The real problem is that shorts don’t have to get a positive locate at the time of the shorting; a mere indication from the broker enables the short for a few weeks, while search for loanable shares goes on. This is a computerized era.? There is no reason why there can’t be real-time data on loanable shares.

There is a second problem, and less so with stocks, than with other financial instruments that are borrowed.? There needs to be stricter rules/penalties on what happens when a party fails to deliver a security.? As it is, when the cost of failing to deliver is miniscule, it can really bollix up the markets.

The longs have adequate tools to fight the uptick rule; they don’t have adequate tools to help against naked shorting and failures to deliver.

Shelter Fallout

Shelter Fallout

Posted on by David Merkel

Though sometimes I do posts that are a melange of different items that have caught my attention, I do try when possible to gang them up under a common theme.I try not to do “linkfests” because I want my readers to get a little bit of interpretation from me, which they can then consider whether I know what I’m talking about or not. Anyway, tonight’s topic is housing. I didn’t get to my monetary policy 101 post this week — maybe next week. I do have three posts coming on Fed policy, credit markets, and international politics/economics. (As time permits, and ugh, I have to get my taxes done…. 🙁 )

1) The big question is how much further will housing prices fall, and when will the turn come. My guess is 2010 for the bottom, and a further compression of prices of 15% on average. Now there are views more pessimistic than that, but I can’t imagine that a 50% decline from the peak would not result in a depression-type scenario. (In that article, the UCLA projections are largely consistent with my views.) It is possible that we could overshoot to the downside. Markets do overshoot. At some level though, foreigners will find US housing attractive as vacation/flight homes. After all, with the declining dollar, it is even cheaper to them. Businesses will buy up homes as rentals, only to sell them late, during the next boom.
2) But, the reconciliation process goes on, and with it, losses have to go somewhere. In some cases, the banks in foreclosure refuse to take the title. Wow, I guess the municipality auctions it off in that case, but I could be wrong. Or, they let the non-paying borrowers stay. I guess the banks do triage, and decide what offers the most value to act on first, given constraints in the courts, and constraints in their own resources. Then again, developers can reconcile the prices of the land that they speculated on to acquire. In this case, cash is king, and the servant is the one that needs cash. I just wonder what it implies for the major homebuilders, with their incredible shrinking book values. Forget the minor homebuilders… Can one be worse off? Supposedly my father-in-law’s father lost it all in the great depression because he was doing home equity lending. There are wipeouts happening there today as well. Add in the articles about unused HELOC capacity getting terminated (happened to two friends of mine recently), and you can see how second-lien lending is shrinking at just the point that many would want it.

3) The reconciliation process goes on in other ways also. Consider PennyMac, as they look to acquire mortgage loans cheaply, restructure, and service them. Or, consider Fannie and Freddie, who are likely to raise more capital, and expand their market share (assuming guarantees don’t get the better of them). Or, consider the Fed, which has tilted the playing field against savers, and in favor of borrowers, particularly those with adjustable rate loans. No guarantee that the Fed can control LIBOR, though…

4) The reconciliation process steamrollers on. We’ve seen Bear Stearns get flattened trying to pick up one more nickel, and maybe Countrywide will get bought by Bank of America, but you also have banks with relatively large mortgage-lending platforms up for sale as well, like National City. Keycorp might bite, but I’ve seen Fifth Third rumors as well. Then there is UBS writing down their Alt-A book, along with a lot of other things.

5) A moment of silence for Triad Guaranty. A friend of mine said that they were the worst underwriter of the mortgage insurers. Seems that way now. Another friend of mine suggested that MGIC would survive off of their current capital raise. They stand a better chance than the others, but who can really tell, particularly if housing prices drop another 15%.

6) Beyond that, the financial guarantors have their problems. FGIC goes to junk at S&P. MBIA goes to AA at the operating companies, and single-A at the holding company at Fitch. I personally think that both MBIA and Ambac will get downgraded to AA by S&P and Moody’s. I also think that the market will live with it and not panic over it. That said, BHAC (Berky), Assured Guaranty, and FSA (Dexia) will get to write the new business, while the others are in semi-runoff.

7) Now for the cheap stuff. Amazing to see vacancy rates on office space in San Diego rising. I think it is a harbinger for the rest of the US.

8 ) Buy the home, take the copper, abandon the home, make a profit. Or, just steal the copper.

9) Bill Gross. A great bond manager, but overrated as a policy wonk. Many would like to see home prices rise, but others would like to buy a home at the right price. How do we justify discriminating against those who would like to buy a cheap house?

10) “The prudent will have to pay for the profligate.”? Well, yeah, that is much of life, in the short run.? In the long run, the prudent do better, absent aggressive socialism.? The habits of each lead to their rewards, and the ants eventually triumph over the grasshoppers.

Seven Notes on Equity Investing

Seven Notes on Equity Investing

Posted on by David Merkel

1) A lament for Bill Miller.? Owning Bear Stearns on top of it all is adding insult to injury.? Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.? I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.? During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.? When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.? What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.? The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)? Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.? Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.? What a concept amid falling housing and equity prices.? Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.? My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.? I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.? When there are problems, major economic actors are not passive; they look for solutions.? That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.? It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.? Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.? These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.? They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.? They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.? When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.? But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.? Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.? Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.? But without fully invested conventional wisdom, contrarianism has little to fight.

Federal Office for Oversight of Leverage [FOOL]

Federal Office for Oversight of Leverage [FOOL]

Posted on by David Merkel

I want to go back to an article that I wrote early in the history of this blog, when nobody read me except a few RealMoney diehard fans — Regulating Systemic Risk From Hedge Funds.? It was a critique of the ?Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.?? Yes, the “shadowy” President?s Working Group on Financial Markets.? Some will call it the “Plunge Protection Team.”? Well, if they are that, they are certainly not playing up to their billing.? As an aside, I tend not to believe in conspiracy theories, because most bad plans of our government don’t require them.? As Chuck Colson pointed out regarding the Nixon Administration and Watergate leaks — he felt that information tightness in the Nixon White House was so effective, that if a conspiracy could work, it would have worked there.? (Since it didn’t work, and the information leaked out, it had a surprising effect on Colson’s life, as he concluded that the disciples of Jesus (Y’Shua) could not have conspired to steal the dead body, hide it, and fake a resurrection.? But that’s another story.)?? Suffice it to say that I don’t think the government intervenes in the major financial markets of our country — there would be too many accounting entries to hide, and someone would have a real incentive to leak the information, or write a book about it.

Going back to my article, I tried to point out the difficulty of gathering data and analyzing it.? It was also somewhat prescient as I said, “Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won?t do them; they are friends with too many people who benefit from the current setup. If they won?t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.”

There is another reason why they would not act then, as I had pointed out at RealMoney over the years.? Bureaucrats are resistant to offering changes where if thy would get harmed if the changes led to a market panic.? Once the market panic starts, they can move with greater freedom, because no one will be able to tell whether changes imposed during the panic intensified the panic or not.

So, color me skeptical on efforts to monitor and control systemic risk.? It would be very hard to do effectively, and there are too many powerful interests against it.? Also, it would be difficult to get the gross exposure data necessary for inhibiting crisis, because many financial instruments would have to be split in two or more pieces.

As to the articles I have read on Treasury Secretary Paulson’s plan, they divide into credulous (one, two), mixed, and skeptical/hostile (one, two).? Let me simply observe that any plan for the control of systemic risk has to overcome:

  • Political opposition
  • Lack of effective data
  • Lack of an effective model
  • Lack of willingness to implement the conclusions generated by the staff/modeling
  • Inter- and Intra-agency disagreements
  • Data and action lags

If it is already difficult for the Fed to implement contracyclical monetary policy, just imagine how difficult it will be for them to deal with a problem that is far more tricky because of its multivariate nature.? Imagine them trying to analyze the effects from currencies, commodities, operating businesses, credit, ABS, RMBS, CMBS, equity-related businesses, counterparty risk, etc.? This is not trivial, and Paulson I suspect knows it all too well, which has led him to make a modest proposal that will likely not be effective, but will likely run out the shot clock for the Bush administration, leaving the issue for the next President to deal with.

The Fed is not by nature an activist institution, and it would have to become far more activist in order to effectively regulate the bulk of all financial institutions in the US.? I don’t see it happening.

As an aside, I am ambivalent about Federal regulation of insurance, and this RealMoney article of mine still expresses my views adequately.? Still, it would make sense to hand over oversight of financially sensitive insurers, such as the financial guarantee insurers and the mortgage insurers to the Feds, together with whoever oversees the ratings agencies.? An integrated solution is preferable.? (I still like my proposed name for the new regulator, “Federal Insurance Bureau” [FIB… well, it can’t be the FBI].

As for some of the fog that a regulator of investment banks would exist in, consider these two articles on hedge fund distress.? What affects the hedge funds, affects the investment banks.? They are symbiotic.

As a joke, given that it is the first of April, if we do get a regulator for overall financial solvency and systemic risk, I believe it should be called the Federal Office for Oversight of Leverage [FOOL].? After all, I think it is taking on a fool’s bargain.

Mark-to-Market Accounting Is not the Major Problem

Mark-to-Market Accounting Is not the Major Problem

Posted on 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.

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