Archive for the ‘Leverage’ category

Free Download of Valuation and Common Sense Book

December 19, 2013

RISKVIEWS recently got the material below in an email.  This material seems quite educational and also somewhat amusing.  The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.  

For example, the table following shows a plot of Required Equity Premium by publication date of book. 

Equity Premium

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice. 

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic.  See post Friedman Model.


Book “Valuation and Common Sense” (3rd edition).  May be downloaded for free

The book has been improved in its 3rd edition. Main changes are:

  1. Tables (with all calculations) and figures are available in excel format in:
  2. We have added questions at the end of each chapter.
  3. 5 new chapters:


Downloadable at:

32 Shareholder Value Creation: A Definition
33 Shareholder value creators in the S&P 500: 1991 – 2010
34 EVA and Cash value added do NOT measure shareholder value creation
35 Several shareholder returns. All-period returns and all-shareholders return
36 339 questions on valuation and finance

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:


Downloadable at:

     Table of contents, acknowledgments, glossary
Company Valuation Methods
Cash Flow is a Fact. Net Income is Just an Opinion
Ten Badly Explained Topics in Most Corporate Finance Books
Cash Flow Valuation Methods: Perpetuities, Constant Growth and General Case
5   Valuation Using Multiples: How Do Analysts Reach Their Conclusions?
6   Valuing Companies by Cash Flow Discounting: Ten Methods and Nine Theories
7   Three Residual Income Valuation Methods and Discounted Cash Flow Valuation
8   WACC: Definition, Misconceptions and Errors
Cash Flow Discounting: Fundamental Relationships and Unnecessary Complications
10 How to Value a Seasonal Company Discounting Cash Flows
11 Optimal Capital Structure: Problems with the Harvard and Damodaran Approaches
12 Equity Premium: Historical, Expected, Required and Implied
13 The Equity Premium in 150 Textbooks
14 Market Risk Premium Used in 82 Countries in 2012: A Survey with 7,192 Answers
15 Are Calculated Betas Good for Anything?
16 Beta = 1 Does a Better Job than Calculated Betas
17 Betas Used by Professors: A Survey with 2,500 Answers
18 On the Instability of Betas: The Case of Spain
19 Valuation of the Shares after an Expropriation: The Case of ElectraBul
20 A solution to Valuation of the Shares after an Expropriation: The Case of ElectraBul
21 Valuation of an Expropriated Company: The Case of YPF and Repsol in Argentina
22 1,959 valuations of the YPF shares expropriated to Repsol
23 Internet Valuations: The Case of Terra-Lycos
24 Valuation of Internet-related companies
25 Valuation of Brands and Intellectual Capital
26 Interest rates and company valuation
27 Price to Earnings ratio, Value to Book ratio and Growth
28 Dividends and Share Repurchases
29 How Inflation destroys Value
30 Valuing Real Options: Frequently Made Errors
31 119 Common Errors in Company Valuations
32 Shareholder Value Creation: A Definition
33 Shareholder value creators in the S&P 500: 1991 – 2010
34 EVA and Cash value added do NOT measure shareholder value creation
35 Several shareholder returns. All-period returns and all-shareholders return
36 339 questions on valuation and finance

I would very much appreciate any of your suggestions for improving the book.

Best regards,
Pablo Fernandez

What is Too Big to Fail?

November 20, 2010

There seems to be various discussions going around about who needs to be considered Systemically important to qualify for “Special Attention” from regulators. Very large money managers are saying that they are not systemically important.

But it seems to me that there are quite a number of considerations. And everyone seems to be arguing solely from the part of that list that exempts them.

When thinking about money managers, I would think of the following:

  1. How is their liquidity managed? Can they really raise funds fast enough to satisfy a run on the bank?
  2. If they were to try to liquidate their funds, what would that do to the financial markets?
  3. How interconnected are they to other financial firms? Do regulators now have information about that?
  4. What about the future? (Isn’t that our concern, not the past or even the current situation?)
  • Could they shift their liquidity practices to become much more illiquid?
  • Their argument revolves around leverage, how much could they change their leverage under their current regulations? They can quickly leverage through derivatives as well as borrowing.
  • Could they become the center of new risky financial behavior that would endanger the financial sector?

That last point is a major concern of regulators regarding the Insurance industry. And they have history on their side. The insurance industry helped the financial sector to blow the mortgage business up to 4 or 5 times the underlying.

All you need to do that is a big balance sheet and a willingness to take one side of a trade without balancing it with the other side. And the money managers as well as the insurance companies both have exactly those characteristics.

Commentary on Timeline of the Global Financial Crisis

December 2, 2009

Link to Detailed Timeline

The events of the past three years are unprecedented in almost all of our lifetimes.  One needs to go back and look at how much was happening in such a short time to get an appreciation of how difficult it must have been to be in the hot seats of government, central banks and regulators, especially during the fall of 2008.

On the other hand, it is pretty easy, with 20-20 hindsight, to point to events that should have made it clear that something bad was on its way.

The timeline that is posted here on Riskviews is an amalgam from 5 or 6 different sources, including the BBC, Federal Reserve and Wikipedia.  None of them seemed to be very complete.  Not that this one is.  My personal biases left out some items from all of the sources.

Let us know what was left out that is important.  This timeline was created over a one year period and there was little effort to go back and pick up items that did not seem important at the time, but that later were found to be early signals of later big problems.

The reaction that I have had when I used this timeline to make a presentation about the Financial Crisis is that it is pretty unfair to go pointing fingers about actions taken during the fall of 2008.  When you look at the daily earth shaking events that were happening, it is really totally overwhelming, even a year later.  If the events that occured daily were spread out one per month, then perhaps a case could be made that “they” should ahve done better.

Going back much further, I am not willing to be quite so kind.  This crisis was manufactured by collision of two deliberate government policies – home-ownership for all and deregulation of financial markets.  That collision was preventable.  Neither policy had to be taken to the extreme that it was taken – to what looks now like an absurd extreme in both cases.

And in addition, the financial firms themselves are far from blameless.  Greenspan’s belief that the bankers were capable of looking out for their shareholder’s best interest was correct.  They were capable.

Read the history.  See what happened.  Decide for yourself.  Let me know what I missed.

Link to Detailed Timeline

Black Swan Free World (8)

October 26, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

8. Do not give an addict more drugs if he has withdrawal pains. Using leverage to cure the problems of too much leverage is not homeopathy, it is denial. The debt crisis is not a temporary problem, it is a structural one. We need rehab.

George Soros has said that he believes that the GFC is the beginning of the unwinding of a fifty year credit buildup.  Clearly there was too much leverage.  But does anyone know what the right amount of leverage for a smoothly functioning capitalist system should be?

There is always a problem after a bubble.  Many people keep comparing things to how they were at the very height of the bubble.  Stock valuations are compared to the height of the market.  Employment is compared to the point where the most people had jobs.  But these are often not the right comparisons.  If in the month of May, for 30 days, I had an outstanding offer for my house of $300,000 and on one day a person flew in from far away and offered $3 million, and if I never made that sale, do I forever after compare the offering price for selling the house to $3 Million?

People talk about a “New Normal”.  Possibly, the new normal means nothing more than returning to the long term trend line.  Going back to where things would now be if everything had stayed rational.

That may seem sensible, but this new normal may be a very different economy than the overheated and overleveraged one that we had.

Taleb suggests that the only possible transition from excessive debt is cold turkey.  If Soros is right and we are going to transition to a new normal that is more like 50 years ago than 5 years ago, there that will be a long bout of DTs.

What we are seeing in the way of debt is the substitution of government debt for private debt.  While Taleb is probably too harsh, the Fed does need to be careful.   Careful not to go too far with the government debt.  The Fed should be acting like the football player who passes ahead of the teammate, not to where they are standing right now.  The amount of debt that they should be shooting for is a level that will make sense when the banks fully recover and again take up lending “like normal”.  That will keep enough money flowing in the economy to soften the slowdown to the economy from the contraction of bank lending.

However, if the Fed is shooting to put us back where we were at the peak, then we are in trouble and Taleb’s warning holds.  I would restate his warning as “Using too much leverage to combat the problem of too much leverage…” But using the right amount of leverage is just what is needed.

But that does mean learning to live with much less leverage.  It means that we need to better understand how much leverage is the right amount.  And we need to stop blaming the Chinese because they hold so much dollars and want to lend them to us.  We need to develop a structural solution to the global imbalance that the Chinese balances are a symptom of.

Like some of our other problems, the purely market based solutions will not work.  China is not playing by the market based rule book.  They are a mercantilist economy that is taking advantage of the global market economy systems.  We need to stop whining about that and develop strategies that work for everyone.

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Coverage and Collateral

October 22, 2009

I thought that I must be just woefully old fashioned. 

In my mind the real reason for the financial crisis was that bankers lost sight of what it takes to operating a lending business. 

There are really only two simple factors that MUST be the first level of screen of borrowers:

1.  Coverage

2.  Collateral

And banks stopped looking at both.  No surprise that their loan books are going sour.  There is no theory on earth that will change those two fundamentals of lending. 

The amount of coverage, which means the amount of income available to make the loan payments, is the primary factor in creditworthiness.  Someone must have the ability to make the loan payments. 

The amount of collateral, which means the assets that the lender can take to offset any loan loss upon failure to repay, is a risk management technique that insulates the lender from “expected” losses. 

Thinking has changed over the last 10 – 15  years with the idea that there was no need for collateral, instead the lender could securitize the loan, atomize the risk, thereby spreading the specific risk to many, many parties, thereby making it inconsequential to each party.  Instead of collateral, the borrower would be charged for the cost of that securitization process. 

Funny thing about accounting.  If the lender does something very conservative (in terms of current standards) and requires collateral that would take up the first layer of loss then there will be no impact on P&L of this prudence. 

If the lender does not require collateral, then this charge that the borrower pays will be reported as profits!  The Banks has taken on more risk and therefore can show more profit! 

EXCEPT, in the year(s) when the losses hit! 

What this shows is that there is a HUGE problem with how accounting systems treat risks that have a frequency that is longer than the accounting period!  In all cases of such risks, the accounting system allows this up and down accounting.  Profits are recorded for all periods except when the loss actually hits.  This account treatment actually STRONGLY ENCOURAGES taking on risks with a longer frequency. 

What I mean by longer frequency risks, is risks that expect to show a loss, say once every 5 years.  These risks will all show profits in four years and a loss in the others.  Let’s say that the loss every 5 years is expected to be 10% of the loan, then the charge might be 3% per year in place of collateral.  So the banks collect the 3% and show results of 3%, 3%, 3%, 3%, (7%).  The bank pays out bonuses of about 50% of gains, so they pay 1.5%, 1.5%, 1.5%, 1.5%, 0.  The net result to the bank is 1.5%, 1.5%, 1.5%, 1.5%, (7%) for a cumulative result of (1%).  And that is when everything goes exactly as planned! 

Who is looking out for the shareholders here?  Clearly the deck is stacked very well in favor of the employees! 

What it took to make this look o.k. was an assumption of independence for the loans.  If the losses are atomized and spread around eliminating specific risk, then there would be a small amount of these losses every year, the negative net result that is shown above would NOT happen because every year, the losses would be netted against the gains and the cumulative result would be positive. 

Note however, that twice above it says that the SPECIFIC risk is eliminated.  That leaves the systematic risk.  And the systematic risk has exactly the characteristic shown by the example above.  Systematic risk is the underlying correlation of the loans in an adverse economy. 

So at the very least, collateral should be resurected and required to the tune of the systematic losses. 

Coverage… well that seems so obvious it doed not need discussion.  But if you need some, try this.

Black Swan Free World (7)

October 17, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

7. Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”. Cascading rumours are a product of complex systems. Governments cannot stop the rumours. Simply, we need to be in a position to shrug off rumours, be robust in the face of them.

Hyman Minsky’s Financial Instability Hypothesis talks about the financial markets working in three regimes, Hedge, Speculative and Ponzi.   Under Hedge financing, investments generally have sufficient cashflow to pay both principle and interest.  Under Speculative financing, investments generally have cashflows sufficient to pay interest, but depend upon rolling over financing to continue.  Ponzi financing does not have sufficient cashflows to pay either interest or principle.  Ponzi financing requires that values will increase enough to pay both principle and interest to repay financing.

Speculative financing requires a belief that the value of the collateral will be stable to justify future refinancing or rolling over of the financing.  That belief could be called confidence.

Ponzi financing requires a belief that the value of collateral will grow faster than the interest rate charged.  That belief requires a significantly higher amount of confidence.

There are several other levels that a financial business could operate.  For example, the value of the collateral could be viewed in terms, not of its current value, but of its value in an adverse scenario.  A very conservative lender could then make sure that each investment used that adverse value as the actual amount of collateral granted.  In that situation, the investor does not want to rely upon the belief that the asset value will be stable.  A significantly more aggressive investor will want to make sure that their portfolio in total adjusts the value of collateral for the possible loss in an adverse situation, allowing for the effects of diversification in the portfolio.

Credit practices in the US have drifted against the path of having the borrower put up cash for that difference between adverse value and current value.  Instead, practice has changed so that the lender will hold capital against that adverse scenario and charge the borrowed the cost of holding that capital.

What has changed with that drift, is who will bare the losses in the adverse scenario.  That has shifted from the borrower to the lender.  So the loan transaction has changed from a simple credit transaction to a combined credit and asset value insurance transaction.  (Which makes me wonder if the geniuses who thought of this thought to charge appropriately for the insurance or if they just believed that if the market bought it when they securitized it, then the price must be right.)

This will look different from the former loan business where the borrowed bore the asset value risk because the lender will have fluctuations in their balance sheet when the adverse scenarios hit and the collateral value falls below the loan value.  And that is exactly what we are seeing right now.

In addition, as we are seeing now, when there is a extremely severe drop in the value of collateral, having the banks hold the risk of the decline in collateral value, then a drop in the collateral will have a significant impact on bank capital.  The impact on bank capital may have a major impact on the bank’s ability to lend which will impact on all of the rest of the economy that had no connection to the impaired asset class.

So to Taleb’s point about confidence,  it seems that he is stating that lending practices should revert to their prior level where collateral was valued under an adverse scenario.  Then there will be little if any confidence involved in the lending business.  And less chance that a steep drop in any one asset class will spill over to the rest of the economy.

So the dividing line would be that the financial firms that could be subject to future government bailouts would need to value collateral pessimistically and to avoid loans that are not fully collateralized.

Sounds SAFE.

But here is the problem with that proposal…

If any other firms, outside of that restriction are permitted to lend in the same markets, business will ultimately shift to those institutions.  They will be able to offer better loan terms and larger loans for the same collateral AND in most years, they will show much higher profits.

Bad risk management will drive out good.  The institutions that take the most optimistic view of risk, those who have the most confidence, will drive the firms with the more pessimistic view (whether that is their own view or the view imposed by the regulators) out of the market.

And then when the next crisis hits, regulators will find that the business has shifted to the non-regulated firms and they they will instead need to bail them out, unless they make it illegal for non-regulated firms to do any of the kinds of finance that is related to a government’s need to bailout.

Then the bank would almost always have real collateral and any drop in confidence could be resolved by assigning that collateral over to someone with cash and settling any needs for cash that the lack of confidence creates.

Taleb is not clear however whether he is referring to banks or the financial system in general or to the government with his statement.  The discussion above is about banks.

Trying to think about this idea in the context of the entire financial system, I wonder if he was suggesting a return to the gold standard.  When there was a gold standard, there was no need for confidence in the currency.  If you stay with the current currency regime, then the confidence idea, I suppose, relates to the question of inflating the currency.  If the government does seem to consistently hold the money supply at a reasonable level in proportion to the economy, then there will not be a problem.  However, I cannot think of any way of looking at the floating currency system that does not REQUIRE confidence that the government will hold inflation in check.

Applying the idea to the government, I would also say that confidence is required there as well.  A government that could be counted on to fund fully for spending programs would instill confidence, but there could be no surity, especially under the US system where the next congress could immediately trample on the good record of a all preceding governments.

Black Swan Free World (10)

Black Swan Free World (9)

Black Swan Free World (8)

Black Swan Free World (7)

Black Swan Free World (6)

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

Black Swan Free World (6)

October 13, 2009

On April 7 2009, the Financial Times published an article written by Nassim Taleb called Ten Principles for a Black Swan Free World. Let’s look at them one at a time…

6. Do not give children sticks of dynamite, even if they come with a warning . Complex derivatives need to be banned because nobody understands them and few are rational enough to know it. Citizens must be protected from themselves, from bankers selling them “hedging” products, and from gullible regulators who listen to economic theorists.

It is my opinion that many bubbles come about after a completely incorrect valuation model or approach becomes widely adopted.  Today, we have the advantage over observers from prior decades.  In this decade we have experienced two bubbles.  In the case of the internet bubble, the valuation model was attributing value to clicks or eyeballs.  It had drifted away from there being any connection between free cashflow and value.  As valuations soared, people who had internet investments had more to invest in the next sensation driving that part of the bubble. The internet stocks became more and more like Ponzi schemes.  In fact, Hyman Minsky described bubbles as Ponzi finance.

In the home real estate bubble, valuation again drifted away from traditional metrics, the archaic and boring loan to value and coverage ratio pair.  It was much more sophisticated and modern to use copulas and instead of evaluating the quality of the credit to use credit ratings of a structured securities of loans.

Goerge Soros has said that the current financial crisis might just be the final end of a fifty year mega credit bubble.  If he is right, then we will have quite a long slow ride out of the crisis.

There are two aspects of derivatives that I think were ignored in the run up to the crisis.  The first is the leverage aspect of derivatives.  A CDS is equivalent to a long position in a corporate bond and a short position in a risk free bond.  But few observers and even fewer principals considered CDS as containing additional leverage equal to the full notional amount of the bond covered.  And leverage magnifies risk.  Worse than that.

Leverage takes the cashflows and divides them between reliable cashflows and unreliably cashflows and sells the reliable cashflows to someone else so that more unreliable cashflows can be obtained.

The second misunderstood aspect of the derivatives is the amount of money that can be lost and the speed at which it can be lost.  This misunderstanding has caused many including most market participants to believe that posting collateral is a sufficient risk provision.  In fact, 999 days out of 1000 the collateral will be sufficient.  However, that other day, the collateral is only a small fraction of the money needed.  For the institutions that hold large derivative positions, there needs to be a large reserve against that odd really bad day.

So when you look at the two really big, really bad things about derivatives that were ignored by the users, Taleb’s description of children with dynamite seems apt.

But how should we be dealing with the dynamite?  Taleb suggests keeping the public away from derivatives.  I am not sure I understand how or where the public was exposed directly to derivatives, even in the current crisis.

Indirectly the exposure was through the banks.  And I strongly believe that we should be making drastic changes in what different banks are allowed to do and what different capital must be held against derivatives.  The capital should reflect the real leverage as well as the real risk.  The myth that has been built up that the notional amount of a derivative is not an important statistic and that the market value and movements in market value is the dangerous story that must be eliminated.  Derivatives that can be replicated by very large positions in securities must carry the exact same capital as the direct security holdings.  Risks that can change overnight to large losses must carry reserves against those losses that are a function of the loss potential, not just a function of benign changes in market values and collateral.

In insurance regulatory accounting, there is a concept called a non-admitted asset.  That is something that accountants might call an asset but that is not permitted to be counted by the regulators.  Dealings that banks have with unregulated financial operations should be considered non-admitted assets.  Transferring something off to the books to an unregulated entity just will not count.

So i would make it extremely expensive for banks to get anywhere near the dynamite.  Or to deal with anyone who has any dynamite.

Black Swan Free World (5)

Black Swan Free World (4)

Black Swan Free World (3)

Black Swan Free World (2)

Black Swan Free World (1)

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