Thursday, July 3, 2008

FAS 157: Blackstone has it wrong

(Information Arbitrage) There have been some rumblings over the past several months about accounting rules being a key contributor to the banking sector meltdown, and I've let it slide. But now that Steve Schwartzman and Tony James of Blackstone have publicly stated their views that FAS 157 - or Fair Value Measurement rules in normal-speak - is perhaps even dangerous, I have to put my blogging hiatus to the side. Because this view is so myopic, slanted and not acknowledging of the complexity of the issue that some additional (and more detailed) perspective is warranted.

I've always felt that primary responsibility of bank leadership was to maximize return while managing risk to an acceptable level, and in a financial firm this really comes down to the concept of gap management (the difference between the duration of assets and liabilities, or the net interest rate sensitivity of the firm). Before the rates thrifts could pay for deposits was de-regulated, they had a wonderful business of lending long at comparatively high rates (principally in residential mortgages) and borrowing at comparatively low rates (via core deposits). Because rates were undifferentiated core deposits were very "sticky," as there wasn't a price motive to switch from one thrift to another. Therefore, the implied duration of its loan book was long while the implied duration of its core deposit base was long as well, giving them a matched book and a steady stream of earnings. Now this is a simplified view of things but you get the point. When this came to a screeching halt in 1982 and thrifts needed to compete more aggressively for both mortgage assets and deposits, that nicely managed gap widened dramatically. Assets were still long-dated, but lower yielding than before due to competition. Liabilities were now more expensive and of a much shorter duration, causing a massive funding mismatch that contributed to the S&L crisis of the late 1980's.

Why my little walk down memory lane? Because my thesis is that we are pretty much experiencing the same phenomenon today. Assets whose duration have unexpectedly lengthened due to lack of liquidity, while most banks have funded themselves in a seemingly opportunistic but highly risky way through repurchase agreements, asset-backed commercial paper and other short-term financing instruments. And when the music stops and investors stop wanting to lending short? The predictable cash crunch ensues. This is a classic failure of gap management, the key building block of running a successful financial firm. Some may throw up smoke and say "Well, the trading risks of investment banks are much more complicated than the simple mortgage loans of the 1980's. This is totally different."

Bull. Trading risk becomes liquidity risk when you can't trade. If you can't finance a book to take into account the vagaries of different market (read: liquidity) scenarios, then nothing else matters. Just ask Bear Stearns. So, if you are a prudent gap manager and operating in a FAS 157 world, what would you do? Do real stress-testing of liquidity scenarios and construct a capital structure that address much of the liquidity risk posed by non-standard assets. Because in an adverse scenario where liquidity dries up, there is a flight to quality and spreads blow out, the bank will experience a large mark-to-market gain on its liabilities, both avoiding a huge hit to equity and mitigating the need to run out and secure costly financing under highly adverse circumstances (like Citigroup, Merrill Lynch, Lehman, Washington Mutual and the rest of them). This could have prevented a lot of pain to a lot of shareholders. Sure, they might not have ridden as high during the up-market, but they would been more than compensated with downside protection. It's called volatility reduction. Or prudent gap management.

By way of background, let me share some of the Financial Accounting Standards Board's summary of what FAS 157 is intended to do:

The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability.


This Statement emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability.


This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine.


This Statement clarifies that a fair value measurement for a liability reflects its nonperformance risk (the risk that the obligation will not be fulfilled). Because nonperformance risk includes the reporting entity’s credit risk, the reporting entity should consider the effect of its credit risk (credit standing) on the fair value of the liability in all periods in which the liability is measured at fair value under other accounting pronouncements...

I think this stuff is pretty straightforward and reasonable but hey, that's just me. Messrs. Schwartzman and James, however, feel quite differently. From today's New York Times:

But Mr. Schwarzman is convinced that the rule — known as FAS 157 — is forcing bookkeepers to overstate the problems at the nation’s largest banks.

“From the C.E.O.’s I talk with,” Mr. Schwarzman said during an interview on Monday morning, “the rule is accentuating and amplifying potential losses. It’s a significant contributing factor.”

Some of his bigwig pals in finance believe that Wall Street is in much better shape than the balance sheets suggest, Mr. Schwarzman said. The president of Blackstone, Hamilton E. James, goes even further. FAS 157, he said, is not just misleading: “It’s dangerous.”


The idea seems noble enough. The rule forces banks to mark to market, rather to some theoretical price calculated by a computer — a system often derided as “mark to make-believe.” (Occasionally, for certain types of assets, the rule allows for using a model — and yes, the potential for manipulation too.)

But here’s the problem: Sometimes, there is no market — not for toxic investments like collateralized debt obligations, or C.D.O.’s, filled with subprime mortgages. No one will touch this stuff. And if there is no market, FAS 157 says, a bank must mark the investment’s value down, possibly all the way to zero.

That partly explains why big banks had to write down countless billions in C.D.O. exposure. The losses are, at least in part, theoretical. Nonetheless, the banks, in response, are bringing down their leverage levels and running to the desert to raise additional capital, often at shareholders’ expense.


Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really worth much more than anyone currently expects. And if they are so mispriced, why isn’t some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?

For Mr. Schwartzman’s part, he says that the banks haven’t been willing to unload the investments at the distressed prices. Besides, the diligence required for most buyers is almost too complicated.

I think Steve and Tony are only looking at half the problem. In a mark-to-market world, you can't only look at the asset side, you need to look at the liability side as well. And, oh yes, there is also that niggling issue of liquidity. As Mr. Schwartzman says, "...the banks haven't been willing to unload (the) investments at distressed prices..." Well, a firm earns that right by having a capital structure and funding plan that can support a long-term hold strategy. Otherwise, they should suffer the vagaries of the market. But this is an issue simply not addressed by the bright men of Blackstone or their Wall Street buddies.

So why do risk managers and bank managements' so consistently make bad decisions? Probably because there is an over-reliance on measures that are seemingly quantifiable. They can measure delta. They can measure vega. They can measure theta. They can measure gamma (or at least they think they can). They can estimate credit loss ratios. But what about liquidity? When you are quantifying factor exposures, how exactly do you model liquidity as other risk factors change? It is a very, very hard question. Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down. My sense is that there is currently a fear to manage without a machine telling you what to do. It is kind of like the drunk looking for his lost keys by the streetlight, simply because this is where he can see. But the likelihood of his keys being within the illumination of the streetlight is very, very low. Some of the best risk managers, guys like Gus Levy of Goldman Sachs and Ace Greenberg of Bear Stearns, didn't rely on computers but relied on instinct, savvy and experience. We need more of this. It's called leadership. Let's not cloud the issue. It's not about FAS 157 or any other accounting rule. It has been and always will be about management.

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