The Efficient Markets Hypothesis is a staple of finance theory - it states that stock prices adjust nearly instanteously to reflect new information. In its stronger forms the EMH is used to support claims concerning the impossibility of riskless arbitrage, or the efficacy of fundamental or technical analysis as a means for "beating the market"
In a sense the EMH is a truism - because in an era of nearly instanteous communication and electronic trading - of course stock prices are going to relect available information as soon as it becomes available. And because the market as a whole cannot "beat" itself, individual instances of what seems to be arbitrage opportunities or outperformance can be explained away as outliers or temporary phenomena
The problem is that information is only as good as peoples' ability to rationally understand and make use of it. If information is misconstrued, or interpreted in an irrational manner, the resultant stock prices will blindly reflect that mis-interpretation or irrationality. Garbage in, garbage out. The fact that there are so many participants in the market doesn't eliminate this possibility - indeed at times it exacerbates it. The great mass of traders and stock market participants are not a calm, deliberative assembly - they are more like an unruly mob, and ever since the Tulip Bulb mania we have many examples concerning the madness of crowds.
The recent change to mark-to-market accounting rules and the market reaction brought this back to mind. The effect of this chage - first felt on April Fool's day appropriate enough - was a big instant leap in the KBW index of US bank stocks, which in turn fuelled the recent overall market rally. But in fact, the relaxation of mark-to-market does absolutely nothing of substance. It doesn't change a single item on any bank balance sheet or add additional capital. To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet. It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3". Efficient stupidity in action.
The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems. But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3". I can see why the banks might want such flexibility. What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.
Do all the modern analysis of the flow of information take into account the «packaging» of the info ? How it is presented, by whom, etc.? Obviously, when I look at the flow of information between négociants and merchants of the 1750s, it is easy enough to do - and I can see how nowadays, the multiplicity of information is supposed, or assumed to render such concerns meaningless, but I am not convinced.
Quote from: Oexmelin on April 03, 2009, 09:37:38 AM
Do all the modern analysis of the flow of information take into account the «packaging» of the info ?
I don't know about "all" - there is far more literature out there on these issues than I could ever hope to read. There is an argument that given the muliplicty of media sources and sheer size of the markets that any "spin" will be seen through by enough as to render it ineffective. There are plenty of good example for that - market analysts are used to discounting and seeing through statements made by CEO/CFOs in investor calls for example. But herd behavior can counteract that process.
Quote from: The Minsky Moment on April 03, 2009, 09:23:26 AM
The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems. But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3". I can see why the banks might want such flexibility. What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.
It is not about the value of the stock, but about how others think about it. Clearly many investors think that others will see those stocks as more attractive. So they think those stocks will rise.
QuoteJohn Maynard Keynes said that picking shares was like a beauty contest where 'it's important to choose not who you think is the prettiest girl, but who the judges will think is the prettiest girl'. One of the key lessons I've learnt over the last 30 years or so of being an investment manager is that, although perception and reality are both factors in choosing investments, perception is probably the more important.
Doesn't the change have ramifications for government regulation/intervention that in turn affect rational investor expectations?
Quote from: The Minsky Moment on April 03, 2009, 09:23:26 AM
The Efficient Markets Hypothesis is a staple of finance theory - it states that stock prices adjust nearly instanteously to reflect new information. In its stronger forms the EMH is used to support claims concerning the impossibility of riskless arbitrage, or the efficacy of fundamental or technical analysis as a means for "beating the market"
In a sense the EMH is a truism - because in an era of nearly instanteous communication and electronic trading - of course stock prices are going to relect available information as soon as it becomes available. And because the market as a whole cannot "beat" itself, individual instances of what seems to be arbitrage opportunities or outperformance can be explained away as outliers or temporary phenomena
The problem is that information is only as good as peoples' ability to rationally understand and make use of it. If information is misconstrued, or interpreted in an irrational manner, the resultant stock prices will blindly reflect that mis-interpretation or irrationality. Garbage in, garbage out. The fact that there are so many participants in the market doesn't eliminate this possibility - indeed at times it exacerbates it. The great mass of traders and stock market participants are not a calm, deliberative assembly - they are more like an unruly mob, and ever since the Tulip Bulb mania we have many examples concerning the madness of crowds.
The recent change to mark-to-market accounting rules and the market reaction brought this back to mind. The effect of this chage - first felt on April Fool's day appropriate enough - was a big instant leap in the KBW index of US bank stocks, which in turn fuelled the recent overall market rally. But in fact, the relaxation of mark-to-market does absolutely nothing of substance. It doesn't change a single item on any bank balance sheet or add additional capital. To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet. It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3". Efficient stupidity in action.
The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems. But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3". I can see why the banks might want such flexibility. What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.
Well, that's always been one of my main problems with a lot of economic models--the assumption that actors in a system behave rationally.
Quote from: The Minsky Moment on April 03, 2009, 09:23:26 AM
But in fact, the relaxation of mark-to-market does absolutely nothing of substance. It doesn't change a single item on any bank balance sheet or add additional capital. To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet. It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3". Efficient stupidity in action.
I'm not sure I entirely agree with this. Wouldn't falling asset values force the bank to put some of its assets up for fire sale? That can cause some real losses.
Quote from: DGuller on April 03, 2009, 01:39:54 PM
I'm not sure I entirely agree with this. Wouldn't falling asset values force the bank to put some of its assets up for fire sale? That can cause some real losses.
Changing the accounting treatment doesn't change the actual value though. Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale).
Quote from: Jos Theelen on April 03, 2009, 12:41:16 PM
It is not about the value of the stock, but about how others think about it. Clearly many investors think that others will see those stocks as more attractive. So they think those stocks will rise.
You are correct that collective delusions can have real economic effect, especially over the short-term. In that sense, the move could work and investor decisions to buy could be validated. But if the fundamentals don't catch up, eventually the gap between perception and reality will bite.
Then the interesting question - which goes back to the one I was wondering about earlier - is how collective «delusions» are made, born, transfered, etc. This is why information is much more than spin - it is also about a shared culture of the ideal investor, about how asumptions are made, about who the credible vectors of information are...
There is always comfort in a crowd. One of the dynamics that often comes into play in bull market bubbles is pressure to avoid being "left out". If everyone else around you is in the market and making gains, envy and peer pressure become motivating factors. Even if you have some fear about the sustainability of the bubble, you fear that if you don't go in, and the market goes up, you will fall behind your neighbors and peers, have "missed the opportunity" for big gains, and feel regret. And if the market does crash, at least you will have commiseration.
The contrarian investor is always lonely, and doesn't get invited to cocktail parties.
Quote from: The Minsky Moment on April 03, 2009, 03:44:10 PM
Quote from: DGuller on April 03, 2009, 01:39:54 PM
I'm not sure I entirely agree with this. Wouldn't falling asset values force the bank to put some of its assets up for fire sale? That can cause some real losses.
Changing the accounting treatment doesn't change the actual value though. Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale).
But changing the accounting treatment does change the amount the bank has to keep on deposit to cover their debts.
Granted, it is just playing games with numbers, but that doesn't mean changing the numbers does not change things - it does.
I am not sure it changes them for the better, but the banks apparently think so.
Sure is a good thing we are tightening up regulation on them, and making sure they do not make more high risk decisions!
If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant. They don't mature for thirty years. If I buy a $100 savings bond that matures in thirty years, for example, I'll pay less than $100 dollars for it. I'm not sure how much, let's say $60. Is the value of the bond $60? Yes. Is that information useful? No. I don't plan to redeem it until it matures, so its value to me is $100.
Sure, the savings bond is less likely to go into default than a mortgage paper, but the concept is the same from the holder's perspective. I suppose if I had $60 invested in a mortgage security with a high rate of foreclosure in it, say 5%, and a long term maturity total of $100, then I'd say it's not unreasonable that I should be able to rate the value of my holding at $90 instead of $60.
Er...am I defending getting rid of M2M? I guess it kinda looks that way, even though I don't want that precisely. It seems like there ought to be a different rule for valuing longer-term assets than there is for things like stocks.
Quote from: The Minsky Moment on April 03, 2009, 03:44:10 PM
Quote from: DGuller on April 03, 2009, 01:39:54 PM
I'm not sure I entirely agree with this. Wouldn't falling asset values force the bank to put some of its assets up for fire sale? That can cause some real losses.
Changing the accounting treatment doesn't change the actual value though. Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale).
The fire sale may be caused by regulations or other things that require minimal capital.
Berkut, Guller -
There are two regulatory requirements that could be at issue here. One is the amount of reserves the bank is required to keep at the Fed. Reserve requirements are a function of the level of deposits (liabilities) and hence an accounting change that relates to valuation of assets should not have an effect.
The second are min capital requirements, and these are based on assets. However, the minimum capital requirement is calculated based on the *face value* of the asset, not the actual value. Were the requirements instead based on actual value, then a revaluation of assets upwards would increase (not decrease) the required regulatory capital.
Quote from: MadImmortalMan on April 03, 2009, 04:19:56 PM
If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant.
I believe existing rules allow avoidance of MTM treatment if you are holding a long-maturing asset, and if you plan to hold to maturity. Also, under the old MTM rules, even if an asset did not qualify for hold for maturity accounting, a write down of "other than temporarily impaired" assets could be avoided if the bank asserted it had the intent and ability to hold the asset until the impairment ceased. That requirement has been relaxed.
Quote from: The Minsky Moment on April 03, 2009, 04:56:39 PM
Berkut, Guller -
There are two regulatory requirements that could be at issue here. One is the amount of reserves the bank is required to keep at the Fed. Reserve requirements are a function of the level of deposits (liabilities) and hence an accounting change that relates to valuation of assets should not have an effect.
The second are min capital requirements, and these are based on assets. However, the minimum capital requirement is calculated based on the *face value* of the asset, not the actual value. Were the requirements instead based on actual value, then a revaluation of assets upwards would increase (not decrease) the required regulatory capital.
What about contracts where minimum capital is specified, in one way or another?
My two cents: it isn't a major change in accounting.
A brief timeline and overview:
FAS 157
In 2008 companies were required to adopt FASB's FAS 157 (the FASB is the group that sets US accounting rules). This statement gave a methodology to use whenever other accounting statements required fair value. Over the decades fair value concepts were in a number of statements, but these would often give conflicting definitions of how to determine fair value. The idea of 157 is that the exit price of the asset or liability should be used, with market values determining fair value. Market values are only to be used if the market is "orderly." Assets in this category are "Level 1".
If an "orderly" market does not exist, a model is to be used to estimate a selling price. This model should use market inputs when they are available to derive a risk adjusted fair value using discounted cash flows. (For example, if I lent the government $100 for 1 year in an OTC transaction, the interest rate on a 1 year T bill would be a good discount factor for one year). These are "level 2" assets.
If market factors are not available to determine the asset value, then I need to fully construct a model. This is "level 3."
SFAS 157 requires disclosure of all fair value assets, and which category they are in. The methodology for Level 2 and 3 assets must be explained, especially for level 3 assets.
Late 2008 Clarification
In the later part of last year, when there were protests over FAS 157, the SEC and FASB issued a joint statement reiterating FAS 157 only requires the use of Level 1 methodology if the market is orderly.
Recent FASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.
I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.
Quote from: The Minsky Moment on April 03, 2009, 05:12:34 PM
Quote from: MadImmortalMan on April 03, 2009, 04:19:56 PM
If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant.
I believe existing rules allow avoidance of MTM treatment if you are holding a long-maturing asset, and if you plan to hold to maturity. Also, under the old MTM rules, even if an asset did not qualify for hold for maturity accounting, a write down of "other than temporarily impaired" assets could be avoided if the bank asserted it had the intent and ability to hold the asset until the impairment ceased. That requirement has been relaxed.
Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.
To gain held to maturity accounting, management has to positively assert an intention to hold to maturity and does not foresee any likely circumstances that may cause an early sale due to liquidity constraints. If you are talking about assets that will be maturing over 10-15 years, both of those are difficult for management to sign their names to.
Quote from: alfred russel on April 03, 2009, 05:24:39 PM
My two cents: it isn't a major change in accounting.
. . .
RecentFASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.
I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.
But in addition to the new position on 157, the FASB also changed guidance on recognition of temporary impairments:
QuoteThe Board decided to replace the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert
a. It does not have the intent to sell the security; and
b. It is more likely than not it will not have to sell the security before recovery of its costs basis.
That looks like a pretty significant change to me.
Quote from: alfred russel on April 03, 2009, 05:31:15 PM
Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.
Actually, I had thought held-to-maturity was rare and that was one reason for concern about tinkering to MarktoMarket.
But according to the folks at McKinsey, *60 percent* of the assets on bank balance sheets are accounted for using held to maturity.
That raises the suspicion that the bank management may be trying to hide assets that they really don't intend to (or are not capable of) holding to maturity, and FASB has now given them cover.
I am not an accountant but I have seen in gory detail what happens when financial institutions blow up, and everyone sues everyone in sight, and the old books and audit papers are examined to figure out what the hell happened. There can be some difference between the theory and the artfully worded pronouncements of GAAP and GAAS on the one hand and the sticky details of what actually happens between auditor and client in the concrete application on the other hand.
Trying to get a handle on what's going here. Minsky's saying the market could not beat itself, but the new rules might allow it to do just that through Level 2 and Level 3 accounting, and AR's saying that essentially, nothing has changed in whether or not they can do that; am I right? :huh:
Quote from: DontSayBanana on April 07, 2009, 08:33:53 PM
Trying to get a handle on what's going here. Minsky's saying the market could not beat itself, but the new rules might allow it to do just that through Level 2 and Level 3 accounting, and AR's saying that essentially, nothing has changed in whether or not they can do that; am I right? :huh:
Joan was saying that investors got duped by the decision to not require companies to list assets at current market prices.
Quote from: Admiral Yi on April 07, 2009, 08:39:03 PM
Joan was saying that investors got duped by the decision to not require companies to list assets at current market prices.
Ah. Well, in that case, I'd say they're both right. While the government may not have really lightened up on accounting rules, this thread is proof enough that not everyone who's got hands in this is as qualified an accountant as the situation really demands; a lot of people may not be doing enough due diligence to know about the difference between the Level 1, 2, and 3 accounting... so while the accountants certainly should not be getting duped, that might not mean the
investors, by and large, aren't getting duped, and we could still see reflections of herd-mentality stocks transactions.
Quote from: The Minsky Moment on April 07, 2009, 03:19:26 PM
Quote from: alfred russel on April 03, 2009, 05:24:39 PM
My two cents: it isn't a major change in accounting.
. . .
RecentFASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.
I don't see this as a big change, and any company that tries to hide a bunch of losses by avoiding level 1 treatment under this revised guidance is going to have to disclose this in the footnotes for the world to see.
But in addition to the new position on 157, the FASB also changed guidance on recognition of temporary impairments:
QuoteThe Board decided to replace the existing requirement that the entity's management assert it has both the intent and ability to hold an impaired security until recovery with a requirement that management assert
a. It does not have the intent to sell the security; and
b. It is more likely than not it will not have to sell the security before recovery of its costs basis.
That looks like a pretty significant change to me.
It isn't.
An overview of the old accounting rules for those that aren't up on them: at a high level, excluding equity transactions (selling or buying stock and dividends), an increase or a decrease in an asset not involving a liability must equally increase or decrease comprehensive income.
Comprehensive Income has two components: net income and other comprehensive income.
Investments were and are classified as in one of three categories, and the accounting is as follows (excluding "other than temporary impairment", which I'll address below, and has changed):
1. Held to Maturity: The Company can affirmatively state that they both intend to and are able to hold the investment to maturity. These are recorded as assets at amortized cost (usually about equal to the amount paid for the investment). The value does not change with market fluctuations.
2. Trading Securities: These are assets that are being actively marketed and are expected to be disposed in a short time. They are recorded at their fair value. Any increase or decrease in fair value is recorded through Net Income.
3. Available for Sale: These are all assets that don't fit into the other two categories. They are recorded at fair value. Any increase or decrease in the fair value is recorded through Other Comprehensive Income.
None of what I wrote above changed in the past few years.
What has been tweaked is the concept of "other than temporary impairment." This is an old concept that applies to both Held to Maturity and Available for Sale securities. In the past, if the fair value of either category of asset declined and management determined the decline was "other than temporary," the asset was impaired and the difference was recorded through net income. Note that in terms of asset value this only effects Held to Maturity assets, as Available for Sale were already held at fair value. The difference for Available for Sale is that rather than recording the decline through Other Comprehensive Income it is being recorded through Net Income.
The recently approved standard tweaks this treatment, but only for debt securities (equity investments are not changed, and I do not believe loans qualify as debt securities, though I'm not sure of this). The change is that for Held to Maturity securities and the subset of Available for Sale Securities that management does not intend to sell and is most likely able to hold the security past the point it will recover its value, the impairment is bifurcated into two categories: the impairment due to the credit worthiness of the counterparty and the impairment due to market conditions. The loss due to the former category is still recognized in Net Income, but the latter category is now recognized into Other Comprehensive Income (which is then amortized into Net Income over the life of the security).
All of this has to be disclosed. There is no change in reported asset values.
Quote from: The Minsky Moment on April 07, 2009, 03:27:12 PM
Quote from: alfred russel on April 03, 2009, 05:31:15 PM
Any asset that is exempt from fair value standards--such as those that are held to maturity--doesn't have to be marked to market (assuming it isn't "other than temporarily impaired). That has always been the case. Held to maturity assets are less common than you would think because the accounting guidance has a presumption that assets are not held to maturity and are at least available for sale.
Actually, I had thought held-to-maturity was rare and that was one reason for concern about tinkering to MarktoMarket.
But according to the folks at McKinsey, *60 percent* of the assets on bank balance sheets are accounted for using held to maturity.
That raises the suspicion that the bank management may be trying to hide assets that they really don't intend to (or are not capable of) holding to maturity, and FASB has now given them cover.
I am not an accountant but I have seen in gory detail what happens when financial institutions blow up, and everyone sues everyone in sight, and the old books and audit papers are examined to figure out what the hell happened. There can be some difference between the theory and the artfully worded pronouncements of GAAP and GAAS on the one hand and the sticky details of what actually happens between auditor and client in the concrete application on the other hand.
I'm not an accountant either (though I do work with this stuff) and I've never worked in banking. But I'd be interested to see what McKinsey is considering as a held to maturity investment. It is possible they are considering line items like equity method investees, joint ventures, intangibles such as goodwill, and PP&E as held to maturity assets.
Quote from: alfred russel on April 03, 2009, 05:24:39 PM
Recent FASB Staff Position (157-e)
Approved yesterday, this will immediately provide concrete guidance on whether a market is "orderly," which requires the Level 1 methodology. Under this guidance, the presumption is that any transaction that occurs is orderly, and certain factors must be shown to be present in order to ignore that transaction and use Level 2 or 3 methodology.
I had read the comment draft, and when I read in the press of the changes figured that it was approved. But I should have read the version that was approved, because it was tweaked (I don't believe they released the final official draft yet). Where I wrote that there is a presumption that the transaction is in an orderly market was altered in the final draft to state that management must weigh the evidence of an orderly or disorderly market and determine which is most appropriate based on the preponderance of the evidence.
In related news bank shares jumped today based on a record Wells Fargo profit report.