MBIA: Is Fair Value Accounting a Good Deal for Investors?

"Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring. The new era concepts had their roots first of all in the obsolescence of the old-established standards. During the last generation the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as it once was, a warranty of stability." ("The New Era Theory", Security Analysis, Benjamin Graham & David Dodd (1934))

We trolled extensively in the risk channel last week, speaking to practitioners and industry observers on both coasts, including the PRMIA West Coast Credit Risk Forum in San Francisco, where IRA CEO Dennis Santiago held forth on our favorite subject, credit stress testing.

There seems to be growing unanimity of opinion among investment and risk professionals that many structured assets and associated fair value accounting rules are Acts of Satan; that the rating agency duopoly headed by Moody's (NYSE:MCO) and S&P, a unit of McGraw Hill (NYSE:MHP), bears primary responsibility for the subprime fiasco; and also that the $3 trillion market for non-GSE paper need be fixed pronto or the global economy tanks in 2008.

Have a look at this chart of non-borrowed reserves using the data from the Fed's H-3 since 1975, this c/o Henry Smyth, Director of Granville Cooper Asset Management Ltd. The past two weeks, the number has been negative. We may have fixed the LIBOR issue, but the forced redemption of $3 trillion in private label securitizations seems to be drying up market liquidity in the US banking system.

An investment banker suggests Donald MacKenzie's 2006 book, An Engine, Not a Camera: How Financial Models Shape Markets [MIT] as a good background primer to understand how we reached the current global finance snafu. But to truly understand just how far from wisdom the global markets have strayed, we suggest first reading Chapter XXVII of Graham & Dodd, from which the quotation above is excerpted.

G&D italicized the word investing because they differentiated their value investing approach with the future-oriented, "new era" speculation which has been Wall Street's dominant culture since the 1920s. But for those of you who don't own a copy of G&D, you need look no further than the SEC EDGAR portal and the filings of MBIA (NYSE:MBI) to get a sample of how "new era" accounting speculates as to the value of assets, with dismal results for investors. In the January 31, 2008, press release included in the 8-K dropped on that date, MBI includes the following statement:

The decline in net income for the year was primarily due to the previously announced pre-tax net loss which amounted to $3.5 billion, or on an after-tax basis, $2.3 billion or $18.04 per share, on financial instruments at fair value ("mark-to-market") and foreign exchange. Significantly wider spreads and ratings downgrades of securities backing Collateralized Debt Obligations ("CDO") during the fourth quarter adversely affected the mark-to-market valuation of the Company's insured credit derivatives portfolio. As MBIA previously announced on January 9, 2008, the Company estimates a credit impairment of $200 million included in the pre-tax net loss of $3.5 billion on its insured credit derivatives portfolio for three CDO-squared transactions on which the Company expects to incur actual losses in the future. MBIA continues to believe that the balance of the mark-to-market losses are not predictive of future claims and, in the absence of further credit impairment, the cumulative marks should reverse over the remaining life of the insured credit derivatives. Additionally, the mark-to-market does not affect rating agency evaluations of MBIA's capital adequacy, except to the extent of impairments.

Notice that MBI's headline-grabbing loss of $3.5 billion comes as a result of a "fair value" accounting adjustment, not an actual cash loss. The cash "impairment" is just $200 million in the most recent reporting period. Unlike a credit default swap contract, where the obligor must immediately compensate the covered party for the full principal amount of the loss (net of recovery value), bond insurance requires only that the underwriter guarantee timely interest payments and, as contracted, the eventual repayment of principal -- eventual meaning upon maturity.

Notice too that the MBI statement anticipates a "bounce" in the future and, as a result, advises investors that yet another adjustment to the "fair value" of its insured credit derivatives book is likely. On similar terms, MBI also wrote down the value of its 17% equity stake in Chanel Re from $85.7 million to zero, but likewise states that an additional adjustment is possible.

As with Citigroup (NYSE:C), Merrill Lynch (NYSE:MER) and other financial institutions which have taken huge, non-cash "fair value" losses due to the collapse of the market for private label securitizations containing subprime assets, MBI might in the future take a gain on these very same positions. Thus while the GAAP "fair value" accounting suggests that MBI is badly decapitalized, in cash terms the impairment to date appears relatively minor.

One of these days, we hope somebody explains to us why these "fair value" adjustments are useful to investors, especially when applied to illiquid assets and liabilities. If corporate managers made such adjustments without a mandate from the Financial Accounting Standards Board and SEC, we'd be prosecuting them for securities fraud.

Indeed, if you go back and read the academic literature on fair value accounting, you see that, as with more general theoretical discussions of market efficiency, a high level of transparency and thus market liquidity was assumed in the utopian world where fair value accounting rules were to operate.

Applying the rules now mandated by FAS 157 to illiquid assets strikes us as a really bad idea, in large part because such an exercise is entirely subjective and violates the basic rules of forensic investigation. It is easy to get a price on any asset, just pick up the phone. But to determine "fair value" is an entirely different matter.

Last September, at the meeting of PRMIA at the Harvard Club in New York, Sylvain Raynes of RR Consulting, a veteran of MCO's structured finance unit who lectures at Baruch College, talked about the idiocy of applying fair value to finance:

Valuation is not the most important problem of finance. It is not the most interesting problem of finance. Valuation is the only problem of finance. Once you know value, everything happens. Cash moves for value. More price does not mean more value. If we do not recognize the fundamental difference that exists between price and value, then we are doomed. Historically this distinction did not really matter in corporate finance because the two, price and value, were supposed to be the same, to remain equal forever. Who has been telling us that? These people do not live in New York; they live in Chicago. The Chicago School of Economics has been telling us for a century that price and value are identical, i.e. that they are the same number . This means that there is no such thing as good deal or a bad deal, only fair deals. When I was a kid, my father took me to a car dealership and showed me a Mercedes Benz and he said '$10,000.' Now I thought, 'Wow, this is a good deal.' And I grew up and went to school, and all of a sudden they started to tell me that this not a good deal, but a fair deal. No, my father was right. I think the Chicago School is wrong.

Valuing assets that are not freely traded in a public market is problematic and fraught with conflicts, but that is precisely what the FASB and SEC have done to investors with the "three levels of hell" method for fairly valuing assets. To review, below are the three buckets into which assets must fall under fair value accounting:

Level 1: assets that have observable market prices.

Level 2: assets don't have an observable market price, but are based on them, like a swap contract.

Level 3: assets where valuation is reliant on management estimates.

In our view, use of fair value accounting is making financial statements more difficult for investors to understand. Assets which are marked for sale and do not fit into either Level 1 or 2 should be accounted for based on historical cost, not thrown into the subjective mosh pit of "management estimates." Observed prices for real transactions are the only "values" which matter to investors. As one senior banker told The IRA last week, changes such as fair value accounting "make GAAP accounting increasingly useless for judging the true cash performance of a company."

Does this mean that MBI does not need more capital to support its now multi-line insurance business? Oh no. But understanding MBI's true financial position would be a lot easier for investors (and builders of advanced analytics) without the dubious help of fair value accounting.

Comments

[westwest888:]

I think the value of something with no price is 0. Think of it like an IRR problem at a factory. You buy capital equipment at some huge outlay -1M. It has a miserable salvage value after you buy it and install it, like $0.20 on the dollar. And then you get a stream of cash flows from it's output for 30 years at 10k a month.

2008 Feb 12 09:14 AM