Stocks – Page 131 – The Aleph Blog

Mark-to-Market Accounting Is not the Major Problem

Posted on 21 March 200823 May 2013 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

Fifteen Notes on the Credit Markets (and other markets)

Posted on 21 March 200821 March 2008 by David Merkel

1)? A number of blogs pointed to this piece by Howard Marks of Oaktree, and I thought it was very well-thought out for the most part.? There are few people who think about history in the markets; they just follow present trends.? Learning how to see unsustainable trends and avoiding them not only reduces risk, but enhances long-term return.

2) Crisis!? Choose how you want to view it:

3) Tony Crescenzi sounds an optimistic note on the short-term lending markets.? His opinion should be taken seriously.? The money markets are a specialty of his.

4) To err is human, but to really mess things up, you need derivatives.? With Bear Stearns, different parties have different incentives regarding the firm.? Senior bondholders and derivative counterparties owed money by Bear are much, much larger than the teensy equity base of the small-cap firm.? It is my guess that they are protecting their interests by buying stock at prices over the terms of the deal.? They want the deal to go through.

5) How are the European investment banks?? My guess is that they have greater accounting flexibility, and things are better than US investment banks, but worse than currently illustrated.

6) Save our markets by risking our national credit?? I’m skeptical of many government solutions that bail out the markets, including those the Fed is pursuing.? Same for the GSEs… it seems like a free lunch to allow the GSEs to lever up further, but the losses are growing at Fannie and Freddie from all of the guarantees that they have written.? The US government backstops the whole thing implicitly, but even the capacity of the US government to fund these bailout schemes is limited.? Calling Fitch! — you often have more guts (or less to lose) than S&P and Moody’s.? Let’s have a shot across the bow, and downgrade the US to AA+.

7) Are mortgage rates finally falling?? I guess if the expectations of Fed policy get low enough, it will overcome the increase in swaption volatility.? Then again, PIMCO, Fannie, Freddie, and many others are buying prime mortgage paper again.

8 ) Thornburg, alas.? Dilution and more dilution, in order to survive.? (That could be the fate of many financial and mortgage insurers.)? Misfinancing in the midst of a crisis gives way to a need for equity that kills existing shareholders.

9) In terms of actual losses, Commercial Real Estate lending is not in as bad of a shape as residential lending.? That said, it’s not in great shape and the market is slowing dramatically.? What lending market is in good shape today? 🙁 We overlevered every debt market that we could…

10) When actual stock price volatility gets high, that is typically a sign of a bear market.? When it actual volatility peaks, that is often a sign of an intermediate term bottom.

11) Finally, an article on ETNs that mentions credit risk, if briefly.? Be wary of ETNs, they are obligations of investment banks, most of which have high credit spreads that you are not being compensated for in the ETNs.

12) Give the guys at Dexia some credit for being opportunistic during the crisis of financial guarantors… they had the balance sheet, conservative posture, and the team ready to take advantage of the dislocation in their subsidiary FSA.

13) Someone tell me otherwise if I am wrong, but I am not worried about the assets in my brokerage account.? In a crisis, there is SIPC and excess insurance.? Brokerages are prohibited from commingling client assets, and even if their are delivery failures from securities lending, those issues are solvable, given time and the insurance.

14) I worry about inflation in the US, because it is a global problem.? As the dollar declines, it slows foreign economies because they can’t export as much, and it raises prices here because imports cost more.

15)? This is an article that is just too early.? So the markets have rallied, and commodities have fallen?? It’s only one week, and that is no horizon over which to make the judgment that Fed policy is succeeding.? Look at it in 9-12 months, and then maybe we can hazard a good guess.

Predictably Irrational

Posted on 19 March 2008 by David Merkel

Zubin Jelveh has a good post over at Portfolio.com on rationality and markets. Here’s my take:

Behavioral economics is very useful to practitioners, and we are grateful to those who say it is not, because it makes it more useful to the rest of us.

Think of the Adaptive Markets Hypothesis as a tree, and every anomaly/strategy as a bird. As a strategy works, the bird gets fed more, reinforcing the return pattern. When a bird gets too fat, the branch breaks, and the strategy can have a colossal failure. The bird hits the ground, walks away, and the branch re-grows. Eventually, after the bird slims down, he flies back to the branch.

Anomalies/strategies come and go. Too much money can pursue any strategy, even indexing. Wise investors try to ask the question “Where is there too much investor interest?” and then they avoid those strategies until they blow up.

To give an example, it is a great time now to manage unlevered structured product, agency or non-agency, MBS or ABS. Too many levered players have blown up, and there is a lot of good paper that needs a home.

I have talked about this a numberf of? times before, but one of the more fun times was this article.? :)? Here’s another one.

The concept of rationality is a fuzzy one.? I’m not sure that all rational people could agree on a definition. 🙂

My view is that people are not uniformly rational, but that they are in aggregate predictable.

Investment Banks Are Priced Like Bermuda Reinsuers

Posted on 18 March 2008 by David Merkel

Late in the day, I looked at a table of valuations of the remaining major investment banks, and thought, “Huh, they’re priced like Bermuda Reinsurers.? Price-to-book near 1 or lower, and expected P/Es in the middle single digits.”? Well, that got me thinking… how are those two groups of companies alike?

?When losses come they can be severe.
Both have strong underwriting cycles where a lot of money is made in the boom phase, and a lot gets lost in the bear phase.
Earnings quality can be poor, unless management teams have a bias against meeting Street expectations, and allowing earnings to be ragged.
The opacity of the investment banks’ swap books is matched by that of the reinsurers’ reserving.
Both businesses are highly competitive, and global in scope.

Now, what’s different?

The reinsurers typically don’t have asset problems, only reserving problems.
The Bermuda reinsurers know that one day a change in their tax status may come (somehow forced to pay US tax rates — ask Bill Berkley), and that would lower earnings.
The financial leverage of the reinsurers is a lot lower.
The financing of reinsurers is a lot more secure.

The risk-reward seems balanced to me across the two groups.? The reinsurers are lower-risk/lower-reward, and the investment banks are higher on both scores.? Choose in accordance with your risk tolerance — as for me, I’ll look at the reinsurers.

National Atlantic Notes

Posted on 17 March 2008 by David Merkel

Given the furor of the day, I thought I might have to abandon the National Atlantic Teleconference call.? I didn’t miss the call.? The transcript is here (thanks, Seeking Alpha).? Let me quote my portion of the call.

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Operator

Thank you, sir. Today?s question-and-answer session will be conducted electronically. (Operator Instructions). We?ll go first to David Merkel of Finacorp Securities.