We are dealing with something not normal over the last 70 years, and overall market values are reflecting that

TO BE NOTED: From The Aleph Blog:

"Of Course not at Par; That’s Par for the Course

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157. (Really SFAS 133, but SFAS 157 clarified it.)

• Accounting rules have little impact on stock prices. Almost every academic study on accounting rules supports that idea. Why? Investors attempt to estimate the stream of free cash flows that an asset will throw off. Accounting rules can help or hinder that. Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
• Parties involved confuse regulatory with financial accounting. Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes. This was foolish, because there is no one accounting method that is ultimate. Every financial statement answers one main question. For GAAP, the balance sheet asks “What is the net worth?” Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
• There are always two ways to do accounting. You can do mark-to-market, or you can do book value accounting with impairment. Darkness encourages skepticism. In a period where there are few credit risks, book value accounting will be well-received. In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided. Regardless, the cash flows will still flow.
• Equity-like investments deserve equity-like accounting. They should be market to market, as equities are. With derivatives, this is the reason that we mark them to market, their values are so variable. So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
• But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression. Here’s the problem: we have a lot of people alleging that those values can’t be right. Let them stand up and start buying to prove it all wrong. Part with precious liquidity to gain uncertain yield. It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall. Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
• Some argue that there is an inconsistency between loans and bonds. Bonds get marked to market, while loans are marked at book. There is no inconsistency. The loans are held to maturity, unless sold. The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans. Most companies have not chosen that option, largely because they want the right to sell assets if they want to. But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
• We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors. SFAS 157 does not mean last trade. In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
• Now all of this said, practically, SFAS 157 leads to overestimating the value of assets. In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse. They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression? In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner. We are in a situation where marginal cash flows to purchase dud assets aren’t there. Mean reversion is a long way off, and the valuations of financial assets reflect that consistently. Try selling a bunch of whole loans held at par. See what the offers are. Why aren’t banks doing that to raise liquidity? Because the prices don’t justify it.

You can’t fight cash flows. Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured. In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally. There are misapplications of SFAS 157, forced by auditors, I believe. SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more. After that, let the regulators set their own solvency rules.

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PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.” There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack. (Much as I had hubris toward the end of the bull phase… let me stab myself.) In ordinary bear markets, there is some strength somewhere to support asset values. That is not true now. We are dealing with something not normal over the last 70 years, and overall market values are reflecting that. Eventually accounting values will get there, as they did in the thirties."

But this has some chance of success in my opinion, and so is worth a try

TO BE NOTED: From The Aleph Blog:

"Liquidity and the Current Proposal by the US Treasury

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II). I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it. Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

• Small markets are illiquid because they are small. Big sophisticated players can’t play there without overwhelming the market, making volatility high.
• Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze. Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default. There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
• Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
• Some assets are opaque, where the entity is private, and does not publish regular financial statements. An example would be lending to a subsidiary of a corporation without a guarantee from the parent company. They would never let and important subsidiary go under, right?
• The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults. As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid? On day one. Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations. For most of the small tranches, that’s the last time they trade. They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued? During the boom phase of the market. During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large. Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial. She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.” Losses would never be that great. Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets. She said that the market was too rational to have that happen again. I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity. Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times. In the bust times, they are not only not liquid, they are permafrost. In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age? Typically, they don’t track them individually. There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services. During the boom phase, tight spread relationships show good prices, and an illusion of liquidity. Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas. The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows? All of a sudden those pricing grids and formulas seem wrong. They have to be based on transactional data. There are few new deals, and few trades in the secondary market. Those trades dominate pricing, and are they too high, too low, or just right? Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low? Well, not necessarily. SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them. More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants. How do you eat an elephant? One bite at a time. They write it down to 80, because that’s what they can afford to do. The model provides the backing and filling. Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then. Of course, this is all subject to limits on income, and needed writedowns on other assets. I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

• Banks and other financial institutions gather up loans and bonds that they want to sell.
• Qualified bidders receive information on and bid for these assets.
• High bid wins, subject to the price being high enough for the seller.
• The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased. (I am assuming that 1:1 leverage is the minimum. 6:1 leverage is definitely the maximum.) The assets collateralize the debt.
• The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
• The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
• The assets are managed by the buyers, who can sell as they wish.
• If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price. The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
• If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price. The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end. Why? The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity. (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted. Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold? If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

• Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay. Not bad.
• Auction? Does the winner suffer the winner’s curse? Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
• What sorts of assets will be auctioned? [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors? Where have the models failed in the past?
• There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market. The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations. Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way. I give one broker the trade, and let him beat the bushes. If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done. He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there. He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

• What to sell?
• What is marked lower than what the bank thinks the market is, or at least not much higher?
• Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be a generic risk?
• Loss tolerances — where to set reservation prices?
• Does participating in the program amount to an admission of weakness? What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant. Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value. Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent. Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

• Will the action process lead to overpriced assets, and we take losses? Still, the banks will be better off.
• Will any significant amount of assets be offered, or will this be another dud program? Quite possibly a dud.
• Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS? Possibly, and the banks might look more kindly on that idea.
• Will the taxpayers be happy if some asset managers make a lot of money? Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet. There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery. There is no guarantee that investors and the government might not get hosed. Personally, I don’t think the banks will offer many assets, so the program could be a dud. But this has some chance of success in my opinion, and so is worth a try. If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen. Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up."

1. David Merkel Says:
   March 25th, 20091:19 pm at

   RB — since writing, I have had more time to think.

   Because of the auction process, subsidized funding, and the free put option, this will tend to get the buyers to overpay, which might induce the banks to part with more dud assets. Then the pricing grids will reflect those overstated prices, making the banks look better than they should. The banks get time, but the underlying problems in the eventual cash flows don’t disappear.

   Losses will get taken later by the asset managers, but mostly, by the government. Maybe things will be better then — some suggest that the economics team for Obama is merely playing for time and hoping.

Me:

1. Don the libertarian Democrat Says:
   March 27th, 20098:04 am at

   An excellent post. One of the few commentaries on this plan that I can understand, and relates well to what I actually read in the government White Paper and further comments.

   The holding company post was very good as well.

"I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid. "

David Merkel on the Aleph Blog with a post that I agree with:

"Fair Value Accounting — It Is What It Is December 27th, 2008

I’ve written on mark-to-market accounting before. Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.( A GOOD RESOURCE )

• Pandora and the Fair Value Accounting Rules
• Mark-to-Market Accounting Is not the Major Problem
• The Economics of SFAS 157
• Accounting Rules Do Not Affect Cash Flows
• Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

So, it’s interesting to me to see the FASB interested in continuing with Fair Value accounting, despite all of the criticism. It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved. The value of common financial instruments did not usually change much( GOOD POINT ); unless an equity had a public market, revaluations occurred only for reasons of impairment. But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities( YES ).

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power. Many assets have not been marked down to their fair value( I AGREE ).

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid( I AGREE ). When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model( A GOOD PROPOSAL. I HAS PROPOSED DOING BOTH, WITH MTM BEING NECESSARY, AND ALLOWING FMV IN CERTAIN CASES ). It is the best that can be done. But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm. Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting? Of course, in the short run. In the intermediate-term, the errors catch up, and destroy the cheater. In the long run, cash flows determine the value of a business.

So, be wary in the present environment. Just because a financial institution trades below book value does not mean that it is cheap. Much of the cheapness stems from the opaqueness in pricing of unique risks( TRUE. I WOULD ADD FEAR. ).

The challenge is analyzing what an asset is truly worth, and when that value can be realized. That is the challenge with financials today."

His plan might be a better solution than mine.