Fed Asset Bubble Spotting?

Nov. 20 (Bloomberg) -- Federal Reserve officials are stepping up scrutiny of the biggest U.S. banks to ensure the lenders can withstand a reversal of soaring global-asset prices [ref] http://www.bloomberg.com/apps/news?pid=20601103&sid=aP_4vjiIq7KU [/ref]

Translation: The Fed has twigged that its actions can cause asset bubbles and that when they burst that can be dangerous.

That’s good news!

All the same, I’m a bit undecided about Mr. Bernanke. Everyone is down on him for pumping a load of money into the banks and letting them borrow from him at 0% so they could lend to the Treasury at 3.5%; but then everyone agrees it would have been much worse if he hadn’t; personally I’m moving towards giving him the benefit of the doubt.

But there is no question that he’s sneaky, whilst Henry Paulson was making a big deal about that $700 billion, he was quietly shovelling $3 trillion or so out of the back-door  into the system, and all the time he just sat there with a bemused look on his face like as if he couldn’t quite remember which day of the week it was. But there again, in these “difficult” times, sneaky is good news.

There are two issues now (a) liquidity and (b) solvency.

Mr. Helicopter has no problem with pumping in liquidity; he can shift a trillion without anyone hardly noticing. But the question that I hope is going through his mind and the minds of the 220 PhD economists at the Fed, is whether or not banks will be solvent, in the future, if something happens.

That’s about valuation, not of what the assets are worth today (or more precisely not worth); because there is no requirement to sell them today, what matters is what they will be worth at the point in time that there may be a requirement to sell them. 

That’s a fairly new concept in financial circles which have been sheltered from that particular reality by a combination of benign accounting rules, Basel II, and implicit and explicit forbearance.

It’s all about the Valuations:

I read two good articles about valuation this year, one on oil reserves [ref] http://seekingalpha.com/article/174575-the-oil-casino-sec-heading-for-monte-carlo-part-i?source=hp_wc [/ref] and another on M&A [ref] http://epicureandealmaker.blogspot.com/2009/05/my-kid-could-do-that.html [/ref]

Valuation is a funny thing, so simple, yet hardly anyone understands the concept, ask twenty economists how to do a valuation and you will get a hundred different answers. In the comments to those two articles I noticed, there was a general sense of outrage that perhaps investors and/or regulators were cuckooed by the valuations.

As if a valuation is something that should be cast in stone and third-parties should be able to rely on them, like the Ten Commandments.

The reality is that a valuation is a normally just a starting point for a negotiation, and value, as any investment banker will tell you is what you can sell something for, to someone who is dumber than you are.

There are of course two problems with that line, first, by definition, value is going to be determined by the dumbest person in the room, and second, if you can’t find anyone dumber than you are, you are stuck.

But all the same; sometimes people convince themselves or others that a valuation is more than that, and that’s how they get cuckooed.

And there has been a lot of cuckooing over the past few years; investors are outraged, so are the taxpayers who have paid out and committed trillions of dollars to bail out the cuckooed.

Here’s an idea, if you believed that you could value an MBS by taking the value of an equivalent US Treasury less how much it cost to buy a CDS for it from AIG, and then you found that wasn’t a very reliable way to do a valuation, well you got what you deserved; and if you thought that the books of Petrobras were as clean as the books of BP, well…diddums.

The Best Way to Start a Bubble is to get a Valuation

The Wikipedia account of the South Sea Bubble makes interesting reading (http://en.wikipedia.org/wiki/South_Sea_Company ), change the dates and the players and you might have been talking about the Credit Crunch, although that was on a much larger scale than the South Sea Bubble.

The key to that scam was convincing people (some were very clever people, Sir Isaac Newton for example), that some time in the future there would be a pot of gold, and that everything was “safe” and above board.

And it worked great, a dream, just like how investors were cuckooed into believing that house prices in USA would go on going up forever.

Granted the details were different, in the South Sea Bubble the promoters gave shares away to members of the aristocracy to create a feeling of “safety”, in the most recent scam, ratings agencies and Monte Carlo analysis were used to create that same delicious feeling; that’s progress for you.

After the South Sea Bubble popped a resolution was put to Parliament that the bankers involved in the scam should be tied up in sacks filled with snakes and dumped into the Thames.

The resolution was not carried; perhaps history might have been different if it had been?

How to cheat on a valuation

Cheating on a valuation is as old as the hills, the key is to create a black box, then you feed numbers into the box, and by magic a valuation pops out of the other end; nothing new there.

There is nothing new about banks lending money against collateral either. That’s what was called the “Pound of Flesh” in Shakespeare’s Merchant of Venice; prudent bankers would commission valuations of the pound of flesh, so that in the event that a loan was not paid back, they would be made whole.

The point of course is that the estimate had to be what the banker might get for the pound of flesh at some unspecified time IN THE FUTURE.

The way the scam worked in the housing bubble was that the “players” persuaded the banks (and since the individuals were on bonus many did not require much persuading, particularly since it wasn’t their money), that the mark to market price on the day the loan was exchanged for the collateral, was a great marker for how much they would be able to sell the collateral for in the future.

That was a dumb idea in 1720, and it was an equally dumb idea in 2006.

What’s new?

Valuation Standards

There appears to be a slow realization creeping into the consciousness of investors and regulators, that perhaps the valuation standards that were employed to report on the condition of publically listed companies, investment banks etc, prior to the credit crunch (and are still employed), weren’t very good.

For example, when (then) Secretary Henry Paulson announced to the world in July 2008 “The US Banking System Is A Safe And sound One”…

Was he lying?

I doubt it; I suspect that he was convinced at that time that the US banking system was indeed safe and sound.

And how did he reach that conclusion?

Simple, he looked at the valuations of assets, took that away from the liabilities (no need to value those particularly if you are intending to have your old firm get paid 100 Cents on the dollar), and bingo! The US banking system was safe and sound.

Here is a piece of news, it wasn’t then and it isn’t now.

International Valuation Standards (IVS)

IVS were formally introduced in 2000, initially they were designed only for valuation of real estate; over the years they have been expanded to value more or less anything.

Although they are approved and accepted as by far the best valuation standards ever devised by mankind, by every valuation institute in the world of any consequence, IVS are not used for doing valuations by many people (I use them but I am a distinct minority).

One reason for that is that it’s a lot harder to cuckoo someone if you are following IVS, than if you are following any one of the thousands of valuation principles that are floating around.

For example if in 2000 IVS had been mandated for valuation of housing which was used as collateral for mortgages and mortgage backed securities (and all the rest that followed on), there would not have been a housing bubble and there would (probably) not have been a credit crunch.

But of course that would not have been much fun. And one has to remember that some people became indescribably rich thanks to the credit crunch; although since bubbles are zero-sum, a lot of people became indescribably poor.  Swings and roundabouts!

What’s special about International Valuation Standards (IVS)?

For a start IVS was written by a bunch of people, who spent most of their lives doing valuations and know every trick in the book (Americans, Brits and Australians mainly). They were designed so that even a very smart operator would find it hard to cuckoo someone if IVS was used.

Key principles in IVS which are not commonly found in other “systems” of valuation; are as follows:

1: The person doing the valuation has to explain in plain English (or whatever), how he did the valuation, in terms that his client can understand. It’s that simple, if you are too dumb to understand the explanation for the valuation, you tell the person doing the valuation to go back and do it again until even you can understand it.

By definition, if a really-really dumb person can’t understand the valuation, it wasn’t done properly.

And if there is a black box or some magic trick involved, he has to explain how that works; this is something that the rating agencies are dead against, since apparently their systems of valuation (like the ones they used to stamp AAA on all those dodgy bonds), are “proprietary”. The same goes for the Monte Carlo wizards that are “valuing” oil reserves.

2: As part of that process, the valuer has to obtain sufficient market-derived data to be able to demonstrate that whatever magic he performed, worked reliably in the past. Of course the Monte Carlo Black Box Shysters will argue that this is impossible because the technology is new! And SECRET!

3: Needless to say the valuer is supposed to abide by certain ethical constraints, for example they are not supposed to take a kickback or an inducement to pump up the “value” like a free pass to the revolving door (that’s a novel idea).

4: IVS recognises only two values (1) Market Value (i.e. mark-to-market when the market is working properly), and (2) Other-than-market-value which is an estimate of what the mark-to-market value would be if the market was working properly.

This is the thing, the person doing the valuation is supposed to (a)  tell the client if the market is not working properly or in other words if it is in what George Soros calls “disequilibrium”, and (b) if the market is not working properly the person doing the valuation should always report other-than-market-value, and should thus qualify the valuation.

By that definition, Alan Greenspan would not be allowed to do a valuation; because he is proud of the fact that he doesn’t know how to spot a bubble (i.e. he doesn’t know how to tell if the market is in disequilibrium).

For example, if a house was being valued in 2006 in USA, under IVS it would be incumbent on the person doing the valuation to point out (a) the market was in disequilibrium (anyone who knew anything about valuation knew that), and (b) that if the bank was using the house as a collateral against a loan, they would be prudent if they considered a value of about 60% of the price at the time.

That’s if they wanted to be reasonably sure that in the event the person borrowing the money didn’t pay them back, then they would stand a good chance of being made whole by selling the property.

That’s not “risk management” by the way, that’s “stupidity management”.

5: IVS also mandates that the purpose of the valuation should be clearly stated, that sounds pretty obvious, but a lot of people don’t “get” that.

For example valuing a house in 2006 for the purpose of making sure that the buyer and the seller were not in cahoots to cuckoo the bank, and the price paid at the time reflected the market realities (at the time), that’s one value; but if the purpose was to estimate how much the bank might reasonably expect to sell the property for in five years time, that’s another value.

One of the reasons that there was the housing bubble in USA (and the hangover afterwards) is that NONE of the valuations were done explicitly for the purpose of figuring out a likely re-sale value in case of default.

That was in retrospect, probably not very smart, a sort of 1720’s vintage not very smart.

But IVS is Expensive!

You bet it is, that’s because it’s a lot more work and you need someone who can work out if there is a bubble or a bust. Sure you can buy an automated valuation on the Internet for $50 or less, a “proper” valuation costs a lot more.

I got a comment from a banker a while back on this subject, he said that Big And Very Important Banks, couldn’t afford to do valuations of their toxic assets properly, because they had thousands on their books, and that’s why they went with the equivalent of the “back of the envelope” valuation (A US Treasury less the CDS), or if they really wanted to splash out they benchmarked against an “exchange” with some selected tame bonds traded by their cronies and called that “mark-to-market”.

Certainly it would have been much more expensive to go through the inconvenience of doing valuations in accordance with IVS, like every year or so.

But what I’m not convinced about is whether the banks could afford to not do the valuations properly. Because if they could have afforded that (to not do the valuations properly), then why did they all line up for bail-out money, when it turned out, Big Surprise, that the valuations were wrong.

Here’s an idea, perhaps instead of handing over trillions of dollars to banks who “can’t afford” to do valuations properly, the regulators or the Fed might like to give them money to do the valuations properly; instead of giving them bail outs. I suspect that might work out a lot cheaper for the long-suffering US taxpayer.

Same goes for oil companies, and in fact any company that works out a large part of its P&L from an estimate of what an asset will be able to sell for, some time in the future. That is if investors are expected to make rational and informed decisions when they put money in such entities.

Well don’t we just live in interesting times!

The past year has certainly been a roller coaster, established words of wisdom have been trashed all over the place, economics as a “profession” is in complete disarray, ratings agencies, once “Gods” with the magical rubber stamps, are viewed on about par with realtors selling sub-prime.

Who knows, perhaps the Fed will start mandating that valuations are done according to IVS.

Now that would be really radical!