The Wall Street Journal has published several page one articles recently concerning Facebook's putative $100B market value. I had to go to the Journal's site to confirm Tuesday's edition's lead which contained that number, it seemed so staggering. Facebook is looking to sell just 10% of that value in its IPO scheduled for early next year.
Much is being written regarding the appropriateness of that valuation. I'm not in that business, so I'm not going to argue over billions.
What I am, though, is a strategist who has learned to apply that type of critical thinking to business and equity management.
Among online ventures, I would agree that Facebook should be at the upper end of the valuation scale. Here's why.
Zuckerberg's- and his famous twin collaborators- big idea was initially simply replacing the once-popular college paper 'picbooks' or 'facebooks,' which I first encountered as a graduate business school student at the University of Pennsylvania, with an online version. From there, the rest is history.
Like Google's Brin and Paige, Zuckerberg and his colleagues invented one thing, which just happened to be a popular 'app' for which, in time, advertising was a natural fit. For Google, the search results were just begging for nearby ad placement. And the best part was that, unlike passive television, active searches allowed Google to sell literal terms to advertisers, thus making specific buyers much more valuable.
Facebook has the same characteristic. By developing an application which induces people to spill their guts about their lives onto a webpage, it's tailor made for associating advertising with these pages. And because of its communal nature, it multiplies that value through the various platinum-plated, self-organized, genuine communities of great and frequent interest.
For a marketer, it's a dream come true. Instead of searching for, say, early adopters, you have the ability to link to the close friends of one by virtue of the site's very nature.
How can that not be valuable? Or, as the late Steve Jobs might say, 'insanely' great and valuable?
And because Facebook is simply a generic self-expression tool, it's potentially usable by every living person on the planet, and maybe, in the future, the dead, as well, in absentia. So the accessible market is literally the entire global population that has web access.
Search engines have come and gone. Who even recalls Webcrawler or Lycos anymore? But, like telephony or the mail, social networking technologies become more valuable and monopolistic by their very nature. That's why MySpace became such a money sink and, ultimately, loss for NewsCorp. Second place in social networking is nowhere. Especially when the market share leader is so far ahead as Facebook is.
Thus, while Linked-In is, by comparison, relatively narrow, with its business- and skills-focus, and Groupon is deal-specific, Facebook is perhaps the most common of social networking applications. It probably does belong, if not now, then eventually, in Google's league, which is now about $200B.
Stunningly, that's only twice what Facebook's IPO-imputed valuation. Barring gross mismanagement, I think that sort of valuation range is quite reasonable and appropriate. In the future, who knows by how much that could increase?
From an equity management perspective, of course, that doesn't mean my portfolios would include Facebook in the future. Google never made it into the portfolio. In the early years, its valuation was simply too rich, relative to its growth rate. By the time the valuation had become reasonable, according to my selection criteria, its growth, too, had moderated. Perhaps Facebook will undergo the same dynamics. It will be interesting to see.
Showing posts with label Market Value. Show all posts
Showing posts with label Market Value. Show all posts
Friday, December 02, 2011
Wednesday, October 01, 2008
Others Agree- The Culprit is A Foolish Congressional Insistence On "Mark To Market" Accounting
According to my search of this blog for 'mark to market,' I first touched on the topic in this post back in February of this year.
Among my favorite, later posts on the topic are these, here, here, here and here. In that first linked post, I wrote,
"You see, this entire financial services debacle is unique because it involves tradeable instruments. Whole loans could be valued at par so long as they were performing. But once magically transformed via financial engineering into CDOs and their ilk, market price became the dominating valuation metric. And, as I and others have noted for some time now, markets for structured instruments can vanish in an instant. Thus, zero price.
There is no ability for anyone to know how much is a sufficient writedown of an asset with no trading market, except 100%. And who wants to do that?
Yes, financials are still reeling. And it won't stop until all the CDOs are basically written off. Totally.
Or, short of that, a vibrant market suddenly erupts all at once as a few hedge funds and private equity groups, like Paulson's ,written about in yesterday's Journal, swoop in and briefly create a market in the instruments for pennies on the dollar.
The holders will get to value the instruments, though probably at lower values than they wished. But above zero.
As I've written elsewhere, these private firms will then enjoy a spectacular rise in value of these structured instruments which are mostly still performing assets.
But for publicly-held companies, there's absolutely no reason for any investor to take a chance on what has become a blind pool of assets which are valued based upon non-existent markets for complex instruments."
I wrote those passages assuming that mark-to-market regulations would not be modified.
Why another post on this? In today's edition of the Wall Street Journal, three of my favorite writers- two of them distinguished economists- write about the current financial sector debacle.
Holman Jenkins, Jr., spotlights mark-to-market accounting in his editorial, as does Brian Wesbury, in his piece. Nobel Laureate Edmund Phelps does not mention it, but, instead, in his piece entitled "We Need To Recapitalize the Banks," weighs various government interventionist proposals to remedy the current situation.
Taking Phelps' article's title as a perspective, one may think of the current financial sector mess as having four possible solutions, ranked below from simplest and least expensive, to most complex and expensive:
1. Per this post, scrap the current mark-to-market regulations and, instead, allow use of net present valuation for performing instruments. Remove the requirement that lower, 'fire sale' current values pertaining to 'non-active' trading markets be used in lieu of 'hold-to-maturity' values for performing assets.
2. Congress authorizes Treasury to sell default insurance on structured finance instruments, thus allowing banks to value the assets at economic value on their balance sheets.
3. Congress authorizes Treasury to invest directly in US commercial banks, taking warrants as a sweetener, so that taxpayers will benefit when the equity values of the banks recover. Capital is rebuilt, with taxpayers afforded some protection.
4. Paulson's plan of simply using $700B of taxpayer funds to buy distressed structured finance securities from bank balance sheets, at undetermined prices.
Jenkins and Wesbury both are in agreement with me on this issue. They believe that the first solution is sufficient to effectively recapitalize banks by allowing them to value structured financial instruments on their balance sheets at long-term, economic values which will not require massive writedowns.
To be honest, I feel very comfortable in such intellectual company. Wesbury wrote,
"So what is to blame for the "worst financial crisis since the Great Depression"?
The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.
Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.
Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.
Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.
Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared."
In his remarks, Wesbury sees the same scenario I did earlier this year. Without a reform of mark-to-market accounting, only private equity will be capable of holding structured financial assets which have no actively-traded market. And they will make a killing, buying for pennies on the dollar and recovering the full economic value over time.
Wesbury ends his piece as follows,
"Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism."
It's a brilliant insight, as he notes that, until mark-to-market is suspended or modified, private investors won't touch bank equities, because they know the government if forcing those institutions to incur punitive valuations.
Holman Jenkins, similarly, writes,
"The Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.
Even as this agnostic column was giving birth to itself, the SEC's chief accountant released a new "interpretation" late yesterday meant to relax these vexatious rules. The Dow jumped 485 points. Were investors reacting to the SEC announcement -- or hope of the Paulson plan being revived in Congress? Perhaps they concluded that the two are one in the same.
Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.
Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.
Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.
But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.
Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.
A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.
A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.
No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?
Let's find out."
The third writer, Phelps, didn't mention mark-to-market explicitly. Instead, he revisited macroeconomics, and ended up simply judging default insurance to be, to him, not necessarily better than purchasing the assets. I don't agree.
Phelps reviews several other alternatives, including the Paulson plan, and prefers simply injecting capital into banks, in exchange for warrants.
But Phelps provides the important overview of the real issue- how to most efficiently, effectively and, then, quickly recapitalize banks.
And if this can be done via accounting rule modifications, that would be the route that trumps the other three. On all dimensions.
Among my favorite, later posts on the topic are these, here, here, here and here. In that first linked post, I wrote,
"You see, this entire financial services debacle is unique because it involves tradeable instruments. Whole loans could be valued at par so long as they were performing. But once magically transformed via financial engineering into CDOs and their ilk, market price became the dominating valuation metric. And, as I and others have noted for some time now, markets for structured instruments can vanish in an instant. Thus, zero price.
There is no ability for anyone to know how much is a sufficient writedown of an asset with no trading market, except 100%. And who wants to do that?
Yes, financials are still reeling. And it won't stop until all the CDOs are basically written off. Totally.
Or, short of that, a vibrant market suddenly erupts all at once as a few hedge funds and private equity groups, like Paulson's ,written about in yesterday's Journal, swoop in and briefly create a market in the instruments for pennies on the dollar.
The holders will get to value the instruments, though probably at lower values than they wished. But above zero.
As I've written elsewhere, these private firms will then enjoy a spectacular rise in value of these structured instruments which are mostly still performing assets.
But for publicly-held companies, there's absolutely no reason for any investor to take a chance on what has become a blind pool of assets which are valued based upon non-existent markets for complex instruments."
I wrote those passages assuming that mark-to-market regulations would not be modified.
Why another post on this? In today's edition of the Wall Street Journal, three of my favorite writers- two of them distinguished economists- write about the current financial sector debacle.
Holman Jenkins, Jr., spotlights mark-to-market accounting in his editorial, as does Brian Wesbury, in his piece. Nobel Laureate Edmund Phelps does not mention it, but, instead, in his piece entitled "We Need To Recapitalize the Banks," weighs various government interventionist proposals to remedy the current situation.
Taking Phelps' article's title as a perspective, one may think of the current financial sector mess as having four possible solutions, ranked below from simplest and least expensive, to most complex and expensive:
1. Per this post, scrap the current mark-to-market regulations and, instead, allow use of net present valuation for performing instruments. Remove the requirement that lower, 'fire sale' current values pertaining to 'non-active' trading markets be used in lieu of 'hold-to-maturity' values for performing assets.
2. Congress authorizes Treasury to sell default insurance on structured finance instruments, thus allowing banks to value the assets at economic value on their balance sheets.
3. Congress authorizes Treasury to invest directly in US commercial banks, taking warrants as a sweetener, so that taxpayers will benefit when the equity values of the banks recover. Capital is rebuilt, with taxpayers afforded some protection.
4. Paulson's plan of simply using $700B of taxpayer funds to buy distressed structured finance securities from bank balance sheets, at undetermined prices.
Jenkins and Wesbury both are in agreement with me on this issue. They believe that the first solution is sufficient to effectively recapitalize banks by allowing them to value structured financial instruments on their balance sheets at long-term, economic values which will not require massive writedowns.
To be honest, I feel very comfortable in such intellectual company. Wesbury wrote,
"So what is to blame for the "worst financial crisis since the Great Depression"?
The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.
Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.
Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.
Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.
Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared."
In his remarks, Wesbury sees the same scenario I did earlier this year. Without a reform of mark-to-market accounting, only private equity will be capable of holding structured financial assets which have no actively-traded market. And they will make a killing, buying for pennies on the dollar and recovering the full economic value over time.
Wesbury ends his piece as follows,
"Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism."
It's a brilliant insight, as he notes that, until mark-to-market is suspended or modified, private investors won't touch bank equities, because they know the government if forcing those institutions to incur punitive valuations.
Holman Jenkins, similarly, writes,
"The Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.
Even as this agnostic column was giving birth to itself, the SEC's chief accountant released a new "interpretation" late yesterday meant to relax these vexatious rules. The Dow jumped 485 points. Were investors reacting to the SEC announcement -- or hope of the Paulson plan being revived in Congress? Perhaps they concluded that the two are one in the same.
Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.
Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.
Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.
But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.
Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.
A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.
A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.
No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?
Let's find out."
The third writer, Phelps, didn't mention mark-to-market explicitly. Instead, he revisited macroeconomics, and ended up simply judging default insurance to be, to him, not necessarily better than purchasing the assets. I don't agree.
Phelps reviews several other alternatives, including the Paulson plan, and prefers simply injecting capital into banks, in exchange for warrants.
But Phelps provides the important overview of the real issue- how to most efficiently, effectively and, then, quickly recapitalize banks.
And if this can be done via accounting rule modifications, that would be the route that trumps the other three. On all dimensions.
Wednesday, September 17, 2008
Ken Lewis' Appetite- An Addendum
In my prior post, I discussed, at length, why I think Ken Lewis has made a disastrous mistake for his shareholders in his purchase of Merrill Lynch at $29/share.
He could have waited longer, or even for bankruptcy, in order to pick up the firm's "assets," such as they are, more cheaply. Perhaps buy the interest in BlackRock at a lower price. Maybe directly hire whole brokerage offices or just brokers, if Lewis and his management truly feels they are still valuable.
But, having watched CNBC yesterday, there is one narrow, one-time opportunity which Lewis may, unwittingly or with intent, be pursuing.
Because so much of the recent write downs of assets by investment and commercial banks are more correctly described as 'markdowns,' as a CNBC guest noted, BofA may be betting on the eventual remarking of Merrill assets upward.
As I have noted in prior posts this spring, such as here and here, totally aside from Ken Lewis' claim to have foreseen the collapse of investment banking seven years ago, two types of institutions can weather markdowns- private equity and commercial banks. Specifically, at the end of the second post, I noted,
"Now, however, we have performing structured finance instruments which have no markets because of their questionable asset value, not their income streams. And commercial banks are as culpable as any other financial institution in this mess.
BofA, Chase and Citigroup aren't your father's bank anymore. It's debatable, in the wake of Glass Steagall's demise, that any publicly-held brokers or investment banks should or can really exist independently of a commercial bank. In the new environment of securitized toxic structured finance instruments, a large commercial bank is uniquely able to survive, by dint of its Fed access and judicious use of its 'investment account' provisions."
While I stand behind my prior post's conclusion regarding the long term nature of consistency, or lack thereof, of Ken Lewis' BofA, I will agree that, because of a commercial bank's ability to use the investment account, Lewis may have cleverly executed a one-time low-ball purchase of some assets that will continue to perform and, eventually, be remarked up. This will result in a one-time gain, probably reflected, at some point, in the equity price of BofA.
Lewis may even use the old commercial bank trick of carefully 'realizing' higher values on these securities in a more or less consistent stream of markups.
But that won't be long term operating profit. It will be managed recognition over time of a one-time asset buy at bargain basement prices.
I still do not think that BofA is now poised to perform well as an equity in the future, aside from the unpredictable effects of periodic markups of securities it may have purchased with Merrill Lynch.
He could have waited longer, or even for bankruptcy, in order to pick up the firm's "assets," such as they are, more cheaply. Perhaps buy the interest in BlackRock at a lower price. Maybe directly hire whole brokerage offices or just brokers, if Lewis and his management truly feels they are still valuable.
But, having watched CNBC yesterday, there is one narrow, one-time opportunity which Lewis may, unwittingly or with intent, be pursuing.
Because so much of the recent write downs of assets by investment and commercial banks are more correctly described as 'markdowns,' as a CNBC guest noted, BofA may be betting on the eventual remarking of Merrill assets upward.
As I have noted in prior posts this spring, such as here and here, totally aside from Ken Lewis' claim to have foreseen the collapse of investment banking seven years ago, two types of institutions can weather markdowns- private equity and commercial banks. Specifically, at the end of the second post, I noted,
"Now, however, we have performing structured finance instruments which have no markets because of their questionable asset value, not their income streams. And commercial banks are as culpable as any other financial institution in this mess.
BofA, Chase and Citigroup aren't your father's bank anymore. It's debatable, in the wake of Glass Steagall's demise, that any publicly-held brokers or investment banks should or can really exist independently of a commercial bank. In the new environment of securitized toxic structured finance instruments, a large commercial bank is uniquely able to survive, by dint of its Fed access and judicious use of its 'investment account' provisions."
While I stand behind my prior post's conclusion regarding the long term nature of consistency, or lack thereof, of Ken Lewis' BofA, I will agree that, because of a commercial bank's ability to use the investment account, Lewis may have cleverly executed a one-time low-ball purchase of some assets that will continue to perform and, eventually, be remarked up. This will result in a one-time gain, probably reflected, at some point, in the equity price of BofA.
Lewis may even use the old commercial bank trick of carefully 'realizing' higher values on these securities in a more or less consistent stream of markups.
But that won't be long term operating profit. It will be managed recognition over time of a one-time asset buy at bargain basement prices.
I still do not think that BofA is now poised to perform well as an equity in the future, aside from the unpredictable effects of periodic markups of securities it may have purchased with Merrill Lynch.
Sunday, August 10, 2008
Why Financial Services Losses Are Different This Time
This morning, over coffee, I had the occasion to discuss the current situation of publicly-held US commercial banks with two friends after playing squash. All of us have had, or currently have, positions with major US banks. And we all agreed that the long term outlook for the current crop of America's five large commercial banks- BofA, Chase, Citi, Wachovia and Wells Fargo, plus the investment bank Merrill Lynch, Lehman and Morgan Stanley- is dim.
I wrote about some elements of this recently, here and here.
For commercial banks, the reason they may finally be fatally wounded is that, this time, it's not loan portfolios against which reserves can be taken, and losses can be 'worked out,' that have wounded them.
Nor can historical values be claimed and the assets stuffed into 'investment' accounts to be written off over longer periods of time.
No, this time both investment and commercial banks jumped into marketable securities and got burned. Now hostage to 'mark to market' rules on illiquid securities, they are paying the price for hanging on to this toxic financial waste which they manufactured.
So the commercial banks can't just massage the loan loss reserves, chargeoffs and investment accounts. This time, they have to abide by market values.
And if someone like Merrill suddenly takes a huge haircut to purge its balance sheet, so must every other institution holding similar paper.
For example, take the ARS settlement of this past week. This has just put another expensive, multi-billion dollar whole in John Thain's Merrill Lynch balance sheet. Didn't he just raise another $8B recently to cover the losses of the sale, with reserve, of a bunch of bad mortgage paper to that Texas private equity outfit, LoneStar?
Which is why no CEO can claim to know that they have hit bottom on the valuation of these structured instruments. Nor have any control whatsoever, short of just basically giving the assets to some private equity shop for a few cents on the dollar.
So, who will be stupid enough to buy any more equity in the three parties to the ARS settlement- Citigroup, Merrill and UBS?
After demonstrating appallingly-bad risk management judgement for the past several years, why should anyone continue to keep these rotten, inept managements afloat? They've lost most of their capital in the past year. Schumepeter would probably observe that they should simply be allowed to perish, as more adept, better-managed competitors fill their niches in our financial services system.
I wrote about some elements of this recently, here and here.
For commercial banks, the reason they may finally be fatally wounded is that, this time, it's not loan portfolios against which reserves can be taken, and losses can be 'worked out,' that have wounded them.
Nor can historical values be claimed and the assets stuffed into 'investment' accounts to be written off over longer periods of time.
No, this time both investment and commercial banks jumped into marketable securities and got burned. Now hostage to 'mark to market' rules on illiquid securities, they are paying the price for hanging on to this toxic financial waste which they manufactured.
So the commercial banks can't just massage the loan loss reserves, chargeoffs and investment accounts. This time, they have to abide by market values.
And if someone like Merrill suddenly takes a huge haircut to purge its balance sheet, so must every other institution holding similar paper.
For example, take the ARS settlement of this past week. This has just put another expensive, multi-billion dollar whole in John Thain's Merrill Lynch balance sheet. Didn't he just raise another $8B recently to cover the losses of the sale, with reserve, of a bunch of bad mortgage paper to that Texas private equity outfit, LoneStar?
Which is why no CEO can claim to know that they have hit bottom on the valuation of these structured instruments. Nor have any control whatsoever, short of just basically giving the assets to some private equity shop for a few cents on the dollar.
So, who will be stupid enough to buy any more equity in the three parties to the ARS settlement- Citigroup, Merrill and UBS?
After demonstrating appallingly-bad risk management judgement for the past several years, why should anyone continue to keep these rotten, inept managements afloat? They've lost most of their capital in the past year. Schumepeter would probably observe that they should simply be allowed to perish, as more adept, better-managed competitors fill their niches in our financial services system.
Thursday, March 06, 2008
More on Marking To Market
Last week I wrote this post regarding the hazards of applying 'mark to market' to every balance sheet in sight. In the post, I asked,
"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?"
I guess I'm in good company, because in yesterday's Wall Street Journal, Holman Jenkins echoed my post and sentiments in a column entitled "Mark to Meltdown?"
Jenkins wrote,
"Overstating the importance of accounting rules is, indeed, the essential error that leads to excessive twiddling with accounting rules. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. A thermometer is equally useful whether it says water freezes at 0 degrees or 32 degrees -- though it still doesn't tell what the temperature will be next week.
But loose as well is a fear that exaggerated writedowns in the current credit crunch are rapidly chewing through the banking system's capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more writedowns and more fire sales. At best, banks will have to keep shopping cheap equity to foreign potentates to keep themselves afloat. At worst, massive regulatory insolvency lies ahead.
This horror show, we hasten to add, has proven more theoretical than actual, but it plays a key role in the meltdown scenarios of NYU economist Nouriel Roubini, which he recently retailed for a congressional hearing. And it's hard to doubt that fears of accounting-prompted distress sales are partly behind the melodramatic yields now available in the corporate and municipal bond markets."
Which is pretty much what I further opined in my earlier post,
"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."
We therefore have the Law of Unintended Consequences extracting perverse, severe penalties from today's credit markets. Somewhat arbitrary accounting rules are now governing the behavior of financial service firms to issue margin calls and trigger the unwinding of highly-leveraged positions in credit instruments, which is causing further, temporary cratering of values of otherwise-performing assets.
As Mr. Jenkins informs us,
"Mark to market was a gift to the world from SEC Chief Richard Breeden in the early '90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.
A rose would smell as sweet if it were called skunk cabbage -- so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still, many questioned Mr. Breeden's initiative at the time, among them Fed Chairman Alan Greenspan and Bank of America's Richard M. Rosenberg. Particularly notable were their warnings that the new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors.
Overlooked, too, was a phenomenon we perhaps understand better today -- the propensity of the speculators who provide much of the market's day-to-day liquidity to go on strike during moments when their services are most needed. "Mark to market" then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if markets existed."
Which, again, echoes something I've written about many times in the past year- the tendencies of younger trading mavens to fail to understand that sometimes markets simply cease to exist, in the classical sense of the definition. If you hold such instruments with borrowed money, you are in a bind. If you are forced to mark such positions to market in the face of a non-existent 'market,' you are also in a bind.
Mr. Jenkins closes his piece with this passage,
"But the best argument was articulated by the late Citibanker Walter Wriston, and it applies equally to most of the accounting innovations with which the world has been oversupplied in recent decades: "Consistency of accounting treatment is always more useful to managers and investors than the latest fad of accounting aficionados." "
Just so. And perhaps we should allow for context, too. As I asked at the end of my prior, linked post, why isn't this a subject on which FASB should rule? Have they been attending to it since, oh, last June, when the effects of this accounting policy began to send credit markets in a downward valuation spiral of 'devalue-sell-devalue-sell-devalue-sell-writedown-close?'
I think the much, much larger issue now is to consider, for the entire financial services sector, the contexts in which mark-to-market makes little sense, and should be suspended, versus when it is appropriate.
As I began to suggest in my earlier post, businesses and companies in the business of trading and investing with the constant expectation of selling and buying securities should probably mark their assets to market daily. If that causes them to use less leverage or avoid exotic structured finance instruments, so be it.
Financial service businesses intending to hold assets, whether they be whole loans, exotics, or what have you, beyond a pre-determined duration, should probably be able to value those assets on the basis of performance, rather than immediate market value.
As I wrote here in September of last year,
"Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?
It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.
Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.
It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"
More than anything else, it seems that commercial banks began behaving like investment banks, and have effectively eliminated an institution which used to anchor the US economy- the bank that judges credits based upon the prospect of actually holding them to maturity.
"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?"
I guess I'm in good company, because in yesterday's Wall Street Journal, Holman Jenkins echoed my post and sentiments in a column entitled "Mark to Meltdown?"
Jenkins wrote,
"Overstating the importance of accounting rules is, indeed, the essential error that leads to excessive twiddling with accounting rules. Whether a company values its assets at historic cost or market value or a value derived by some other formula, investors still have to make their own forecasts and judgments. A thermometer is equally useful whether it says water freezes at 0 degrees or 32 degrees -- though it still doesn't tell what the temperature will be next week.
But loose as well is a fear that exaggerated writedowns in the current credit crunch are rapidly chewing through the banking system's capital cushion. Banks will be forced to dump assets at fire-sale prices, leading to yet more writedowns and more fire sales. At best, banks will have to keep shopping cheap equity to foreign potentates to keep themselves afloat. At worst, massive regulatory insolvency lies ahead.
This horror show, we hasten to add, has proven more theoretical than actual, but it plays a key role in the meltdown scenarios of NYU economist Nouriel Roubini, which he recently retailed for a congressional hearing. And it's hard to doubt that fears of accounting-prompted distress sales are partly behind the melodramatic yields now available in the corporate and municipal bond markets."
Which is pretty much what I further opined in my earlier post,
"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."
We therefore have the Law of Unintended Consequences extracting perverse, severe penalties from today's credit markets. Somewhat arbitrary accounting rules are now governing the behavior of financial service firms to issue margin calls and trigger the unwinding of highly-leveraged positions in credit instruments, which is causing further, temporary cratering of values of otherwise-performing assets.
As Mr. Jenkins informs us,
"Mark to market was a gift to the world from SEC Chief Richard Breeden in the early '90s. With the help of accounting mavens, he argued that requiring banks and other companies to account for financial assets at current market prices, as if the institutions were being sized up for liquidation, would provide a rough-tough discipline for the edification of investors, regulators and managers.
A rose would smell as sweet if it were called skunk cabbage -- so we always maintain when somebody predicts either dire or utopian results from a mere accounting change. Still, many questioned Mr. Breeden's initiative at the time, among them Fed Chairman Alan Greenspan and Bank of America's Richard M. Rosenberg. Particularly notable were their warnings that the new rule, when combined with risk-based capital standards, might lead banks to hold fewer loans on their own books, packaging more of them as complex securities for sale to investors.
Overlooked, too, was a phenomenon we perhaps understand better today -- the propensity of the speculators who provide much of the market's day-to-day liquidity to go on strike during moments when their services are most needed. "Mark to market" then becomes something else, because markets no longer exist for many of these abstruse securities. Banks are left oxymoronically trying to estimate what market prices would be if markets existed."
Which, again, echoes something I've written about many times in the past year- the tendencies of younger trading mavens to fail to understand that sometimes markets simply cease to exist, in the classical sense of the definition. If you hold such instruments with borrowed money, you are in a bind. If you are forced to mark such positions to market in the face of a non-existent 'market,' you are also in a bind.
Mr. Jenkins closes his piece with this passage,
"But the best argument was articulated by the late Citibanker Walter Wriston, and it applies equally to most of the accounting innovations with which the world has been oversupplied in recent decades: "Consistency of accounting treatment is always more useful to managers and investors than the latest fad of accounting aficionados." "
Just so. And perhaps we should allow for context, too. As I asked at the end of my prior, linked post, why isn't this a subject on which FASB should rule? Have they been attending to it since, oh, last June, when the effects of this accounting policy began to send credit markets in a downward valuation spiral of 'devalue-sell-devalue-sell-devalue-sell-writedown-close?'
I think the much, much larger issue now is to consider, for the entire financial services sector, the contexts in which mark-to-market makes little sense, and should be suspended, versus when it is appropriate.
As I began to suggest in my earlier post, businesses and companies in the business of trading and investing with the constant expectation of selling and buying securities should probably mark their assets to market daily. If that causes them to use less leverage or avoid exotic structured finance instruments, so be it.
Financial service businesses intending to hold assets, whether they be whole loans, exotics, or what have you, beyond a pre-determined duration, should probably be able to value those assets on the basis of performance, rather than immediate market value.
As I wrote here in September of last year,
"Could it be that, rather than a uni-directional march toward market pricing and underwriting, credit markets are, in reality, about to swing between extremes? Moving from all-bank balance sheet valuation and warehousing, to heavily market-priced and securitized, and now back toward the original pole of bank-sourced and distributed credit instruments?
It's not something I've read anyone else hypothesizing. Even I just assumed that banks had pretty much become a mere origination platform for credit.
Now, with this latest credit market debacle, the first since really heavily asset securitization of mortgages and corporate loans have kicked in, we are learning that there are market conditions under which non-banks may not be viable for very long, if they originate and/or hold volatile fixed income assets.
It's an interesting phenomenon. Who would have guessed that there was life in the old commercial bank model, yet?"
More than anything else, it seems that commercial banks began behaving like investment banks, and have effectively eliminated an institution which used to anchor the US economy- the bank that judges credits based upon the prospect of actually holding them to maturity.
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?
"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?
Friday, November 02, 2007
Back To Basics: SIVs, CDOs, Banks and Valuing Securities
As the financial markets fallout of sub-prime mortgage lending continues to affect both equity and fixed income markets, it may be instructive and useful to return to some basics about these markets, the institutions in them, investors, and rules about valuation.
Back in the 1980s, as a strategist at Chase Manhattan Bank, I had the occasion to be involved in a project regarding increasing our presence in the mortgage origination business. As part of this, I attended a few conferences on CMOs. These were the original, private-labeled securitizations of mortgages by the likes of Salomon Brothers, First Boston and Kidder Peabody. Names like Lew Ranieri, Dexter Senft and Larry Fink (yes, that Larry Fink) predominated the burgeoning sector's conferences.
The conferences were held by these investment banks in order to facilitate the sale of securitization services to S&L executives. After we all listened to long talks by investment bankers about the mechanics of CMOs, the usual forgettable conference lunch was served.
I spoke with an S&L executive at my table regarding the complexity of issuing CMOs. Yes, he said, they sure were complex. That's why he needed the likes of Kidder, Salomon, et.al., to know how to create and price them to sell.
I then asked him if his S&L also bought CMOs.
"Of course," he replied.
"Well, if they are complicated to price for sale, and you need help for that, how do you know at what price to buy them from these same investment bankers," I asked him?
Rather than answer, he turned away to the man on his other side, and engaged him in conversation, instead.
Nothing has really changed in twenty years. Structured finance instruments have always begged the question of valuation and, thus, the ability to presume true 'market' conditions. That is, continuously priced, and a seller always available for every buyer, and vice versa.
Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?
Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.
So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?
You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.
They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances.
With regard to the SIVs, the question that is troubling credit markets is, essentially,
"Will the SIVs have to sell their structured finance assets to pay off their commercial paper liabilities, what will be the (very low) prices of those assets, and will there be resulting commercial paper defaults?"
It's the uncertainty of the answers to these questions that is 'seizing up' credit markets. Lenders don't lend to counterparties whose financial conditions they do not, for certain, know, without collateral.
Citigroup, BankAmerica and Merrill Lynch have just taken very public, large writedowns summing to roughly $15B over the past month, all attributed, except perhaps BofA's, directly or indirectly, to capital markets activity involving mortgage-related CDOs.
Until holders of suspect CDOs either explain the (presumedly lower) values at which they are marking these instruments, counterparties, including those in traded fixed income markets, will not be showing up to lend money or buy paper.
The banks and related financial entities have only themselves to blame for this 'seizure' of fixed income markets. If they would be forthcoming about valuations, then their true financial condition would be known, risks could be assessed, instruments priced, etc.
Rick Santelli, CNBC's Chicago-based fixed income expert, said it best this morning when he likened the banks' situation to what he would face if he had lost money on assets in a margin account. He'd have to make the margin call, or lose his collateral.
He questioned why banks should be 'different,' and be allowed to delay valuation of CDOs, or be given special license to create the M-LEC to buy more time.
Here's a novel idea. If banks and other entities truly believe that the securities involved should not be marked down as fire sale items, why don't they simply buy the putative owners/losers out of their positions, at face value, and hold the suspect securities themselves?
By doing so, they would literally put their money where their collective mouths are, indicating they believe values will rise in the future, making ownership of the troubled structured finance instruments a benefit, not a loss.
As I observed in this recent post, that's what the legendary financier, J. Pierpont Morgan, did to halt the panic of 1907. Of course, he was the one buying at fire sale prices. In our current situation, this is precisely what banks are trying to avoid- the writedown.
It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.
Or, the banks can make good on the alleged implicit guarantees, take back the commercial paper and senior notes at some artificially high price, and hold the associated assets, absorbing losses into their investment accounts over the next few years.
Either way, the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.
If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track.
I think that anytime someone 'structures' financial instruments in such a way as to prevent their easy valuation and market maintenance, they better be ready to hold them as if they were a painting, real estate, or some other lumpy, illiquid asset.
Because, in truth, that's what they are.
Back in the 1980s, as a strategist at Chase Manhattan Bank, I had the occasion to be involved in a project regarding increasing our presence in the mortgage origination business. As part of this, I attended a few conferences on CMOs. These were the original, private-labeled securitizations of mortgages by the likes of Salomon Brothers, First Boston and Kidder Peabody. Names like Lew Ranieri, Dexter Senft and Larry Fink (yes, that Larry Fink) predominated the burgeoning sector's conferences.
The conferences were held by these investment banks in order to facilitate the sale of securitization services to S&L executives. After we all listened to long talks by investment bankers about the mechanics of CMOs, the usual forgettable conference lunch was served.
I spoke with an S&L executive at my table regarding the complexity of issuing CMOs. Yes, he said, they sure were complex. That's why he needed the likes of Kidder, Salomon, et.al., to know how to create and price them to sell.
I then asked him if his S&L also bought CMOs.
"Of course," he replied.
"Well, if they are complicated to price for sale, and you need help for that, how do you know at what price to buy them from these same investment bankers," I asked him?
Rather than answer, he turned away to the man on his other side, and engaged him in conversation, instead.
Nothing has really changed in twenty years. Structured finance instruments have always begged the question of valuation and, thus, the ability to presume true 'market' conditions. That is, continuously priced, and a seller always available for every buyer, and vice versa.
Senior commercial bank executives formed SIVs to access cheap, short-term funding for the purposes of buying long-term CDOs, paying the difference to the 'owners' of the SIV, and pocketing a fee for this service. The central, and only important question, is, did these executives, as legal representatives of their financial institutions, assure the investors, and/or commercial paper purchases, recourse, under some conditions?
Under parole evidence rules of contract law, large dollar agreements and conditions must be reduced to writing. If they aren't, generally, they aren't considered in existence and, thus, enforceable.
So, were any recourse assurances written into the various and sundry legal documents surrounding these SIVs?
You can bet that if they were, the holders of the commercial paper, and or the so-called 'senior note' holders, a/k/a 'owners' of the SIVs, would be putting those instruments back to the issuers, thus exercising the recourse clauses.
They don't appear to be, so we can reasonably infer that the banks, to the extent they winked and nodded, gave implicit recourse assurances.
With regard to the SIVs, the question that is troubling credit markets is, essentially,
"Will the SIVs have to sell their structured finance assets to pay off their commercial paper liabilities, what will be the (very low) prices of those assets, and will there be resulting commercial paper defaults?"
It's the uncertainty of the answers to these questions that is 'seizing up' credit markets. Lenders don't lend to counterparties whose financial conditions they do not, for certain, know, without collateral.
Citigroup, BankAmerica and Merrill Lynch have just taken very public, large writedowns summing to roughly $15B over the past month, all attributed, except perhaps BofA's, directly or indirectly, to capital markets activity involving mortgage-related CDOs.
Until holders of suspect CDOs either explain the (presumedly lower) values at which they are marking these instruments, counterparties, including those in traded fixed income markets, will not be showing up to lend money or buy paper.
The banks and related financial entities have only themselves to blame for this 'seizure' of fixed income markets. If they would be forthcoming about valuations, then their true financial condition would be known, risks could be assessed, instruments priced, etc.
Rick Santelli, CNBC's Chicago-based fixed income expert, said it best this morning when he likened the banks' situation to what he would face if he had lost money on assets in a margin account. He'd have to make the margin call, or lose his collateral.
He questioned why banks should be 'different,' and be allowed to delay valuation of CDOs, or be given special license to create the M-LEC to buy more time.
Here's a novel idea. If banks and other entities truly believe that the securities involved should not be marked down as fire sale items, why don't they simply buy the putative owners/losers out of their positions, at face value, and hold the suspect securities themselves?
By doing so, they would literally put their money where their collective mouths are, indicating they believe values will rise in the future, making ownership of the troubled structured finance instruments a benefit, not a loss.
As I observed in this recent post, that's what the legendary financier, J. Pierpont Morgan, did to halt the panic of 1907. Of course, he was the one buying at fire sale prices. In our current situation, this is precisely what banks are trying to avoid- the writedown.
It seems to me that they have only two choices. On one hand, simply adhere to the existing rules of valuation, and force greedy investors, who should have known better than to take implicit guarantees from these bankers, to take their losses, as SIVs crater and default on all of their obligations. Suffice to say, it will be a long time before anyone trusts oral assurances from these financial institutions. And that is likely a good thing.
Or, the banks can make good on the alleged implicit guarantees, take back the commercial paper and senior notes at some artificially high price, and hold the associated assets, absorbing losses into their investment accounts over the next few years.
Either way, the solution to unfreezing credit markets is to inject trust and confidence in them by doing something to recognize a value of the assets held in SIVs, and elsewhere, for which there are, in reality, no continuously functioning markets.
If you think this means a clutch of senior bankers who dreamt up these instruments and vehicles in the first place should be cashiered, you're probably on the right track.
I think that anytime someone 'structures' financial instruments in such a way as to prevent their easy valuation and market maintenance, they better be ready to hold them as if they were a painting, real estate, or some other lumpy, illiquid asset.
Because, in truth, that's what they are.
Thursday, June 14, 2007
Blackstone's IPO Underwriting Strategy: Silence The Street
"Bribe" is an ugly word. So I'm not going to use it again in this post.
I read yesterday that Blackstone has employed 17 Wall Street investment banking houses in its IPO process. Even, according to the Wall Street Journal article by 'breakingviews.com,' Goldman Sachs. The latter was originally snubbed for having worked on another private equity shop's IPO.
Additionally, it is alleged that Chase was allowed in, despite its having backed a competing bidder for Equity Office Properties, a recent Blackstone purchase.
To quote the Journal article,
"But perhaps Blackstone has another motive. By bringing everyone on board, it may keep criticism of its trumpeted $33 billion-plus valuation at a minimum. This is particularly important for, say, Goldman, whose own stock trades at a whopping price-to-earnings discount to Blackstone's implied valuation.
Yet, behind closed doors, it's widely believed that those who publicly criticize Blackstone's value won't be invited to sell its IPO. Looks like Wall Street opted to keep its collective mouth shut."
You think?
This is unquestionably the motive for Blackstone's hoovering up any party whose credible scepticism about its IPO valuation might cause investors to balk. The effect is to mute all sell-side criticism. Then you have the unstated silence of anybody else with a trading desk, who hopes to broker any of Blackstone's order volume in this lifetime.
You can search my blog for posts on Blackstone's IPO. For starters, however, read this one, from April.
In this post, I wrote,
"What I find amazing, however, is that investors are lining up to buy shares of an entity in which they can't even measure risk levels. Essentially, they are buying income 'participation shares,' much like I advocated last year in this post regarding corporate governance and takeovers. But, rather than retaining interest in a previously-public firm, they are buying the equivalent of a blind pool.
In a very real sense, Schwarzman has created the best of both worlds- retaining total control and privacy of operations, while establishing a value for the firm, and cashing out while doing it.
Honestly, I have even more respect for him now than I did before. Not that I would be on the other end of an equity transaction from him. And, correspondingly, I have less respect for the investors who buy the Blackstone IPO shares."
I can only reiterate my earlier sentiments. As I said to my partner over lunch yesterday,
"Who would be foolish enough to be on the other side of an equity deal from Goldman or Blackstone?"
I own Goldman in my equity portfolio now. But I only bought it in January, not as an IPO. As such, it is market-valued now, not seller-valued.
With all the hoopla on Capitol Hill this week regarding new taxes for carried interest income in private equity deals, and Schwarzman's $700+MM payday, and $7B interest in Blackstone, the real danger is overlooked.
I contend it is this pervasive, collaborative silence on Wall Street, as it collectively abets Blackstone in valuing its IPO.
Alas, no amount of legislation will ever remedy this. No, for this, we have to trust people to use their common sense. To think.
And that brings me to an old story about the former Governor and Senator from my home state of Illinois, Adlai Stevenson.
When running in one of his campaigns for President against Eisenhower, it is said that Stevenson was approached by a woman who gushed,
"Governor, you have the vote of every thinking American."
Stevenson, perhaps apocryphally, is said to have replied,
"Oh, Madam, I'll need many more votes that that to win the election."
Caveat Emptor, indeed!
I read yesterday that Blackstone has employed 17 Wall Street investment banking houses in its IPO process. Even, according to the Wall Street Journal article by 'breakingviews.com,' Goldman Sachs. The latter was originally snubbed for having worked on another private equity shop's IPO.
Additionally, it is alleged that Chase was allowed in, despite its having backed a competing bidder for Equity Office Properties, a recent Blackstone purchase.
To quote the Journal article,
"But perhaps Blackstone has another motive. By bringing everyone on board, it may keep criticism of its trumpeted $33 billion-plus valuation at a minimum. This is particularly important for, say, Goldman, whose own stock trades at a whopping price-to-earnings discount to Blackstone's implied valuation.
Yet, behind closed doors, it's widely believed that those who publicly criticize Blackstone's value won't be invited to sell its IPO. Looks like Wall Street opted to keep its collective mouth shut."
You think?
This is unquestionably the motive for Blackstone's hoovering up any party whose credible scepticism about its IPO valuation might cause investors to balk. The effect is to mute all sell-side criticism. Then you have the unstated silence of anybody else with a trading desk, who hopes to broker any of Blackstone's order volume in this lifetime.
You can search my blog for posts on Blackstone's IPO. For starters, however, read this one, from April.
In this post, I wrote,
"What I find amazing, however, is that investors are lining up to buy shares of an entity in which they can't even measure risk levels. Essentially, they are buying income 'participation shares,' much like I advocated last year in this post regarding corporate governance and takeovers. But, rather than retaining interest in a previously-public firm, they are buying the equivalent of a blind pool.
In a very real sense, Schwarzman has created the best of both worlds- retaining total control and privacy of operations, while establishing a value for the firm, and cashing out while doing it.
Honestly, I have even more respect for him now than I did before. Not that I would be on the other end of an equity transaction from him. And, correspondingly, I have less respect for the investors who buy the Blackstone IPO shares."
I can only reiterate my earlier sentiments. As I said to my partner over lunch yesterday,
"Who would be foolish enough to be on the other side of an equity deal from Goldman or Blackstone?"
I own Goldman in my equity portfolio now. But I only bought it in January, not as an IPO. As such, it is market-valued now, not seller-valued.
With all the hoopla on Capitol Hill this week regarding new taxes for carried interest income in private equity deals, and Schwarzman's $700+MM payday, and $7B interest in Blackstone, the real danger is overlooked.
I contend it is this pervasive, collaborative silence on Wall Street, as it collectively abets Blackstone in valuing its IPO.
Alas, no amount of legislation will ever remedy this. No, for this, we have to trust people to use their common sense. To think.
And that brings me to an old story about the former Governor and Senator from my home state of Illinois, Adlai Stevenson.
When running in one of his campaigns for President against Eisenhower, it is said that Stevenson was approached by a woman who gushed,
"Governor, you have the vote of every thinking American."
Stevenson, perhaps apocryphally, is said to have replied,
"Oh, Madam, I'll need many more votes that that to win the election."
Caveat Emptor, indeed!
Wednesday, February 14, 2007
Market Value: When and To Whom?
In his Tuesday piece in the Wall Street Journal, Dennis Berman refers to situations in which executives,
"were trying to use overpriced shares to buy other companies in stock deals before the market came to its senses....executives don't dare broach- that their shares might be overvalued."
What does it mean to simply state that a company is "overvalued?" By whom? Or that the market is not 'in its senses?' Over what timeframe? Do such an unconditioned terms or statements even make sense?
Can anything be "overvalued" today? I think not. As my wise old friend and colleague, B, noted some years ago,
"A model can tell you what X was worth yesterday, or what it may be worth tomorrow, but today, it is worth what I can sell it for in the market."
Just so.
And, further, today's market price, or value, for a company, is a function of many buyers and sellers, and non-buyers and non-sellers, whose various and varying expectations constitute the forces which drive the actual price of shares of a company.
In fact, there are so many conditions on the question of "value," much less "overvalue," that it boggles the mind to consider them all.
For example, if I sell one share of a stock I currently hold, Gilead Corporation, it is unlikely to affect the market value of the company. I am essentially a price-taker. However, suppose I own 4% of the firm- a level below that requiring certain SEC filings. Suppose I wish to sell all but one share of my 4% stake in Gilead, today. Would this action affect the company's value? Almost certainly. The flooding of nearly 4% of the ownership in a company into the market at once will change its value very quickly, indeed. It may result in a price decline sufficient to bring in more buyers, who now think the company is "undervalued," relative to their own expectations, and perhaps move the market value back up again.
Thus, the use of sloppy language, such as referring to a company, or its stock, as simply, unconditionally, "overvalued," or "undervalued," obscures clear understanding of the mechanics involved in the valuation of companies. In an open trading market, a company is always "fairly" valued at the moment. That value may appear to be too high, or low, to different investors, or potential investors.
To address Mr. Berman's point regarding "overvalued" companies, I would suggest that what is meant is that there are situations in which a company is "overvalued," in the opinion of some people, relative to some other company. In such cases, there may, indeed, be takeover activity.
But that's not to suggest that either company was "wrongly" valued that day. Or on any other trading day.
"Value" is what you can get for something in a market. Any other "value" ascribed to the item is only a relative estimate, which is itself a function of a particular investor's expectations. Nothing more, and nothing less.
"were trying to use overpriced shares to buy other companies in stock deals before the market came to its senses....executives don't dare broach- that their shares might be overvalued."
What does it mean to simply state that a company is "overvalued?" By whom? Or that the market is not 'in its senses?' Over what timeframe? Do such an unconditioned terms or statements even make sense?
Can anything be "overvalued" today? I think not. As my wise old friend and colleague, B, noted some years ago,
"A model can tell you what X was worth yesterday, or what it may be worth tomorrow, but today, it is worth what I can sell it for in the market."
Just so.
And, further, today's market price, or value, for a company, is a function of many buyers and sellers, and non-buyers and non-sellers, whose various and varying expectations constitute the forces which drive the actual price of shares of a company.
In fact, there are so many conditions on the question of "value," much less "overvalue," that it boggles the mind to consider them all.
For example, if I sell one share of a stock I currently hold, Gilead Corporation, it is unlikely to affect the market value of the company. I am essentially a price-taker. However, suppose I own 4% of the firm- a level below that requiring certain SEC filings. Suppose I wish to sell all but one share of my 4% stake in Gilead, today. Would this action affect the company's value? Almost certainly. The flooding of nearly 4% of the ownership in a company into the market at once will change its value very quickly, indeed. It may result in a price decline sufficient to bring in more buyers, who now think the company is "undervalued," relative to their own expectations, and perhaps move the market value back up again.
Thus, the use of sloppy language, such as referring to a company, or its stock, as simply, unconditionally, "overvalued," or "undervalued," obscures clear understanding of the mechanics involved in the valuation of companies. In an open trading market, a company is always "fairly" valued at the moment. That value may appear to be too high, or low, to different investors, or potential investors.
To address Mr. Berman's point regarding "overvalued" companies, I would suggest that what is meant is that there are situations in which a company is "overvalued," in the opinion of some people, relative to some other company. In such cases, there may, indeed, be takeover activity.
But that's not to suggest that either company was "wrongly" valued that day. Or on any other trading day.
"Value" is what you can get for something in a market. Any other "value" ascribed to the item is only a relative estimate, which is itself a function of a particular investor's expectations. Nothing more, and nothing less.
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