Archive for the ‘Mark to Market’ category

Price and Value

February 6, 2012

With a house, you always hear that the value is whatever someone is willing to pay for it.  But with a house, that value setting transaction is usually for the whole thing.  Partial shares of houses do not usually trade on the market.  So with a house, there are long periods of time when the actual value of the house is an unknown value.  It is usually reasonable to use a process of comparables to value the house.

Partial shares of companies, on the other hand, are traded on open markets.  That gives us a Price to use to impute a value to the ownership shares that are not traded.  The theory is that the shares are all worth the same amount.

The total reliance of modern finance and accounting on traded Price is credited with major improvements in the way that we understand business activities.

But there are unintended consequences of this shift.  And traded Price has never been a perfect measure.

The major fact that should make users of finance and financial statements pause is that when there is an acquisition of a company, the buyer does not rely upon finance theory about market values to set the final price of the transaction.  They rely upon boots on the ground fundamental analysis of the firm through the process called due diligence.

And at the end of that process, there is almost zero record of any firm selling for anything like the market price that existed before the acquisition process became known.

The buyer of a firm knows more than the market and pays a different price than the market. But if traded Price was really what the proponents of its ubiquitous usage say, then the wisdom of the market crowd should have arrived at the same amount.  But it never does.

You can think of it as the market spinning its own myth of the value of a firm and running around trading small lots of stocks that may not have any real impact on the actual transactions for the control of listed firms.

What does that mean for a risk manager?  It means that reliance on traded price is risky.  Traded price is more like a mock casino night.  Everyone pretends like the traded price is the real value of the firm but everyone knows that at the end of the night it is all just a game.  Why is that risky?  Because, like any game, trading shares can be suddenly discontinuous.

The value of a firm is the amount of profits that it can create in the future.  Don’t let any traded price enthusiast tell you anything different.

Those traded price folks tried to sell the idea that a house was worth whatever someone would pay (with someone else’s money).  But in reality, the house can only be worth an annuity on a fraction of the earnings of the folks who live there.  Traders can temporarily come to a different conclusion.  And they can give each other Nobel Prizes for creating clever math around their mock casino night.

Reporting on an ERM Program

August 15, 2011

In a recent post, RISKVIEWS stated six key parts to ERM.  These six ideas can act as the outline for describing an ERM Program.  Here is how they could be used:

1.  Risks need to be diversified.  There is no risk management if a firm is just taking one big bet.

REPORT: Display the risk profile of the firm.  Discuss how the firm has increased or decreased diversification within each risk and between risks in the recent past.  Discuss how this is a result of deliberate risk and diversification related choices of the firm, rather than just a record of what happened as a result of other totally unrelated decisions. 

2.  Firm needs to be sure of the quality of the risks that they take.  This implies that multiple ways of evaluating risks are needed to maintain quality, or to be aware of changes in quality.  There is no single source of information about quality that is adequate.

REPORT:  Display the risk quality of the firm.  Discuss how the firm has increased or decreased risk quality in the recent past and the reasons for those changes.  Discuss how risk quality is changing in the marketplace and how the firm maintains the quality of the risks that are chosen.

3.  A control cycle is needed regarding the amount of risk taken.  This implies measurements, appetites, limits, treatment actions, reporting, feedback.

REPORT:  The control cycle will be described in terms of who is responsible for each step as well as the plans for remediation should limits be breached.  A record of breaches should also be shown.  (Note that a blemish-less record might be a sign of good control or it might simply mean that the limits are ineffectively large.)  Emerging risks should have their own control cycle and be reported as well.

4.  The pricing of the risks needs to be adequate.  At least if you are in the risk business like insurers, for risks that are traded.  For risks that are not traded, the benefit of the risk needs to exceed the cost in terms of potential losses.

REPORT:  For General Insurance, this means reporting combined ratio.  In addition, it is important to show how risk margins are similar to market risk margins.  Note that products with combined ratios over 100% may or may not be profitable if the reserves do not include a discount for interest.  This is accomplished by mark-to-market accounting for investment risks.  Some insurance products have negative value when marked to market (all-in assets and liabilities) because they are sold with insufficient risk margins.  This should be clearly reported, as well as the reasons for that activity.  

5.  The firm needs to manage its portfolio of risks so that it can take advantage of the opportunities that are often associated with its risks.  This involves risk reward management.

REPORT:  Risk reward management requires determining return on risk for all activities as well as a planning process that starts with projections of such and a conscious choice to construct a portfolio of risks.  This process has its own control cycle.  The reporting for this control cycle should be similar to the process described above.  This part of the report needs to explain how management is thinking about the diversification benefits that potentially exist from the range of diverse risks taken.  

6.   The firm needs to provision for its retained risks appropriately, in terms of set asides (reserves or technical provisions) for expected losses and capital for excess losses.

REPORT:  Losses can be shown in four layers, expected losses, losses that decrease total profits, losses that exceed gains from other sources but that are less than capital and losses that exceed capital.  The likelihood of losses in each of those four layers should be described as well as the reasons for material changes.  Some firms will choose to report their potential losses in two layers, expected losses, losses that reach a certain likelihood (usually 99.5% in a year or similar likelihood).  However, regulators should have a high interest in the nature and potential size of those losses in excess of capital.  The determination of the likelihood of losses in each of the four layers needs to reflect the other five aspects of ERM and when reporting on this aspect of ERM, discussion of how they are reflected would be in order.  

LIVE from the ERM Symposium

April 17, 2010

(Well not quite LIVE, but almost)

The ERM Symposium is now 8 years old.  Here are some ideas from the 2010 ERM Symposium…

  • Survivor Bias creates support for bad risk models.  If a model underestimates risk there are two possible outcomes – good and bad.  If bad, then you fix the model or stop doing the activity.  If the outcome is good, then you do more and more of the activity until the result is bad.  This suggests that model validation is much more important than just a simple minded tick the box exercize.  It is a life and death matter.
  • BIG is BAD!  Well maybe.  Big means large political power.  Big will mean that the political power will fight for parochial interests of the Big entity over the interests of the entire firm or system.  Safer to not have your firm dominated by a single business, distributor, product, region.  Safer to not have your financial system dominated by a handful of banks.
  • The world is not linear.  You cannot project the macro effects directly from the micro effects.
  • Due Diligence for mergers is often left until the very last minute and given an extremely tight time frame.  That will not change, so more due diligence needs to be a part of the target pre-selection process.
  • For merger of mature businesses, cultural fit is most important.
  • For newer businesses, retention of key employees is key
  • Modelitis = running the model until you get the desired answer
  • Most people when asked about future emerging risks, respond with the most recent problem – prior knowledge blindness
  • Regulators are sitting and waiting for a housing market recovery to resolve problems that are hidden by accounting in hundreds of banks.
  • Why do we think that any bank will do a good job of creating a living will?  What is their motivation?
  • We will always have some regulatory arbitrage.
  • Left to their own devices, banks have proven that they do not have a survival instinct.  (I have to admit that I have never, ever believed for a minute that any bank CEO has ever thought for even one second about the idea that their bank might be bailed out by the government.  They simply do not believe that they will fail. )
  • Economics has been dominated by a religious belief in the mantra “markets good – government bad”
  • Non-financial businesses are opposed to putting OTC derivatives on exchanges because exchanges will only accept cash collateral.  If they are hedging physical asset prices, why shouldn’t those same physical assets be good collateral?  Or are they really arguing to be allowed to do speculative trading without posting collateral? Probably more of the latter.
  • it was said that systemic problems come from risk concentrations.  Not always.  They can come from losses and lack of proper disclosure.  When folks see some losses and do not know who is hiding more losses, they stop doing business with everyone.  None do enough disclosure and that confirms the suspicion that everyone is impaired.
  • Systemic risk management plans needs to recognize that this is like forest fires.  If they prevent the small fires then the fires that eventually do happen will be much larger and more dangerous.  And someday, there will be another fire.
  • Sometimes a small change in the input to a complex system will unpredictably result in a large change in the output.  The financial markets are complex systems.  The idea that the market participants will ever correctly anticipate such discontinuities is complete nonsense.  So markets will always be efficient, except when they are drastically wrong.
  • Conflicting interests for risk managers who also wear other hats is a major issue for risk management in smaller companies.
  • People with bad risk models will drive people with good risk models out of the market.
  • Inelastic supply and inelastic demand for oil is the reason why prices are so volatile.
  • It was easy to sell the idea of starting an ERM system in 2008 & 2009.  But will firms who need that much evidence of the need for risk management forget why they approved it when things get better?
  • If risk function is constantly finding large unmanaged risks, then something is seriously wrong with the firm.
  • You do not want to ever have to say that you were aware of a risk that later became a large loss but never told the board about it.  Whether or not you have a risk management program.

Take CARE in evaluating your Risks

February 12, 2010

Risk management is sometimes summarized as a short set of simply stated steps:

  1. Identify Risks
  2. Evaluate Risks
  3. Treat Risks

There are much more complicated expositions of risk management.  For example, the AS/NZ Risk Management Standard makes 8 steps out of that. 

But I would contend that those three steps are the really key steps. 

The middle step “Evaluate Risks” sounds easy.  However, there can be many pitfalls.  A new report [CARE] from a working party of the Enterprise and Financial Risks Committee of the International Actuarial Association gives an extensive discussion of the conceptual pitfalls that might arise from an overly narrow approach to Risk Evaluation.

The heart of that report is a discussion of eight different either or choices that are often made in evaluating risks:

  1. MARKET CONSISTENT VALUE VS. FUNDAMENTAL VALUE 
  2. ACCOUNTING BASIS VS. ECONOMIC BASIS         
  3. REGULATORY MEASURE OF RISK    
  4. SHORT TERM VS. LONG TERM RISKS          
  5. KNOWN RISK AND EMERGING RISKS        
  6. EARNINGS VOLATILITY VS. RUIN    
  7. VIEWED STAND-ALONE VS. FULL RISK PORTFOLIO       
  8. CASH VS. ACCRUAL 

The main point of the report is that for a comprehensive evaluation of risk, these are not choices.  Both paths must be explored.

The Risk of Market Value

January 28, 2010

In 1984, Warren Buffet gave a speech about value investing at Columbia University.  Here is a quote from that speech:

“it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem to be able to grasp the concept, simple as it is.” Warren Buffett

Not about risk management but, if you can get your head around Buffett’s comment about upside, there is a logical counterparty about downside.

“Either the idea of buying dollar bills at $2 seems risky to someone immediately or it never will. If the response is, ‘if that is what the market rate is’ then just dig into your pocket and look for some dollars to sell.” Dave Ingram

In the book “The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History”, Greg Zuckerman tells just how difficult it was to be among the few investors who saw that the US mortgage market was overheated – that the market value of the houses and the securities written on the mortgages on those houses were all dollar bills being traded over and over again at $2.

But that was aggressive trading.  The risk management response with that knowledge would been to stay away.  And many, many financial institutions did stay away.  All of the press went to the firms that played that game to their and all of our detriment.

So the Paulson story of good to read because it tells about the other side of some of the trades.  And there always in another side, no matter how poorly the press chooses to cover it.

And the other side of the risk mismanagement by the largest banks and AIG is the risk management of the firms who were not exposed to overpriced mortgage securities.  But it is hard to make a story about the exposures that those firms did not have.

Which is one of the puzzles of risk management.  Sometimes the greatest successes are when nothing happens.

Basis Risk

January 14, 2010

In the simplest terms, basis risk is the difference between the hedge you bought and the risk that you own.  Especially the difference that is most noticeable when you had expected to be needing the hedge.

But that is not the topic here.  There is another Basis Risk.  That is the risk that you are using the wrong basis to judge your gains and losses.  This risk is particularly prevalent right after a bubble pops.  Everyone is comparing their wealth to what they thought that they had at the height of the bubble.

Here are two stories that show the problem with that:

  1. Think about a situation where someone made an error in preparing your brokerage statement.  That IBM stock you have was worth $100,000.  The mistake was that an extra zero slipped in somehow.  The position was recorded as $1,000,000.  Add that in to your net worth and most of us would have an exaggerated feeling of wealth.  Think of how destructive to your long term happiness it would be if you really came to believe that you had that extra $900,000?  Two ways that could be destructive.  First of all, you could start spending other funds as if you had all that excess value.  Second of all, once you were informed of the error, you could then undertake more aggressive investments to try to make up the difference.  The only way to be safe from that destruction is if you never believe the erroneous basis for the IBM stock.
  2. Possibly more realistic, think of someone in a casino.  During their day there they bet on some game or other continuously.  At one point in the visit, they are up by $100,000.  When they leave, they are actually down by $1000 compared to the amount they walked in the door with.  Should they tell people you lost $1000 or $101,000?

In both cases, it sounds silly to even think for long about the larger numbers as your “basis”.  But that seems to pervade the financial press.  Unfortunately, with regard to home values, many folks were persuaded to believe the erroneous valuation at the peak of the market and to borrow based upon that value.

So, now you know what is meant by this type of “Basis Risk”.  Unfortunately, it is potentially much larger than the first type of basis risk.  Behavioral Finance abounds with examples of how the wealth effect can distort the actions of people.  Possibly, the reason that the person in the casino walked out with a $1000 loss is realted to the sorts of destructive decisions that are made when wealth is suddenly increased.  Therefore, it is much more important to protect against this larger basis risk.

To protect against this type of risk requires a particularly strong ability to stick to your own “disciplined realism” valuation of your positions.  Plus an ability to limit your own valuation to include only reasonable appreciation.  Mark to mark is the opposite of the disciplined realism, at least when it comes to upside MTM.  For downside movements in value, it is best to make sure that your disciplined realism is at least as pessimistic as the market. 

This is a very different approach than what has been favored by the accounting profession and adoppted by most financial firms.  But they have found themselves in the position of the second story above.  They feel that they have made gigantic profits based upon the degree to which their bets are up in the middle of the session.  They have not left the casino yet, however.

And that is the last place where disciplined realism needs to be applied.  Most of us have been schooled to believe that “realized gains” are REAL and therefore can of course be recognized.  But think of that second story about the casino.  If you are taking those gains and putting them right back on the table, then you really do not “have” them in any REAL sense.  Firms need to adopt disciplined realism by recognizing that a series of similar positions are in reality not at all different from a single position held for a long time.  The gains should not be recognized until the size of the position is significantly reduced.

A Bird in the Hand

January 6, 2010

is Worth Two in the Bush. 

is an old maxim for risk adjusting asset valuation.  It suggests a 50% discount for recording unrealized values.  Notice that is not a discount for recognizing unrealized GAINS, it is a discount on VALUE. 

You have to wonder whether that 50% discount is because there is only a 50% chance that you will catch a bird in the bush or if it reflects a higher chance of actually catching the bird, plus some risk premium because there is some chance that you will catch none.  Is catching none your risk tolerance, or can you go several days without bird for supper, so you have a risk tolerance of zero birds for two or even three days? 

How do you provide for that worst case?  Do you hold a bird in reserve?  Or half a bird?  How do you keep the reserve bird?  Do you have to feed it or refrigerate it? 

Older versions of the saying show a much higher discount.  Two versions from the 1400’s suggest a 90% discount for birds that are on the fly or in the wood.  Were the risk tolerances much lower then or methods of catching birds much less developed?  We may never know. 

But times change and discounts change.  Following the pattern of diminishing discounts, the current standard is that one bird in the hand is worth one bird in the bush according to current accounting standards.  

That is called mark to market accounting.  Older acounting standards might have applied 100% discounts to unrealized GAINS.  But the current wisdom is to not discount anything ever.  So holding cash is exactly the same as holding paper that does not even promice to be worth any cash if at some time in the recent past, someone thought that paper had a particular value. 

With a 50% discount on unrealized VALUES, there was little chance of ever having to do a write-off.  Usually recoveries even in dire situations exceed 50%.  With no discount, there is a very high chance of a write-off because the assets are booked at a value that is the most that one might expect to recover. 

Clever people have figured ways to go even further.  For assets where there are no easy market prices, they get to count future birds that they haven’t even seen yet. 

That is one reason why banks are fighting so hard to keep derivatives off of exchanges, so that they can keep those future birds on their books and do not have to suffer the discounts that an exchange would impose.


%d bloggers like this: