12 December 2009

Value and Rules ~ Satyajit Das

Wall Street Revalued: Imperfect Markets and Inept Central Bankers by Andrew Smithers (2009)

The Road to Financial Reformation: Warnings, Consequences, Reforms by Henry Kaufman (2009)

A book review...

In a sense, this crisis is about values (the prices paid for many assets) and the rules (regulations governing financial markets). It is also about rules (rigid model based formulations of price) and values (ethics or the lack thereof). These two books provide different perspectives on the issues.

In Wall Street Revalued, Andrew Smithers, an experienced practitioner (in fund management and now as a consultant), explores the value of stocks. This is a theme that Mr.Smithers has written about before, most notably in his 2000 book Valuing Wall Street which together with the Robert Shiller’s better known Irrational Exuberance presciently highlighted the overvaluation of new economy Internet stocks.

Wall Street Revalued argues that assets can be objectively valued and managing asset prices should be one of the central functions of central bankers. Mr. Smithers’ asserts that denial of these fundamental principles lay at the heart of the global financial crisis. On valuation, Wall Street Revalued favours the “q” ratio (the replacement cost of a company’s assets) and cyclically adjusted price-earnings ratio over the previous ten years (a measure also adopted by Professor Shiller).

Eloquent and persuasive, Mr. Smithers make his case well with the advantages of brevity and an abundance of charts and Tables. But some problems remain.

It is not clear how earnings or accurate replacement values can be forecast. This is particularly so at inflection points in economic history – I am sure horse and buggy makers were “cheap” on replacement cost and PE measures after the advent of non-equine modes of transportation. The ability of obscurantist accountants and derivative professionals to affect company earnings and cash flows has become increasingly important. The effect of leverage (both obvious and disguised) also affects these numbers perhaps more that Mr. Smithers acknowledges. How are these to be dealt with at an acceptable level of certainty?

If precise valuation were possible then surely the entire idea would have enabled computers loaded with Mr. Smithers’ data and insight to generate significant excess returns. Markets may deviate from fair value for varying, sometimes lengthy, periods. Echoing Minsky’s famous formulation – “conditionally coherent”, Mr. Smithers argues that markets are “imperfectly efficient”, fluctuating around their fair value.

The question then is over what time horizon will be the true value be achieved? As Keynes stated: “…this long run is a misleading guide to current affairs. In the long run we are all dead.”

As every sensible trader knows, the price you pay is always wrong. If you sell then by definition you are lowest price in the market. If you buy, then your bid is the highest. They also know price is what you pay while value is what you hope and pray for. The mysteries of value remain.

Before Nouriel Roubini, Marc Faber and the others, there was Henry Kaufman – the original ‘Dr. Doom’. He too saw the crisis coming (this disease is clearly infectious!). The text contains an entire section on his prophetic and neglected early warnings.

Road to Financial Reformation provides a personal (at times) and insightful overview of the global financial crisis and brims with suggestions for reform to avoid a future recurrence. Intended for financiers and regulators involved in the industry, the book is a thoughtful analysis of the main issues.

Dr. Kaufman’s major concern is the blind faith in models and questionable innovations. He is critical of the rapid increase in size and concentration of financial institutions. He identifies how securitisation of bank loans “created the illusion that credit risk could be reduced if the instruments became marketable” and led to a decline in the credit quality of debt. He also shrewdly identifies how the idea of liquidity altered from assets (what you could sell) to one centered on liabilities (what you could borrow).

His solutions are unsurprising. He advocates a single regulator and increased regulation. Amusingly, he urges that “amid the blizzard of quantitative, technical offerings…courses in economic and financial history should be required for all business degrees.” As Marx warned history has a tendency to repeat first as tragedy and then as farce. It is not entirely clear why the simple study of it would prevent this.

The reliance on central bankers, on the part of both Mr. Smithers and Dr. Kaufman, to prick asset bubbles and take responsibility for regulating the financial system is brave.

Recently, Ben Bernanke, President of the Federal Reserve, confessed: “I did not anticipate a crisis of this magnitude.” Mr. Bernanke further acknowledged shortcomings in a more traditional area of central bank expertise – ensuring the adequate capitalisation of banks. It is far from clear that central bankers would be capable of identifying mis-valuation and acting on it. Most tellingly, traders and investors did not prove particularly able at this task. And they were better paid than central bankers.

Regulation and governance generally rely on enforcement and strict compliance. Dr. Kaufman conveniently neglects mention of the fact that he had a seat on Lehman Brothers’ board and a member of its finance and risk committee.

The octogenarian Dr. Kaufman was joined on this committee by a Broadway producer, a former officer of US Navy, founder of Spanish-language TV station and a former chairman of IBM (from some 13 years ago). The 5 directors had been on Lehman's board for a collective 55 years. It appears that there were two meetings of finance and risk committee in 2006 and 2007. The composition of the committee is especially puzzling as there was no inkling that the investment bank was contemplating ownership of warships or producing musicals or programs for Spanish language TV.

Whatever the book’s other considerable insights, Road to Financial Reformation does not make the case for the capabilities of central bankers and other worthies oversighting either the markets or individual institutions. It may ultimately be a case of values rather than rules.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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