Another Example of Highly Confusing Fair Value Accounting
I have not been a fan of mark-to-market accounting for assets held to maturity. Marking those assets, without any credit impairment, simply introduces further confusion. Here is another example of weird results from the fair value accounting scheme that is mandated by FASB, the accounting body.
(source: Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math, By Bradley Keoun. June 2, 2008. Bloomberg.com)
I think what is happening makes sense if you believe in fair value accounting (I don't). All that is happening is that mark-to-market is being used on liabilities, just like they are used on assets.
I'm not an accountant but from my layperson perspective, what is happening is logical if you believe in the mark-to-market accounting scheme. If liabilities weren't marked to market while assets were, it would be far worse in my opinion. Instead of investors being consistently "misled" (as now), you would have ended up with one side of the balance sheet using fair values while the other side didn't. Investors would be left on their own regarding the meaning of the balance sheet in such a scenario. At least now you can assume that both sides of the balance sheet reflects market values.
In the end, all of this accomplishes nothing other than to confuse non-accountants (i.e. investors). Neither the unrealized gains on the liabilities nor the mark-to-market losses on the assets are real. What will matter is the actual economic losses and real credit impairment. What the accountants say is getting to be more and more meaningless from an investing point of view.
(source: Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math, By Bradley Keoun. June 2, 2008. Bloomberg.com)
Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.
I think what is happening makes sense if you believe in fair value accounting (I don't). All that is happening is that mark-to-market is being used on liabilities, just like they are used on assets.
Statement 159, formally known as the ``Fair Value Option for Financial Assets and Financial Liabilities,'' was issued in February 2007 by the Financial Accounting Standards Board, or FASB, which sets U.S. accounting rules. It was adopted by most large Wall Street firms in the first quarter of last year and becomes mandatory for all U.S. companies this year, although they have wide latitude in how to apply it, if at all.
The rule was enacted after lobbying by New York-based companies, led by Merrill, Morgan Stanley, Goldman Sachs Group Inc. and Citigroup, which wrote letters to FASB arguing that it wasn't fair to make them mark their assets to market value if they couldn't also mark their liabilities.
I'm not an accountant but from my layperson perspective, what is happening is logical if you believe in the mark-to-market accounting scheme. If liabilities weren't marked to market while assets were, it would be far worse in my opinion. Instead of investors being consistently "misled" (as now), you would have ended up with one side of the balance sheet using fair values while the other side didn't. Investors would be left on their own regarding the meaning of the balance sheet in such a scenario. At least now you can assume that both sides of the balance sheet reflects market values.
So far, most banks' writedowns are ``unrealized,'' meaning they've been unwilling or unable to liquidate distressed assets. If prices reversed, the banks would record mark-to-market profits.
The same is true for the liabilities. Companies can't ``realize'' the mark-to-market gains on their debt unless they buy it back at the discounted price. They're unlikely to do so, because the deterioration in creditworthiness means they'd have to replace the debt with higher-cost borrowings, Willens said.
In the end, all of this accomplishes nothing other than to confuse non-accountants (i.e. investors). Neither the unrealized gains on the liabilities nor the mark-to-market losses on the assets are real. What will matter is the actual economic losses and real credit impairment. What the accountants say is getting to be more and more meaningless from an investing point of view.
I agree that China still looks rather richly valued. Sure, lots of potential for growth but there is a lot of risk. Weak property rights, corruption and political instability could blow up in investor's faces. The market does not seem to account for the substantial downside potential.
ReplyDeleteFor a BRIC investment I would pick India or Brazil. Lots of potential for growth but more political stablility and better property rights. Still, I think they too are too expensive at the moment.
To continue the Ambac conversation I note that William Ackman (great bull and friend of the bond insurers) estimated " only" $2,8 billion in CES/HELOC losses for Ambac. To expect 4x as much wins a bearishness award. Also, with $16 billion CES/HELOC exposure to lose $10 billion fully 60% would have to default with no recovery assuming no subordination. Since AFAIK Ambac does noet insure equity tranches there will be subordination so defaults would have to be even higher. That 75% or so of these loans would default I find preposterous. Pawn shops have better repayment rates then that (and HELOC are " full recourse" too, so no walking away from them).
I am not very worried about a muni blowout or I wouldn't have bought the stock, but Ambac does have a lot of Californa muni exposure. With property taxes collapsing muni finances are sinking like a stone so a spectacular trainwreck can't be ruled out.
I don't think consumer / student / corporate loans will be much of a prolem as they have been structures to survive quite heavy losses and nothing suggests these assets will perform a lot worse then to be expected.
Last but not least, I have decided that I will run a rather concentrated portfolio. Without a team of analysts (unfortunately not able to retain them right now) it is impossible to thoroughly analyse a large number of stocks and buying without good analysis means relaying on luck or hunches. I might as well play the roulette wheel. In addition, my very first investing mistake (with 20/20 hindsight) was diversifying for diversity's sake. The high conviction buys did admirably, but the diversity plays were mediocre and a drag on performance. MAybe this helps with your decision on oncentrating or not.
Running a concentrated portfolio is very risky if you get something wrong (like me :( ). But if you know what you are doing that's the "best" way of investing.
ReplyDeleteI didn't know HELOCs were full recourse. I just read up on them and it seems better than I thought. There is still a high probability of taking big losses since they are subordinated to primary mortgages, but I guess the borrower can't walk way as easily from a HELOC. Thanks for educating me on that :)
you're welcome. And keep up the good work, you point me to some interesting articles.
ReplyDeleteI doubt the Ambac investment was a mistake, just early. But you're in good company, Martin Whitman of Third Avenue and Warburg Pincus were early on MBIA too.
Yeah, but Martin Whitman and Warburg Pincus have averaged down whereas I don't have enough money to do that (actually I can put some of my free money but that would give new meaning to the word concentrated portfolio ;) )
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