Friday, February 29, 2008

Gresham's Law of.... Credit Ratings?

Tuesday's Wall Street Journal lead editorial took on the cozy world of the credit rating agencies on the heels of Monday's reaffirmation of a AAA rating for MBIA and Ambac by S&P and Moody's.

Similarly, on CNBC earlier this week, co-anchor Joe Kernen queried guest host Jack Welch on whether MBIA truly has the financial stability of another AAA credit, GE.

It's worth noting that Jack didn't reply 'from the gut,' to use the title of one of his recent tomes. Instead, he punted and argued for 'getting past this problem' before cleaning up the bond insurers.

The Journal article asks,

"What happens when the feds license only a few companies to provide a service, and then require investors to buy that service?

For the answer, take a look at the mess in today's bond market, where investors have been hanging on whether the main government-appointed credit rating agencies -- Standard and Poor's and Moody's -- would downgrade bond insurers MBIA and Ambac. Equities rallied yesterday when the agencies maintained their AAA ratings.

By now no one should care what the rating agencies think, but the problem is that by law we have to care. Since 1975, the Securities and Exchange Commission has limited competition in the market for credit ratings by anointing only certain firms as "Nationally Recognized Statistical Rating Organizations" (NRSROs). A 2006 law has begun to lead to faster approvals of new entrants, but this follows decades of protection for the incumbent firms."

So there you have it. Our Federal government has done for rating agencies what they did for accountants- required their use, thus creating demand. Only, whereas there are a zillion small accounting firms which practice, there are just a handful of rating agencies.

Still, if you consider the former "Big 8," now down to something like the "Big 3 or 4 (?)," these are the only firms practically large enough to audit large US companies. And their statements no longer mean much on those 10Ks. Auditors long ago stopped avowing that the books they audit are actually correct or non-fraudulent. All they really say now is that their tests didn't find fraud. And, oh yes, they make some statement about following the very loose GAAP principles.

Similarly, rating agencies' ratings are now suspect. Like accountants, they like having customers, so they tend not to be too hard on them- at first. Even now, Ambac is allegedly as strong and as safe in which to invest as is GE.

The Journal goes on to note,

"The SEC went an entire decade, beginning in 1992, without allowing a single new competitor into the market. Thomson reports that in 2007 Moody's rated 95% of corporate bonds, while S&P rated 93%. (Corporate bonds usually carry at least two ratings, so offerings often feature ratings from both S&P and Moody's.) Fitch, at 37%, is the only other firm with significant market share.

Asset-Backed Alert reports a similar story for mortgage-backed and asset-backed issues, which represent pools of auto loans, credit-card receivables and the like. S&P rates 96% of these securities, Moody's 86%, and again Fitch -- also approved by the government -- is the only other significant player, with 58%.

Over time, federal and state laws and regulations have explicitly required NRSRO-rated securities to be held by money market funds, insurers and others. This in turn has created the impression that these ratings are something more than merely financial opinions, which are often less informed than opinions you can read in a newspaper. Every state and federal legislator eager to avoid a repetition of the subprime crisis should begin excising the term NRSRO from statutes and regulations.

With these added strictures about holding assets which have been rated, the agencies truly had a gravy train. By restricting competition by its vetting process, the Federal government has virtually assured an environment of cozy, less-than-meaningful ratings. Without competition to demonstrate who is the more accurate agency, they all rate more or less similarly, collecting fees from the companies who must purchase their ratings, or risk being frozen out of investment by those institutions which require ratings.

In light of the mess now confronting S&P, Moodys and Fitch, the Journal article concludes,

Not surprisingly, the rating agencies are coming up with their own ideas for "reform," none of which seem to include more competition. In its 27-point proposal, S&P suggests more training for its analysts, better review of analytical models, and better disclosure of a security's collateral -- all welcome changes, but remember that Moody's and S&P also suggested reforms after the Enron rating debacle.

S&P also proposes to limit conflicts of interest, by rotating lead analysts and creating a new risk oversight committee, as well as an Office of the Ombudsman. But every business has potential conflicts. In the newspaper industry, we sell ads to the same people we cover. The question is how firms manage these conflicts -- and whether the marketplace is allowed to discipline companies that fail investors."

I think this last point is the crux. There's a conflict of interest whenever a provider of a service is paid by a firm to issue an 'opinion' about that firm. It's simply difficult to believe that, over time, the agencies won't hand out favorable ratings to be sure of continued patronage by a firm.

By now, you'd think there's a sort of Gresham's Law operating in the ratings world. If Ambac and MBIA truly deserve a AAA rating, what does this say about the quality of the other AAA-rated firms issuing debt? Doesn't this debauch the value of every AAA-rated firm's and institution's debt now?

Thursday, February 28, 2008

Auction-Rate Securities Troubles & Liquidity

Last week I wrote this post based upon the Wall Street Journal article describing how two Lehman customers lost considerable value in their holdings which had been invested in auction-rate securities.

An anonymous reader commented,

"This market is experiencing a temporary liquidity crisis. The Maher's haven't lost a dime in these instruments and won't as long as they wait for the market to resolve itself. Even if it doesn't there are 3 ways for a resolution. A secondary market will be created, the debt will be called at par, or refinancing the debt. All of these solutions would enable the Maher's at getting their investments back without incurring a loss."

To which I replied,

"Technically, of course, you are correct in writing that the Maher's won't (lose a dime) as long as they wait for the market to resolve itself.

Just like, say, owning RCA or other equities in 1929?

Given sufficient time, the market could, and probably will, come back to where these securities are at least at par value.

Will a secondary market be created? Why? In whose interest is it to create and trade such an illiquid market? More likely, some hedge fund or private equity trading desk will scoop up the depressed-value bonds.

Can the debt be called at par? If so, why do you suppose this wasn't mentioned in the article? Or this morning on CNBC, when the various co-anchors and guests chortled at how the buyers were at the mercy of the issuers?

Refinancing? Yes, that was mentioned, which is a sort of call.

But the overall point still stands. Buyers evidently don't realize that exotic fixed income securities like this, without committed, guaranteed specialists who make markets, for a fee, always carry a risk that the market for them will simply cease to exist for periods of time.

And in those periods, investors will want some valuation.To that point, there's an interesting piece in today's Journal describing the various viewpoints about 'market value' pricing.

Still, the temporary liquidity crisis is a non-trivial risk, don't you think?"

Last Thursday's Wall Street Journal continued the theme, citing other brokerage customers who are being allowed to use their 'frozen' auction-rate assets as collateral for loans from their brokers.

Liquidity, indeed, is the point here.

According to the later Journal article, quite a few customers at various brokerage firms have been sold ARSs as 'cash equivalents.'


The anonymous commentator on my earlier post continued to bemoan the public's misunderstanding of, and lack of patience with ARSs, finally noting that now, with the spike in weekly reset rates, the instruments are no longer attractive to issuers.

To which I would respond, here, that (obviously) securities markets exist for those instruments which satisfy the needs of both borrowers and lenders, or sellers and buyers. When the normal behavior of a security is in a range outside which the expected behavior of the security by those who designed it, somebody typically loses interest (no pun intended)- either issuer or holder.

For ARSs, the lack of demand at recent auctions have caused what were thought to be occasional emergency measures to become ordinary. The truth is, in an environment that suddenly views most non-vanilla fixed income instruments as suspect and unacceptably risky, the market for these exotics has simply vanished.

Customers are being allowed to use the now-illiquid notes as collateral for loans, while issuers are hustling to call the notes in favor of issuing plain long term bonds.

As a final note, a contact of mine related being in a meeting of a brokerage firm's registered reps, in which it became apparent that many of them had no idea how the ARSs actually work. This is so typical of Wall Street retail brokerage. Brokers sell instruments they don't understand to customers who trust them and, thus, have no understanding of how the assets actually function in various market conditions, or what risks they bear.

When exotic fixed income instruments for which markets can simply vanish are sold as near-cash equivalents, nobody is well-served, and there's going to be pain all around.

Wednesday, February 27, 2008

On "Market Value" Valuation

The Wall Street Journal published an article last Wednesday involving the use of so-called 'market value' methods for asset valuation. In it, the authors wrote,

"Credit Suisse Group yesterday said it expects to take a $2.85 billion write-down of financial instruments affected by the credit crunch, which will result in a $1 billion drop in quarterly profit, just a week after telling investors it had largely escaped the worst of the financial crisis.

The quick about-faces highlight the problem that companies, even those that are supposed to be financial experts, are having with a seemingly straightforward question: How much is something worth?

The difficulty lies in part in the increasing use of so-called market values to determine prices for items that companies aren't necessarily selling. This has become especially tough since the debt crisis has caused large parts of markets to seize up, meaning there often aren't any prices to use as reference points.

Supporters of the market-value approach say it will help prevent the kind of long-term economic malaise that gripped Japan in the 1990s, when that country's banks sat on problem loans. But companies fear it is distorting returns and speeding the financial crisis, even as investors wonder if companies may be overestimating potential losses to establish cookie-jar reserves.

The debate over how best to figure values is more than just academic. Major financial firms have recognized more than $150 billion in losses, based mostly on the use of market values. At the same time, the Securities and Exchange Commission and federal prosecutors are investigating whether some firms may have applied different market values to the same securities, depending on whether they were held by the firm or its clients."

It's an old debate. On one hand, as the foregoing passage notes, market value provides a real sense of the current value at which one could buy, or sell, an asset. That should, theoretically, be good for investors or those who wish to understand the balance sheet of a firm. Ostensibly, using market values provides investors, counterparties, and other interested observers with a clearer picture of the current value of an enterprise.

However, the market value method is not without its detractors. Consider these passages from later in the Journal article,

"Even when used properly, market values can prove problematic, because in trying to reflect investors' perceptions, they can ignore the underlying economic reality, says Damon Silvers, associate general counsel for the AFL-CIO, which has long been critical of the increasing use of market values in accounting. "You have a portfolio of real-estate loans, and those loans are performing, but now you're making it look like you're losing money, when in fact you're not," he says.

Plus, the approach "treats all the assets of an ongoing enterprise as though they are constantly for sale, and that does not convey very good information about the profit of the business, because they're not actually for sale," Mr. Silvers adds.

The debate about the appropriateness of the market-value approach aside, using market values holds another challenge for investors. It requires them to think differently about debt instruments and loans, viewing them like stocks whose value can swing from day to day or quarter to quarter."

These are very valid points.

Why should a firm be forced to keep its balance sheet on a 'breakup' valuation basis? If the firm doesn't plan to sell itself or liquidate, why must every scrap of every asset be current-valued?

What about industry sectors in which substantial investment is required in assets whose value will grow with time, such as cable, mining, or technology? Or commercial banks which legitimately desire to be portfolio lenders to the housing sector, and, thus, are not affected by performing loans whose values are temporarily depressed due to market or credit conditions?

It's one thing to force market valuations on assets which are purposefully traded frequently, such as bond or equity funds. But forcing firms which own significant amounts of assets that are not intended to be liquid seems silly, especially if the 'market' for those assets temporarily dissolves, creating an apparent value of zero.

FASB spent years mulling over inflation accounting in the 1970s and '80s. Would it be asking too much to ask them to consider this issue now?

Tuesday, February 26, 2008

Andy Kessler On 'Net Neutrality' & Ed Markey's Bill

Yesterday's Wall Street Journal featured an excellent editorial by Andy Kessler, an occasional contributor, entitled "Internet Wrecking Ball." In contrast to his last Journal piece, with which I mostly disagreed with, in this post last month, this time Kessler provides good evidence and insight to support his contention that Ed Markey, in combination with a few existing internet titans, are conspiring to give us all second-rate internet capabilities for a long time to come.

Kessler begins his explanation of the issue thusly,

"The Federal Communications Commission is holding a public hearing today at Harvard Law School in Cambridge, Mass., to build the case for the ill-conceived idea of preventing, as Mr. Markey's bill would, network operators from using technologies that may favor one application over another.

It's a bad idea because the only thing Mr. Markey's bill will preserve is mediocrity via the lack of competition, and full employment for regulators micromanaging a business whose very innovation comes from the lack of rules. With net neutrality, there will be no new competition and no incentives for build outs. Bandwidth speeds will stagnate, and new services will wither from bandwidth starvation.

The idea of network neutrality is that all of our Internet packets are equal, and that the spirit of the Internet and its ability to create wonderful new applications like Google, MySpace and Facebook is predicated on open (albeit limited) access for all. Yet, despite an overabundance of bandwidth pulsing throughout the U.S., we are still stuck with rationing to our homes. Haven't we learned that advancing technology is never served by arbitrary rules to divvy up scarce resources? Look at the dearth of good cell phone applications: Rules make incumbents lazy."

Kessler makes a very important point about the pace of technology in this sector. In a classically Schumpeterian manner, yesterday's 'winners' are hoping to codify their victory, thus slowing change to a crawl, if it is allowed to occur at all.

How did this happen to what should be a sector experiencing breakneck competition and improvement in service, capacity, and consumer value? Kessler writes,

"In plain English: Comcast is this country's second largest Internet provider and has been plagued by mostly illegal copyrighted video file sharing that is chewing up half or more of its precious bandwidth. More of that than you'd think consists of "Family Guy" episodes. Comcast, whose growth is slowing and whose stock is down 30%, is acting scared of the day when video is delivered one episode at a time instead of via Basic Cable, threatening its bread and butter.

So Comcast took matters into its own hands and applied a sneaky technical fix, a fake message that severely slowed these peer-to-peer video downloads. By the way, this same technique is used by the so-called Great Firewall of China to censor search requests like "Falun" or "Tiananmen." Nice company.

So that's it, isn't it? Comcast's franchise is threatened so it got out the bag of dirty tricks. Google, who you would think has a huge incentive to kill the video star, supports net neutrality. Google has become an incumbent, protecting its no-longer-modern textual ads."

As I wrote in this post last April, and Kessler now reinforces, Comcast is rightly worried about video programming disintermediation which will render its cable television product offerings nearly worthless much sooner than it had ever imagined. Even Google is sufficiently entrenched in the current technological environment to wish for its continued stagnation. When you're the largest guy on the block, and can intimidate everybody else, you don't mind if inward movement to the neighborhood is prohibited.

"We need policy to help cut a path for more competition, rather than protecting incumbents -- a Bandwidth Competition Act of 2008, not bogus net neutrality. All takers should be allowed access to poles or underground conduits. This is where neutrality should be enforced, instead of being a choke point.

Municipal or privately run wireless data services using Wi-Fi or WiMax should be sprouting like weeds. But they aren't being built because of lack of access to street lights, of all things, to set up access points. Verizon is busy rolling out a fiber optic service, FIOS, that will provide much higher speeds and real competition to Comcast. But it is slow going, as state by state video franchise rules still favor cable over any newcomers.

A stroke of a pen can cure these ills, incumbents be damned. They will adjust. I personally would climb telephone poles on my street to run fiber if I could get 100 megabit Internet service. Any takers? Talk about an economic stimulus; this is the type of infrastructure we need. The stock market will fund it all as well as resolve overbuild problems.

Don't think of Internet access as a static business -- someone put in phone lines 50 years ago or cable lines 20 years ago, and we are stuck with their limitations. Technology changes the game every few years. Even fiber lines put in today will be obsolete within 10 years and need upgrading. Same for wireless systems."

As a veteran of the last years of AT&T's crumbling monopoly, I can attest to all of what Kessler contends. Once access is opened, and bogus arguments for protecting whatever 'embedded base' is the focus of the particular technological debate, competition will blossom, and customers will be incredibly better served.

Once MCI opened the tiny crack in AT&T's armor by suing for the right to lease lines and resell them, thus arbitraging the dominant phone company's pricing policies against the real costs to serve customers, the end of AT&T was just a matter of time.

Like AT&T, Comcast's own infrastructure has a useful life, not an indefinite one. Its regulatory-granted monopoly made sense for the time at which it was granted, with the technology and market forces then in existence.

Things are different now, and the Federal and state regulatory schemes should acknowledge that by providing rules which favor customer benefits, not the maintenance of recently-enshrined oligopolistic market conditions.

Sunday, February 24, 2008

Feldstein On Today's US Economic Dilemma

Last week, in Wednesday's Wall Street Journal, economist Martin Feldstein wrote an editorial entitled "Our Economic Dilemma." In his piece, Feldstein echoed several of my own themes from this recent post, which, in turn, drew on comments and writings from people such as Brian Wesbury and Bill Wilby.

For example, Feldstein wrote,

"But these past recessions were caused by deliberate Federal Reserve policy aimed at reversing a rise in inflation. In those cases, the Fed increased real interest rates until it saw the economic slowdown that it thought would move us back toward price stability. It then reversed course, reducing interest rates and bringing the recession to an end.
In contrast, the real interest rate in 2006 and 2007 stayed at a relatively low level of less than 3%. A key cause of the present slowdown and potential recession was not a tightening of monetary policy but the bursting of the house-price bubble after six years of exceptionally rapid house-price increases. The Fed therefore will not be able to end the recession as it did previous ones by turning off a tight monetary policy."

Clearly, Feldstein believes, as do I, that Fed rate cuts just won't do that much for whatever currently ails the US economy. It's my guess that if you asked Feldstein directly whether the Fed's rate cuts will have done much more than stoke future inflation, he would say "no."
He continues in his editorial,

"The unprecedented national fall in house prices is reducing household wealth and therefore consumer spending. House prices are down 10% from the 2006 high and are likely to fall at least another 10%. Each 10% decline cuts household wealth by about $2 trillion, and this eventually reduces annual consumer spending by about $100 billion. No one can predict the extent to which the coming fall in house prices will lead to defaults and foreclosures, driving house prices and wealth down even further. Falling house prices also discourage home building, with housing starts down 38% over the past 12 months.

But the principle cause for concern today is the paralysis of the credit markets. Credit is always key to the expansion of the economy. The collapse of confidence in credit markets is now preventing that necessary extension of credit. The decline of credit creation includes not only the banks but also the bond markets, hedge funds, insurance companies and mutual funds. Securitization, leveraged buyouts and credit insurance have also atrophied.

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment."

Here, Feldstein explains that the unwise over-expansion of housing, and, by implication, the funding of said over-expansion with opaque CDOs, have resulted in real losses of wealth that will likely affect consumer spending. Thus, growth will at least slow, even if not reverse us into a recession.

Summing up, Feldstein writes,

"There is plenty of blame to go around for the current situation. The Federal Reserve bears much of the responsibility, because of its failure to provide the appropriate supervisory oversight for the major money center banks. The Fed's banking examiners have complete access to all of the financial transactions of the banks that they supervise, and should have the technical expertise to evaluate the risks that those banks are taking. Because these banks provide credit to the nonbank financial institutions, the Fed can also indirectly examine what those other institutions are doing.

The Fed's bank examinations are supposed to assess the adequacy of each bank's capital and the quality of its assets. The Fed declared that the banks had adequate capital because it gave far too little weight to their massive off balance-sheet positions -- the structured investment vehicles (SIVs), conduits and credit line obligations -- that the banks have now been forced to bring onto their balance sheets. Examiners also overstated the quality of banks' assets, failing to allow for the potential bursting of the house price bubble."

However, I'm not entirely convinced of his contentions in these passages. For example, how are examiners supposed to 'allow for the potential bursting of the house price bubble?'

In hindsight, that sounds fine. However, up until said bursting, you can bet the banks in question would be screaming bloody murder and exercising whatever political influence they had, via Congress, to affect the examiners who were, at that point, baselessly criticizing still-performing assets.

As to the SIVs existing, that's another matter. But, even there, ultimately the banks took them back onto their balance sheets because they were obligated to provide funding when external markets dried up.

Who can say which housing loans should have been called into question prior to the beginning of the period during which funding for housing-related structured finance instruments or subprime mortgages ceased to come forward?

Other than making the general comment that growth in mortgage markets remained too high for too long, it's another matter entirely to be the Federal agency which unilaterally reins in credit expansion for those particular loans. What if various minority groups had, in that event, pressured the Fed and banks in question to continue lending, or suffer charges of discriminatory lending practices?

Aside from those last passages, however, I find Feldstein's analysis of the situation very much in concert with my own. We face a demand-pull threat of inflation, not the cost-push sources of prior eras. Money has already been relatively easy when the Fed began to cut rates last year. It's unlikely those lower rates have really sparked much new business activity or lending, because the greatest bar to credit expansion has been counterparty risk, not rate levels.

All of which reinforces my belief that the Fed's prior, and even near term future rate cuts won't materially affect our economy, other than bake in higher inflation rates 18-24 months out.

If this is true, precisely what has the Fed rate cutting program delivered to us as a benefit?