Deus Ex Macchiato

FT alphaville has an interesting post on the Spanish stress test results. They quote Deustche bank research as follows:

We regard the impairment assumptions (both on sovereign and the different credit buckets) as sufficiently severe and consistent. We are, however, less convinced by and have lower visibility on what is included in and how the regulator arrived at some of its forecasts on PPP [pre-provisioning profit], capital gains and other “impairment buffers”. This is particularly relevant as under a marginally tougher set of assumptions in this area, a larger number of institutions would have failed the test (nine instead of five, with another six below 6.5% Tier 1), although admittedly the incremental amount of capital is limited to EUR 3.5B.

The point is that the stress test results are rather sensitive to these PPP estimates. As Alphaville says:

Reducing the PPP forecasts by 20 per cent leaves nine banks below the magic 6 per cent Tier 1 capital ratio used in the tests

Now it’s easy to use this as evidence of stress test fudging, and I won’t bother to do that – the tests have been analysed enough elsewhere, and the markets have their own view. Instead I’ll make a broader point: wouldn’t it be nice in financial statements to get some sensitivity analysis of key variables? That is, instead of getting a static book of a financial statement, with all the numbers hard-wired, what I’d like would be a little model. The default conditions of the model would be the reported financials. But then you could vary a few of the key parameters – loan loss provisions by book, say, or funding cost – and see the impact on the financial statements. That would really give investors a much better idea of what the company’s risks were. For that reason, I suspect it will not happen in my lifetime.

Posted in: Accounting by David /
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Even for me, I will admit that is a cryptic title. It gets worse. It’s about accounting.

Let me explain. The principal US accounting standard about fair value was Federal Accounting Standard 157, or FAS 157 to its (few but loyal) friends. As part of its update, 157 has acquired a new number, and it is now FASB ASC Topic 820, Fair Value Measurement and Disclosure. The FASB text is here.

Why should you care, dear reader? Well, there are two things in 820 that struck me as apposite; one good, one bad.

(At this point if you don’t know about the three levels of FAS 157 you might either like to read about them or skip to the next post.)

The good one first.

Financial statement users indicated that information about the effect(s) of reasonably possible alternative inputs [to level 3 valuation models] would be relevant in their analysis of the reporting entity’s performance.

So, with a reasonable amount of luck, 820 will require firms not just to state the value of their level 3 assets, but also to assess uncertainty in that value. This would be a major step forward in accounting disclosures for financial instruments, and I commend the standard setters for it.

Now the bad part. They have made this a lot less useful than it would otherwise be by extending (or at least clarifying the extent of) level 2.

I used to think that level 2 assets were things valued using a model, but where all the model inputs were current market observables. In other words, a swap valued using a discounted cashflow model calibrated to the quoted libor rates is level 2, but a quanto option valued using historic correlation isn’t, as correlation is not a current market observable (but rather an historic property). In fact anything valued using a model where one input is an historic property – historic vol, historic prepayment rates, etc. – should be level 3.

Unfortunately the text of 820 now includes the clarification that anything based on a market input is in level 2. And since historical volatility is based on a price history, an option priced using historic rather than implied might be in level 2. This is not good. There is a crucial difference between a current price used as an input (or equivalently a convention for quoting prices, like implied vol) and anything else. Level 2 should be kept for purely price based model inputs. That, of course, would also make the level 3 uncertainty disclosures much more useful.

Update. I looked for the corresponding point in IFRS 9 and didn’t find it, because it is in IFRS 7. Duh. Anyway. It’s no clearer there.

Posted in: Accounting by David /
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From Ben Bernanke’s speech, The Supervisory Capital Assessment Program–One Year Later:

Importantly, the concerns about banking institutions arose not only because market participants expected steep losses on banking assets, but also because the range of uncertainty surrounding estimated loss rates, and thus future earnings, was exceptionally wide. The stress assessment was designed both to ensure that banks would have enough capital in the face of potentially large losses and to reduce the uncertainty about potential losses and earnings prospects.

The premise here is I think entirely accurate: it was not just current losses that were spooking investors during the Crunch, it was uncertainty over how large future losses would turn out to be. I’m not sure the FED’s stress assessment did that much – the capital and liquidity injections were much more important – but still, the phrasing is interesting. (Remember that the stress tests were not that stressful.)

Later in the speech, Ben makes another interesting point:

Importantly, to conduct effective stress tests, banks need to have systems that can quickly and accurately assess their risks under alternative scenarios. During the SCAP, we found considerable differences last year across firms in their ability to do that. It is essential that every complex firm be able to evaluate its firmwide exposures in a timely way. One of the benefits of the stress testing methodology is that it provides a check on the quality of firms’ information systems.

As I discussed, one reason for the success of the stress tests was the public disclosure of the results. We are evaluating the lessons of the experience for our disclosure policies.

Clearly there is the potential for disclosures here to be really insightful for investors. We have seen how useless VAR disclosures were for predicting losses during the Crunch: perhaps stress tests results, especially if standardised across the industry and thus directly comparable, will be more useful. It certainly can’t hurt (well, it can’t hurt unless an actual loss appears in a situation which is close to one of the ones tested, and it is much bigger than that test would have indicated). Stress tests are here to say, and financial institutions will need to get used to them; to resource themselves so that they can run them easily; and to prepare for the consequences of disclosing the results of them.

Posted in: Accounting, Fair Value, Mother of all Bailouts by David /
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Not proven, thanks to realistic doubt. Level 3 is your friend.

Posted in: Accounting by David /
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In an interesting FED paper, How Did a Domestic Housing Slump Turn into a Global Financial Crisis? Steven Kamin and Laurie Pounder DeMarco discuss how the subprime issues created a global financial crisis. They agree with the perspective I took in my two articles in Quantitative Finance (here and here) that direct exposure to subprime did not cause the crisis. There were simply not enough subprime mortgages and they were not widely enough held to cause the intensity of problems that we saw. Rather there were other channels of contagion which combined with direct exposure (and counterparty risk) to cause the crisis. Kamin and DeMarco’s list is similar to mine:

• No one knew who held what, and whether it was fairly marked. Without general confidence that institutions had correctly marked their losses, and that they had disclosed all material exposures, confidence was lost.
• Amid heightened demands for liquidity, financial institutions that depended heavily on short-term funding were subject to runs. This follows from the loss of confidence.
• In particular, following Paribas’ refusal to redeem shares in several of its SIVs and conduits, the ABCP market dried up, forcing assets back on balance sheet (thanks to backup liquidity lines) and intensifying the funding crisis.
• Historically contagion was caused by direct interbank exposure. In this crisis in contrast, it was caused by mark to market. Selling, sometimes forced (by funding difficulties and/or inability to meet margin calls), lowered asset prices, which caused mark to market losses to all holders. In an illiquid market selling a relatively small position caused big falls which affected all holders who were properly marking their position.
• Investors realised that whether or not a bank had direct subprime exposure, it likely had business practices sufficiently similar to troubled market participants that it was vulnerable. Nearly everyone was too leveraged, had too much funding liquidity risk, too much exposure to complex mark to model instruments, and lax supervisors. This ‘wake up call’ caused a widespread loss of confidence in financial institutions of all kinds.
• At the same as losing confidence in their counterparties, market participants increased their risk aversion. Ratings were (rightly) distrusted; structured assets of all types were viewed with suspicion; risk capital became very scarce. This again caused asset selling which reinforced the price falls/losses/capital reduction/loss of confidence spiral/forced deleverage spiral.

If we want to reduce the likelihood and severity of future crises, we need to address these vectors of contagion. This requires:

• Enhanced disclosures from financial institutions, better valuation methodologies, and much better supervision of valuation. Lehman’s ambitious valuations as disclosed in the Valukas report is evidence enough of the need to do this.
• Better liquidity risk management, and tighter supervision of liquidity.
• Intense supervision of funding liquidity risk in vehicles which are not supported by insured deposits.
• Breaking the link between mark to market and capital.
• Increased diversity in the financial system.
• The introduction of anti-cyclical capital measure which reduce the impact of crises on regulated institutions.

Posted in: Accounting, Mother of all Bailouts, Rules by David /
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There has been considerable interest recently from the BIS in dynamic provisioning. The basic idea is that we should take provisions to reflect what expected losses will be over the life of the loan. Superficially this makes sense: if we know we are close to the peak of the economic cycle, then losses will be higher in the future, and so we should take more provisions. If we are in a downswing, then things will get better, and we need less. Thus dynamic provisioning can be countercyclical.

Note in particular that dynamic provisioning is in addition to specific provisions. This is important because dynamic approaches by their nature are ‘whole economy’ measures: to the extent that a bank’s portfolio is not average, it may need more provisions.

The idea of dynamic provisioning has been around for a while, as this 2002 Bank of England document demonstrates. But recent events have revived interest in it. In particular, as FT Alphaville points out, dynamic provisioning is seen as having been successful in the one place it has been tried, Spain, but it has some significant issues.

• Firstly, it does not fit with the current accounting model for provisions, and the standard setters are not accommodating. As Financial Director reports, the standard setters are also determined that financial regulators shouldn’t dump their problems onto financial reporting.
• Estimating where we are in the cycle can be difficult. In particular, while it is easy to know that we are in a crisis and so to release whatever reserves are available, it is hard to agree that we are in an upswing, and hence more reserves should be built.
• Interestingly the Spanish model is not an expected loss model, but rather uses current specific provisions to indicate the point in the cycle. If those specific provisions are correct, and the future is not a lot worse than the past, then the dynamic provision will be adequate. But if the current crisis is a lot worse, then as the FT points out, the provisions may have to go up. They quote JP Morgan research: ‘for the Spanish banks the scale of the generic provision has been seen to be too small, and may be revised upwards in the future.’ Certainly total provisions for the Spanish banking system at the end of 2007 of only 1.33% of total consolidated assets seem rather small.
• Lastly, the flipside of countercyclical provisioning is a lack of transparency about earnings volatility, and hence difficulty in estimating the true risk of a bank. Risk reports:
  

  the true scale of the problems in Spanish loan portfolios has been masked by the dynamic provisioning system, which requires the banks to make reserves based on past loss experience: “When times are going well, they will report lower profits than they’re really making and when times are worse they will report more profits than they’re really making. So the results seem relatively insensitive to the cycle, but only as long as the economy doesn’t perform significantly worse than you’ve seen in the past

  (Emphasis mine.)

There is no doubt that properly applied dynamic provisioning enhances financial stability. But that is because, in Grant Thornton’s words, it creates a disguised form of capital. I would much rather see procyclicality via capital without yet another layer of earnings manipulation.

Posted in: Accounting, Credit by David /
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Zero hedge picks up on some interesting information at the end of an Economist article:

JPMorgan Chase holds $3 billion of “model-uncertainty reserves”

That number feels reasonable in the context of a bank with nearly a hundred billion of capital. But I’d love to know how they got it past their auditors…

Posted in: Accounting, Model risk by David /
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One of the great advances in 20th century critical thinking was the realisation that seemingly simple notions like race, sexuality, or power, are actually rather nuanced and complex. It’s time to do the same to another 19th century idea that is too simple for the general good: valuation.

The issue is that some accountants, regulatorys, commentators, and other interested parties still cling to the idea that there is a single correct valuation for a security or a derivative which, with sufficient effort, can be discovered. Obviously in this paradigm failure to discover and use this value is at best incompetance and at worst fraud. The usually excellent Jonathan Weil falls for this in a recent Bloomberg article about Lehman, for instance:

The requirement that publicly owned corporations disclose complete and accurate financial reports is part of the bedrock of U.S. securities laws.

It is impossible to prove that your financials are accurate if your balance sheet involves illiquid instruments. A better requirement would be to require publicly owned corporations to disclose complete financial reports, to disclose the basis of their valuations, and to disclose an estimate of the uncertainty in them. Indeed with the three levels of FAS 157 and increasing tolerance for valuation adjustments, accounting standards are starting to move towards acknowledging the inherent uncertainties in valuation anyway.

I am not saying, by the way, that Lehman did not break the law – just that it is rather difficult to prove that they did, given the nature of their balance sheet. It may well be true that

one pile of bad investments … had been carried by Lehman at $52 billion, but after their analyses the firms [considering buying Lehman before the bankruptcy] estimated their value at closer to $27 billion to $30 billion.”

This alone does not prove fraud. It shows that there is a huge difference between going concern and liquidation value in a crisis. It shows that Lehman was almost certainly under reserved on a moral basis. But a 30% uncertainty in valuation on illiquid instruments in troubled markets is not that surprising.

It is only by acknowledging how hard it is to value some instruments, and how wrong you can be while performing the process honestly, that we can prove who isn’t being at all honest.

Posted in: Accounting by David /
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That’s Norwalk, Connecticut.

In Risk, we find:

faced with accounting changes that would result in more financial instruments being reported at fair value through the income statement – meaning changes in value would appear as profits or losses – regulators have been quietly discussing radical new rules that would separate profits into buckets depending on the liquidity of the underlying assets.

The new reporting regime would then allow regulators to restrict how gains on less-liquid instruments are used. As a result, derivatives and structured product businesses could find a huge chunk of their profits fenced away.

This is a variant on an idea I suggested earlier, and a bad variant to boot. The good thing about separating realised from unrealised gains is that only the latter are a good form of capital. If you have rigourous valuation risk management, then the P/L on the illiquid books is just as good as the P/L on the liquid ones, since both have sufficient valuation adjustments to cope with the uncertainties involved. Supervisors would be better off doing the boring (but hard) job of ensuring that firm’s are valueing their books properly, and then treating all unrealised profits as potentially suspect, not just level 2 and level 3 ones.

Posted in: Accounting, Capital and Contingent Instruments, Regulation by David /
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This came up in FT alphaville a little while ago, and I should get back to it. It is a somewhat complicated story, so let’s take it slowly.

Firstly, the new Basel proposals:

No adjustment should be applied to remove from the Common Equity component of Tier 1 unrealised gains or losses recognised on the balance sheet.

In other words, Basel says that in future, the regulation should go like the accounting. So how does the accounting go?

Going forward, the IASB suggest that there will be two measurement-categories for financial instruments

• fair value; or
• amortised cost.

And in particular available for sale accounting – which is pretty commonplace at the moment – will disappear.

Thus firms have to elect either fair value or accrual for an asset, and if they select fair value, gains and losses will immediately feed through into regulatory capital. We have commented on the vicious circle this introduces earlier – small losses erode capital which increases leverage which forces asset sales turning unrealised losses into realised ones.

Banks will not want that. So what will happen? JPMorgan (via FT alphaville) suggest:

By avoiding adjustments for unrealised gains or losses, the regulators are putting more pressure on the accounting model. In other words, if the accounting treatment assigning a valuation measure (i.e. amortised cost or fair value) is essentially automatically determining the regulatory treatment, this may lead banks to be more motivated to exploit perceived advantages of using accounting categorisations that are most favourable for regulatory purposes. This may encourage banks to maximise the amount of financial instruments which are classified in the amortised cost category, so there are no mark-to-market gains or losses on balance sheet and regulatory capital is more stable.

That seems entirely likely. Thus the combination of a seeming rationalisation – making the regulation follow the accounting – and doing away with AFS means that we will get less transparency on the value of bank assets and less volatile, i.e. accurate regulatory capital estimates. Bravo.

Posted in: Accounting, Basel by David /
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Every so often, a commentator either states `Bank A is insolvent’ or suggests that it might be. Wikipedia’s article on Citigroup, for instance, states (at least as I write this)

During the most recent tax-payer funded rescue, by November 2008, Citigroup was insolvent

What exactly might this mean, and how can we judge if claims like this are true? This is quite an important question, after all, so there should be no room for loose language.

Unfortunately, there are two senses in which `solvent’ is used. The first is

Being able to meet obligations as they become due

I.e. liquid, and the other is

Having a positive market value

I.e. value of assets great than the value of liabilities.

Thanks in the main to the actions of central banks, very few banks recently have suffered from the threat of illiquidity. The massive opening of the window since Lehman has ensured that banks can borrow as much as they need to meet claims, and thus the risk of the first type of insolvency has been averted. Therefore as a practical matter if this is what you mean by insolvency, no significant institution has been insolvent since Lehman.

The second notion, balance sheet insolvency, is more subtle. This is because in order to judge if the value of a firm’s assets is greater than the value of their liabilities, we need first to value both the assets and the liabilities. That is hard for two reasons:

1. We need a valuation principles for each class of asset and liability; and

2. We then need to apply those principles to obtain values.

The first, then, implies that everyone agrees how to value assets and liabilities; and the second, that carrying out that process is more or less mechanical.

Neither of these things is true. The extent to which fair value should be used is controversial, for instance, for much of a bank’s balance sheet. The recent fight over IFRS 9 is evidence enough of that. Then even if we can agree how much of the balance sheet to apply fair value to, determining those fair values is difficult, as is determining the appropriate level of loan loss provisions. That is why accountants are paid the big bucks*.

In other words, determining the truth of a statement like `RBS is solvent’ or `Citigroup is insolvent’ involves an enormous amount of work, and reasonable men can reasonably differ on the right answer. Without a substantial additional statement about how the bank concerned’s assets are to be valued in practice, such a statement is essentially meaningless.

The clearest definition of solvency – being able to meet claims and having a positive value under audited accounts – is met by pretty much all banks all of the time. So if a commentator says that a bank is insolvent despite being able to meet claims and despite having audited accounts showing it is solvent in the balance sheet sense, you might want to ask them what exactly they mean by that statement, and in particular what valuation principles they adhere too.

* This is what passes for a joke among accountants. Least said, soonest mended.

Posted in: Accounting, Liquidity and liquidity risk by David /
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Reuters reports:

Half of the losses suffered by banks could still be hidden in their balance sheets, more so in Europe than in the United States, the International Monetary Fund’s chief, Dominique Strauss-Kahn, was quoted as saying on Tuesday.

That is what is possible with accrual accounting, as practiced in Europe. Viva fair value.

Posted in: Accounting, Mother of all Bailouts by David /
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‘To frag’ is video game speak for to kill within the game. To efrag, in contrast, is to cravenly bend to the interests of German, French and Italian banks, or so it seems. From risk.net:

In a move that leaves the reform of financial instruments accounting under a Brussels-shaped cloud, the key European Commission advisory panel on Wednesday afternoon delayed endorsement of the first phase of the project, relating to the classification and measurement of assets…

The panel – the European Financial Reporting Advisory Group (EFRAG) – has promised to revisit endorsement in January, but opinions are split on whether that will happen

The issue is, of course, that IFRS 9 will, despite considerable watering down, still create more earnings volatility than the large European banks are used to. They lobbied the Commission and EFRAG, and bought some time. The FT puts it like this:

A decision by the German financial industry to back postponement of the standard until next year was decisive in the Brussels decision, people familiar with the situation said.

This is disgraceful. The IASB has gone to considerable efforts to consult widely and yet move quickly. IFRS 9 is not perfect, but it is a considerable improvement in IAS 39, which in turn is better than what came before it. Even the chairman of PwC is in favour of it. For an unelected group in the pocket of a narrow industry lobby to have a decisive vote in delaying a change like this across the whole EU is deeply unhelpful for both the financial system and European companies.

Posted in: Accounting by David /
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Felix Salmon discusses some recent JPM research on MBIA:

in a note issued this morning they said that MBIA’s tangible book value is actually negative, to the tune of about -$40 per share.

OK, the full article has some caveats. But the mere fact that a reputable investment bank (if that is not an oxymoron) can suggest that MBIA is insolvent should raise some warning signs about the extended historical fiction that is insurance accounting.

Posted in: Accounting, Insurance and Actuarial Practice, Monoline by David /
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In an article reminiscent of Cows accused of spending a lot of time in fields, Floyd Norris writes in the NYT:

Politicians Accused of Meddling in Bank Rules

He continues with more sound (if rather obvious) comment:

Accounting rules did not cause the financial crisis, and they still allow banks to overstate the value of their assets, an international group composed of current and former regulators and corporate officials said in a report to be released Tuesday.

The report, from the Financial Crisis Advisory Group, also deplored successful efforts by politicians to force changes in accounting rules and said that accounting standards should be kept separate from regulatory standards, contrary to the desire of large banks.

The report is here.

Posted in: Accounting by David /
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OK, the revised version is perhaps a touch less catchy. Bloomberg reports:

The FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

So the Americans are showing some guts. Good on them. This will be an interesting showdown. The FASB, in white hats, are holed up in a one horse town with the evil banker boys coming after them; their old allies, the IASB gang, have abandoned them, and they only have unarmed readers of financial statements supporting them.

Posted in: Accounting by David /
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No, not a (really rather good) novel by the 1st Baron Tweedsmuir, but rather the steps to revise IAS 39. For those of you who have not been following this slightly less gripping drama, this is the international accounting standard relating to the valuation of financial instruments.

The IAS 39 replacement project is proceeding in three phases:

1. Classification and measurement
2. Impairment methodology
3. Hedge accounting

We are at phase 1, but this is in many ways the most important one as it relates to the fundamental question what is a financial instrument worth?

The current proposals are a bit of a curate’s egg. The good parts first.

• The available for sale category is eliminated. All instruments are either held at fair value or amortised cost.
• The treatment of embedded derivatives is simplified.
• There will be only one approach to impairment, and it will be used for all instruments in the amortised cost category.
• Only loan-like instruments can valued using amortised cost.

Much of the complexity of IAS 39 is eliminated, and the resulting accounting standard should be easier to apply.

The big problem, though, is the availability of amortised cost for some assets. Provided a financial asset is debt like, managed on a yield basis, and the institution’s strategy is to hold it to maturity, then they will be able to use amortised cost accounting. This means that the ability to lie about what your assets are worth is preserved. It means that the same bond can be held at two different values by different institutions as one could use fair value and the other amortised cost. If a very firm approach is taken to impairment, and this approach is actually implemented by the audit firms, then perhaps this will not be a total disaster. But I still worry that the basic principle of true and fair has been obscured by the banks’ desire to smooth earnings.

In their podcast — even accountant standards setters make podcasts, — the IASB say:

While fair value could provide useful additional information [for investors], the board believes that the cost of providing that information likely outweighs the benefits [in some cases].

I have to say that I don’t share this belief. I think that the benefits of trying to estimate fair value are great both for the reader of financial statement and for the preparer. Of course, finding fair value can be as hard as finding an allicorn, and there can be considerable subjectivity in the process. But I still want to know what an institution estimates its assets are worth now, not what they might be worth if their strategy is successful.

Posted in: Accounting by David /
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Without good data, it is rather hard to do good analysis. Therefore if accounting standards are sensible, they become invisible: investors use the data, and take it for granted. But if accounting standards are bad – if they allow reporting companies to conceal material facts – then the users of financial statements are put at a huge disadvantage. Credit rating and securities analysis becomes a lot more difficult. This is why the basic test for accounts is still ‘are they true and fair?’

I think the major accounting standards setters, the FASB and the IASB, have a very difficult job to do. They are subject to intense, well resourced lobbying from the financial services industry. Moreover, being accountants, they are not experts in all of the products they have to write rules for.

The recent news here is deeply depressing. On Sunday, the observer reported that the IASB may lose the power to make accounting standards in Europe. This is pure politics: the banks have lent on the European commission, and the commission is leaning on the IASB. The IASB is trying to hold the line, but the pressure to allow banks to lie about the value of their balance sheets is considerable.

In the US, things are just as bad. Today FT alphaville picks up a story from the WSJ that the FASB is coming under huge pressure to relent on the reclassification of off balance sheet vehicles. This comes after the shameful capitulation of the FASB on fair value.

The problem here is that one side – the issuers of financial statements – is well organised and the other – the readers – isn’t. It would be a great shame if the result of the asymmetry was a permanent degradation in the quality of financial information. But right now, ‘true and fair’ seems further away than ever.

Update. Floyd Norris has an excellent post on the flexibility that the current loosened US rules give in the NYT. The key point is that if a sale is ‘distressed’, it can be ignored for the purposes of fair value. One fund bought more of a security that they already owned, and were marking at $98.93, for $9.50. They then

contacted the selling broker-dealer to determine whether the sale was “distressed” (and thus could potentially be disregarded for purposes of determining the fair value of the security). On May 28, 2008, the broker-dealer responded that the security was “not coming from a distressed seller, just one that wanted to get out.” Notwithstanding this response, the Ultra Fund’s portfolio management team informed the Valuation Committee that they believed the sale was distressed

(Quote from SEC litigation against the fund.)

Now, admittedly this is illegal and I am not claiming that the large banks would go this far. But it does illustrate how valuations can be manipulated once you are allowed to ignore current transactions.

Posted in: Accounting by David /
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Jonathan Weil has been over them carefully. Frankly, reading his article, one wonders (a) why the accounts were signed off and, (b) why anyone would want to buy any of the bank’s securities given these tricks.

Posted in: Accounting by David /
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Willem Buiter, reneging on his earlier negativity on the IASB, quotes from a statement made on April 2, 2009 by the Trustees of the International Accounting Standards Committee Foundation:

Sir David Tweedie, Chairman of the IASB, reported to the Trustees that at their joint meeting last week the IASB and FASB agreed to undertake an accelerated project to replace their existing financial instruments standards (IAS 39 Financial Instruments, in the case of the IASB) with a common standard that would address issues arising from the financial crisis in a comprehensive manner. Though the IASB is consulting on FASB amendments related to impairments and fair value measurement, the Trustees supported the IASB’s desire to prioritise the comprehensive project rather than making further piecemeal adjustments.

This is good. They are not being rushed into anything, and they are not following the FASB in giving in to the banks. However it does make it vital that the IASB gets sufficient informed comment on fair value during its consultative process. I would encourage anyone who cares about these issues to visit the IASB page here, download the consultative document, and comment on it.

Posted in: Accounting, Fair Value by David /
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Thanks to AIG, the weird and wonderful world of finite reinsurance has come under broader scrutiny recently. (You may recall that a finite reinsurance policy between AIG and Gen Re was the method used to inflate AIG’s earnings in the case that came to the courts in 2008.)

Now, thanks to the Big Picture, further amusing documents have achieved more general publication. I don’t agree with much of the thrust of the post – which frankly contains altogether too much credit derivatives related hysteria. But the extra light on finite reinsurance is welcome.

When is finite reinsurance a valid business tool, and when does it verge on fraud? This is difficult to answer because finite reinsurance is a very sophisticated tool that can be used in myriad ways. But let me illustrate a good and a bad situation.

Good finite reinsurance. Suppose a company has a liability with a known size but uncertain timing. Asbestos-related claims are a commonly cited example: the firms knows it will have to pay workers for past exposure to asbestos, and it can estimate the size of those claims reasonably well, but it does not know when the claims will be presented as the sickness has a long and uncertain gestation period. The uncertainy thus created weighs on the share price, even though the company has every intention of paying and the resources to do so. Therefore it purchases a finite reinsurance policy whereby it pays a premium equal to (roughly) the present value of the expected claims to a large, well capitalised reinsurer. The reinsurer takes two risks: one small (that the claims will be larger than expected: this is unlikely as typically the risks insured under finite schemes have rather little uncertainty in claims); and one larger (that the claims will be presented earlier than expected, and hence the invested premium will not have grown sufficiently for them to make a profit). From this we see that finite schemes are often about transferring timing or investment risk rather than the risk of uncertainty in claims.

Bad finite reinsurance. Consider the effect of the scheme above though. Before the reinsurance, the firm had a known hit to earnings in the future but with uncertain timing. Afterwards, it has a stream of expenses – the premium payment or payments on the policy – but no uncertainty. Earnings have been smoothed. Clearly we can extend that effect more broadly via policies which pay out money in the future for an appearance of risk reduction today (buying surplus for an insurer, i.e. flattering their capital position) but where all of the risk comes back in later years, or via policies which move current profits into later years, smoothing earnings. Accounting rules do not permit you to arbitrarily reserve whatever amount of current earnings you like against some future risk, especially a very unlikely and hard to quantify one, but finite reinsurance policies achieve the same effect.

Finite reinsurance can therefore be used, quasi-legally, to manipulate earnings for many companies. It can also be used to manipulate insurance companies’ capital position. If ever there was an area of finance crying out for better regulation, I’d say it was insurance.

Posted in: Accounting, Insurance and Actuarial Practice by David /
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Narrowly winning the award for most depressing news of the week (the runner up being Gillian Tett getting an award – and not one for most ignorant commentator on credit derivatives in a mainstream newspaper), Bloomberg announces:

The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value rules… The changes to so-called mark-to-market accounting allow companies to use “significant” judgment when gauging the price of some investments on their books, including mortgage-backed securities.

This is just terrible news for readers of financial statements, investors, and financial stability.

Update. You have to love Willem Buiter sometimes. His latest is entitled How the FASB aids and abets obfuscation by wonky zombie banks. Zombies are scary enough. But wonky zombies? Are they going to explain the dynamics of the money supply to you before they eat you? Or would that be wonkish zombies? Seriously, though, it is a good post: I recommend it. My only remark is that Willem is not sanguine about the IASB, whereas I am slightly more hopeful that they will not fall further into sin.

Posted in: Accounting by David /
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This is so incredible, so bizarre that I have to blog.

The FASB has lost its mind. It is proposing that:

U.S. companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks

(Quotation from an excellent Bloomberg article by Jonathan Weil. This is a large, forceful slap in the face to the users of financial statements. As Weil says:

if these rules had been in place last year, a company that still owned shares of American International Group Inc. or Fannie Mae, for instance, could exclude those stocks’ price declines from net income entirely. It would make no difference that the companies were seized by the government last year, or that both are penny stocks.

Idiocy on this scale is deeply depressing. One can only hope that this proposal goes nowhere.

Posted in: Accounting by David /
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My apologies for an incendiary title. I don’t really mean it of course. I think I have a slight case of hyperbole from Francine McKenna. Still, in this article at The Huffington Post, she points out that

The Big 4 public accounting firms haven’t yet been asked the hard questions by governments, legislators, or regulators.

Which is true. She also points out that they share some of the characteristics of organised crime. Which, so far as the analogy goes, is also true. But the big issue is liability.

Governments all over the world are protecting and shielding the public accounting firms from failure under any circumstances, even in the face of repeated failure on their part… The firms and their partners … are unequivocally self-interested.

As one would expect them to be. But the time for pandering to their self-interest is over. If they want to give opinions on accounts, then they should be liable for them. If they don’t feel ready to take responsibility, then they should not sign off the accounts. Removing caps on auditor liability is a really easy way to dramatically improve the quality of audited financial statements.

Posted in: Accounting by David /
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(HT The Big Picture.)

What is interesting about this is the GIAs. I _think_ that these are GICs, i.e. guarantees of minimum investment returns, sometimes on variable balances. Obviously as rates have fallen, GICs have become more valuable to the holder and riskier to the writer. Insurers have conspicuously underpriced the implied puts in GICs for years, and now it seems that for AIG these have come home to roost.

Posted in: Accounting, Insurance and Actuarial Practice by David /
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Willem Buiter has a discussion of how good bank/bad bank separations might work in detail: the mechanics come from Robert Hall and Susan Woodward. I will simplify the argument a little, and discuss the issues.

Consider a bank with:

Assets		Liabilities
Good loans	1000	Deposits	1200
Bad loans	500	Bonds Issued	600
Other assets	380	Shareholder’s funds	80

(Let’s ignore the off B/S stuff for this post and assume that all of the other assets are good.)

The proposal puts the deposits and good assets in the good bank, and calls the difference between assets and liabilities ‘capital’. Thus we have for the good bank:

Assets		Liabilities
Good loans	1000	Deposits	1200
Other assets	380	Shareholder’s funds	180

Notice that the good bank is well capitalised under this proposal.

The bad bank owns all of the equity in the good bank. For it we have:

Assets		Liabilities
Bad loans	500	Bonds Issued	600
Equity in good bank	180	Shareholder’s funds	80

It is fairly likely that the equity holders in the bad bank will be wiped out over time, which is right and proper. If the good bank makes money and declares a dividend, the bad bank will receive that income as it stands. Meanwhile the debt holders of the bad bank now have a claim on a rather worse quality institution, at least at first sight. This is a proposal with rather little moral hazard.

The issue comes when we consider the bad bank’s position. It is not capitally adequate, not least because material holdings in credit institutions (i.e. its shareholding in the good bank) is a deduction from equity. One might argue that it does not need a banking license as it is now in run off, but still, it is so leveraged that its management will have to sell some of the equity in the good bank. Does a forced seller of bank equity (albeit good bank equity) really help financial stability?

Also notice that the bad bank would consolidate the good bank from an accounting perspective. Again, to get deconsolidation it would have to sell at least 50% of the good bank’s equity.

The proposal in short makes sense from a moral hazard perspective, and transfers the taxpayer’s deposit guarantee to a well capitalised institution. But it does force the bad bank to sell its position in the good bank almost at once, and that is a rather worrying side effect.

Posted in: Accounting, Capital and Contingent Instruments, Mother of all Bailouts by David /
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I have a terrible confession. I have never liked Elvis. But aside from dead musicians, Bloomberg is doing a great job on chronicling the absurdities of accrual. David Reilly says:

Of the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent is marked to market prices, according to my analysis of company data. General Electric Co., meanwhile, said last week that just 2 percent of assets were marked to market at its General Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank.

What are all those other assets that aren’t marked to market prices? Mostly loans — to homeowners, businesses and consumers.

…investors already believe banks are underestimating just how bad losses will be on their unmarked loans. GE investors, for example, fled the stock due to concerns over its corporate loans and lending to Eastern Europe.

If investors could get a better sense of the losses actually facing GE, they might have more confidence in its financial strength. In other words, we need more mark-to-market accounting, not less.

Posted in: Accounting by David /
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There is a `the banks are insolvent’ meme going around at the moment. It’s rubbish, but something close to it may be true.

The reason it is rubbish is that solvency means assets > liabilities under the firm’s accounting standards. This is clearly true for all the large banks.

What the commentators mean by `the banks are insolvent’ really, then, is `under my idea of what accounting standards should be, the banks would be insolvent’. Clearly this is a little different, however rational the particular accounting counterfactual concerned is.

Let’s look at some of the choices in the space of accounting methods.

• Pure accrual accounting would value every asset and liability under accrual accounting, with whatever loan loss reserves the firm can get past its auditors being taken. Under this measure pretty much every bank is solvent.

• Pure rigourous fair value would use fair value for everything, with prudent valuation adjustments being taken wherever there is uncertainty. Under this measure, many banks would be insolvent.

Most banks definitions of solvency are closer to the first than the second of these at the moment, of course. I suspect that most commentators who say that the banking system is insolvent are implicitly thinking of something like pure rigourous fair value. In any event, there are many, many accounting standards between these two extremes, of which any given bank’s choice is one.

Two more things to note.

First, insolvency implies that the bank is not capitally adequate, but capital adequacy is a stronger constraint. It implies solvency* plus capital > capital requirements**. Losses challenge both solvency and capital adequacy as they erode capital, but the capital adequacy test is hit before the solvency one.

Second, solvency or insolvency have nothing to do with liquidity. A bank can be insolvent and perfectly able to fund itself (if that fact is well enough hidden) and highly solvent but unable to fund.

For further reading, see a good if long post by John Hempton here.

*Actually this is not quite true as the regulatory notion of solvency is not quite the same as the accounting one. Regulators apply a few (typically minor, in the big scheme of things) valuation adjustments to GAAP.

**The definition of Capital is much more country specific than that of Capital requirements. The `Basel 2 capital requirement’ is close to being the same everywhere (although there are some differences in national implementations). But the definition of capital varies significantly, especially in the treatment of things like deferred tax assets, goodwill, and unrealised gains on held to maturity positions.

Posted in: Accounting, Capital and Contingent Instruments, Liquidity and liquidity risk by David /
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Creditflex’s story (via Alea) that Spain’s banks and cajas are negotiating on a one-to-one basis with the Bank of Spain to “fine-tune” their 2008 accounts in order to avoid taking catastrophic write-downs on loans makes me wonder if anyone knows the answer to this question.

Posted in: Accounting by David /
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This one is really hard. On the one hand, Barclays announced that they don’t need more capital, and that their earnings are strong. (Bloomberg story here: Barclays letter to investors here.) And obviously one does not want to do a Peston, and spread irresponsible rumours. But there is still a nagging suspicion that there is something rank* about their balance sheet — that they may have been less than honest about all their writedowns. I suppose this is yet another accounting problem: once suspicions arise that a bank might be abusing accrual, it is very hard for them to convince everyone that they are clean.

* But not as rank as a Durian, obviously.

Update. Up 73% in one day. Wow. Just wow.

Posted in: Accounting by David /
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The Washington Post has a nice article on the European Commission’s bullying of the IASB.

In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.

The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit.

We already know that David Tweedie, chairman of the IASB wasn’t happy about this and reportedly threatened to resign. But what is new is that the Americans are waking up to the implications of this bullying.

“Right now, there is no credibility,” said Robert Denham, chairman of the Financial Accounting Foundation, which oversees the FASB. “If we are going to have global accounting standards, my view is that is not going to work if the IASB is going to be jerked around by the European Commission.

Over lunch on the 24th a leading member of the IASB suggested to be that the FASB was irrelevant and that IAS would soon rule the world. Perhaps the Americans won’t go gentle into that good night.

Posted in: Accounting by David /
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MTM means for course `mark to me’. It appears that AIG has determined the most reliable source of fair values for some transactions is — itself. Think of a number. Wow, the number I just thought of was … the number I was thinking of. I must be right.

I exaggerate of course. Let Bloomberg take up the story:

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe…
[These swaps] are different because they didn’t insure against losses… they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps.

[AIG has] unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial-products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis [AIG risk officer] said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

There is more to trouble an AIG investor, European bank regulators, the SEC, the FED, and AIG’s auditors in this, if it’s true, than you can shake a stick. Here are a few of the issues.

Firstly you would have thought that the Gen Re case had taught AIG that doing transaction purely for regulatory manipulation without risk transfer is a bad idea.

Secondly, what do European bank regulators think of this? (I’ll leave Basel 2 being described as an accounting standard as a signal that this new item may not be entirely reliable. And while we are asking questions, where exactly in Europe hasn’t Basel 2 been implemented yet? And what is a default swap that does not transfer losses, and how exactly does it qualify for capital relief?)

Thirdly, if both the transaction and AIG’s accounting for it are correctly described, why on earth do their auditors, PWC I think, let them get away with this? Hasn’t AIG had enough auditing issues at AIG FP already?

Fourthly does the FED really want an almost 80% state owned company doing this kind of transaction? And accounting for it this way?

Posted in: Accounting, Insurance and Actuarial Practice, Regulation by David /
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Bloomberg has a nice article on one of my favourite pieces of actuarial insanity, guaranteed annuity contracts. The basic story is that life insurance companies wrote long-dated equity index and basket puts in size and didn’t price them properly, because their actuaries didn’t understand derivatives. With the recent market falls, they are beginning to see just quite how stupid an idea this was.

It’s ending in tears. In September, the insurance raters A.M. Best and Fitch moved the life-insurance industry into its negative-outlook column. In October, Moody’s, and Standard & Poor’s did the same. A.M. Best has downgraded 30 life and annuity companies so far this year.

Of course, because all of this is in an insurance wrapper, there is no requirement to mark to market, so investors cannot see the size of the problem.

In the meantime, the industry is proposing to handle its problems the good, old-fashioned, American way: by putting lipstick on its books.

As the value of GMWB [guaranteed minimum withdrawal benefit] annuities tumbles, the carriers are required to raise the reserves they hold against these products, as a way of assuring that consumers will be paid. Raising reserves, however, could starve their working capital at a time when they’re also writing down toxic mortgage assets. The companies say they’re already holding plenty of reserves, so they’re asking the states, which regulate the industry, to loosen the rules.

Astonishingly, some of the state regulators seem sympathetic:

The National Association of Insurance Commissioners will discuss the proposed changes this month. Iowa insurance Commissioner Susan Voss calls some of the reserves “redundant” and suggests that NAIC will go along.

Short now, short in size. It is a very cheap way to get protection on an extended period of low equity markets.

Posted in: Accounting, Insurance and Actuarial Practice by David /
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A more or less parenthetical remark by Meredith Whitney (quoted in the FT) resonated with me. The note from Oppenheimer included a number of recommendations: here is the third:

Delay the introduction of accounting rule FAS 140 until 2011 or 2012. These moves to bring off-balance-sheet assets back on balance sheet for the sake of transparency are a mirage. The primary assets that will come back on to balance sheets are credit card loans. Frankly, there is more transparency in off-balance-sheet master trust data than in on-balance-sheet accrual accounting.

What struck me was how true this is. The buyers of credit card backed securities won’t put up with accrual: they know it hides all sorts of issues they need to see and is usually used to smooth earnings. So why should we put up with it for on balance sheet assets?

This in turn brought to mind a section from a nice short summary on the Japanese crisis I have been reading. From The Japanese banking crisis in the 1990s by Kazuo Ueda:

Large Japanese banks had capital ratios of barely above 8% at the start of the 1990s, with about half of the 8% accounted for by unrealised capital gains on their equity positions. Since then, banks have been
writing off bad loans by basically using operating profits and realising latent gains on equity positions.

Unrecognised losses in accrual accounted loans only being taken when enough earnings materialise to absorb them. Does that sound familiar? You can’t fix the problem until you can see the problem. At least a diligent attempt at establishing fair value helps you to see the problem.

Posted in: Accounting by David /
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How should we view Warren Buffett’s short put position? The FT has some comment which clarifies both Buffett’s thinking and the conflict between insurance and capital markets views of risk. It is useful background to my earlier post about this position.

First the facts. Berkshire has sold long dated out of the money (forward) puts on major indices and received premium upfront. These puts are getting closer to the money as the indices concerned fall, giving rise to mark to market losses.

John Gapper’s FT article points out that Buffett is usually thought of as a great investor – and he really is one – but what is less commonly discussed is where the money came from for that investment. The answer is that it is often from writing insurance. That is, Berkshire is a classic insurance company: it writes insurance, receives premiums, and invests them in the attempt to produce a bigger pot of money than is needed to meet claims. It has been highly successful at this.

The two different communities, insurers and derivatives folk, look at risk in entirely different ways. An actuary would ask how like a risk is to be manifest and what it will cost the insurer if it is based on history. A derivatives trader would ask what the market price of the risk is. Thus insurers and investment banks made great trading partners as the insurer will often take risk for far less than the bank thinks it is worth. This is one of the reasons AIG wrote so many default swaps: they thought that they were being well paid for them.

Another point is that for classical insurance risks like catastrophe, auto or terrorism, the accounting for the risk is on the basis of received claims. You don’t take a mark to market hit on the hurricane book if the weather gets worse in the North Atlantic: you only have to provision for the loss when claims are both likely and can be estimated. This is very close to accrual accounting in banks loan books.

Derivatives, though, are different. Here Warren has to mark to market, so Berkshire suffers earnings volatility regardless of whether the puts really will pay out or not, a fact that anyway won’t be known for many years. Why are investors spooked by a mark to market write-down on a derivative with eleven years left to run when they are perfectly unphased by the warming Atlantic, something that could – if it generates more hurricanes like Katrina – devastate Berkshire’s cat book? Investors seem overwhelmed by the risk that they are being forced to look at, yet indifferent to the ones the accounting glosses over. Interesting, isn’t it?

Posted in: Accounting, Insurance and Actuarial Practice by David /
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Or perhaps post-industrial wasteland is more apposite, for those of you who have been to Santander’s headquarters in Boadilla. Anyway. The self-proclaimed over-capitalised and conservative bank isn’t. Well-capitalised that is. There is a 7.2B EUR rights issue, according to the FT.

There are two readings of this. One is that if even a bank as old fashioned as SAN needs new money, the financial system is going to hell in a handcart and practically everyone needs new capital.

The other (not necessarily exclusive) interpretation is that SAN has some accrual accounted nasties on its balance sheet which, if they were fair value accounted, would already have produced substantial write-downs. SAN can only go to the fountain once because the admission that it needs new capital is tantamount to the one that its loan loss provisions are not sufficiently prudent. And once you say that, investors might never trust you again.

Personally, I am in favour of transparency. If I were CFO of a bank with a substantial banking book under accrual, I would disclose my estimate of fair value for the book just to keep the analysts quiet. Like JPMorgan seems to (the details are not clear), I would also use that estimate as the basis for my loan loss provision. But then I (thank the Gods) don’t work in Boadilla.

Posted in: Accounting, Capital and Contingent Instruments, Credit by David /
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Bloomberg Opinion has a nice piece by Jonathan Weil. He points out that Wachovia’s accounts show it having a positive net worth of about $50B but Wells Fargo is buying it for $15B. The difference, of course, is accounting. Or as Mr. Weil puts it:

The reality is that Wachovia’s management, including Chief Executive Officer Robert Steel, still won’t admit the company’s balance sheet is a farce and has been for a long time. More worrisome, though, is that nobody with any authority is calling them on it, even today. That includes Wachovia’s auditor, KPMG LLP, as well as the Securities and Exchange Commission and banking regulators such as the Federal Reserve and FDIC.

If those lapdogs won’t stop Wachovia from conjuring up bogus asset values, it’s only prudent to assume they’re letting lots of other companies bake their books in less obvious ways.

This is a glaring example, it is true. Clearly Wachovia’s loan loss provisions are not adequate, in Wells’ view, to cover their likely losses. Wachovia seem to think that Wells have a point, moreover, at least to the extent that they have not sought a higher price.

Now I am the first to agree that determining the fair values for anything as complicated as a large bank’s book is difficult. And forced sellers are likely to get less than willing ones. But $35B is a big gap.

Recent accounting changes are making the situation worse, as Deutsche’s recent profit illustrates. This profit was entirely due to an accounting reclassification which, perfectly legally, moved the bank further from fair value. Is this state of affairs really what the users of financial statements want? Both auditors, in their often gutless appraisal of loan loss reserves and of level 3 marking methodologies, and accounting standards setters, in caving to pressure from the banks to permit more earnings manipulation, are to blame. Show some backbone boys. Make them mark it down.

Posted in: Accounting by David /
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Long, long ago, when I was responsible for the valuation of a lot of financial instruments at an investment bank, I used to set a lot of store in valuation adjustments. The basic idea is that the precise fair value of many instruments is uncertain. You value them at your best guess, and you take a valuation adjustment to cover the potential uncertainty. They are a kind of accounting error bar, if you like.

There are two main reasons to do things this way rather than simply to mark conservatively. The first is that value affects risk: if you mark as accurately as possible, your risk measures are as accurate as possible. [This is particularly an issue for derivatives since d (delta) / d (vol) is non-zero: marking to a 'conservative' implied vol gives you the wrong deltas.] The second is that the size of the valuation adjustments are an important signal to management about the size of the valuation uncertainty in the book. That in turn gives important information on illiquidity, marketability etc.

Borio in a fascinating BIS paper The financial turmoil of 2007- argues that firms should disclose these uncertainties, and that this disclosure would be a useful disclosure to the users of financial statements. I agree completely. The only problem is that many people currently think that some firms would be insolvent based on plausible error bars. But they don’t know precisely who those firms are.

Posted in: Accounting, Fair Value by David /
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Yesterday, a most propitious day for stocks, the IASB chose to announce that they will permit a new wave of opacity to sweep over company accounts.

Notice that it is retrospective. This is a very negative development if we ever want to get out of this mess. The taxpayer deserves to at least know what we are bailing out and what condition the banks we now own are in.

Posted in: Accounting, Fair Value, Mother of all Bailouts by David /
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I’ve been a little busy recently so this will be brief. One scary part of the bailout bill was the clauses suspending mark to market. Firstly the idea of government intervening in accounting is a bit worrying: there is a long tradition in the US of the SEC telling firms what the FASB really meant, but Europeans tend to take a dim view of this sort of thing. But what they are suggesting will only increase uncertainty about who has really lost what. Time has more, but my tuppence is that the devil is in the detail of establishing fair value. You don’t need to suspend FV per se, just give people more leeway about what counts as a sighting of that mysterious horse with the horn on its forehead, fair value, when the forest is burning.

Posted in: Accounting by David /
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There is a lot of talk at the moment about fundamental value. This mostly focusses on how good it would be if the market prices of assets rose back towards ‘fundamental value’, and what the government could do to assist that process.

There’s only one problem. You can never know what the number is.

Consider a loan. Either it defaults, in which case you get some interest followed by recovery; or it doesn’t, in which case you get scheduled P&I. In both cases the fundamental value is the PV of the cashflows. But you don’t know whether it will default or not, so you can’t combine the fundamental value on default with that for no default to get a single number.

In credit risk modelling we solve this problem by positing a probability of default, and then deriving that PD from spreads. But that’s an argument that depends on the credit spread being fair compensation for default risk.

And of course ontologically it makes no sense to talk about a ‘probability’ of default. Either default happens or it doesn’t and we only get one chance at finding out. Given that we can’t take the same obligator, duplicate them a hundred times, and look at their performance on each occasion, we can never know that our ‘probability’ is correct. Thus there is literally no such thing as a ‘fundamental value’ in any scientific sense because we could never know whether we had such a thing.

Posted in: Accounting, Fair Value by David /
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Some morning reading:

On the duty of auditors. A taxing matter addresses the inherent conflict of interest and suggests that it might be a good idea for auditors to be hired by the SEC rather than the company.

Ultimate loss projections are increased by Moody’s. MBIA and Ambac have not been in a train wreck for weeks and they are getting jealous of all the attention Fannie, Freddie, AIG, Lehman, Merrill and so on are getting. The FT has the details.

One aspect of a run on a broker/dealer. Dealbreaker points out how a B/D share price fall can push clients into moving money from non-seg’d to seg’d accounts. The result is akin to a run on a bank.

And finally, given that Cristiano Ronaldo is on a lot of people’s lists as `worst role model in sport’, please will the Treasury drop AIG’s sponsorship of Man U as a matter of urgency, or at very least demand that Ronaldo’s legs are pledged as long term collateral and lodged permanently in a vault at the New York FED?

Posted in: Accounting, Broker/dealers, Monoline, Taxation by David /
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Long live son of the Q. If there is one. The FASB explains that:

it expects to issue three separate but related Exposure Drafts on or around September 15, 2008, for public comment…

The proposed Statement to amend Statement 140, would, among other things, remove the concept of a qualifying special-purpose entity (SPE) and would remove the exception from applying Interpretation 46(R) to qualifying special-purpose entities (SPEs).

Now Qs are not the only way to do a securitisation under US accounting, but there are a common way. The standard won’t come into effect until 2010 according to Housing Wire, and we are still a long way from the cliff edge given the comment period. Still this proposed change is something the structured finance community needs to take very very seriously.

Posted in: Accounting, Securitisation and Tranching by David /
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Loath though I am to quote from a Murdoch publication – just look at the sad decline of the WSJ to see what being owned by him does to a paper – I do want to comment on something by Anatole Kaletsky yesterday. Fortunately it is an utterly wrong-headed piece which misunderstands fair value accounting. First the good bit:

the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to gauge – this liquidity and maturity transformation is, in fact, the main social function that a banking system provides.

Agreed. But here’s the thing. Banks can only do that if people have the confidence to give them their money to lend to someone else. That depends, for the retail investor, on deposit insurance; and for the wholesale depositor, on credit quality. Both of those in turn rely on the bank being well capitalised: regulators demand it to reduce moral hazard, and market counterparties need it as part of their risk assessment.

Now how can we tell if a bank is well capitalised if it is allowed to pretend nothing is wrong until it actually suffers losses? That is what accrual is all about – the fiction that all is well while the ship steers at full speed towards the iceberg. At least fair value shows you what is ahead.

Posted in: Accounting, Fair Value by David /
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A question to anyone who knows _a lot_ about public sector accounting. Just how much help exactly can the U.S. provide to Fannie and Freddie before those $5T of mortgages consolidate onto the government balance sheet? And would the US still be AAA with another $5T of liabilities?

Update. Bloomberg has caught up with this one.

There’s nothing sacrosanct about the U.S.’s AAA rating, no matter what dogma and orthodoxy might suggest. Many financial assets that claimed AAA status before the credit crunch turned out to be irredeemably tarnished; there’s a non-negligible risk that Treasuries will prove to be similarly spoiled.

The ten year CDS spread on US treasuries settled in Euros is now more than twenty basis points.

Posted in: Accounting, Federal Agency, Ratings by David /
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CFO.com has an excellent post on Fair Value accounting. One quote in particular amused me:

James Tisch, who was effectively the sole voice of dissent on the first panel, complained bitterly that fair value accounting required reams of nearly incomprehensible disclosure information and often forced his company to make poor economic choices.

Tisch … said that if insurance companies had to run mark-to-market accounting through their income statements, “[they] would essentially be out of business”

And that, as we have seen with the financial guarantee insurers, is clearly right. But perhaps if the insurers were forced to use fair value, they might deploy less leverage and pay a little more attention to what the market is telling them.

Posted in: Accounting, Fair Value, Insurance and Actuarial Practice by David /
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A couple of weeks ago I pointed out that while the US institutions have taken their write down medicine, raised new capital, and are busy getting on with trying to figure out what to do next, the Europeans have been much less assiduous in recognising their losses. Now Citigroup, via FT alphaville, comes up with a concrete example: Barclays. The corrected version of the Citi piece is said by the FT to include the following:

Barclays has reclassified some assets, most notably leveraged finance and CDOs, and accounts for them as if they were loans held to maturity. This means that these assets are not marked to market but impairment provisions are raised when the bank believes that there is a risk to the credit outlook. While this is an unusual treatment for leveraged finance, as the financing was originally intended to be sold down, the assets are at least primarily loans. The treatment is even more unusual for CDO exposures.

That four billion really does not look enough now, does it?

Update. It is not just CDOs. From the FT:

The debate has [also] focused on Barclays’ policy of accounting for leveraged loans by looking at the borrower’s financial performance rather than the price at which those loans are trading in the market.

This has puts it at odds with some US and European rivals, which value their leveraged loans on a mark-to-market basis. Most leveraged loans are trading at 80-90 per cent of their face value, with some changing hands for as little as 70 per cent.

Posted in: Accounting, Fair Value, Writedown by David /
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Just like these council workers taking down fly posters only for them to reappear in a few days, so banks are getting ABS off balance sheet by offering to finance them. The FT reports one such set of tricks here and Naked Capitalism has a discussion of Lehman’s deleverage using related shenanigans here. The bottom line is obvious: if you can’t sell something but you need to look as if it is gone, find somewhere to park it, pay the parking fee and transfer any risk you can get rid of, and hope that when or if the asset comes back, it is worth more.

Posted in: ABS, Accounting by David /
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Tom Selling from The Accounting Onion was kind enough to point out his blog to me. Reading a post on FAS 157, it suddenly occurred to me that the implementation the audit firms have permitted of 157 on liabilities, based on the FASB staff position, isn’t consistent with the conceptual framework of 157.

The standard says:

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Suppose I run David’s Broker/dealer, DBD. DBD bonds are liquid and so have an observable credit spread. If DBD credit spreads go out, DBD bond holders using fair value suffer losses which are reported in their P&L. But if DBD wants to buy back those bonds in an orderly transaction between market participants, DBD bond holders are very likely to force it to pay par plus accrued (at least if DBD is a going concern). Moreover it’s illegal for DBD to buy its own bonds back in the secondary market in most jurisdictions so the value of the liabilities for DBD is not symmetrical with the value to the holders: it cannot take advantage of its elevated credit spread even if it has the money to buy back the bonds. Hence the staff position doesn’t reflect economic reality, and what most people feel in their gut – that 157 gains on liabilities due to credit spread widening are bunk – really is true.

I’ll end with a quote from the amusingly petulant comment the Basel Committee issued on IAS 39:

it would be wholly unsatisfactory if an entity which was insolvent in the sense of its assets being worth less than the par value of its liabilities nonetheless appeared to be solvent because the fair value of its liabilities was recognised on its balance sheet, with the fair value below nominal value…we recommend that the exposure draft’s guidance on the fair value option be revised …[to] exclude the mark to market of own credit risk from the fair value option by limiting the mark solely to valuation changes due to general market movements

Posted in: Accounting, Fair Value by David /
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More from the ECB financial stability review. We take up the story with a discussion of the losses in large complex financial institutions:

The impact of the sub-prime crisis can be seen in the figures disclosed by banks in their financial statements in two main ways: valuation changes on various assets and increases in credit impairments. Most of the figures recorded in banks’ accounts are valuation changes and relate to securities whose value has been adversely affected by the sub-prime turbulence. Under International Financial Reporting Standards, euro area banks value these securities depending on the accounting category in which they were included at the time of recognition [principally] fair-value [and] available for sale.

(The emphasis is mine.)

In other words the impact so far on Eurozone banks has mostly been confined to fair value instruments. For accrual accounted loans we have not yet seen massive increases in loan loss provisions. Clearly there are some European countries with their own property market issues – the UK, Spain, Ireland, the Baltics, perhaps Poland – so we definitely have not seen the end of this story yet.

The ECB then points out the inherent superiority of FAS 157 vs. IAS 39:

the way in which banks calculate mark-to-market valuation changes and whether these valuation changes are comparable across banks have attracted increased attention in the current period. Before the turmoil, under IFRS, banks disclosed limited information concerning the amount and type of assets that were marked to model. This situation in the euro area is in contrast to the United States where new Generally Accepted Accounting Principles (GAAP) require certain disclosures concerning the portion of assets in a portfolio that are purely marked to model.

In other words the Europeans can hide both their methodology and the split between mark to market and mark to model whereas the Americans can’t.

Posted in: Accounting, Writedown by David /
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Of financial statements that is. The IIF has recently pleaded for more laxity in applying fair value accounting in disrupted markets. Specifically they want banks to be permitted to use book value where it suits them, but not to be locked into hold to maturity if they do that. As Lex says:

However diplomatically couched, the proposals are unedifying. After precipitating a crisis and then borrowing large amounts of public money, it takes an audacious industry to cast accounting as a villain…The IIF wants “stable valuations” that “increase market confidence”. This is not the purpose of accounting standards. Even if market prices have overshot … relying on banks’ interpretations is worse.

Exactly right. Nothing forces users of financial statements to act based on the earnings disclosed. But now that, for the first time, these readers are seeing the real volatility of earnings, rather than the smoothed version produced by accural, they are bidding down financial shares. They are better educated and hence able to make more informed decisions. The IFF wants to take that information away – somehow I don’t think the readers will stand for it.

Posted in: Accounting by David /
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From the FASB:

Statement 163 requires that an insurance enterprise recognize a claim liability prior to an event of default (insured event) when there is evidence that credit deterioration has occurred in an insured financial obligation.

Specifically, from the standard itself:

The recognition approach for a claim liability relating to a financial guarantee insurance contract requires that an insurance enterprise recognize a claim liability when the insurance enterprise expects, based on the present value of expected net cash outflows to be paid under the insurance contract discounted using a risk-free rate, that a claim loss will exceed the unearned premium revenue.

For the monolines, of course, that means a realistic assessment of eventual credit losses. Now that isn’t an easy thing to do, and there is still a lot of wriggle room in how that standard is applied, but at least sticking their heads in the sand is no longer a sanctioned accounting standard.

Posted in: Accounting, Monoline by David /
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From the often amusing Long or Short Capital:

The latest credit product is the new OFF-off-balance sheet provided by Private Equity Shop Y and Hedge Fund X. In exchange for below market financing, loose structural terms, and a 10-20% down payment, the off-off-balance sheet structure is designed to take an undiversified smorgasborg of the bank’s very own hung deals fresh from the bank’s books.

Recommendation: Being that off-off is a double negative, we think that maybe, just maybe, that selling loan assets to highly leveraged entities to which you provide the financing is more of a shell game than a credible solution.

Which is not to say that in terms of the optics, the accounting, and the regulatory capital it doesn’t work really well. It’s just the actual risk transfer part that’s the issue.

Posted in: Accounting, Photography, Regulation by David /
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I have two conjectures for today. The first is that Ambrose Evans-Pritchard needs to drink better Rioja. He presents a bearish blog in the Telegraph, backed by a second class Reserva. I would suggest at least a 904 GR for such musings, and ideally the Murrieta.

Secondly and rather more importantly, it can be suggested that the loss trajectory for European banks will be rather different from their American cousins. Suppose we believe Evans-Pritchard’s loss figures: $123bn for Eurozone banks compared to $144bn for the US, and ignore for a moment the rather important distinction between bank and non-bank risk holders. (The US has far more of the latter.) My guess would be that most of the US risk is fair value accounted. So the Americans have taken or are in the process of taking their losses. Most of the European risk is probably accural, so losses will depend on the bank’s projected loan loss reserves rather than current fair value. At very least that will spread them out over many years – remember RMBS is often 30 year paper. Moreover if actual experienced defaults are better than the current fair values predict then the losses will be lower.

One could argue that this cancer will eat away at the European banking system for many years, long after the Americans have taken their medicine and moved on. Or one could argue that right now it allows European banks to keep lending and hence to both protect Europe’s economy from the worst of the losses and make themselves some money to pay for the losses. But certainly the bearish case for Europe is less convincing than that for the U.S.

Posted in: Accounting, Economic Theory, Fair Value, Markets, Wine by David /
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On Wednesday the Basel committee announced some changes to the Basel II framework. The press release is fairly short on detail, but it does give some insight into the forthcoming detailed proposals. Let’s take a look.

The Committee reiterates the importance of implementing the Basel II framework.

This is shorthand for ‘please Mr. Fed would you implement our Accord?’

…the Committee will revise the Framework to establish higher capital requirements for certain complex structured credit products, such as so called “resecuritisations” or CDOs of ABS.

Clearly CDO squared products and CDOs of tranched ABS have been a major issue so this is reasonable. But CDOs of pass throughs have much less model risk and behave in a much smoother fashion so I hope these will not be tarred with the same brush.

It will strengthen the capital treatment of liquidity facilities extended to off balance sheet vehicles such as ABCP conduits.

The issue here is implicit support: legally many of these lines were low risk, but reputational concerns forced banks to provide support where it was not contractually required. Rather than charging for liquidity, which will simply encourage the use of non-bank liquidity providers, the committee should cap the benefit available for securitisation.

The Committee will strengthen capital requirements in the trading book… The Committee … is extending the scope of its existing proposal guidelines for “incremental default risk” to include other potential event risks in the trading book … (planned 2010).

This is so frustrating. The capital requirements in the trading book are already high compared with the banking book, and the incremental default risk proposals are hardly a model of cogency or risk sensitivity. If the trading book charges are imprudent then the banking book ones are far too low. They should also be revising the correlations in the IRB formula and increasing the risk weights for risk below BBB- in the revised standardised approach. And surely they can get their act together a little faster than 2010?

The Committee will monitor Basel II minimum capital requirements … over the credit cycle… [and] will take appropriate measures to help ensure Basel II provides a sound capital framework

So no discussion of procyclicality and no acknowledgement of the need for anti-cyclical capital requirements especially for fair value assets. This is disappointing. Basel II seems to have become a self-sustaining industry where wholescale change is almost impossible. The extended timeframes and modest revisions are evidence that major regulatory change will need more impetus than just the biggest banking crisis in a generation.

In July the Committee will publish for consultation global sound practice standards for the management and supervision of liquidity risks.

What about capital for liqudity risk?

Weaknesses in … valuation practices for complex products have contributed to the build-up of concentrations in illiquid structured credit products and the undermining of confidence in the banking sector. The Committee is taking concrete action to promote stronger industry practices in this area.

What pray might those be? If it doesn’t trade, it isn’t Level 1. Stronger practices whatever they may be need to acknowledge that fair value is often an estimate and that uncertainty in valuation will always be with us. This is fundamentally an investor education problem: equity holders suffer the same realised earnings volatility whether the asset is fair value accounted or not; hiding that volatility via loan loss provisions in the banking book just turns the spotlight away, it does nothing about the real risk. Supervisors seem to be aware of the issues with structured credit in a fair value context but reluctant to acknowledge that these risks are still there in an accrual context, just concealed by the accounting.

Are these changes going to help? A little, although putting a charity slot in the wall of the BIS might be more effective: there is much more that needs to be done, and done quickly.

Posted in: Accounting, Basel, Fair Value, Liquidity and liquidity risk, Photography, Regulation by David /
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Perhaps the most important part of Chapter 2 is a (mitigated) vote of confidence from the IMF in structure finance at the beginning:

Structured finance can be beneficial by allowing risks to be diversified

Before we get into the detail of the IMF report, that comment is worth noting. Now for the ‘but’s, or rather for my comments on selected ‘but’s.

• First a remark from the IMF about ratings: In particular, when reliable price quotations were unavailable, the price of structured credit products often was inferred from prices and credit spreads of similarly rated comparable products for which quotations were available. For example, the price of AAA ABX subindices could be used to estimate the values of AAA-rated tranches of mortgage-backed securities, the price of BBB subindices could be used to value BBB-rated MBS tranches. [...] In this way, credit ratings came to play a key mapping role in the valuation of customized or illiquid structured credit products, a mapping that many investors now find unreliable. This is important and has not received that much comment thus far. Many firms are currently marking a lot of ABS, some of it rather different from typical US subprime, as a spread to the ABX. They are doing this because they can’t think of anything better to do. But of course this only works if AAA ABX is comparable with AAA something else. So not only were ratings important for some purchasing decisions, they continue to be important for marking inventory. Which is scary.

• Credit rating agencies insist that ratings measure only default risk, and not the likelihood or intensity of downgrades or mark-to-market losses, many investors were seemingly unaware of these warnings and disclaimers. True, but really can we have a small does of caveat emptor please?
• Next a very sensible observation on fair value: Accounting frameworks require professional judgment in determining the mechanisms for fair value, including the use of unobservable inputs in cases of the absence of an active market for an instrument.

  Such judgment allows the possibility of different outcomes for similar situations, which in times of market uncertainty may compound the risk of illiquidity. As instruments turn illiquid moreover, they move from level 1 or level 2 of the FAS 157 hierarchy to level 3. The IMF notes that some people have drawn the wrong conclusion from this:investors seem to have a perception contrary to what the standard setters intended because a firm risks a negative market reaction with a reclassification of assets from level two to three, as events during the turmoil indicated.

• Reasonably enough, the IMF is concerned about SPV assets coming back on balance sheet at the worst possible moment, with no hint prior to that of the exposure. They opine:investors would benefit from more comprehensive regulatory requirements for disclosures about the scope and scale of exposures to OBSEs. [...] Increased disclosure achieved through consolidation or some form of parallel disclosures of an entity’s unconsolidated and consolidated positions also means these entities have a direct impact on the institution’s regulatory capital requirements, funding sources, and liquidity. (OBSE is IMF speak for SPV.) If this suggestion is taken seriously it will mean a huge change to IFRS. My sense is that the regulators will go further and faster than the accountants on this (not least because the accountants are saying “completing a final standard by mid-2011 will be extremely difficult, perhaps impossible”). Certainly caps on the regulatory benefit for securitisation are under active consideration.
• Will banks voluntarily take more of the OBSE’s assets onto the balance sheet to provide greater assurance to investors as to the vehicle’s quality? Only if that is the only way to get the securitisation market restarted and/or if regulators make them. Or should banks be required to retain a stake in the performance of these assets, thus having the incentive to conduct better due diligence? Yes.
• In general, variations in the regulatory treatment of securitization among different types of financial institutions may provide an opportunity for regulatory arbitrage across financial sectors. Some securitization exposures are evaluated for regulatory purposes differently for insurance companies than for banks. Finally in between congratulating themselves on the level playing field between banks someone in the supervisory community has noticed that the playing field between banks and non-banks is far from level. Basel 2 is flawed in many ways but it looks pretty good compared with insurance capital requirements for the monolines.
• Finally it is worth noting that the banks did not play the SIV and conduit game cynically: many of them seemed to have believed that risk really had been transferred. Or as the IMF puts it the perimeter of risk for financial institutions—that is, the risk assessment of all of an institution’s activities, including its related entities—did not adequately take into account the size and opacity of institutions’ exposures to SIVs, commercial paper conduits, and their related funding support. Given the size of the SIV and conduit activity, this failure of risk assessment is a big deal for the banking system.

Posted in: Accounting, Basel, Regulation by David /
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The FT has a rather alarmist article about ABS valuation. Unsurprisingly to anyone who has been in the market, but a surprise apparently to a regulator was the fact that for some ABS

There was little confidence about how to value the holdings

The wrong conclusion is drawn from this

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. [...]

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

The market infrastructure isn’t the problem and neither is the complexity of the techniques used. It is simple old fashioned invisibility of the model inputs. Let’s take a German middle market corporate with no issued bonds and privately held equity. What is the fair value spread for a loan? Well, there are things you can do based on discounted cashflows and models of corporate structure and so on, but they are approximate. If you came to try to sell that loan, you might get a different price from your model. It is the same with IPOs (which is why there is a pricing range which is often revised before the company comes to market).

There may well be problems with CDO models – the right choice of copula is unclear in some situations for instance. And market infrastructure is not perfect, particularly on the legal side. But fixing these issues won’t give a market price to something that does not trade. It might however help if commentators who are perfectly comfortable with utterly subjective loan loss provisions in the banking book accepted that when the same kind of assets are subject to fair value the determination of those fair values can be problematic. That doesn’t mean the assets are bad, just that market participants need to understand and manage valuation risk.

The place this really gets delicate is when actions depend on estimates of fair value, for instance in a SIV where the definition of solvency might depend on the ratio of the FV of assets to the notional of liabilities. Writing that kind of clause is asking for trouble if there is any doubt that the FV of the assets is easily determined.

Posted in: Accounting, Fair Value by David /
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Broadly I am a supporter of the use of carefully estimated fair values for financial instruments: I think that accrual accounting hides a lot of information that the users of financial statements deserve to know. However, there is one aspect of fair value that is troubling: how it combines with leverage to provide another incentive to procyclicality. To see this, suppose we start with a bank that is Basel 1 adequate, i.e. its leverage is less than 12.5:1 (remember 1/8% = 12.5).

This bank uses fair value for all of its assets, and the markets rise, so we find

Of the 100 of P/L 50 is dividended to shareholders and 50 is kept as retained earnings. Retained earnings are a component of capital so we have:

At this point management will be concerned that the ROE of the bank will suffer due to the falling leverage, so they acquire more assets to get the leverage back to 11:1, originating 450 of new assets.

Unfortunately now the market falls back and the 1650 of assets are now worth only 1600. This causes a loss of 50. Losses are a deduction from capital, so now we find

At this point the bank is capitally inadequate and either has to sell 350 of assets or raise 28 of new capital to get its leverage back under the regulatory maximum of 12.5:1. In other words, when times are good, the bank extends more credit, and when they are bad, it either has to raise new capital (and until it has recapitalised it cannot lend further) – or perhaps even worse, it may well sell assets into a falling market, exacerbating the decline.

One could argue this is not the fault of fair value, but rather of the leveraging up that took place during the rising market. However in order not to encourage this, shareholders need to understand that, unlike an accrual accounted bank, a fair value bank will have low leverage in a rising asset price environment and higher leverage in a falling one. I am not convinced that is well understood at the moment so the temptation to overleverage may well be there.

Posted in: Accounting, Fair Value by David /
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Naked Capitalism points out a scary new letter from the SEC to CEOs regarding valuations under FAS 157. The NY Times has a good summary: If Market Prices Are Too Low, Ignore Them. The offending part of the guidance is:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale.

My contempt for this is boundless. The point about mark to market is that you estimate the price of a current transaction. If there are more buyers than sellers, then prices will be falling. Whether some of those sellers are forced is irrelevant. If you had to sell today, you would be joining them, so the price they are getting is the best pricing source for a current transaction. End of.

Posted in: Accounting, Fair Value by David /
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It is always good to take a look at the positions you were thinking about after the fact and see how they did. Let’s see:

• A short in gold. Definitely not a good start, although I am sanguine about this one in the longer term. Gold at over $1000 does not make sense.

• Long the iTraxx and short the components stock. Too early to tell.
• Long yen, short dollar. With the dollar at a hundred yen, that is doing very nicely. I’d probably take it off here.
• A modest long MBIA and Ambac stock. This is basically a long irrationality position. It is underwater so far and needs a tight stop/loss: one issue will be whether the recently announced ratings reforms break their business model even further.
• Short Baltic Dry. That worked, and would have been taken off by now.
• Long a FTD basket on the subordinated prefs of national champion banks. Positive carry but looking sickly on a mark to market basis. Still a trade I believe in though.

Maybe I do have a future in global macro… from these shoots and so on.

Incidentally, the FTD position is interesting given AIG’s comments on fair value. According to the FT:

American International Group is urging regulators to change controversial accounting rules on asset valuations to stem the tide of writedowns that have wreaked havoc on Wall Street. [...]

Under AIG’s proposal, which has been presented to regulators and policymakers, companies and their auditors would estimate the maximum losses they were likely to incur over time and only recognise these in their profits.

All other unrealised losses would be recorded on the balance sheet but would not affect profits. In AIG’s case, this method would have reduced the impact of the $11bn writedown on fourth-quarter results to $900m.

Given AIG’s losses, this is not just nonsense, it is self-serving nonsense. ‘Let me make up the earnings I would like to have had’ is not an accounting principle, it is a CFO’s fevered fantasy.

The FT reports a more measured version of that sentiment:

“It might be hurting but fudging the accounting is not the answer,” said one Big Four partner. “Investors can make their own mind up as to whether the outlook will get better, but they can’t do that for a company without a clear, fairly valued starting point.”

“If management are going to use more of their own judgments in valuations, I’d think markets would be looking to build rather more risk premium into these companies,” said Ken Wild, global leader for international accounting standards at Deloitte.

And that is exactly the point. Investors, like Buffett, are mature enough to understand volatility in earnings if a good enough case is made for the position that is generating that volatility. But that case has to be made. It is not good enough for corporates to say ‘trust me’ and neglect to provide the users of financial statements with information on what the real earnings are. For the FTD basket the case is basically ‘too big to fail’. I think that’s a reasonable investment: you might well think it is nonsense. But the point is that if I was investing your money, then you would need to know what the market thinks of the position I put on, not just what I think of it.

Posted in: Accounting, Markets by David /
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There is a lot going on at the moment, and I don’t have time to write the extended posts I would like to on each of these topics, so for the weekend here’s some material to be fleshed out later.

• Is global regulation or accounting a good thing? A post at Information Arbitrage made me consider the issue. They are in favour, pointing out that a complicated amalgam of rules, regulations and standards [...] places enormous friction on global transactions and doesn’t really protect investors any better than under a standard, global, common sense regime. Certain inhomogenous standards are costly and advantage some institutions over others. But crucially that diversity may protect the system. At least in a country-specific regime, if a rule leads to perverse behaviour, it only screws up that country. If global rules are wrong, the whole system suffers. Given that we do not know how to write completely safe regulations for financial institutions, perhaps having a choice of regimes is a good thing?

• Q. When is it a good idea to voluntarily modify the term of issued securities to your financial detriment? A. When it avoids having to pony up cash that otherwise it might stress you to find. Financial Crookery explains all in a post on LYONS.

  

• Spreads, including the Libor/OIS spread, the iTraxx, and the Italy/Germany spread, are going out again, and the FED is trying to bring it in by expanding the size of TAF auctions. What is interesting about this is that liquidity, rather than rates, are being used as the tool of choice. Alea notes some unfortunate timing too, here, and Interfluidity has a provocative post here.

  

• Corporates think CDS spreads are wrong, and are pricing new debt off secondary bond prices rather than CDS again. Given some parts of the CDS market are pretty much one way right now, that makes sense.
• What did banks do wrong? See here for a summary.
• What is a safe level of capital for liquidity risk? Carlyle’s fund was apparently leveraged 28:1 and they are being carried out. That implies that for a leveraged Agency position – a position with no credit risk remember – the capital for liquidity risk is at least 4%. Scary, huh?

Posted in: Accounting, Liquidity and liquidity risk, Markets, Regulation by David /
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The Basel committee is meeting soon, unusually enough actually in Basel, although I suspect in a rather nicer hotel than this.

Gillian Tett discusses the gathering. The BCBS has a significant problem on their hands:

Thus the crucial question confronting the central bankers this weekend, as they fly in to snowy Switzerland is twofold: first, are we on the verge of a new downward lurch? And second, is there anything the G10 bankers can actually do to stop this?

The problem Tett identifies relates to mark to market:

But these days the US government faces a crucial impediment to repeating this trick. Back in the days of the S&L crisis, US banks were not forced to mark their books to the firesale prices. But now the mark-to-market creed has taken hold. And it is a fair bet that if US banks were forced to mark their books to the initial clearance price for a CDO squared, say, some would run out of capital. Hence the trap: in the modern financial system, you can have mark-to-market accounting systems, or quick action to establish clearing prices, but probably not both, without blowing up some banks.

That’s not hard to fix. Give a temporary waiver to the bank for capital calculations relating to these assets. Allow banks to move existing ABS securities and derivatives into the banking book for a short period, and let the banks know how long they have to get back inside the park. And don’t tell anyone you are doing it. That will restore confidence. Tett herself is skeptical that this is possible:

But I would be surprised if any action occurs soon.

Perhaps coordinated action is unlikely. But it would not surprise me if this was already happening.

Incidentally this brings out an interesting point. Do the regulators have the power to do this? They have complete power over regulatory capital, but not over accounting. I’m not sure if it would even, strictly speaking, be legal for a bank to move a fair value asset under IAS 39 into the banking book and not mark it. The regulators could permit the banks to ignore the deduction to Tier 1 caused by losses on these instruments, but the key difference is that these losses would still have to be published in the banks’ income statements. Perhaps that is something the central bankers should discuss.

Posted in: Accounting, Basel, Regulation by David /
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Berkshire has sold long dated equity index puts in size. Buffett comments on the position in his letter to shareholders:

Sense like that is one of the reasons he is as incredibly well regarded as he is.

Posted in: Accounting by David /
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John Dizard continues the battering of mark to market in the FT:

Many now believe that like the fictional nuclear Doomsday machine, the unbending application of mark to market rules is not, in the end, a sane way to manage the world.

Here’s the problem: the mark-to-market rules assumed there would always be someone willing to buy or sell an asset at a price that bore some relation to the economic value it represented.

Well, no. Or at least, not really. The accounting principal after all is only known colloquially as ‘mark to market’. The formal name is ‘fair value’, and fair value can be applied to assets with no market, as in FAS 157’s level 3. Marking to a proxy has a long and honourable history which goes back much further than the current crisis. Anyone who has ever had a very large position or a highly structured position has probably marked to a proxy somehow or other (remember normal market size trades are a proxy for larger positions, and not necessarily a good one at that).

What would happen if we did not do that, that is if we went back to accrual? Then investors in banks would have no clue about the value of the assets on bank’s balance sheets, and they would instead have to trust to something even more subjective – loan loss provisions.

Now of course fair values can change without there being a material change in the likelihood of an asset failing to pay: changes in liquidity premiums, in the cost of financing the position, and in the volatility of the position can all do that. But those changes are important information for the users of financial statements.

Dizard continues:

Right now, though, the problem is that the capital bases of the major banks and dealers are being reduced by losses on the mark-to-market value of securities faster than they can raise new money. That means that because nobody wants to buy a lot of the structured credit products, credit made available by the entire system could contract. That would lead to more losses, and a further contraction of credit.

We call that a depression. Yes, eventually you get to a level of prices where transactions will “clear”, because some people will have enough gold or soyabeans or yuan to buy the distressed assets.

And we need to know where that level is. If we intervene before it is reached, there will be an enormous loss of confidence. Rather than being in the situation of knowing the worst is over, we will instead wonder whether it is, leading to, yes, further falls in asset prices.

A rather odd bit comes later:

Furthermore, as one board member of a very large dealer told me: “Aside from the shrinking capital (from mark to market losses), you are getting more and more assets being put in the illiquid “bucket” [by the accountants]. Those illiquid assets require a bigger capital charge, so you are getting a double whammy.”

What? What capital requirement, exactly, causes this double whammy? I’d love to know. It’s nothing in Basel 2, that is for sure, but the SEC website isn’t that easy to search. The closest I can find is:

The requirements of paragraph (a)(7), as revised, are intended to help ensure that a broker-dealer maintains prudent amounts of liquid assets against various risks that it assumes and that it maintain a robust internal risk management system.

But I can’t track down the full text of the illusive 15c3(1)(a)(7) or any of its relatives.

Dizard gets very interesting next:

Also, it has been suggested by some dealers, whose capital bases are getting too stretched to adequately maintain market liquidity, that they be given access to the Federal Reserve’s discount window and the generous Term Auction Facility. That would provide enough extra liquidity to keep more securities from being dumped into the capital-eating illiquid valuation “buckets”. This idea is likely to be taken seriously by the authorities.

Yep. The banks have become addicted pretty quickly to the crack cocaine of the TAF, aka ‘post what you like and we will give you money’. The broker/dealers want some of that happy powder. Ignoring for a second the question of why being able to repo something with the FED makes it liquid, this might even be the right short term policy response. Keep fair values for the assets, but provide funding for them. The difficulty will be weaning the banks and the dealers off this cheap liquidity.

Posted in: Accounting, Fair Value, Liquidity and liquidity risk, Regulation by David /
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This is a valid question as we go into any restructuring of the bond insurers, and the answer is more complicated than it appears at first sight. Here are some of the issues.

Many corporate bonds pay interest and final principal – you get coupons for some period, then a return of principal.

A standard CDS on a corporate bond uses a notion of credit event which typically includes default, failure to pay and bankruptcy. If the bond displays a credit event, then the CDS protection buyer stops paying the premium on the CDS and has the right to receive recompense in a short period, perhaps 3 or 5 days. This recompense is either through the right to deliver a bond and receive par (physical settlement) or through the right to receive an estimate of par minus recovery as a cash payment (cash settlement). Some key features include rapid payment, the ability to go short – by purchasing cash settled CDS without owning the bond – and the derivatives (i.e. mark to market) nature of the instrument. Note too that the premium is risky in a standard CDS: if default happens, you stop paying it.

There are insurance policies which behave much like CDS. These are part of a wider class of insurance known as financial guarantee policies. The difference here is that they are legally insurance (and hence have a different legal, accounting, regulatory and tax framework). In particular this is not a mark to market instrument, and in most jurisdictions you have to be an insurance company to write insurance. Note also that insurance typically requires an insurable interest – I cannot profit from buying fire insurance on your house even if it burns down – so if you purchase a financial guarantee policy directly it might not allow you to go short.

The fact that there are two instruments, CDS and financial guarantee policies, which can act much the same way yet have very different accounting should be a matter of shame to the FASB and the IASC.

Another possibility for obtaining protection is a bond wrap. Bond wraps are part of a wider class of insurance policies known as financial guarantee policies. In a bond wrap the policy runs to maturity of the bond, you have to keep paying premium until that date (so the premium is not risky), and the policy writer agrees to make good the scheduled cashflows of the bond should the original bond issuer suffer a credit event. Thus here you get paid on the original schedule, and if there is a credit event you substitute the risk of the issuer for that of the policy writer. Most of the muni policies the monolines have written are in this form. The advantage from their perspective are not only insurance accounting, but also lack of cashflow stress: unlike a CDS you typically have plenty of time to find the cash to make the principal repayment.

With amortising securities the issues become more complex since there is the possibility of a principal and interest payment at each coupon date. You can write standard CDS on amortising securities, but it is also possible to write a pay as you go CDS. This imports bond wrap technology into derivatives, and gives the protection holder the right to demand payments on the original schedule from the CDS writer.

For corporate bonds, amortising or not, matters are fairly straightforward since the failure to receive any cashflow (or at least a material one) is an event of default. For ABS you might not want that feature though: in a typical credit card deal, for instance, there will be a certain level of delinquencies which all parties expect, and if you have a credit event which triggers cash settlement based on default, then many junior ABS would suffer that event in the first month. Moreover in many ABS the collateral prepays, so you do not know when you will get your principal back. This means that to define a CDS or financial guarantee you need to tease out the cashflows each security should get in a given month given the level of prepayments, see what cashflow it actually gets, and define protection based on the difference.

Matters get even more difficult when you have amortising collateral in a CDO but some of the tranches have bullet maturities. Remember too that in some cases the CDO issuance SPV can be technically unable to pay without the CDO collateral having lost value: this can happen in particular due to liquidity risk. Figuring out exactly who pays whom what when something bad happens in a CDO of ABS is sufficiently complex that standard documentation has not been available until recently. Most transactions historically used bespoke documentation, and figuring out exactly which risks were transferred was not a trivial business.

Finally, note that the legal final maturity of ABS is often well beyond the last cashflow date. For a mortgage deal, for instance, it might be 35 years. So a contract which only gives you the right to claim ultimate principal at legal final maturity is like buying protection on a long dated zero coupon bond.

My guess is that most but not all of the monoline’s structured finance business involved taking middle or upper tranche ABS and writing pay as you go style protection on it in the form of a financial guarantee. This has considerable accounting advantages over writing standard bullet CDS, as well as the advantages the monolines enjoy as a result of insurance rather than banking capital. Finally it means that the monolines have relatively little immediate cashflow stress even though their structured finance portfolio would be, on a mark to market basis, highly underwater. None of that means that there is no problem with their business — just that if this is going to be a train wreck, it will be a slow motion one.

In any event we do need to know the answer to this question as it determines the capital needs. If they have written CDS with collateral agreements then the monolines need enough capital to support the mark to market volatility of the trades. If they have just written insurance then they only need enough to support the ultimate realised losses on the portfolio. Those numbers are very different (and it impacts how right Bill Ackman is).

Some people have suggested that one of the villains of the current crisis is mark to market. I don’t agree: mark to market gives one view of the value of a portfolio; insurance accounting another. But certainly having a portfolio of similar risks subject to wildly differing accounting principles in the same legal entity is unhelpful.

Posted in: Accounting, CDS and Negative Basis, Insurance and Actuarial Practice, Monoline by David /
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Standard Chartered has withdrawn support from its SIV, Whistlejacket. It appears that like many SIVs, the value of Whistlejacket’s assets has been falling fast. The contraction of the ABCP market meant that Whistlejacket had been unable to roll its short term funding. Standard had previously pledged to support Whistlejacket by writing it short term liquidity, effectively stepping in the place of the ABCP buyers. However it appears as if that liquidity line was contingent on the net asset value of the SIV being sufficiently big and, with falling markets, that test was no longer met. Hence any liquidity provided by Standard would not be contractually required – in Basel II terminology it would be implicit support. The consequences of taking Whistlejacket’s assets on balance sheet by providing implicit support were presumably too much for Standard Chartered.

This brings us to a difficult question that both regulators and accountants need to answer. When is an SIV yours, i.e. when should it consolidate for regulatory and/or accounting purposes?

A few thoughts.

• Accounting consolidation should follow regulatory consolidation and vice versa. Whatever they do, the regulators and accounting standards folks should agree about when a securitisation is ineffective. If a SPV consolidates, there should be full regulatory capital on it. If it doesn’t then some measure of regulatory capital relief should be available.
• The IAS (if not the FASB) consolidation rules are based on the ideas of control and benefit. Broadly the test for whether you consolidate a SPV require a test of who benefits from its activities and who controls it. The principles here are not bad, but I would suggest that they don’t allow for the idea of contingent control – mostly I do not control the SPV, but if something bad happens (like the closure of the ABCP market) then I get it back. Perhaps in order to clarify the situation consolidation should be automatic if an issuer has a position in multiple positions in the capital structure (such as equity and a supersenior liquidity line). That would at least make the assessment of benefit and control easier.
• Regulators must accept that there are legitimate reasons for securitising assets and must provide a safe harbour for good structures. Failure to do this will not just damage the banks – it will damage the financial system.
• Regulatory capital relief should be contingent on alignment of interests. Whenever the seller of an asset has an incentive to conceal information from the buyer, and especially if the seller is also the servicer, then clearly trouble is possible.
• Regulatory capital relief should be based on the extent of the risk transferred. Overly penal rules which do not have this effect – such as Basel II – simply encourage regulatory arb transactions rather than genuine risk transfer. Despite a number of attempts the supervisors have not yet managed to write rules that do not permit capital arbitrage so there is no reason to believe they can get it right on the next attempt.
• If issuers are found to have provided implicit support they should be required to restate their regulatory capital, earnings and balance sheets for all periods when they took advantage of the sham securitisation, and to make public disclosure of this restatement.

I do believe that securitisation is a useful tool for the financial system. We are still learning how to use it appropriately. Now a concerted effort is needed to rewrite both regulatory and accounting rules to incentivise effective structures. Making consolidation harder to avoid or capital higher won’t do that. It will just encourage another round of game playing which, when the next bubble bursts, will have even worse consequences.

Posted in: Accounting, SIVs and Conduits, Securitisation and Tranching by David /
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The FT asks a question:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope?

Roger Ehrenberg has an answer:

Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:
1. Increase transparency among regulated institutions
2. Homogenize global accounting standards
3. Homogenize global regulatory frameworks
4. Aggressively strip conflicts of interest out of the system
5. Clarify the roles and responsibilities of fiduciaries
6. Develop common sense compensation policies and practices

Let’s examine these one by one.

1. Increase transparency among regulated institutions
Accounting disclosure of derivatives is pretty much useless. Even with Basel 2 the disclosures on market risk in general are only marginally more useful: the VAR typically tells you little. We need more useful disclosure on market risk, liquidity risk, off balance sheet risk and credit risk mitigation.

2. Homogenize global accounting standards
I don’t see this as pressing. Standards are coming together already and while significant differences remain, they are not nearly as important as the things you get no information about from financial statements. See 1. above.

3. Homogenize global regulatory frameworks
Yes, but the issues are mostly not between banks in different countries but rather between banks and non-banks in the same country, notably between banks and insurers but also between banks and broker/dealers. The monolines would never have been able to get into their current state if they had been regulated under Basel 2.

We also desperately need to fix the market risk capital regime. I have talked about this before so I won’t go over old ground: suffice it to say, VAR is no longer a useful measure of market risk capital (if it ever was).

4. Aggressively strip conflicts of interest out of the system
This is definitely right. Legal and regulatory steps to align interests are necessary as clearly the buyers of securities either couldn’t or wouldn’t do the job.

5. Clarify the roles and responsibilities of fiduciaries
What Ehrenberg means is that if you give your cash to someone with the mandate to manage it conservatively and preserve capital, and they buy a Libor + 40 AAA floater that subsequently defaults, you should have someone you can sue. Certainly the idea that a rating substitutes for due diligence is bizarre and it should not be defensible in court. But right now it probably is.

6. Develop common sense compensation policies and practices
This is just a variant of 4. The way people are paid should not set up a conflict of interest between shareholders and the risk takers they pay, nor between those risk takers and the broader financial system.

Conclusion
I do not believe that the credit crunch was brought about chiefly by malevolence or bad faith. Of course there was some of that, but mostly it was a series of small incentive structures combining to produce a systemically disastrous result. Hence we need to fix the rules of the game to produce better incentives.

Posted in: Accounting, Basel, Monoline, Ratings, Regulation by David /
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Bloomberg has an interesting article Citigroup SIV Accounting Looks Tough to Defend. The author, Jonathan Weil, makes the point that Citi is caught between the devil and the deep blue sea:

• If it supports its SIVs, accounting consolidation kicks in since the firm is deemed to be providing implicit support and under FASB Interpretation No. 46(R) that brings them back on balance sheet.
• If it doesn’t support its SIVs, the reputational damage will be severe.

Weil argues this is one of the reasons for the MLEC plan: it would allow Citi to dig some of SIVs out of the mud without forcing it to consolidate. This is a good point and it might well be true. But there is another dimension, too: regulatory consolidation. It is a little known (if deeply, deeply boring) point that regulatory consolidation is not the same as accounting consolidation.

Regulatory consolidation very roughly works by identifying which parts of the group are financial, putting all of their risk on the top company balance sheet, subtracting the equity invested in non-financial subsidiaries, and calculating regulatory capital on the result. Accounting consolidation again very roughly seeks to identify whether an entity which a firm has a relationship with is controlled by, owned by or gives the results of its activity to the firm. If so, that entity is consolidated. In detail the topic is complex, particularly in the context of firms which have both banks, insurance companies and other activities in a single group – financial conglomerates – or where careful structuring has been used to try to dodge the consolidation provisions of IAS 27, SIC 12 or whatever for a given securitisation SPV, SIV or conduit. For now, though, note that in principle at least an entity can be consolidation for accounting purposes but not regulatory purposes and vice versa. And that’s fairly odd. I can see that it makes sense to deconsolidate non-financial subsidaries of a financial holding company for regulatory capital purposes. I can even see how you might want to treat the same risk in different operating companies differently – for instance if a holding company owns both a bank and an insurance company. But the idea that an entity such as a conduit is consolidated for accounting purposes but not for regulatory capital seems deeply imprudent. And of course many conduits have been structured to ensure that provided no implicit support is given they will not consolidate for either purpose.

It is worth noting that for FAS accounters, FIN 46(R) on the Consolidation of Variable Interest Entities includes provisions for the recognition of an implicit variable interest, aka implicit support. This occurs amongst other things when a bank provides a conduit with credit or liquidity support that it is not contractually obliged to provide.

That brings us to the heart of the dilemma. Implicit support is poison. Regulators and auditors can only spot it after it has happened. But if conduit paper has been sold with a nod and a wink, so that the buyers expect implicit support and will exact reputational damage if it is not provided, then there is something rotten in the state of finance.

Posted in: Accounting, Regulation, SIVs and Conduits, Securitisation and Tranching by David /
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Be careful what you embrace, particularly in the area of valuation policy. According to Bloomberg:

Absolute Capital Management Holdings Ltd. will stop clients from pulling money from eight hedge funds with $2.1 billion of assets after co-founder Florian Homm quit.

Investors will be asked not to remove cash for a year as the firm restructures the funds, Absolute Capital said in a statement today. Seven of the pools invested in over-the-counter U.S. stocks that can’t be sold at the prices at which the firm had valued them, affecting as much as $530 million of assets.

If an asset is marked at price different from where you can sell it, how exactly is that mark to market?

Update. I like this fragment from the Independent so much I want to quote it.

Sandy Chen of Panmure Gordon [Absolute Capital's Broker] said the apparent valuation shortfall “could prove fatal for the equity funds” and highlighted “the risk of investor lawsuits as an unquantifiable threat to earnings”. He slashed his price target from 750p to 150p…

Is that target change great? I just wish more analysts were willing to move their forecasts with such speed and robustness.

Posted in: Accounting, Fair Value by David /
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Or perhaps it is. I’ve just got around to looking at FASB Statement 157 on Fair Value from the tail end of last year. It is remarkably sensible. The definition of fair value is more or less the same as before

The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Note though that the definition is based on an exit price (for an asset, the price at which it would be sold) so the intention is clearly to mark at bid/offer rather than mid or acquisition price. This presumably means everyone will show a loss when the buy assets (since they will buy at the offer, mark at the bid), although there is some mealy mouthed language that the standard “does not preclude” the use of mid-market prices or other “conventions as a practical expedient”.

The innovative part of 157 is the hierarchy of valuation principles:

Level 1. Valuation using quoted market prices for identical assets or liabilities in active markets.

This is the traditional idea of fair value: I have 2000 shares of IBM, and I mark them at the market price.

Level 2 — Valuation using observable market-based inputs, other than Level 1 quoted prices (or unobservable inputs that are corroborated by market data)

This is what firms mostly do in OTC derivatives: we see traded implied vols for some plain vanilla options (or perhaps simpler exotics in some markets) and we use those implieds (together with rates, dividend rate estimates, underlying prices and so on) as inputs to a valuation model to mark the entire book. Here we are saying ‘this 1478 strike 70 week OTC call on the SPX I own is worth $50,000 because brokers are quoting a 1450 strike 78 week call at $57,400 and Black Scholes calibrated to that known price give me $50K for my asset’.

Level 3 — Unobservable inputs (that are not corroborated by observable market data)

This is where we mark a mountain range option to (spread to) a historical correlation, for instance, or a private equity position based on projected cash cashflows.

Firms are required to use the lowest level possible, so the most market based marking must be used. Best of all, firms are required to disclose the split between the levels, and to discuss the basis of unrealised level 3 gains and losses. This should be a really useful disclosure for the readers of the financial statements issued by large financial institutions.

Now, consider Jos Ackermann’s recent call for banks to reveal their losses in the current subprime/ credit crisis. He’s right of course: banks should have an idea of what their exposure is, and they have a duty to reveal that to their investors. But at the moment a lot of securities and derivatives that would have been valued at level 1 last year would currently have to be valued at level 3 – there isn’t a market for many credit products right now. This shows the importance of FASB’s hierarchy: knowing that a bank has definitely lost $1B is very different from knowing that on the basis of non-market based estimates a bank thinks it might have lost $1B.

Update. Bloomberg backs me up here:

Dealers stopped providing prices on subprime bonds when trading dried up during July and August [...] the firms are reluctant to give low quotes that suggest clients have lost money and are even more hesitant to give high estimates that they would then have to honor as market-makers by purchasing the securities.

“The dealers are finding themselves away from their desks a whole lot more, [...] No one is willing to put out a quote.”

It was liquid, now it’s not, and you should be disclosing that fact.

Posted in: Accounting, Fair Value by David /
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The collapse of Metronet and the attendant comment suggests it might be worth saying something about risks in equity and debt finance.

The classic model of a company is that it can raise money in two ways: by issueing shares, or by borrowing money. The best thing that can happen to a lender is that they get paid back: there is no upside to making a loan other than receiving your interest. Therefore lenders demand that they get paid before shareholders – if a company has funds, it must pay its creditors first, and only after that do shareholders receive a dividend. Moreover if a company cannot pay its debts, debt holders can typically seize the company and sell or liquidate it to get (some of) what they are owed.

In exchange for taking the risk that they might not receive anything, shareholders collectively own the company and so receive anything that is left after debt holders have been paid. This is sometimes called a residual interest: it is potentially high risk and high reward position, since if the company’s earnings can’t support its debt, they might get nothing; but if earnings are high, then there is a lot left for them after interest costs.

One key capitalist idea, then, is that shareholders take risk in exchange for potentially big rewards. If you don’t like the idea that you might lose everything, don’t buy equity.

Now consider a company in a long term PFI contract such as Metronet. The rewards are potentially very high, as the profits of someone like Amey indicate. But so are the risks, as we see with Metronet or the late and unlamented Railtrack. Is this a good deal for the tax payer?

There are two arguments for PFI: a specious one; and a sensible one. The specious one is that PFI gets infrastructure built without the government having to raise money. But that is just accounting trickery: the tax payer pays eventually, after all. A PFI contract is an ongoing liability just as a bond issued by the government to pay for maintaining the underground without a PFI contract would be.

A private firm doing government work will demand an extra return over and above what they think it will cost in order to pay their shareholders: they are right to do that as their shareholders are taking risk. So on average PFI contracts are more expensive than their fair cost. Are they still the best that is available? That depends on whether the PFI contractor can get the job done and make their profit for less than it would cost the government to do the job themselves. There is a natural assumption that private enterprise is more efficient than government – that may even be true – but is it so efficient it makes up for the extra profit shareholders demand?

Here’s a view from the capital of London financing, Canary Wharf, to end.

Posted in: Accounting, PFI, Transport Policy by admin /
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