Straight-talk on FAS 157: Blackstone and their Banker Buddies Have it Wrong

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. 

——-

——-

COMMENT:

AUTHOR: STS

EMAIL: seth_stafford@comcast.net

URL: 

DATE: 07/03/2008 03:25:29 AM

Have you been reading Rebonato?  ”The Plight of the Fortune Tellers” makes the same general point about shallow quantification of decisions that require judgment.

I do wonder, though if the fetish for mark-to-“whatever’s flattering to my balance sheet today” DID lead to an overemphasis on as nearly-real time valuation as possible while that was convenient.   Is there no basis at all for the general concept of inventory/”held to maturity”?  I’m not arguing that  Blackstone owns anything deserving of that treatment, only asking whether the industry might in fact have gotten carried away with up-to-the-minute marks.

——-

COMMENT:

AUTHOR: philip

EMAIL: epeeist04@yahoo.com

URL: 

DATE: 07/03/2008 04:06:16 AM

Great post.  Their arguments simply don’t hold water.   Lack of accountability, lack of risk management, and lack of leadership.  Will this impending train wreck help any of this get better on Wall St.?  I hope so.

——-

COMMENT:

AUTHOR: JKH

EMAIL: jh@rogers.com

URL: 

DATE: 07/03/2008 06:34:50 AM

Excellent.

I’ll repeat the comment I just posted on Naked Capitalism:

The entire Ehrenberg post is a true gem.

Gap management was the original form of bank balance sheet risk management. Itís still important in commercial banks, although securitization deflected focus to some degree. And Investment banks in particular developed a very lax attitude to the importance of the idea in whatever risk monitoring they did, (although they should have learned from the Salomon Brothers event.)

The importance of FAS 157 on liability valuation is also critical, but gets little attention.

As far as the final paragraph is concerned, itís gold. But it’s also the case that the best financial services CEOs, who understand risk management does not mean quantitative slavery, also tend to see FAS 157 as accounting and capital slavery. They argue that FAS 157 content should be applied rigidly to disclosure, rather than inflexibly to accounting.

The CEOs of the 3 best run financial institutions in Canada (Manulife Financial, Royal Bank, Bank of Nova Scotia) have recently and separately made quite public statements that are remarkably similar connecting these two points on risk management and FAS 157. (And none of these institutions has any major problems with sub-prime or securitization exposures).

——-

COMMENT:

AUTHOR: flow5

EMAIL: sbh_home@hotmail.com

URL: 

DATE: 07/03/2008 02:04:09 PM

Gap management is impossible:

The DIDMCA of March 31st 1980 created the legal framework for the addition of 38,000 more commercial banks to the 14,000 we already had, and in the process, the abolition of 38,000 intermediary financial institutions. The intermediary financial institutions effected were the nation’s savings and loan associations, mutual savings banks, and credit unions. Trust companies and stock savings banks have been commercial banks for many years. Thus by edict, the principle financial intermediaries were destroyed and a money creating System was fostered, which the Fed cannot monitor, and has yet to bring under control.  

ìBanks have long contended that the costs of reserve requirements (i.e., forgone earnings) put them at a competitive disadvantage relative to non-bank competitors that are not subject to reserve requirements”  ñ Testimony of Treasury 

ìThese measures should help the banking sector attract liquid funds in competition with non-bank institutions and direct market investments by businessesî - Testimony of Treasury

The fact is that never are the commercial banks intermediaries in the lending (savings-investment) process:

Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

From a systems viewpoint, commercial banks as contrasted to financial intermediaries: prior to the DIDMCA; (S&Ls, MSBs, CUs), never loan out, and canít loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the ownerís equity or any liability item.

When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, State, and other Governmental Jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (Demand Deposits).

The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of “free gratis” legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.

Since 1942, money creation is a system process.  No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand.   

From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his bankís clearing balances, and probably its “free gratis” legal reserves, not a tax [sic] ñ and thereby itís lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit.  Hence, all CB liabilities are derivative.

That is, CB time/savings deposits, unlike savings accounts in the ìthriftsî, bear a direct, one-to-one, unvarying relationship, to transactions accounts.  As TDs grow, TRs shrink pari passu, and vice versa.  The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.  

Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries.  Indeed, as evidenced by the existence of ìfloatî, reserve credits tend, on the average, to precede reserve debits.  Therefore, it is a delusion to assume that savings can be ìattractedî from the intermediaries, for the funds never leave the commercial banking system.  

Consequently, the effect of allowing CBs to ìcompeteî with S&Ls, MSBs, CUs, MMFs, IBs and other intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80ís) ñ reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

However, disintermediation for financial intermediaries-S&Ls, MSBs, CUs, (non-banks), etc., is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures. In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the “thrifts” with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency).  This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

 In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.  

Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process.  Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred.  The reverse process, which is called  ìdisintermediationî, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

Professional economists have no excuse for misinterpreting the savings investment process.  They are paid to understand and interpret what is happening in the whole economy at any one time. For the commercial banking system, this requires constructing a balance sheet for the System, an income and expense statement for the System, and a simultaneous analysis of the flow of funds in the entire economy.  

From a System standpoint, time deposits represent savings have a velocity of zero.  As long as savings are held in the commercial banking system, they are lost to investment.  The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.  Deregulation created stagflation.

From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the ìfootingsî of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity of money.  Here investment equals savings (and velocity is evidence of the investment process), where in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money.

The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system.   Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy.  Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment….If there is to be a growth in time deposits there should be an offsetting increase in velocity.

It began with the General Theory, John Maynard Keynes gives the impression that a commercial bank is an intermediary type of financial institution serving to join the saver with the borrower when he states that it is an ìoptical illusionî to assume that ìa depositor and his bank can somehow contrive between them to perform an operation by which savings can disappear into the banking system so that they are lost to investment, or, contrariwise, that the banking system can make it possible for investment to occur, to which no savings corresponds.î

In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term financial intermediary in order to make the statement correct.  Perhaps this is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, Reg Q, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, etc.

How does the FED follow a “tight” money policy and still advance economic growth?  It should repeat the 1966 economic prescription. What should be done? The commercial banks should get out of the savings business (REG Q in reverse - but the non-banks should remain unrestricted).  What would this do?  The commercial banks would be more profitable - if that is desirable.  Why?  Because the source of all time deposits within the commercial banking system, is demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts.  Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know.  The growth of the intermediaries/non-banks cannot be at the expense of the com. banks.  And why should the banks pay for something they already have?  I.e., interest on time deposits.

Note: commercial banks are not financial intermediaries. The only time a commercial bank becomes a financial intermediary is when a 100% reserve ratio is applied to all of their deposits.

——-

COMMENT:

AUTHOR: ryan

EMAIL: issong@uobkayhian.com

URL: 

DATE: 07/03/2008 09:53:17 PM

Well done. You nailed the whole matter. Thanks for sharing your thoughts.

——-

COMMENT:

AUTHOR: Keith

EMAIL: keithjbutler@att.net

URL: 

DATE: 07/08/2008 08:07:08 AM

thanks for coming out of hibernation

——-

COMMENT:

AUTHOR: Todd

EMAIL: todd.walters@gmail.com

URL: 

DATE: 07/19/2008 11:32:29 PM

“Sometimes risk management requires judgment beyond computers, which is hopefully one of the biggest take-aways from the current credit melt-down.”

This point is a critical one and could benefit from some further elaboration. You seem to be getting at the distinction between RISK and UNCERTAINTY. The former is concrete and can be quantified, computerized, endlessly modeled. For example, there is risk in rolling dice, but no uncertainty, because you can predict the exact odds of rolling a certain number, or of rolling a certain sequence of numbers. But many financial forecasting models are based on the primary financial definition of risk: the historical volatility of an asset’s return or price level. 

But unlike a roll of the dice, you can never pin down exactly the odds of various future financial outcomes because reality (as opposed to rolling dice) is infinitely complex, with unknowns bound to impact those outcomes. The classic case of the huge impact of failing to acknowledge this distinction between risk and uncertainty was seen in the failure of Long-Term Capital Management (LTCM) in 1998. Footnote: I can’t take credit for these insights, I’m just regurgitating from my recent readings of Roger Lowenstein’s book on LTCM, When Genius Failed, and Nassim Nicholas Taleb’s Fooled by Randomness.

Also: there was an interesting op-ed in the Wall Street Journal the other day on the future of securitization in the post-subprime-crisis world. It made the point that securitization’s ability to facilitate gap or duration management is a key benefit that should be harnessed going forward.  Here’s the link: http://online.wsj.com/article/SB121564797624340969.html?mod=opinion_main_commentaries

Great post and great blog, by the way.

——-

————

2 years ago | view comments |  Wall Street