Category: Structured Products and Derivatives

Blame Game

Blame Game

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rethinking Insurable Interest

Rethinking Insurable Interest

Posted on by David Merkel

Let’s take a short break from “all credit crisis, all the time.”? I want to talk about an issue that troubles us in a number of ways.? The legal doctrine of “insurable interest” [II] is critical to the life insurance industry.? II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person.? The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.

This protection exists for several reasons:

  • Insurance exists to reduce risk, not promote gambling.
  • The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured.? Absent that, the IRS will eliminate those favors.
  • We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person.? Even though murder by the policyholder would invalidate the claim, that can be hard to catch.

Now, those who know me as a life actuary know where I am going next.? I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like.? Good guess; I’ve written about those before.? I’ve turned down job offers in that area for ethical reasons.? You only get one reputation in the business, so you better guard it carefully.

But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed.? I’m going to write about credit default swaps.

Wait.? What do credit default swaps have to do with insurable interest?? Legally, nothing at present.? This article will suggest that there should be a link.

Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm.? Corporations are corporate persons under the legal code.? Should they not get the same protection?

Credit default swaps pay off when a corporation “dies.”? I know there are additional complexities here, but play along with me for now.? There are parties that get hurt when a corporation dies:

  • Suppliers
  • Employees
  • Sponsored pension funds
  • Debt/loan holders
  • Stockholders
  • And maybe more…

They have an insurable interest in the continued well-being of the corporation.? They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more.? Any excess exposure is gambling, not insurance, and should be forbidden by law.

Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds.? Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.

Now, if you see my logic, forward this article to your Senators and Congressmen.? Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.

At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.

Industries Don’t Learn From Each Other on Credit Issues

Industries Don’t Learn From Each Other on Credit Issues

Posted on by David Merkel

As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.? I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”? For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.? Why might a company do that?? Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.? Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.? As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.? The agents will write all that they can.? One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.? Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.? Credit triggers are designed to deal with small issues, not large ones.? Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.? But where have we seen this before?

  • Life Insurers with fixed rate GICs (early 90s)
  • Life Insurers with floating rate GICs (late 90s)
  • Utilities in the early 2000s (think Enron-like structures)
  • P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.? Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.? Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.? Normal companies stay away from the cliff.? Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.? Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.? Now we suffer for it, while bad debts get liquidated, or inflated away.

Entering the Endgame for Monetary Policy, Part II

Entering the Endgame for Monetary Policy, Part II

Posted on by David Merkel

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.? Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.? That’s an estimate on my part.? Why does balance sheet quality at the Fed matter?? If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.? Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

Credit: The Economist

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”? I know Tyler and de Tocqueville said something like that as well.? At a time like this there are a lot of demands on the public treasury, and they are growing:

There is a trouble here.? In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?? This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.? As in the Great Depression, there was too much debt financing of assets.? The debt was more liquid than the assets, as well.? Borrow short, lend long.? Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).? Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.? That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

  • Inflation when the Fed monetizes the debt,
  • Depression from vastly increased taxes,
  • Debt repudiation (whether internal, external, or both), or
  • Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good. ;)? No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.? Trouble is, we don’t internally fund our debts.? At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.? Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.? Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.? Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.? There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.? My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”? The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.? I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.? Yeah, the pain’s gotta go someplace

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

Bound for the Zero Bound, or, Will They Accept Dollars in Exchange for Helicopter Fuel?

Posted on by David Merkel

These are the times that try my soul as a portfolio manager.? During crises, I am forced to make tradeoffs of the short-, intermediate-, and long-terms.

  • Short-term: technical oversold/overbought-ness.
  • Intermediate-term: valuation levels.
  • Long-term: what industries benefit from economic change?

This is a difficult balancing act.? What makes matters more complex here is trying to understand what impact the actions of the Fed/Treasury are likely to have on the Dollar.? I hope to have another post up on the balance sheet of the Fed, for now, here’s the graph that Ron Smith called “the hockey stick.”

As I note in the graph above, the changes are even larger than the change in the weekly average figures.? Now, this isn’t presently going to be inflationary, because the Fed is (sort of) acting as an agent for the US Treasury in bailing out lending markets.? The US Treasury creates T-bills or notes, gives them to the Fed, and the Fed uses them as collateral in their collateralized lending programs.

The difficulty comes here: it’s easy to create these programs, but hard to shut them down.? Now the Fed will buy commercial paper.? Talk about unbacked paper money, CP is unsecured by any assets of the company receiving the loan.? jck at Alea rightly calls this not-so-wee beastie the Super-SIV.? As I commented there:

  • # 1 David Merkel Says:
    October 7th, 2008 at 9:58 am     I think you pegged it calling it the Super-SIV. As I commented in late 2007 as the Fed began this series of interventions in lending markets, it is easier to start these actions than to complete them. It is hard to estimate all of the consequences.Just as I think George Bush, Jr., started to go wrong when he concluded that he had found his mission (fight terrorism, without boundaries), Ben Bernanke faces a similar problem (do whatever it takes to stop the Second Great Depression, without boundaries).

    History is being made here, and it will be volatile?

    And jck responded:

  • # 2 jck Says:
    October 7th, 2008 at 10:14 am     one thing we know for sure, is that the policy of ?promoting? liquidity appears to have backfired, no reasonable person would claim that markets are functioning better now than when they started?in fact some people would say they are a lot worse.
    as you say David, very hard to get out of this, I don?t expect to see a normal Fed balance sheet, i.e treasuries_t-bills in my lifetime.
    I will pop in for a comment on your euro piece a bit later?busy???

    • The question is: what are the endgames for these programs… TAF, CPFF. PDCF, TSLF, TARP, the bailouts of Bear and AIG, etc?? Once a market gets a taste of cheap credit, it is difficult to get them to give it up; they begin to depend on it.

    And there are more demands for use of the credit of the US Government.? Bill Gross wants Fed funds at 1%, and wants the Fed to guarantee that institutional transactions clear.? Sounds simple, but the devil is in the details.? The essentially means that the Fed takes short term risk of financial firms failing while securities are in the course of settlement.? The losses could be significant in a crisis, but so could the calming effect.

    The Treasury/Fed hopes that if they can calm the markets, eliminating fear of cascading defaults, eventually the markets will regain a tolerance for risk, and they can slowly eliminate the new lending programs.? My sense is that is the Japanese solution, and we are still waiting after two decades to see if it works.? Other “solutions” include:

    • Inflating away the value of the promises made. (I.e., monetizing some of the T-securities that have been printed and given to the Fed.)
    • Increasing taxation to pay for the credit losses from the bailouts.
    • Creating a two-tier currency system, where foreign lenders get paid back in a cheaper currency, but domestic lenders don’t get so badly affected.
    • Or, a combination of the above four.? Like jazz, I think policymakers are making it up as they go along, and will use a wide variety of solutions.

    And, all of this hinges on the willingness of those who buy Treasury and Agency securities to continue to do so.? On the bright side, the disarray in Europe is making the US Dollar and Japanese Yen more attractive, giving the US the opportunity to issue more debt at a time when it will be needed for the TARP.

    I come down on the side of an eventual inflation, monetizing the debts of the US Treasury, though that is a minority opinion at present.? It certainly isn’t showing in the TIPS market.? Take a look at one of Greenspan’s favorite graphs, five year inflation, five years forward:

    After six years of stability in this statistic, expected inflation has gone over Niagra in a barrel.? Call me a nut, but I like TIPS even more here.? Very cheap inflation insurance, which I think we will need when this comes into its endgame.

    Most of the pressure is toward a lower Fed funds target rate, but given that the Fed has sterilized their prior cuts, I don’t see what great good it will do.? It just gets us closer to the zero bound, after which, Japanese quantitative easing exists, and the infamous helicopters of Friedman and Bernanke.? As it stands now, I don’t put much credibility in a Fed funds rate cut.? The Fed seems committed to using its balance sheet to intervene in lending markets, not the more traditional stimulus of the economy as done in the past.

    Truth, I am not sure where this ends, but from my recent discussions with Ron Smith and Dr. Jeff Miller, the solutions aren’t easy or pretty.? The time to have acted was 5-15 years ago, and we don’t have a wayback machine.

    A Proposal for Money Market Funds, and More

    A Proposal for Money Market Funds, and More

    Posted on by David Merkel

    Unlike many, I have long felt that money market funds possess credit risk.? Does that mean that I don’t own money market funds?? I have a lot of money in money market funds, but I review the holdings of my funds to make sure that there are no “yield hogs” in the funds that might imply unreasonable risk.? I don’t go for the treasury only funds — I am willing to take ordinary high quality risk, so long as the managers aren’t doing anything to weird with structured products, ABCP, etc.

    Money market funds break the buck when the market value of the instruments drops below 99.5% of par.? That rarely happens, though in this environment it is a risk, if a fund hasn’t availed itself of the cheap insurance offered by the US Treasury.

    The real risk comes when a fund “breaks the buck” and allows withdrawals at par for a time, leading to a “run on the fund.”? My proposal says this: When a fund “breaks the buck,” it announces a credit event.? It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.

    Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 100.25, and the number of shares reduced to the level that supports that NAV.? If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.

    No one will like the concept of a credit event in money market funds.? That said, the idea would have many salutary effects on money market funds:

    • It would eliminate runs on the funds.
    • It would get people used to the idea that there is some risk in money market funds, though limited.
    • It would eliminate the need for the government to intervene and insure money market funds.
    • It would allow some money market funds to take more risk, and offer more return.
    • The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.

    Now, my main application was money market funds, but there are two other areas to consider.? Area one: short-term income funds.? Here is my poster child.? Under my proposal, instead of freezing redemptions, units are eliminated for the capital losses to the degree that it is not in the interests of anyone to liquidate assets.? A run on the fund would increase the NAV relative to the price.

    Here’s area two: stable value funds.? I’ve written about this before, but stable value funds possess more levers to continue operating, even when the NAV drops below 99.5% of par.? Stable Value funds don’t typically reveal the NAV, and when the NAV is lower than the price, they lower the credited rate relative to the earnings rate in order to bring the two back into balance.

    But what if a Stable Value fund is in a deep hole?? What if the credited rate is nearing zero, and investors are fleeing, worsening the problem?? My view is that at some threshold for NAVs the Stable Value funds have to announce a credit event and reduce units.? That value might be 96-97% of par, with a revaluation of units around 101-102% of par.? Even if there is no fleeing, the excess would be amortized into the credited rate over time.

    On the negative side, this could lead money market funds, short-term income funds, and stable value funds to be more aggressive.? That said, it would encourage invest to analyze these funds that are not riskless, because they could undergo devaluations.

    For those who hold pseudo-cash through money market funds, short-term income funds, or stable value funds, you need to be aware that they are not riskless, and that in their present form they may deliver capital losses, and more so if withdrawals are not limited.? My proposal provides an orderly way for recognizing and dealing with those losses in a way that does not require the government to step in with guarantees.

    Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

    Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

    Posted on by David Merkel

    I have been overloaded the past few days.? I took the FINRA series seven exam today and passed (88%, no section below 75%).? I may have my first client.? A dear friend of mine died.? The market has been lousy, and I have done worse than that.? Reporters have been regularly calling to talk about the markets.

    When I thought I needed to reposition my portfolio a week ago, it was after the last H.4.1 report.? Well, the next one has come out and it is worse.? The Fed is stretching itself thin, with the aid of the Treasury.? I’ll post on that tomorrow.

    I was a little surprised about some of the responses to my article on accounting rules not affecting cash flows.? Uh, that should be obvious.? But those that disagree point to arrangements where perceived reductions in credit quality lead to a need for more capital.

    Let me first say that that is not a problem with the accounting rules.? It is a problem with liability stability.? What is the possibility of a run on the bank/company/fund?? Even if it is remote, have you guarded against it?

    Runs occur in unusual ways.? Derivative agreements that require more collateral on a downgrade?? Enron-like structures that issue preferred to redeem senior debt, after some triggers are hit?? Uncertainty about ability to roll over short-term financing lines?? Ratings triggers on floating rate GICs?? Ratings triggers on regular GICs (a separate event)?? Ratings triggers on property-catastrophe reinsurance?? Over-reliance on factors to finance inventory?? Dare we mention the S&Ls in the late 80s/early 90s) Visiting the local loan shark each evening? 😉

    Most insolvencies occur because assets are considerably less liquid than liabilities, and the margin of assets over liabilities on? a “fair value” basis is thin to negative.? The company is playing near the cliff, and is relying on the kindness of strangers not to push them over.

    What I have been arguing for the last five years, whether here or at RealMoney, is that companies of all sorts need to play at a lower level of leverage.? FInancial slack is valuable, especially in a bear market.? Just ask Warren Buffett.

    Almost any company that goes bankrupt, does so because the need to cash out liabilities runs ahead of their ability to cash out assets, without having fire sales where the total value of assets drops below that of liabilities.? I.e., they run out of cash!

    That is why I don’t buy arguments that mark-to-market accounting is doing firms in.? First for financial firms, SFASs 133 and 157 don’t affect solvency, only the views of shareholders.? The regulatory/statutory accounting matters.? Also, private agreements, whether margin or derivative agreements, matter even more, because they can result in a call on cash during a crisis.? To eliminate MTM accounting is to eliminate doing business.? (Can you get a brokerage to look at your margin account only once a year, or less often?)

    The problems for financial firms arise from too much debt that is too short term in order to finance longer dated assets.? They run the risk that they will hit a cash crunch.? Sorry, but that’s the way that it goes, and it doesn’t matter what the accounting rule is if you don’t leave sufficient margin to survive the worst case scenario.

    The crises today boil down to an asset-liability mismatch in both time and liquidity, which are correlated.? It points toward a cash flow crunch, over which accounting rules have no control.? This is endemic to the market during crises.

    Aside from all of the scholarly articles indicating that accounting rule changes have little impact on valuations, this line of argumentation explains why accounting changes have little effect on the prices of stocks.? If it doesn’t happen broadly, it is unlikely to happen narrowly.

    Under the wrong circumstances, and we are living in wrong times now, almost any security can be equity-like, having an uncertain outcome.? Even T-bills face that uncertainty in purchasing power terms.? (Should we bring back the debates of adjusting accounting for inflation?? Dead issue for 20 years, could it live again?)? Equity-like instruments should be marked to the best current estimate of value, which does not mean last trade if the markets are thin.? Instead, if reliable markets don’t exist, and the calculation of market inputs is uncertain, then go back to a cash flow model with a “reasonable” discount rate.

    If a thinly traded security is genuinely “money good” SFAS 157 offers enough flexibility to not mark it down heavily.? Granted, you might have an argument with your auditors and consultants, but SFAS 157 is not the ogre that everyone makes it out to be.? (The rating agencies, regulators and margin clerks may disagree though… and that means companies need a greater than normal provision against bad times.)

    Nor is it freedom for a management to ignore the trading values of illiquid assets, because rating agencies and counterparties will still watch those factors, and a run on the company is as likely in a fog as on a sunny day.

    The only way to avoid runs on the company is to hold enough slack assets that you know you will be alright in the worst of times, meaning a depression scenario, or, scenarios where nothing trades.? Does your company/strategy possess bicycle stability or table stability?? Is there a chair to sit on if the music stops?

    What’s that you say?? Holding that much capital would kill our ROE?? That’s the thinking that got us into this mess, and is what makes risk management so tough, because the short run need for profits always leads to a diminution of risk control.? Now we are not only paying the price for it with individual companies, but across our corporate sector as a whole.

    Deleveraging is painful.? There are almost always defaults and reductions of future profitability involved.? And, bailouts of the sort that our government that out government is pursuing have a low probability of success.? So, analyze your own investments for survivability this weekend.? Who can survive for two years without financing at any reasonable rate?? That’s an acid test.? I just wish that when I reviewed the recent actions of the Fed, I had acted more quickly.? Alas, perhaps my next post should be what do you do when you find yourself behind the curve…

    Accounting Rules Do Not Affect Cash Flows

    Accounting Rules Do Not Affect Cash Flows

    Posted on by David Merkel

    At my congregation, I have a friend who is a lawyer at the Justice Department.? (Such is life for a congregation located near DC.? I am one of the few that does not derive his income from the government.)? He has asked me a couple of times about SFAS 157, and the effect it is having on the current crisis.? My recent comment to him was:

    Accounting is a way of portioning economic results by time periods.? It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk.? If we were back in an era where the financial instruments were simple, then the old rules would work.? But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.

    Equity instruments have always been marked to market, because of their volatility.? Similarly volatile debt instruments should be marked-to market.? Even the the old-style “hold-to-maturity” bonds would get marked down if there was a “permanent impairment of capital.”? Even today, the same rules apply, the companies could specify certain volatile bonds as hold-to-matutrity or available-for-sale.? But when the auditors look at the bonds, and ask what the market price is, the challenge is to explain why there is no permanent impairment of capital.

    Those that are complaining about SFAS 157 and SFAS 133 are barking up the wrong tree.? They wouldn’t be complaining if the companies in question had not bought inherently volatile assets.? These accounting rules reveal the results of their actions.? The regulators could ignore the rules of FASB, and allow the financial institutions to balue them otherwise. The regulators have a different attiuude; they don’t care about profitability, but they do care about solvency, and avoiding “runs on the bank.”
    A very well-established rule in academic finance is that changes in accounting rules do not have much impact on stock prices on average, because they don’t affect cash flows, and free cash flows are the major basis for evaluating stock prices.? If a financial company holds an impaired security, eventually that will factor into the cash flows regardless of what the accounting rules are.
    There are a number of articles today on this issue:

    FASB has offered a little more room to interpret the mark-to-market rules, but only a little.? Congress could mandate more latitude, though I think it would be a mistake.

    Mark-to-market accounting should pay a role in valuating volatile financial instruments.? Now that financial institutions have bought financial instruments more volatile than tha buy-and-hold attitude of the old days would have done, ther rules must adjust to present a fair value.
    I don’t see any way that lets the markets gain from the suspension of the rules.? The rating agencies will still do calculations of risk based liquidity on financial firms to set ratings.? Here’s a way to test though.? Go back to my old proposal that we have two income statements and two balance sheets.? Let the market see both a fair value and an amortized cost appproach.? If fair value is distorting, then investors will welcome and use the amortized cost figures in their calculations.? More information is better than less, and it is trivial to add back an amortized cost balance sheet and income statement.
    For complex balance sheets in volatile times, I know which one that investors will prefer — fair value.? Let the advocates of eliminating fair value explain why reducing information to investors is such a great benefit.? In the end the cash flows will be the same, and maybe it will take a little longer, but the results of bad investment decisions will be revealed, and the same firms will fail — perhaps in yet more ugly ways, as their shenanigans will go on longer, with less to recover for the bondholders, and wiping out the equity entirely.
    In the absence of fair value, suscpicion will take the place of information, and companies will still get marked down as failure takes place in fixed income assets classes.? The same things will happen, just in a messier way.? You can’t fight the cash flows arising from bad investment decisions, and too much leverage.
    Back to One-Off Bailouts

    Back to One-Off Bailouts

    Posted on by David Merkel

    The House vote rejecting the Bailout bill leaves us where we were before: the Treasury, FDIC, Fed, and all the quasi-financial arms of the government do one-off bailouts as needed.? That may be better than the proposed? bailout for a number of reasons.

    • For raw reasons of liberty, it is good to keep the government reactive rather than proactive.
    • The bailout as proposed did not meet our most pressing needs.? Our biggest problems are in the short-term lending markets, and the bailout did not address that directly.
    • Doing triage on the banks, and recapitalizing the survivors (at a price) may have been the optimal strategy.? Why save non-regulated entities?
    • The prior actions of the Fed and Treasury aimed at the short-term lending markets.

    My last piece on this topic was pessimistic.? I am still pessimistic, even as the Fed expands the dollar swap facilities, and the TAF.? The commerical paper market is shrinking.? People are fleeing Municipal Money Market Funds.? The repo market is freezing.? And, longer maturity investment grade credit is hurting as well.

    There will be limits at some point, though.? Look at a scaled version of the asset side of the Fed’s balance sheet:

    Now, the lowest quality assets of the Fed are in the middle of the graph. Also note that until the last month, total assets at the Fed were fairly constant. Now add in the expansion of the TAF.? Does the Fed decrease its holdings of Treasuries still further, or does the Treasury keep creating more Treasuries and give them to the Fed?

    This game could continue on for a while.? The Treasury and Fed create credit using the balance sheet of the US Government and the Fed, and use it to bail out damaged lending markets.? And, as I measure it, that has already supplied $500 billion or so to the lending markets, with another $300 billion or so on the way.

    My question: if the prior bailouts through the Fed have not worked, why should the proposed $700 billion bailout work, particularly when it is targeted at longer term assets of banks?

    A couple of notes before I close:

    • This piece that Barry cites is a great read.? I have long felt that our nation as a whole blames its politicians too much, and does not blame itself enough.
    • Yesterday was my biggest percentage and dollar loss ever.
    • Adding insult to injury, I accidentally destroyed my main work computer by spilling juice on it.? My productivity has fallen.
    What A Fine Mess You Have Gotten Us Into

    What A Fine Mess You Have Gotten Us Into

    Posted on by David Merkel

    One week ago, I posted Oppose The Treasury?s Bailout Plan.? Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.

    But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult.? Further, the talk that the baioout won’t cost anything is highly unlikely.? Of all of the US Government’s bailouts, only the Chrysler bailout made money.? So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order.? Bailouts don’t make money, and that should not be expected.

    But hey, if they are going to play for profit, let them play big.? I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well.? Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each?? Let them lever up 10:1 — you have $7 trillion of buying power.? Let the public participate along side the government and the power expands further.? With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.

    The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions.? Also, if the risk is smaller than $7 trillion, these institutions won’t do well.? Also, what of the financials who don’t have government sponsorship?? Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress?? (Oh, that sounds like one-off bailouts?? Could be a lot cheaper than the current plan…)

    And what of the borrowing?? Can this be funded at reasonable yields, and with the dollar at current purchasing power levels?? I have my doubts, though the markets have been benign over the last few days.

    Consider the actions of the Federal Reserve in concert with the Treasury.? As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions.? This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others.? With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.

    Three notes to close:

    • I don’t know what Monday will bring in entire, but a failure of Fortis seems likely.?? Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
    • What the FDIC did with WaMu affects other banks like Wachovia.? Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.? Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
    • We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.? If one of them fails, the game is over.? Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.? Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

    All “solutions” to the crisis at this point in time are bad solutions.? The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries.? (No ownership, no lending, no derivative agreements.)

    I don’t know what next week will bring us.? Last week was bad for me on a relative performance basis.? My inclination is to look at companies that have good global demand, and not much debt.? As for bonds, keep them short, unless you are buying long TIPS.