Friday, January 30, 2009

Claim of Originality....

You read it here first.  Financial Reporting Arbitrage.

First, the term, arbitrage.  Per wikipedia:
In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets.
People have already used the term regulatory arbitrage or jurisdictional arbitrage, and I won't go into detail on those usages, except to say that they are a generalization of the more basic, literal meaning of arbitrage.

What I am talking about is based on some well known and frequently discussed phenomena.  Namely that the accounting value for a transaction can and frequently differs from its economic value.  This has been clearly articulated by Warren Buffett as follows:
Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles
than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable).
This is only one example of accounting conventions deviating from economics. US GAAP has been around a long time, and is fairly robust. It has been able to deal with a general external economic environments that have placed extreme pressure on businesses. It has evolved to work in the real business world, and tends to be more practical then theoretical. And, like most social constructs that evolve from practice, contains certain inconsistencies and contradictions that are unavoidable.

If we go back to Warren Buffett's observation, and accept the fact that it crops up in more situations then simply accounting for acquisitions, or the amortization of goodwill, then consider a manager with the opposite philosophy.  The person on the other side of that trade -- who is more motivated to seek accounting earnings then economic earnings.

In a sense, this is hardly news.  Managers have tried to game accounting since the Italians developed double entry bookkeeping.  However, consider the following -- in order to realize or monetize economic profits, they frequently need to be mediated by an accounting framework.  The proposed definition:
In economics and finance, financial reporting arbitrage is the practice of taking advantage of a financial reporting differential of the same or similar economic transactions between two or more valuation frameworks.
A simple and perhaps trivial example of a reporting differential is the differing accounting treatment of corporate debt. Consider a 5%, 10 year fixed rate investment grade corporate debt that could be financed either by a bond issue or by a bank loan. The cash flows on this hypothetical debt are identical. At issue, the financial reporting is identical -- there is no immediate arbitrage opportunity. However, if interest rates rise, the financial reporting value of the bond will decline (assume that it is a listed, traded bond) for the bond owner, remain the same for a loan, and the liability of the firm issuing the debt will remain fixed.  A current example of this occurring can be seen with REITs buying their bonds at 10 to 20% discounts from par in order to improve their balance sheets.

At this point, one might wonder what is so unusual about a firm changing their capital structure -- especially since a firm never makes a change without labeling it a benefit.  Yet we know that stock buybacks have proven a disaster for financial firms over the last few years.  In the above case, the optics of the REIT's balance sheet has improved, but its cash position has worsened and it has less financial flexibility.  All they have done is recognize the economics of their bonds, which must be carried at par on their balance sheet.

A more interesting example of financial reporting arbitrage occurred when banks insured CDO's with bond insurers.  Banks were forced to mark structured finance products to "market" and the insurers were able to account for them based on modeled loss estimates.  As long as the insurers maintained a AAA rating, the banks could report the assets at par and the insurers could report them using their modeled loss estimates.  The fact that this didn't work over an extended period of time and included a whole host of problems other then the embedded financial reporting arbitrage makes this example more complex.  However, the financial reporting arbitrage was the motivating factor in a lot of the bizarre activity seen a year ago.

Instead of simply developing a new term for age old tendencies, this term points to activity that is at the heart of what went wrong.  Arbitrage is a capital market term.  Risk free arbitrage can't exist in an efficient market, and any inefficiencies quickly disappear under normal circumstances.  However, the aggressive capital markets thinking that began to dominate finance led to innovation that overwhelmed traditional accounting and regulatory practices.  Where they couldn't simply be bowled over, they went around traditional institutions, by simply disintermediating those institutions.  For example, instead of banks originating mortgage, which they would then hold on their books, independent brokers originated mortgages which were then securitized -- bypassing traditional, regulated lending institutions.

Most of the financial businesses have to deal with inherent mismatches in the duration of assets and liabilities.   A typical financial structure is to fund long term assets with short term liabilities.  With a positive yield curve and leverage, it is highly profitable.  The S&L crisis stemmed from a mismatch in low yielding, long duration assets (5% residential mortgages) and high cost, short term funding (demand deposits with increasing costs).  A good deal of enterprise risk management was developed in response to this problem, which focused on nominal interest rate changes driven by inflation.  To some extent, huge resources went into a financial Maginot line to protect against this specific risk.  

Risk management was inverted and used to determine maximum risk that could be accommodated at a particular price.  It was like that was a competition to see who could create the absolute worst AAA credit.

Accounting can't explicitly quantify risk within the confines of a balance sheet or income statement.  This is hardly a surprise and people have been dealing with this for a long time and had become fairly adept at it.  However, capital markets innovation gave people the tools to deconstruct, rearrange, and re aggregate risk in new ways.  Markets became very efficient, not at allocating capital, but at arbitraging the various limitations in financial reporting.  A quantum leap from old fashioned fraud, or more recent creative accounting.  

And there you have it -- financial reporting arbitrage.

Tuesday, January 27, 2009

Modest Proposal

With all the bashing regarding private jets, bonuses, etc. in banking, I have a great idea.

Pay all wages over $30,000/year in toxic assets.  Both BAC and C have already designated toxic assets that are backstopped by the Treasury.  Simply let the TARP auditors select from those assets, AT CURRENT BOOK VALUE, put them in a pool, and let the employees figure out how to liquidate them to get as much salary as possible out of them.

Since Andrew Cuomo is making noise about clawing back the MER bonuses, just do a deal and give them $4 billion in CDO's.  

This would spur some real innovation.  The could take their pick and either try to create more elaborate structured securities to sell to someone, or deconstruct them into whole loans and try to sell them, refinance them, do workouts, foreclose and rent.  Whatever.  

Do something.  Or anything to align the interests of the public and the employees.

I would bet they would find a way to extract more then book value out of them.

New FDIC Regulations

The FDIC is issuing a new regulation that would limit the interest rates PAID by poorly capitalized banks on brokered deposits.  It is less then meets the eye -- but it is a start to prevent the absolute worst "zombie" behavior last seen in the S&L crisis.  That is, institutions doing a last gasp of lending, trying to lend their way out of insolvency.  It was a little different at the time, because S&L's had negative interest rate spreads on their older assets, so if they could only lend enough at positive spreads, it would work.  That is, their average interest rate margins would turn positive.   

The main points are:

1.  The term, zombie banks, that was used by Krugman last week is appropriate for situations where failed institutions that are kept alive by non market forces (S&L - via brokered deposits, Airlines via bankruptcy for example) lead a rush to the bottom and blow up the entire industry.

2.  Right now, banks have strongly positive net interest rate margins.  Their immediate problem are weak or bad assets and it isn't easy to see how this could be improved by a lot more imprudent lending.

3.  The idea of going from no regulation to some regulation seems like a big deal, even if it doesn't make a difference right now.

One other thing that has come up recently is the idea that regulatory forbearance has proven to cost money in prior bailouts.  The difference between today's problems and the S&L situation is highlighted by the fact that lack of credit and lending is now considered the major problem.  Not continued irresponsible lending.

Monday, January 26, 2009

Why not Nationalize?

The New York Times discusses nationalization.  There is one good reason NOT to do it overtly -- namely the fact that you now "own" the problems in an entirely different way.
Moreover, Mr. Obama’s advisers say they are acutely aware that if the government is perceived as running the banks, the administration would come under enormous political pressure to halt foreclosures or lend money to ailing projects in cities or states with powerful constituencies, which could imperil the effort to steer the banks away from the cliff.

“The nightmare scenarios are endless,” one of the administration’s senior officials said.
Indeed.  One advantage of simply bailing out the banks is that they are still available as whipping boys.  Once you own them, you own all of their problems.  And they need to be merged, downsized, etc.  Once you own them and are committed to "creating jobs" -- how do you explain firing thousands of bank workers.  

The same dynamic is in play with the auto companies.  The absolute last thing the government wants is a jobs program that involves something like building and selling cars.  The Japanese can no longer do it profitably (for now).  Any direct government jobs programs need to be more like the WPA programs.  If the newspapers keep collapsing, a writer's project could be appropriate.  Pay bloggers.  For example.

Friday, January 23, 2009

Felix Salmon Defends Credit Default Swaps

After giving Michael Lewis a well deserved thrashing regarding the market for credit default swaps, Felix Salmon then provides a justification for this market:
And yes, there is "a really useful reason for a credit default swap" -- it's pretty much the same as the really useful reason for the existence of equity markets. In the stock market, there are lots of sellers, and lots of buyers, and the public visibility of the market-clearing price creates a lot of value. The bond market, by contrast, has always been much more illiquid: bond investors tend to be buy-and-hold types (remember those pension funds and insurance companies) who buy up bonds at issue and then hold them to maturity. As a result, it can be very hard to short any given bond, or to get a useful bead on exactly what the market-clearing price on any given company's debt might be. Unless you have a liquid CDS market, which is very useful indeed when it comes to price discovery.
The primary purpose of the equity markets is price discovery?  I always thought the primary purpose was to raise capital.  Or perhaps not only to raise new capital, but to reallocate capital through repurchases and acquisitions.  

Even though it is a rather backwards justification of the social benefits of the equity markets, it seems irrefutable that the primary purpose of the bond markets is to assist corporations and governments to finance their activities.  The fact that bonds get a credit rating -- which might be useful for something other then buying and selling the bonds per se -- is simply fortuitous, if in fact it is a benefit at all.

The primary purpose of the bond markets is NOT price discovery!

Another example of a benefit is this:
there were the long-term investors -- pension funds [for example] who would sell five-year credit protection with every intention of simply insuring that credit for the full five years, and pocketing the insurance premiums. Those players can't be considered to be speculators...
They certainly weren't supposed to be speculators!  However, lets examine a hypothetical transaction.  A pension fund decided that they couldn't just buy bonds and stocks -- they decided they HAD to emulate Yale and were sold a portable alpha strategy.  Your typical pension fund administrator should not be allowed within 500 feet of an investment banker, based on the same logic that applies to keeping children out of casinos.  Part of the a portable alpha strategy is a replicating portfolio.  The idea is to use derivatives of various types to replicate a benchmark using part of the cash and then use the remainder to buy some pure alpha from a hedge fund.  One type of derivative used are credit derivatives.

In theory, a treasury plus a CDS is equivalent to the underlying bond.  So you don't need to buy the real bond, you can buy as much exposure to the bond as you would like by buying a CDS.  The premium from the bond and the interest from the treasury would give you as much or more then the underlying bond -- even after fees and expenses.  Plus it isn't always easy to buy the exact bonds you might prefer in the real world.  You might not be able to find a sufficient quantity of the preferred real bond.  

It just so happens that some of the higher yielding bonds with investment grade credit ratings were financial entities like Lehman.  Which is why there were a lot of Lehman CDS's floating around.  A real bond pro would have understood that any outlier is more likely miss rated then miss priced.  Or at least could tell the difference.  But our naive pension fund buyers were loading up on the highest yield at any specific rating.  

However, more to the point, the purpose of the bond markets is to provide financing to real world entities -- businesses and governments, not to grease the wheels of structured finance.  And the idea that ALL the pension funds and endowments were going to do better then average by routing every dollar in cash through investment banks and their structured finance units is beyond naive.  After all, even though a lot of financial theory assumes a frictionless world of highly efficient markets, someone has to pay for all the trappings of investment banking.  

We haven't begun to see the damage these instruments have caused in pension funds and endowments, but we will soon enough.

As far as the liquidity argument is concerned, exactly how much liquidity has the CDS market provided during the credit freeze?  If this were such a liquidity enhancer, then what the hell happened?  

One thing that we do know is that people could attempt to short bonds via CDS's in quantities that exceeded the par value of the underlying issues by massive amounts.  As great as shorting is, perhaps the limitation of shorting no more then the entire amount of the underlying issue should be maintained.  

Perhaps some of the more adventurous pension funds might have tried to actively manage their the credit quality of their bond portfolio by selling these overpriced bonds rather than goofing around with portable alpha.

The flaw with the entire notion that derivatives provide much needed liquidity has been totally discredited by the failure of these markets.  Only the most ideologically predisposed theorists could argue with a straight face that, if only we had larger credit derivative markets, the credit markets would have continued to function smoothly.

In fact, we just experienced unprecedented MARKET FAILURE.

The thought that people insist on looking for some higher truth -- like price discovery -- in an environment where markets have massively failed is mind boggling.

Thursday, January 22, 2009

They are running out of places to put it .....

From the Oil and Gas Journal:
MARKET WATCH: Signs of supply cuts raise crude prices
Sam Fletcher
Senior Writer

HOUSTON, Jan. 22 -- The new front-month March contract for crude rallied above $43/bbl Jan. 21 on the New York market among hopeful signs that members of the Organization of Petroleum Exporting Countries are adhering to their pledge to reduce production by 4.2 million b/d from September output.

OPEC sources said Saudi Arabia plans to cut its production an additional 300,000 b/d below its current quota before the group's Mar. 15 meeting. "This shows that the Saudis believe it is imperative to match a lower demand with a lower supply," said analysts at Pritchard Capital Partners LLC, New Orleans.
I'm not sure that oil is going to continue to sink, but over the last year, markets have moved much more quickly then a real physical commodity can adjust.  

Tuesday, January 20, 2009

Overend, Gurney and Company

From Wikipedia:

After Samuel Gurney's retirement, the bank expanded its investment portfolio, and took on substantial investments in railways and other long term investments rather than holding short term cash reserves as was necessary for their role. It found itself with liabilities of around £4 million, and liquid assets of only £1 million. In an effort to recover its liquidity, the business was incorporated as a limited company in July 1865 and sold its £15 shares at a £9 premium, taking advantage of the buoyant market during the years of 1864-66. However, this period was followed by a rapid collapse in stock and bond prices, accompanied by a tightening of commercial credit. Railway stocks were particularly badly affected.[4]
Overend Gurney's monetary difficulties increased, and it requested assistance from the Bank of England, but this was refused. The bank suspended payments on 10 May 1866. Panic spread across London, Liverpool, Manchester, Norwich, Derby and Bristol the following day, with large crowds around Overend Gurney's head offices at 65 Lombard Street.[5] The failure of Overend Gurney was the most significant casualty of the credit crisis.[6] The bank went into liquidation in June 1866.[7] The financial crisis following the collapse saw the bank rate rise to 10 per cent for three months. More than 200 companies, including other banks, failed as a result.
The directors of the company were tried at the Old Bailey for fraud based on false statements in the prospectus for the 1865 offering of shares. However, the Lord Chief Justice Sir Alexander Cockburn said that they were guilty only of "grave error" rather than criminal behaviour, and the jury acquitted them. The advisor was found to be guilty. Although some of the Gurneys lost their fortunes in the bank's collapse, the Norwich cousins succeeded in insulating themselves from the bank's problems, and the Gurney bank escaped significant damage to its business and reputation.[7]

And Walter Bagot's comments:

The peculiarity in the case of Overend, Gurney and Co.—at least, one peculiarity—is that the evil was soon discovered. The richest partners had least concern in the management; and when they found that incredible losses were ruining them, they stopped the concern and turned it into a company. But they had done nothing; if at least they had only prevented farther losses, the firm might have been in existence and in the highest credit now. It was the publicity of their losses which ruined them. But if they had continued to be a private partnership they need not have disclosed those losses: they might have written them off quietly out of the immense profits they could have accumulated.

And  further:

No one in the rural districts (as I know by experience) would ever believe a word against them, say what you might. The catastrophe came because at the change the partners in the old private firm—the Gurney family especially—had guaranteed the new company against the previous losses: those losses turned out to be much greater than was expected. To pay what was necessary the 'Gurneys' had to sell their estates, and their visible ruin destroyed the credit of the concern.

Events/Lessons learned:
1.  Founder retired, and company took on more risk.
2.  Lost money and in order to raise capital, became a public company.
3.  Family provided guarantees on the debt.
4.  It did well at first as a public company.
5.  It then was under pressure and ask for help from the Bank of England.
6.  Help was refused.
7.  It collapsed.
8.  One contributing factor is that the guaranteer family was publicly bankrupt.
9.  200 additional companies also failed as a result of this.

Citi needs to Disappear

I'll start and end with the "money quote" and let the readers get this little history first hand.
"I assumed,'' Reed [Citibank chairman in 1992] said, ""when we're paying guys $1 million a year you assume they know what the fuck [they're] doing.''
Some things never change.  

Worse then the 30's and 80's?

The current headlines that our banking system is or will be insolvent and needs to be nationalized is gaining some currency.  Today, Roubini made that assertion and Sunday, Paul Krugman referred to the money center banks as insolvent.

In finance, solvency is the ability of an entity to pay its debts with available cash.
A traditional bank in a fractional reserve banking system funds loans of varying terms with demand deposits. Demand deposits are money in checking and savings accounts, and are effectively debt. They typically hold a small fraction of their total assets (loans) as capital. Since typically loans are for longer terms then the deposits, and since banks have limited capital, they can never pay ALL their debts at once with available cash.

So in this almost trivial and totally obvious sense, banks are never solvent.  The entire banking system is designed to manage this inherent mismatch between assets and liabilities.  It can get out of whack in several ways.  In the 1930's, general price deflation from 1929 to 1933 was between 30% and 40%.  The assets or loans of a bank were "upside down."  The collateral couldn't be sold for anything close to the stated value of the loans, for simple liquidity reasons, if nothing else.  About half the banks failed and half didn't.  Yet technically, they were all insolvent in more then the trivial sense that they couldn't pay their depositors in cash immediately.

In the 1980's things were also dire for banking for the exact opposite reason.  General price inflation rather then deflation.  According to William Issac, former head of the FDIC:
The underlying economic problems of the 1980s were more serious than the economic problems confronting us this time around – at least until very recently. The prime rate exceeded 21%, and the economy plunged into a deep recession in 1981-82, with the agricultural sector in a depression. These economic problems led to massive problems in the banking and thrift industries. The savings bank industry was more than $100 billion insolvent if we had valued it on a market basis, and the S&L industry was in similar condition. A bubble burst in the energy sector, and a rolling real estate recession hit one region after another. Continental Illinois (the eighth largest bank) failed, many of the large regional banks went down (including nine of the ten largest banks in Texas), and hundreds of farm banks failed, as did an even larger number of thrifts. Three thousand banks and thrifts failed from 1980 through 1991, and many others went out of business through mergers.
And there is more. Things could have been even worse:
It could have been much worse. The money center banks were loaded up with third world debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of our money center banks would have been insolvent. Indeed, we developed a contingency plan to nationalize them.
However, inflation was tamed, the banks were able to fund their loans at a profit due to falling interest rates, and we all know the history.  

The current situation is the exact reverse of the situation in the 1980's -- but a basic principle is that banks are designed to be "unbalanced."  One aspect of this is that they go from insolvency in the trivial sense to insolvency in a more tangible sense.  If they are sound enough to survive in less extreme circumstances -- then they need to "get to the other side" and it is in the interest of regulators and politicians to apply some judgment regarding how that is achieved.

Monday, January 19, 2009

Krugman Imitates Andrew Mellon

In today's column, titled Wall Street Voodoo, Paul Krugman adopts at least part of Andrew Mellon's mantra,  "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," he said. "People will work harder, live more moral lives."

Krugman wants to liquidate the large banks.  He starts by creating an example of a hypothetical money center bank:
To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.
So far so good. Not much different then my hypothetical bank balance sheet in a prior postwhere I tried to explain why it is meaningless to say that a bank is "technically insolvent" based on hypothetical mark to market accounting.

It is a little over simplified, since Gotham's toxic assets probably had a par value of $600 billion, had already been written down by $200 billion, and very likely couldn't be sold for $200 billion, since no one that would be likely to buy them wants to own more of them.  Krugman's critical assumption is that the current "market value" with poorly functioning credit markets and zero interest in complex asset backed securities is the best estimate of their economic value.  Krugman continues:
So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.
I would contend that Gotham isn't a typical zombie bank or institution. Anyone that remembers the true Zombie S&L's knows that they tend to double and triple down on their bets because they have nothing to lose. However, right now people are accusing the so called Zombie -- Gotham -- of refusing to loan out any of the TARP funds. Not the behavior of your typical zombie.
Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future.
Here Krugman agrees that we can't just let the financial system blow up. He is saying that Lehman was a mistake but maybe not with Gotham, which is much larger.
A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.
Not quite so fast -- this misses some critical details regarding what actually happened. First, the government already owned the failed banks, since they insured deposits through the FDIC and FSLIC. They then easily sold the performing loans and took the non performing loans -- see through office buildings were popular at the time -- put them in the RTC, and liquidated them. In the process they liquidated Texas. William Seidman sold it all, as quickly as possible, and drove the prices through the floor. A lot of people still remember and don't have particularly fond memories of this period. But this was only Texas, which at the time wasn't considered too big to fail. Perhaps most importantly, the liquidated assets were empty buildings and becoming less valuable by the day. This is fundamentally different then an asset backed security which is just a piece of paper. Unless you make the argument that the asset backed security, per se, is significantly impacting the value of the underlying assets, there is no inherent benefit of liquidating the paper as opposed to holding the paper. At this point Krugman backtracks and concedes the possible weaknesses in his arguments:
In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?
Good questions. However, I think it is obvious that these toxic assets simply have to be held to maturity to see what they are worth. Liquidating them serves no purpose other then to drive down all asset prices. Whatever their theoretical market value is today, dumping a lot of them will make it lower. You simply can't liquidate your way out of this without producing a full blown financial panic, which Krugman recognizes.

The government already has trillions of dollars of assets on its balance sheet.  Most of these are good money at current price levels and there are reasonable prices that could be paid for the "toxic" asset backed paper -- once again, assuming that today's price levels are reasonable and there isn't significant general price deflation.  

So Krugman wants to liquidate Gotham.  Fine.

But it is one thing to liquidate Texas and another to liquidate the entire US -- including not just bankers but labor, stocks, all real estate.  I don't think the US is ready for the full Andrew Mellon treatment.  It was tried once and people still remember well enough not to want to try it again.

Exactly What is a "Toxic Asset"

Let's start with what a toxic asset ISN'T.  It isn't a simple bad asset -- one with no value and no prospects.  A bad asset is one that generates no cash, has no resale value, and no prospects.  It is worth zero.  A stock in a bankrupt company for example, is worthless, not toxic.

Rather, a toxic asset has the following qualities.  It is impaired in some fashion.  It is worth less then par.  In addition, it is difficult to tell what it is worth.  It's value is significantly greater then zero, but covers a wide range of values with a great deal of uncertainty.  Like an asset that is worth between 20% and 70% of par.  

Also, you need to own enough of them that you can't simply write them to zero or sell them for their lowest possible value or whatever a liquidation would produce.  

In order to get a reasonable approximation of ultimate value of a toxic asset, you need to hold it to maturity and just see how much cash it generates.

However, you can't afford to hold it to maturity, since the uncertainty is sufficient to ruin your business.

So ......

You can't sell it because there isn't a liquid market for it.

You can't keep it since it is undermining the credibility of your balance sheet.

You can't write it to zero since you would be broke.

If you had enough time, you might be fine, but you don't have enough time.

That is a toxic asset.  You can't afford to keep it and you can't afford to sell it.  Since keeping it is the "default" you keep it until it kills you.  Thats toxic.

The real "crime" of our new toxic assets was their very creation.  Once they were created, they became a management problem.

Sunday, January 18, 2009

This Stock Tip Needs More 'Splainin

This might be a little unfair, since Barron's Rountable is caveat emptor and no one should expect a full blown analysis for the $5 cover price.  

However, Archie MacAllaster, who had a rather dismal year, recycled one of his 2008 picks - Hartford Insurance Group - HIG.  Archie didn't mention that it was a 2008 pick [but Barrons, to its credit, did show a table of all the 08 picks with their predictably awful results].   
Next, Hartford Financial Services . It was trading for 17.09 Friday [Jan. 2] [And 13.90 Jan 18th] . The range has been 85.11 to 4.16. How about that?  [How about the fact that he recommended it at $82.95?] The yield is a little under 8%. Book value is $41 a share. Earnings in 2007 were $8.25 a share.
Fair enough -- if it was a buy @ $82, its a steal at $14, no? Here is the main problem - his next sentence.
Recently Hartford raised its 2008 earnings estimate to $4.70 to $4.90 from about $4.30 to $4.50. I think they'll make better than $5 and maybe $6 a share in 2009.
True -- Hartford did confirm these earnings estimates. Here is a slide from their pitch:

Note the $.62 cents from a decrease in prior period P&C reserves.  Nothing inherently wrong with booking it, but the timing of a reserve release is to a large degree, arbitrary.

The problem with this picture, is that one might think that with rather robust earnings of close to $5/share that the Hartford would be able to maintain or strengthen its capital position.  It would be obvious, in fact.  But obviously wrong.

Here is the "money" slide from the HIG presentation:

HIG lost $11.6 billion in capital (pre tax) that isn't recognized in their earnings estimate.  The recognized portion - the $3.5 billion, is part of net earnings, but the $11.6 is shown as 'Other Comprehensive Income'.

It's a pretax number, but it is big.  And it is a reason that The Hartford is selling for 40% of book value.  

Archie makes a couple more comments:
The company has given itself all kinds of flexibility.
How so?
MacAllaster: They raised a couple of billion dollars in Europe. They bought a savings bank in Florida. They got some money from the TARP. They won't have any financing problems. Hartford will be 200 years old in 2010. It has $350 billion of assets, and in five or 10 years will have a much bigger net worth than today. Meanwhile, you're buying it around four times earnings.
They don't have all sorts of flexibility because they don't have that much capital to support what Archie refers to as $350 billion in assets.  

Fortunately, they have $311 billion in assets @ September, 2008 AND almost half of the assets are in separate accounts.  That leaves $12 billion in capital to support the other half of the assets.  The $12 billion includes whats referred to as DAC or deferred acquisition costs, which are prepaid expenses.  It also includes a tax asset, which will require profits to be useful.  Plus some goodwill.

That means they are a bit leveraged with the $12 billion supporting over $150 billion in assets.  The $12 billion includes the deferred tax asset and the prepaid expenses and goodwill, which pretty much account for all their capital.  

They don't have "all sorts of flexibility" but are rather are a little light on capital with a market that has turned against everyone but short sellers.  They should be getting the TARP money, but it isn't finalized yet.  And if it is, that fat 8% dividend may disappear as part of the deal.

The accounting for insurers tends to be inherently complex.  You have three sets of books (GAAP, Statutory, and Tax).  GAAP gives capital a haircut in the balance sheet but doesn't run it through income.   

I actually think HIG has a lot of merits as an investment.  However, anyone that naively thinks that a firm quoted as making a profit has not lost capital is missing critical fundamentals.  

A straight tip is fine, but throwing in the "earnings" without more explanation and referring to a capital stressed firm as "having all sorts of flexibility" is a bit much.  

What you get with Hartford is a heavily leveraged bet on the financial markets.  If they stabilize and prices increase, it will be a huge winner.  If we see more deep declines in asset prices, HIG has big capital issues. 

Something intelligent about TARP

From Michael Santoli in Barrons:

FOR MOST OF LAST WEEK, BEFORE CONGRESS signaled it would release the second $350 billion in financial relief money without a steep political ransom, most every microphone in Washington served as an invitation to some Representative from Gerrymandera to bluster and posture. Before new "TARP" money flowed, he or she would insist, banks would need to detail precisely how the earlier batch of funds had been used for the public benefit.
This might sound like a stringent and onerous demand. But such an explanation, for the largest TARP beneficiaries, could be summed up in a two-sentence letter to the House Financial Services Committee: "Dear Mr. Chairman: Our bank used the TARP funds to continue its existence. Oh, and capital is money, and money is fungible, so therefore every loan we've made and every credit line we've rolled over since the fall has in part been a use of TARP funds."
Finally someone else notes the painfully obvious point regarding the inherent impossibility of tracking specific use of TARP funds, as I posted much less succintly last week.

TARP plugged large holes in the banks' capital bases. The credit mess, as noted here repeatedly, is not a crisis of confidence, but a crisis of capital, complicated by a collapse in collateral values. Honest observers can argue about whether TARP made sense or not, or whether the firms it kept afloat would be better off sunk. But the "They're not lending the taxpayers' money freely enough" mantra is misguided.
It's obvious that a bank isn't going to say that they are desperate for additional capital unless under utmost pressure. The rumor that Jamie Diamon was furious about having to take TARP money strikes me as absurd. Although it makes total sense to SAY that you don't need it, want it, and are furious that they made you take it.
Banks and thrifts have continued to lend plenty. Robert Albertson, chief strategist at boutique investment bank Sandler O'Neill + Partners, detailed in a recent report that banks have persisted in increasing loan volumes.
"Bank lending historically and appropriately contracts during a recession," Albertson writes. "The odd and untold truth is that bank loans have actually been expanding in this one."
I haven't heard a lot of credible claims that solid credit risks can't get loans on good terms. In fact, I am hearing the opposite. That stronger credits are having money pushed at them at favorable rates. Banks certainly have the liquidity to lend. My local branch "tightened standards" and stopped doing HELOCs on second homes for example. But they have said that they have been getting lots of deposits as people have moved money from MM funds to local banks. That people with FICO's in the 600's are having trouble getting new car loans may be a problem, but I'm not really sure if people with less then strong credit scores SHOULD be buying new cars on credit. But that's just a personal prejudice.
While politicians and cable-news shouters whine about "timid banks" sitting on taxpayer cash, they neglect the larger reality that scarce credit has much more to do with the near-disappearance of the non-bank, securitization-enabled "shadow banking" market. This accounts for a couple of trillion dollars in reduced lending capacity, and it won't return soon. The de-leveraging process is ongoing, and is irrevocable -- even by one-party control of Washington riding an impressive President-elect's ascension.
And once again, the money quote. The meta picture is that there is forced deleveraging of the hedge funds, etc. Assets have to be sold, and to prevent a meltdown, when someone reduces leverage, someone else needs to lever up. In this case, it is the Treasury and to some extent, the legacy banking system. They can't replace it one for one, but to the extent they are buying or lending on assets at realistic or even bargain prices, they should do fine. As long as we avoid a total meltdown. But more importantly, facilitating a more orderly unwind of leverage is the only alternative to rapid and potentially catastrophic financial panic.

I would love to have the luxury of letting C or BAC just fail and see what happens, IF it would be possible to have a "do over" without cost.  The problem with a panic is that reasonably strong firms get dragged down with the less solvent.  An orderly process with adequate liquidity for those that need it and can demonstrate solvency and sufficient time for reasonably strong firms to straighten up their balance sheets is sensible.  Anyone that thinks that a panic is a great idea to cleanse the system, ala Andrew Mellon, is simply being reckless or talking their book.

Banks Technically Insolvent?

Analysts working for RBS, one of several British banks to have received emergency funding from the UK Government last year, told the City that "the domestic UK banks are technically insolvent on a fully marked-to-market basis".

The warning does not mean British banks are about to go bust, because the assessment is purely theoretical, and RBS said the position was "not unusual at this stage in the economic cycle".
Exactly what does this mean? If insolvency on a theoretical "mark to market" basis isn't UNUSUAL, then perhaps that theoretical metric isn't useful.

With fractional reserve banking and a reserve to asset ratio of 10%, then once the theoretical M2M of the assets would wipe out capital. Since all assets except treasuries have taken significant haircuts, then how could they not be "technically insolvent" on a theoretical basis?

Look at a simplified, hypothetical balance sheet:

Assets:                                            Liabilities:
Loans   10,000                              Deposits: 9,000
                                                        Capital:     1,000
               ______                                   ______
Total    10,000 10,000

Any asset impairment over about 5% puts this balance sheet under stress. Capital ratios to assets would go from 10% to 5% or less.

But lets assume that people think that the impairment is temporary, the deposits are guaranteed, and the interest rates paid on the demand deposits has declined along with short term rates to, say 4%. Let's also say the loans were made at an interest rate of 7%. Lets also assume that 5% of the loans are delinquent. Finally, assume that various fee income offsets the expenses and the only income items are the interest income and costs. In this case, the interest income is 665 and the interest expense is 400 and the net income is 265 before any provisions for loan losses.

Now, give the 5% delinquency rate, lets assume that we write off all 5% with an expected recovery rate of 50%. that would give us a loan loss provision of 250, making the income net of loan loss provisions 15. Or break even.

This could go on for say 3 years and the bank capital would remain flat as the net interest margin offsets the loan losses.

If you tried to sell the loans in a secondary market under stressed conditions, there is no way that you could get close to the 10,000. If the loan loss provision is supportable, under current US GAAP accounting, the bank ISNT INSOLVENT.

The theoretical balance sheet and discussion of income, etc. may be incomprehensible to people that aren't familiar with basic bookkeeping and hopelessly simplified for those that do. However, it is designed to show the impact of leverage on a typical bank and how they are inherently vulnerable to a "run on the bank" without some sort of liquidity backstop, since the (demand) deposits could be all withdrawn more quickly then the loans could be liquidated.

Remember in the US in the Great Depression years of 1929-1933 price levels fell between 30 and 40%. Roughly half the banks failed and half of them didn't. However, ALL OF THEM would have been technically insolvent if they had capital ratios of less then 40%.

So, if every single US bank was "technically insolvent" on a theoretical mark to market basis during the Depression, then should all of them have failed? I think more then enough of them actually did fail. If we demand accounting standards that would have forced every US bank during the depression into insolvency, then I would say that the standards are fundamentally flawed.

Maybe people need to go back and rethink why they believe accounting rules designed for derivatives traders are superior to traditional rules that allowed the strongest banks to survive the US depression of the 1930's.

Friday, January 16, 2009

More Irving Fisher

Anyone that doesn't think that the Fed simply messed up during the GD (the first Great Depression in the 1930's) as well as the executive branch (lack of fiscal stimulus) should check out the Stamp Scrip writings by Fisher.  The idea is that with a shortage of money, scrip would be issued in the denomination of $1, and in order to use it, it had to have a 2 cent stamp affixed every week.  At the end of the year, the group issuing the scrip and selling the stamps would redeem the scrip for $1, funded with the proceeds of the stamps.  The weekly stamp feature acted as a "tax" on hoarding and the velocity of the script was kept relatively high.

This can only work in a situation where there is significant excess capacity.

Fisher tells a joke that illustrates the concept in an interesting fashion:
A travelling salesman stopped at a hotel and handed the clerk a hundred dollar bill to be put in the safe, saying he would call for it in twenty-four hours. The clerk, whose name was A, owed $100 to B and clandestinely he used this bill for the liquidation of his debt, thinking that before the expiration of 24 hours he could collect $100 from his own debtor, whose name was Z. So this 100 dollar bill went to B, who, greatly surprised, used it to pay his own 100 dollar debt to one C, who (equally surprised) . . . and so on, and so on, all the way down to Z, who, with much pleasure, returned the bill to A, the clerk, who, in the morning, restored it to the salesman. And then did A, the clerk, stand petrified with horror to see the salesman light a cigar with it.
"Counterfeit," said the salesman, "a fake gift from a crazy friend, Abner; but he didn't put it over, did he?"

Thursday, January 15, 2009

Man Bites Dog

This actually qualifies as, for lack of a better cliche, a black swan.

Found on the internet....

From the archives

Commercial History and Review of 1930
The Economist Feb 14, 1931

United States

"Continuous but orderly deflation in security prices, commodity prices, credit outstanding and in the manufacture, distribution and sale of goods has been characteristic of the past year...Perhaps the most upsetting influence was the severe decline in prices of wheat and cotton both of which fell to the lowest level since 1915, and the reduced output and low prices of corn, tobacco and other farm products...Steel ingot production, according to the AISII was 39.6m tons, the smallest since 1924 and a drop of 27% from 1929...Motor production was estimated by the Department of Commerce at 2.5m vehicles, 38% under 19229 level. Railway freight car loadings were reported by the ARA at 45.8m, a reduction of 13.1% from 1929...Credit deflation and the decline in interest rates and loss of deposits made the year a rather indifferent one for the commercial banks...Federal Reserve Bank policy was one of consistently cheap money. The decline in the New York discount rate began in the autumn of 1929 and for reductions brought the rate down from 4 to 2 percent, the lowest in the history of the Reserve system."

Wednesday, January 14, 2009

Deflationary Spirals

Per Irving Fisher in The Debt-Deflation Theory of Great Depressions.

The central idea is that debt liquidation causes deflation which then increases real debt.

The more debtor's pay, the more they owe. He calculates that the debt was paid down by 20%, but in "real" dollars, increased by 40%.

Similar to the well known paradox of thrift, this assertion hangs on a strong, fixed relationship between asset prices and overall price levels.

We have seen a bit of this cyclical behavior already.  Some of it is part of any market cycle, but the parts of most interest are where he notes that the money interest on safe loans falls and the money interest on unsafe loans rises.  In other words, interest rate spreads increase.

Also of note is that relatively early on, commodity prices fall.  

Another interesting point is that he believed that the Fed had a number of opportunities to reflate and didn't take them.  He didn't seem to think that it would have been difficult, rather it simply wasn't tried before things got out of hand.  

His recognition that you don't get debt levels down by liquidation under extreme circumstances is astute.  

I suppose the part I find least convincing is the idea that high debt levels, per se, cause deflation.  However, once a spiral starts, high debt levels make it much worse -- of that there is little doubt.  

Tuesday, January 13, 2009

The WSJ Interviews David Swensen

The Wall Street Journal interviews David Swensen, the influential portfolio manager for the Yale endowment.  Swensen is pitching a revised copy of his book, Pioneering Portfolio Management.
WSJ: Does the poor performance of most assets last year suggest you need to tinker with the endowment's portfolio to better withstand another year like 2008?

Mr. Swensen: I don't think it makes sense for an institutional investor with as long an investment horizon as Yale's to structure a portfolio to perform well in a period of financial crisis. That would require moving away from equity-oriented investments that have served institutions with long time horizons well.
He's a smart guy, with good ideas.  An endowment like Yale has unique and different objectives then most investors.  Everyone says they are in it for the long term, but an endowment is in a different category then individuals or most institutions.  

Yale has some huge advantages.  It's big enough to afford the best resources.  Yet it is "only" $30 billion or so.  The reason I use the word "only" is that it is roughly 1/10 the size of CALPERS  and there are real limits of scale when dealing with a lot of alternative assets.  Just how much money can be put to work in Timber, for example?  Not much.  Real estate doesn't seem t me to be an asset class per se.  It's easy to say now, but it isn't "exposure" to real estate that one should be looking for.  Rather it is exposure to a real estate strategy that offers more then just loading up on a commodity.

Based on my earlier post and the endowment interested in total return, time diversification is not, in and of itself, an advantage.  This would argue for the type of diversification sought by Swensen.

However, this year the winning alternatives all fell apart in the fall and it suddenly seemed a lot less smart.  Emerging markets, betting against the dollar, commodities, etc.  

If there really is "excess alpha" out there, Yale is going to be at the front of the line.  I'm not sure it exists -- but if it does exist, there isn't a lot of it

I haven't read the book, but the idea of pension funds trying to square the circle by letting investment firms sell them a canned version of Yale's strategy is obviously a fundamentally bad idea.  

Monday, January 12, 2009

Money on the sidelines?

As long as we are talking fallacies -- from John Hussman:
Balances in money market funds are also not “cash on the sidelines.” Securities are simply evidence that money has been intermediated from a saver to a borrower. Once the security is issued, it exists until it matures or is otherwise retired. If I have $1000 “on the sidelines” in Treasury bills, it represents money that has already been spent by the Federal government. If I sell this T-bill to buy stocks, somebody else has to buy it, and there will be exactly the same amount of money “on the sidelines” after I buy my stocks than before I bought them. It is simply a fallacy of non-equilibrium thinking to imagine that money “goes into” or “comes out of” secondary markets in securities.
So maybe we aren't in equilibrium. I think it is possible to say that people or groups that traditionally have x% of their assets in stocks have X% minus something in stocks and a higher then typical allocation to cash. It is also very likely that this ratio could be effected by the fact that stock prices have dropped. Another tautology.

I think part of the problem is that we are thinking of cash as both an asset class and as a medium of exchange.  People have also bid up the price of Treasuries and when or if they decide to move on to another asset class, another asset bubble will deflate.  At which point some of it will simply evaporate.  

Sunday, January 11, 2009

A Break from all this financial chatter

Seems like Mickey Rourke is making his big/last comeback with the Wrestler. I don't really want to see Rourke this way. I prefer to remember his absolutely brilliant performance in the minor role of Teddy, an arsonist, in Lawrence Kasden's Body Heat. Courtesy of youtube, here is the section -- especially from the 1 minute to 2:30 section.

I found the first minute of Bob Seager Music not too great, but Rourke is utterly convincing.

As far as a tie to the financial theme of the blog, his "fifty ways things can XXXX up, and if you can think of twenty five, your a genius. And you ain't no genius."

Caution -- R rated/language.

Modest Proposal

Given all the whining that we are hearing about the Treasury not getting enough for their TARP money, I have a modest proposal.

Some creative new credit derivatives based on the Treasury positions purchased using bailout money. For example, Maiden Lane III.

Everyone has some exposure to the US Treasury and FRBNY, and should be able to hedge via credit defaults and the Maiden Lane SIV's would be good underlying. The press is uniformly negative about their prospects, which should provide nice premiums to sellers of the swaps.

Even though it is true that you can buy swaps on US Sovereign debt, the additional utility of being able to hedge more specific bailout programs could come in handy for their various counter parties. Like the next round of financial entities that may need a helping hand.

I would personally go long on the Maiden Lane III swaps.

And then there is the secondary benefit of assisting the Treasury in their marks. We are all in favor of price discovery and credit derivatives are highly effective, no?

OK.... Maybe I would settle for a proposition bet on Intrade.

Saturday, January 10, 2009

Second Guessing TARP

There's a lot not to like about TARP, but there is even less to like in this critique by Bloomsberg
Jan. 10 (Bloomberg) -- Henry Paulson’s bank bailouts, done under “great stress” during the worst financial crisis since the Great Depression, failed to win for U.S. taxpayers what Warren Buffett received for his shareholders by investing in Goldman Sachs Group Inc.
I wasn't aware that the Treasury had the same objectives as Berkshire. Among other things, after finding out that tough love didn't work too well with some of the earlier interventions, the Treasury decided to go easy. Unlike the UK, they are no longer trying to extract a pound of flesh and want to inject capital on relatively favorable terms. They still have a net interest margin of a couple percent, so the easier they make it for the firms to survive, the better their chance of getting their money back at a profit. Note that some of the largest TARP recipients have been able to raise private capital AFTER the TARP injection.  Getting private investment after bailout money puts the Treasury in an even more favorable position. 

The money quote is this from Nobel Prize winning economist Joseph Steglitz:
“If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired,” he said
Yes, but the Treasury isn't Goldman. The TARP isn't a profit center, its an effort to stabilize the financial system. Plus, the Treasury gets a little kicker that Steglitz either forgot or conveniently omitted. Namely that the Treasury has a perpetual 1/3 interest in every dollar Goldman earns in the future. Why doesn't someone ask Buffett if he would like to swap out their total respective positions. Buffett's yield and options for the Treasury's yield, options, and future taxes. I think Buffett wouldn't need an hour to agree to this deal -- you would just hear the word, "yes."

Why is Warren Buffett a Cheapskate?

Warren Buffett was notorious for frugality in his younger years.  He has mellowed a bit, but the various stories always make him seem eccentric at best and if one were less charitable, just plain goofy.

One explanation, from the book, Snowball, is:
 ...a small sum could turn into a fortune.  He could picture the numbers as vividly as the way a snowball grew when he rolled it across the lawn.  Warren began to think of time in a different way.  Compounding married the present to the future.  If a dollar today was going to be worth ten some years from now, then in his mind the two were the same.
Most people don't think this way. Everyone knows that when you are young, you can afford to take risks, and as you grow closer to retirement, you need to invest more conservatively. You are effectively diversifying over time. This is one case where what everyone knows is simply wrong.

John Norsted, a paleo blogger, has discussed this at length on his website.  Per Norsted, 
If there is one thing I would like people to learn from this paper, it is to disabuse them of the popular notion that stock investing over long periods of time is safe because good and bad returns will somehow "even out over time." Not only is this common opinion false, it is dangerous. There is real risk in stock investing, even over long time horizons. This risk is not necessarily bad, because it is accompanied by the potential for great rewards, but we cannot and should not ignore the risk.
Norsted continues:
While the basic argument that the standard deviations of the annualized returns decrease as the time horizon increases is true, it is also misleading, and it fatally misses the point, because for an investor concerned with the value of his portfolio at the end of a period of time, it is the total return that matters, not the annualized return. Because of the effects of compounding, the standard deviation of the total return actually increases with time horizon. Thus, if we use the traditional measure of uncertainty as the standard deviation of return over the time period in question, uncertainty increases with time.
I'll try to make this a bit simpler. An individual typically wants to compound her (his) savings over her (his) working life, and end up with a terminal amount at retirement that is the right number to fund her (his) lifestyle.  We care about the final number.  In a simplistic example, if a person starts with a fixed sum at age 20 and makes no further contribution, the terminal amount will be the product of the annual returns over 45 years [times the initial investment].  With annual returns expressed as factors, like (1+r1) x (1+r2) x (1+r3) .... (1+r45).  r is the return and the number refers to the percentage return in that particular year.  Like (1.05) x (1.15) x (1.01) etc. High School algebra: AxB = BxA.  The order of the terms is totally irrelevant.  The return in year 1 is exactly as important as the return in year 45.  

Lets say the r's are selected from a uniform distribution of 2% to 8%.  Like drawing a slip of paper out of a hat with an equal number of 2%'s, 3%'s, etc.  The average annualized return could be just as easily be 2% as 8% after the first pick.  Draw a larger sample and the mean annual return will tend to get closer to 5%.  But normal people don't care about their annualized returns.  They care about their accumulated dollars.  The predictability of their terminal return decreases the longer the series.

In 1948, consider that Buffett could have debated if he wanted to spend an extra dollar on a meal.  If he ordered the T bone instead of a burger, that dollar, compounded at 20% over 60 years would amount to $56,000.  Even today, a Saudi Prince would balk at $56,000 to upgrade from a burger to a steak.  

After his early 20's, Buffett never held a job and never made more in salary then his living expenses.  So he really did take his small stake and simply run it up to a huge number.  Sort of. 

Real life is more complex, but the basic idea is that retirees spend dollars, not annualized returns.  Returns are multiplicative, so it doesn't matter how you order the good years and the bad years.  Losses in the early years are exactly as harmful as losses in later years.  

Norsted does a great job in the cited paper.  I am skipping over the nuances and complexity of how this would play out in more complex scenarios, but Norsted discusses them.  In addition, these findings are true using the currently maligned normal distribution.   Any adjustment for "fat tails" or "black swans" simply strengthen the argument.



Friday, January 9, 2009

What Happened to the TARP? Law Professor Wants Answers

This from the AP:
"These are powerfully important initiatives," said Harvard law professor Elizabeth Warren. "I'm very pleased that the incoming administration is focused on these issues."

She offered no specific advice on how to free up more credit. "It's going to take a variety of tools," she said. "They may have to move through multiple approaches."

The Congressional Oversight Panel she heads released a report Friday featuring questions about how banks are spending taxpayer money, how the money will combat the rising tide of home foreclosures and Treasury's overall strategy for the rescue.

But Treasury's Dec. 30 response "did not provide complete answers to several of the questions and failed to address a number of the questions at all," said the panel's second report.

The new document cited an Associated Press investigation that found none of the banks was willing to disclose what they were doing with hundreds of billions of dollars* distributed through direct injections of federal money.

"For Treasury to advance funds to these institutions without requiring more transparency further erodes the very confidence Treasury seeks to restore," it said.

Appearing Friday on ABC's "Good Morning America," Warren said that Treasury "didn't put any tracking mechanisms on it."
Like a bank that marks the serial number on bills to foil bank robbers? The treasury put in capital via preferred shares. I suppose banking is inherently confusing because they are in the business of "renting" money. A vanilla bank can also "rent money" from depositors. The idea is that the difference between what they pay to "rent money" [borrow] is less then what they charge to "rent money" [lend].

They also have capital which is measured in money.

It is obvious that some banks would have needed to raise outside capital at a higher cost then TARP money to acquire weaker banks, like the WFC acquisition of WB. In those cases, the weaker banks may well have had to call on the FDIC, so money would have been spent out of one pocket or another [the FDIC is "insurance" like Social Security is "insurance"]. Seems like not a bad outcome.

However, it would be interesting for a bank to look at all activity since they received TARP money and simply segregate those that appear to have the highest social benefit. They could then say that they used the Treasury TARP funds for those activities. Workout some loans -- that's TARP money. Lend to small businesses -- That's TARP money. Etc.

At this point, someone in the press might wonder how one could demonstrate that it was TARP funds that were used for a particular loan. The bank would then say that it's true because they say it's true.  The press asks a stupid question.  Something is inherently unmeasurable yet the press, Congress, and a Law Professor want it measured.  Perhaps it takes an equally stupid answer from a bank to move the discussion to something that makes at least a little sense.  I wouldn't want to be that bank -- I'd let someone else go first.

*Note that some banks, in fact, did say something: 
JPMorgan Chase, which got $25 billion, said it plans to lend $5 billion to non-profit and health care companies in the coming year.
Maybe they should have said they were going to lend all $25 billion to non-profit and health care companies as well as low income individuals, via credit cards [with interest at 20%+].

Wednesday, January 7, 2009

The Snowball: Warren Buffett and the Business of Life - Micro Review

Anyone with a serious interest in Warren Buffett will like this book. Alice Schroder has done an excellent job in "Snowball" and one can find a wealth of information on her facebook page, as well as links to mainstream reviews.

I am going to split my comments into a few sections, and focus on things that may not have been covered in a more typical, balanced book review.  

Reasons to read Snowball:

1.  His transformation from what we might refer to today as a "nerd" into the uber wealthy, popular business icon is fascinating and inspirational.  Thomas Edison, Henry Ford, Buffett, and Bill Gates have made this transformation.  It isn't just wealth and it isn't just starting out in technology or with technical expertise [in Buffett's case, security analysis].  It's also capturing the public's imagination and becoming larger then life.  Compared to the Gatsby fable, where wealth is created out of the ether by someone with personal beauty and charisma -- bootstrapping one's way to  success based on technical excellence and imagination is closer to the authentic American dream.  And more accessible, at least in fantasy, to numbers people with more brains then charm.

2.  Salomon Brothers.  An insider's view of the 1991 Treasury Bond scandal.  This section alone is worth the price of the book -- the near meltdown of the investment bank was eeriely prescient of the collapse of investment banking in 2008. The most interesting thing is that at the time,  the Fed and Treasury seem oblivious regarding the possibility of systemic risk that might have been caused by its failure.

3.  Perhaps it will discourage a few people from trying to casually beat the market averages.  Graham warned that an average result easier to achieve then most people imagine and even slightly superior results are strikingly more difficult. Buffett's idea of fun is spending hours devouring annual reports, 10k's, financial newspapers and publications.  Unless the idea of devouring the Bond Buyer Daily with coffee sounds energizing, think about indexing.

4.  It's exhaustive but not exhausting and well written.  Lots of detail, footnotes for those that are interested, and well edited.  I found one mistake (very minor).  I'm willing to defer to other reviewers opinions on this, but I found it "a good read."

5.  A person can learn a lot about running a business from Buffett.  People tend to be blinded by his capital allocation skills, but Buffett does a lot of things right that a "ham sandwich" could copy.  This is not the main focus of the book, but it is in there.  A hint -- think incentives.  But in a smarter way then just tossing out zillions in options to senior management.  Buffett has spend a significant part of his life figuring out how to use money as an incentive -- with his children, himself, family, and businesses.  Buffett is true expert at this, and the examples in the book are more informative then typical B school or psychological perspectives.  There was a lot of press about how the TARP plan should have been more like Buffett's investments in Goldman and GE.  This could be debated for hours, but for all the rhetoric about corporate perks and jets, the Senate should have just insisted on this stipulation:  Require senior management to refrain from selling any shares for 3 years and to hold at least 75% of their net worth in the firm.  The auto guys would have just turned around and re-boarded their private jets.  

6.  Alice Schroder is not only an MBA and a noted insurance security analyst, but:
Schroeder worked as a certified public accountant at Ernst & Young from 1980 to 1991. Until 1993 she was project manager with the Financial Accounting Standards Board.
She not only has a rock solid accounting background,  but she also worked at FASB! I would consider a person with that background an expert in not only the practice of accounting, but also the more theoretical nuances of the field.  Accounting is the place where real economic activity is translated into figures on balance sheets and income statements. Warren's world.

Whatever passion Buffett reveals regarding social and political issues, he is a zealot regarding issues like amortization of good will and expensing employee stock options.  So much of Buffett's life is wrapped up in the decades of financial deals that a biographer who could immediately pick up the financial underpinning of this activity has a tremendous advantage.  I don't remember a single line of technical jargon in the bok -- no debits, credits, or accruals. Rather, her descriptions of the economic form and substance of the deals are uniformly spot on. Buffett is a master at making arcane financial concepts sound like ordinary common sense in his annual shareholder letters. Yet I can't enumerate the number of occasions where I have seen people try to discuss those same subjects using a Buffett analogy and end up horribly off key. In Snowball, the descriptions have the feel of a Buffett explanation -- a sort of effortlessness that belies the underlying complexity. [pop quiz:  Is insurance float an asset or liability?  Hint:  Read the paragraph after the second balance sheet in a prior post.]

Sunday, January 4, 2009

Jan 5th Barrons - WTF

Cover Headline -- 'Are Treasury Bonds Safe'

Back Cover -- Full page ad -- ProShares Ultrashort Treasuries (PST and TBT).

I don't see anything wrong with this -- no conflict of interest other then those inherent in print journalism.

It's more of a Mega Market Call.  These babies are going through the roof Monday.  Watch the prices compared to the underlying net assets.  I've already commented on the ultras.