Monday, November 7, 2011

Earnings Obfuscation Under FAS 157

The Jaded Consumer has previously discussed how FAS 157 impacts American Capital Ltd. (ACAS), but this only scratches the surface of the pricing errors one can find in the wake of SEC filings whose earnings reports are poisoned by FAS 157. Watch this explanation of how –

"What's that?" you say. "Poisoned?"

Yes, my friend. Poisoned. You see, the Securities Exchange Commission is supposed to require filings with representations about earnings and performance so that the public is informed. When Joe Public reads a number like quarterly earnings, Joe wants to know if it's better than last quarter or the quarter that occurred the same time last year, and wants to understand whether the company is gaining or losing money and whether that gain/loss is slowing or accelerating. Joe Public may be using stock screening tools to identify in batches companies with improving profits (or exclude companies without them), and he may have little depth of knowledge about the particular companies whose headlining numbers he's reading. Goodness knows, Joe Public may be buying on a friend's stock tips or the raucous exhortations of a television personality.

So let's look at a company that's not speculative at all, for the purpose of identifying to the reader how FAS 157 confuses the public about a company's earnings and creates opportunities to catch utterly rock-solid and well-known companies being mispriced in the public markets.

So-Called Efficiency
Yeah, the markets that are supposed to be "efficient" so that all information is reflected in the prices – those markets. Markets that are so inundated with information of varying degrees of kind and quality that no participant can plausibly comprehend it all. Markets whose participants frequently have full-time work doing things so totally unrelated to the markets that they are inclined to buy or sell or invest or withhold investment on the basis of trust in third parties who themselves almost certainly arrived at a decision on the basis of incomplete information. Markets whose prices are not fixed by an arbiter of fairness, but on the purely mechanical conditions of the number of buyers, the size of their orders, and the prices at which their brokers will admit they are willing to pay for the size of order the brokers are willing to admit their clients are interested to obtain – and the number of sellers whose brokers are equally opaque with respect to the intentions of their clients. If you want the price of a thinly-traded stock to go down, simply enter a sell order and watch the numbers drop (which is a major reason to be skeptical of many pink-sheets listings). Or, as Cramer has described, wait until just after lunch when trading in all the issues is thinner and – by using the leverage inherent in standard options contracts – push even major issues one direction or another (I recall Cramer describing this technique as also involving a bogus rumor, which though poor-quality news – and easily exposed after time – still drives people into fear-based or greed-based moves, their confidence in which is increased by the "real" position taken by the manipulator to make the rumor look like it has substance). One can create or destroy quite a lot of market cap – utterly out of proportion to the capital at risk – or at least appear to.

But I don't have personal experience manipulating stock prices, except by accident while attempting to enter or leave a thinly-traded equity position. And in that case, I was accidentally manipulating the price against my own interest, which – lemme tell ya – is sorta a drag. Look carefully at trading volumes before buying thinly-traded issues; if your position is bigger than daily trading volume, how do you plan to exit? Even a big fraction of daily volume is frightening to think about planning an exit.

FAS 157 In Action
So what's accidental manipulation got to do with buying mispriced stocks after an earnings release that's impacted by FAS 157? Simple. When the earnings report comes out with a number that is heavily influenced by FAS 157, some people will look at the number – which is a good number so far as SEC compliance is concerned – and confuse it with an earnings number that one might take to the IRS. Depending which way that error runs, people may confuse the company with one that is unexpectedly profitable – or conclude that it's suffered a terrible hit that has, in fact, not occurred.

I promised a safe, stable, low-risk example. So, I give you Berkshire Hathaway. Berkshire Hathaway (BRK.A, BRK.B; after the 50:1 split that took place at the time of the Burlington Northern acquisition in 2010, BRK.B represents 1/1500 the equity interest of a BRK.A) is a holding company that includes retail insurers like GEICO, a reinsurance business so big that it was about the only place in which Lloyds could offload Equitas, which held the long-tail risk of its asbestos liability overhang (and where AIG just did the same thing), and a whole slew of portfolio companies in which Berkshire Hathaway invests money received from its insurance business in order to make money while waiting to see what long-term risks materialize. If you haven't read a Berkshire Hathaway annual report, you haven't seen how an annual report should spell out business to investors.

Berkshire Hathaway's earnings derive primarily from the consolidation of portfolio company earnings into its own balance sheet. Those earnings result from a diverse array of businesses (in no special order): GEICO, Dairy Queen, Sees Candies, Star Furniture, Burlington Northern Railroad, ISCAR Cutting Tools ... I could go on, but you can read the annual reports yourself. Berkshire also receives dividends from Bank of America, Coca-Cola, American Express, and so on. All good earnings. All pretty easy to understand. What's not to like?

Indeed. Berkshire's broad-based and powerful cash-generation is greatly to be admired. It's the kind of thing that, in the hands of investor-friendly and transparent operators such as Berkshire Hathaway's present management, inspires immense confidence. You see the earnings number, and you know there's no accounting game: you can take it to the bank.

And, yet ... FAS 157.

FAS 157 is an accounting standard. FAS 157 requires booking changes in values of derivatives (among other things) as income or loss in the period in which the value change occurs, without regard to the realization of that gain or loss. In other words, a company that reports that its book value has increased because its holdings are more valuable also reports that its income is up by the same amount, despite that no realization has occurred (and, due to market conditions, may never occur). This has the impact of causing unrealized gains and losses to be counted twice: first, against book value (which one would expect), and second, against earnings. It's that second application that's unexpected. Reported earnings are going to be understood by the public as earnings, not holdings. Reactions are sure to follow the headline number (earnings up!) rather than the number you or I would work out using the tax accounting with which we are more familiar – but investors will treat the headline number as if it were a taxable income number.

When The New York Times publishes an article titled "Derivatives Cut Into Berkshire Hathaway's Profit" there's no asterisk to indicate that the "profit" described in the title isn't taxable profit, or even realized profit, but a number that reflects an accounting principle no investor would ever apply to his own bookkeeping. Readers assume the New York Times is being accurate when its lead paragraph proclaims that Berkshire's profit declined "after losing more than $2 billion on derivatives related to stock market performance." Then, the lead of ¶2: "That was nearly three times what Berkshire lost on the same instruments a year ago." Readers' conclusion is obvious: Berkshire has no idea what it's doing with dangerous derivatives, and is in the grips of an ongoing losing streak. Quotes from Buffett on derivatives' dangers seem to fly in the face of the reported derivatives exposure, and suggest the company's leadership is unable to implement its publicly-proclaimed beliefs. The New York Times isn't some kind of outlier in describing earnings reports impacted by FAS 157. Bloomberg's headline, "Berkshire Profit Declines 24% on Buffett's Derivative Bets" is at least as lurid.

Readers value the company accordingly. Maybe readers think Warren has lost it, or that Berkshire is awash in rogue traders who imperil its good business with scary derivative-related risk. Who knows? What we do know is that Berkshire's shares are trading as if it's making a lot less money than it is.

Berkshire's Earnings and FAS 157
In the most recently-reported quarter, operating earnings of $2,309 per A-share exceeded estimates surveyed by Bloomberg (which averaged just under $1,800). Instead of publishing "Berkshire Beats Operating Earnings Estimates by 28%", Bloomberg publishes what in places reeks of character assassination. This is because Berkshire's assets (Berkshire holds investments in Coca-Cola, American Express, Bank of America, and lots of other long-term investments that it won't exit and whose price changes don't impact earnings) include some asset types subject to FAS 157, so that their change in asset value must also be reported as a change in income. In this case, it's derivatives.

In Berkshire's 2008 annual report, Warren Buffett explains how unnamed investors paid Berkshire $4.9 billion (cash Berkshire can use; there's no counterparty liability) for custom-made equity index options for which no market exists (neither party can possibly buy/sell to close the position before expiration), and which can only be exercised (if at all) on the date(s) of expiration (ranging between 2019 and 2028). In other words, market volatility can't cause early exercise; the option is either worth $0 (Berkshire hopes), or is worth more than $0, at the expiration date 15 or 20 years following issuance, and Berkshire either makes a payment under a contract (which may or may not be greater than the premium) or does not. If each of the indexes are 25% below their level at the date the options were written, Berkshire will be on the hook for about $9 billion. While there's risk of paying out more than was received in premiums, there is certainty of being able to invest the $4.9 billion for well over a decade and a very good chance that the indexes aren't so far below their value the day the options were written that Berkshire pays in 2019 (or 2028) more than it received in premiums. This is, in essence, like its insurance business: it invests a float while awaiting possible risk. This is in many ways better, because (unlike life or health or auto risk) the risk can't come due until expiration date. Berkshire has also insured some bonds, and some of that bond insurance (but not all of it) is subject to FAS 157.

It's worth pointing out that Warren Buffett's 2008 letter to shareholders makes a detailed explanation both of the risks in the derivatives, and the case to be made that the mark-to-market valuation given the equity index options systematically overstate Berkshire's risk. In the 2008 letter, he explains why, despite the apparent outrageousness of the liability overstatement, Berkshire Hathaway reported a "liability" in connection with its derivative holdings that led to a mark-to-market "loss" exceeding $5 billion. If you have any doubts about this as you read here, Buffett's letter provides delicious examples anyone can follow. Despite that the 2008 annual report listed Berkshire's derivative contract liabilities at $14.612 billion, it's worth noting that in the 3Q2011 report, Berkshire Hathaway's derivatives liability stood at $10.421 billion – not a bad move, considering what's happened to credit and equity between 2008 and the end of 3Q2011.

Berkshire Hathaway didn't exit derivatives positions in the last quarter for a realized loss of $2.443 billion, or even $2.443 million. First, neither party can exercise the 15-year and 20-year options except on the expiration date, and only then if they are in the money, and in that case the exercise only results in payment to the extent they are in the money. Second, 3Q2011 investment gains were $100 million in the insurance segment and $0 in the finance and financial products segment.

The fact that Berkshire Hathaway reported $2.278 billion in net earnings in the quarter while claiming to have "lost" $2.443 billion in unmatured derivatives suggests that Berkshire's real financial condition over the quarter amounted to (1) a real but speculatively-scaled reduction in assets associated with the unfavorable market conditions that impact the value of the illiquid derivatives that can't be exited for years, while (2) Berkshire experienced earnings of $4.721 billion.

Valuing Berkshire Hathaway Despite FAS 157
The question of how significantly the asset devaluation should impact valuation of Berkshire Hathaway is a fair question. However, to believe the impact is the equivalent to reducing Berkshire's earnings in the quarter by more than 50% is simply ridiculous. This quarter, FAS 157 caused Berkshire Hathaway's SEC-reported earnings (not its IRS-reported earnings!) to be lowered from $4.721 billion to $2.278 billion – a reduction of about 52%. What that means is that without FAS 157 to confuse people into mistaking Berkshire's unrealized gains/losses in long-term investments for income, its 3Q2011 earnings would have been higher than actually reported – 107% higher.

Yet, that's what FAS 157 requires: if bond insurance transactions are structured as a derivative rather than as an insurance product, it is subject to mark-to-market rules and impacts "earnings" every quarter regardless of actual realizations; yet if the same transaction is structured as an insurance product volatility becomes unimportant and earnings isn't impacted unless actual and anticipated payouts diverge. It's hard to escape the conclusion that FAS 157 causes Berkshire Hathaway's income to seemingly halve or double based on the Black-Scholes valuation of 20-year index puts (which is based on transient volatility and not the likely end-of-the-decade valuation of the equities in question, which is why the model has serious problems with long-term options that bear no pre-maturity exercise risk).

Berkshire Hathaway's income is clearly subject to material misstatements (that are required by the SEC) on the order of 100% or so in a quarter. In the wake of earnings announcements that are based on these reports, Berkshire's price is likely to be based on dramatic misconceptions of its earnings. The tone of the Bloomberg news item in particular suggests that Berkshire is led by a doddering gambler on a long-term losing streak, which can't be good for the non-numerical evaluation of the company, either.

Since more people will read articles like those in Bloomberg and The New York Times than will read Berkshire's annual reports, it's fair to say that Berkshire's valuation is based more on Bloomberg and New York Times spin than on the sober, thoughtful, and respectful content of the reports filed by Berkshire with the SEC. A sober investor might be expected to be able to weigh the impact of current earnings against unrealized changes in asset value, but those aren't the rules we have following FAS 157. Now, we're given an "earnings" number that tries to include unrealized changes in some – but not all – asset classes. The rule leads to confusion because it makes earnings difficult to compare across industries (some transactions of identical substance are subject/not-subject to FAS 157 simply based on the form of the transaction), and because it leads to "earnings" reports that are different from the experience of investors.

FAS 157 increases the opportunity to locate mispriced securities issues.

By identifying companies with significant exposure to FAS 157-generated confusion regarding quarterly profit, it is possible to use vastly overstated/understated earnings to ride substance-free movements in stock prices. Buying on the heels of a selloff resulting from a "bad" quarter like Berkshire Hathaway's recent above-expectations quarter provides an opportunity for outsized recovery following a report with a FAS-157-induced misstatement in the other direction. Don't hate FAS 157, use it to get an information edge on the nitwits that dominate the market.


Anonymous said...

Asset marks. SEC. Regulations.

With specific regards to ACAS I offer the following snippet of the most recent conference call. As always your comments are appreciated and respected.

Our next question comes from Andrew Shanahan from Knighthead Capital.

Andrew Shanahan - Knighthead Capital:

I just had a quick question. If our portfolio companies in Europe are performing so well, why not fully consolidate ECAS to eliminate the volatility we get from using the comparable BDC multiples to value it?

John Erickson:

That's a great question, we would love to do that. Unfortunately at time we do the accounting for it, the FASB and SEC guidance said we could not consolidate it. We thought that we'd have a direct dialogue with the SEC on. Just recently the FASB actually put out a draft release that actually is trying to converge U.S. GAAP with IFRS. And as a part of that process they would actually go back to saying that we have to consolidate ECAS.

So that's actually potentially in the work. It's something that we'll be monitoring and obviously at appropriate time we would be providing more disclosure around. But we've declined consolidating at this point and it's something that is really just driven by GAAP.

Andrew Shanahan - Knighthead Capital

Is that something that the SEC has put up for a comment yet or is it kind of in the pre-comment discussion period?

Pete Deoudes:

Currently the FASB had issued exposure draft on accounting by investment companies. This was about a week ago and it's up for comment period right now. And that comment period ends in the beginning of January. And the expectation would be shortly thereafter they would issue a final accounting guidance on that.

John Erickson:

Which the best guess would be applicable for 2013.
Pete Deoudes

They haven't provided any kind of guidance in terms of any types of implementation day or an adoption day.

John Erickson:

Or voluntary adoption those type of things.

Pete Deoudes:

They won't provide that until. They actually issue the final guidance.

Jaded Consumer said...

If ACAS were allowed to consolidate ECAS assets and results with broader ACAS assets and results, ACAS would eliminate the double-discount issue affecting the NAV impact of holding investments in ECAS. On the other hand, this will prevent ACAS from applying a NAV premium to ECAS once performance begins justifying a NAV premium.

With FAS 157 causing earnings to include unrealized gains, ACAS' post-consolidation earnings would look very nice when the portfolio companies are heading up. This may help share prices during rising markets.

Then, of course, people will be comparing ACAS' dividend (driven by taxable income) to its SEC-reported FAS-157-compliant "income" and either asking why ACAS doesn't pay more, or how ACAS can "sustain" a dividend that doesn't match "earnings". Under FAS 157, there will never be peace because SEC "earnings" won't be the same as IRS "income" unless assets are static. And what's that likelihood?

Thanks for stopping by!

Anonymous said...

you rock thank you for the comments