Finance Bitch #1

The Obamanons are rolling out some convoluted derivatives regulation, and there is some discussion over how this might hurt airlines, farmers, and other "real" companies--as opposed to financial firms. Pathological hatred of bankers aside, I want to explain what I think is a very important detail in this discussion, especially as oil prices are rising and the bogeyman of "speculators" comes back. Incidentally, the price of oil dropped last week, so people stopped talking about speculators for a week.

Anyway, I'd just like to make sure all my readers understand the two main reasons that derivatives are used. Derivatives are, as their name suggest, financial instruments that derive their value from other assets. There are several kinds of derivatives, the main categories being futures, forwards, options, and swaps. Futures are standardized contracts that guarantee the delivery of a certain asset--say, oil--for a pre-specified price. Forwards are similar contracts, except that they are not standardized, but rather custom-made. Options give the holder the right, but not the obligation, to purchase or sell an asset for a pre-specified price. This is how stock options work, with the hope that the holder will work to improve the stock price and make it in his interest to exercise the options. Finally, swaps, the much-maligned instruments that AIG used, are actually very useful, and involve the "swapping" of cash flows on different securities.

Now, here are the two main ways derivatives can be used: to hedge or to speculate. Hedging consists of balancing out a long (profit when prices rise) position with a short (profit when prices fall) position. For instance, a farmer who sells corn might sell corn futures so that he can sell his corn at a known price instead of hoping that the price rises when he goes to market. When he grows his corn, he is long, and thus his future creates a balancing short position in corn.

Speculating, contrary to popular political wisom, is not a form of 21st Centural witchcraft. In fact, it is simply the opposite of hedging, whereby the investor takes either a long or short position in an asset, without balancing out the position. If you own stock and don't simultaneously short the stock, you are speculating in that stock. Similarly, if a bank wants to purchase an interest-rate swap to hedge against movements in interest rates, you can speculate in certain interest rate movements by taking the other side of that swap and not hedging yourself. To bring it closer to home, if you buy health insurance, you are shorting your health in order to balance out your automatic long position in your health. The insurance company, on the other hand, is taking an unhedged long position in your health.

Ok. Now you know.

Accounting Bitch #3

Here's an aggravating link from my good friend Billy over at UT Austin. The article discusses Goldman Sachs' change of their calendar, a move that just happens to leave the disastrous month of December as a footnote in their financial statements, enabling them to show quasi-healthy profits this quarter.

What's aggravating is the sheer meaninglessness of corporate financial reporting. As I've said before, the best option for an investor is to look at cash. Look at the cash a firm generates. Poor cash management is what typically brings down corporations, and the current myriad accounting rules only serve to hide poor cash management. On the other hand, the rules can also mask a good cash position, such as in the case of mark-to-market, where banks were forced to write down assets to ridiculously low levels, even though those assets were still generating cash.

Look to cash. Always look to cash.

Tax Bitch #1

Apparently I'm a rich college student, because I owe Barack Obama $400 this year! Most of this is due to a couple scholarships I received which counted as "Other Income" and "Self-Employment Income" (Don't ask, I don't know how that works, either).

In the course of attempting to find ways to escape his Highness' tax collectors, my Dad and I came across a few delightful nuggets of information you might not have known about the tax system in this country.

For instance, if your child has been kidnapped, the residency requirement for child exemptions will be waived, and you can still consider that child a dependent. Phew! I guess it's good you aren't taxed for having your kid snatched.

Also, you can take the child exemption for any child born alive, even if that child dies soon after birth. You cannot, however, take the exemption for stillborn children. Thanks for plugging up that loophole, boys. I can just see a bunch of rich bastards knocking up their wives and then whacking them in the gut with 2x4s just for the tax savings.

Finally, and I am sure I will expand on this much in the future, double taxation of dividends is one of the most evil components of the tax system, not only for its distortion of reality, but also for the perverse incentives it establishes for corporate management. Terrible.

Accounting Bitch #2

John Allison's superb speech that I posted on a few days ago raises an accounting issue I would like to bitch about now. The issue is "Fair Value Accounting," and Allison discusses it in depth. I cannot add much to what Allison said, but I can try to sum it up and provide a brief explanation of why this particular accounting requirement is evil, both morally and epistemologically.

The rule in question is one which states that certain assets must be regularly marked down in value to accurately represent their "Fair Market Value," or the value at which they could sell it today if they had to. In most firms, this kind of accounting is limited to what are called "tradable securities," those securities a firm owns, but actively trades. These can be contrasted with available-for-sale securities and hold-to-maturity securities. These are not "marked to market" normally. Typically, these assets do not constitute a large portion of a firm's balance sheet, and the effect is negligible. In fact, this use of mark-to-market is actually quite appropriate.

In finance, however, for the last two years, banks have been required to mark their asset-backed securities to market value. This violates a fundamental principle behind the mark-to-market tool, namely that management must be intending to sell the asset in question. Allison points out that it is dishonest to write down an asset as though it were to be sold when management intends to hold it and collect its cash flows.

Now, this was not much of a problem until the market for mortgage-backed securities dried up and no one wanted to buy them. By law, banks must write down these assets to fire-sale prices because those are the only prices people are willing to pay. This is ludicrous, though, as Allison points out, because a market requires both a willing buyer and a willing seller.

So, you might be saying "Ok, it's a pain, but investors understand that these assets are still bringing in cash and are worth a lot more. They'll price that in. What's the big deal?" Normally, your logic would be correct. However, this is America, where we have laws to make sure logic is never correct. If a bank's equity drops below a certain percentage of capital (say, due to massive write-downs of its assets) it has to go to the capital markets and raise new capital. If it cannot, it must shut down, by regulatory fiat, even though it might still be generating positive cash flow. Another delightful aspect of the combination of accrual-based accounting and bumbling regulators.

Enter bailouts. Enter systemic risk and crisis. Enter his Obama-ness, fixer of things, bringer of change.

Management Bitch #1

Sorry my writing is beings spaced out a bit more lately. This week is heavy on the exams. Which brings me to my post for today. In studying for my management exam (organizational behavior, to be specific) I find myself forced to memorize a litany of useless, repetitive terms in order to do well on the test. Now, I have a deep respect for management studies in many respects, but the let's-make-ourselves-sound-important vocabulary that management intellectuals devise sends me into convulsions, especially when I am expected to regurgitate it tomorrow morning. Here are some of my favorites; see if you can tell what they are or if they are good or bad:

Efficiency Diversity
Repair Service Behavior
Goal Inversion
Management of Cues
Anchoring and Adjustment
Fundamental Attribution Error (No cheating, this one's obviously bad)

Alright, go memorize these and the quiz will be tomorrow. Don't bother finding out what they mean. I just want you to vomit them onto a sheet of paper like I have to in the morning.

Accounting Bitch #1

Occasionally, for the benefit of my non-business-educated readers, I will post on a specific element of business life that defies all logic, and thus creates endless frustration for me. For while at its root business, in all its creative and adaptive brilliance, is a beautiful phenomenon, there are parts of it that could drive an improperly equipped rational person insane. Naturally, most, if not all, of these stem from some kind of government influence, whether tax-, regulation-, or lawsuit-related. Needless to say, I doubt the well will ever run dry on this topic. So, without further ado...

Today's stupid business topic is accounting, and so is titled "Accounting Bitch #1." My first bitch with accounting is a general one. Accounting is "accrual-based" and not "cash-based." Allow me to explain. Most people think you record revenue when someone pays you for something and you record an expense when you pay someone for something. This might be true for some very small businesses, but any business that must report financial results must do so with an accrual-based method. The method is known as GAAP, or "Generally Accepted Accounting Principles." (This, of course, is a misnomer because GAAP consists more of rules than principles, and pretty much everyone hates them) These rules are enforced by the FASB, or Financial Accounting Standards Board, a "non-governmental" agency. I use quotes because once FASB has settled on standards, they are religiously enforced by a batallion of government bureaucrats.

GAAP has evolved over several decades, but today's bitch focuses on the fact that it uses "accrual-based" accounting, whereby revenues and expenses are recognized based on when they are earned, rather than on when cash is exchanged. In theory, there is not much wrong with this approach, and it makes sense in several industries. However, since the rules are enshrined in regulatory stone, all accrual-based accounting does is offer companies legal ways to obfuscate their results. Cash is cash, and it is impossible, without committing fraud, to be misleading about how much cash has come in or gone out, and how much sits in the company coffers. As an example of how accrual-based accounting can be misused, consider that Enron recorded millions of dollars in revenue on unsure projects that had not brought in a dime. Such a practice was completely legal, however, because they had secured the contract. That cash never came in, by the way.

Accounting is a necessary component of capitalism. It is the language of business, the common understanding that enables those with capital to find those with initiative and to create profitable ventures. The more the accounting system loses objectivity (it's been on a steady decline and has been accelerating recently) the more stagnant our economy will become because investors will not trust the numbers they are presented.

Ideally, accounting would be a privately designed system (or competing systems) for keeping track of assets, liabilities, revenues, and expenses. Short of privatization, the government should at least adopt a cash-based system and junk FASB's accrual-based nightmare. More on this in my next accounting bitch: Mark-to-Market rules