Re:Balance -- Jim Peterson

What the Wine Sellers Buy -- A Metaphor for Understanding Subprime

The credit crunch spreads – from tapped-out holders of adjustable-rate mortgages, to specialty insurers desperate to preserve their ratings, to the leaders of Citigroup and Merrill Lynch on begging-bowl fundraisers in Asia and the Middle East, to a swell of big-number litigation enough to enrich the lawyers world-wide.

And as spring foretells the release of the finest French wines, my wine-collecting friend in Paris confronts a crunch of his own. 

He prefers his tangible cellar of fine vintages over a portfolio of financial derivatives. But he has learned that – as with countless investors ranging from holders of the Bear Stearns subprime funds to pension funds and village treasurers and any number of other yield-chasing funds and institutions -- he has an uncomprehended and volatile commodities market exposure.

Like the small investors who clamored to share the sexy returns of the hedge funds, my friend ventured beyond his retail wine shop. Going to an internet wine vendor in 2006, he bought a quantity of a fine Bordeaux 2005, then being offered en primeur – that is, an advance sale just after the harvest but two years before the wine would be ready for retail sale.

In simpler times, the wine makers would sell perhaps half of their production en primeur – only to sophisticated professionals – in a direct form of forward contracting that both financed inventory and mitigated price volatility.

But the en primeur market then became open to individual players. Buyers of the 2005 vintage made the leap of faith that as this wine is even now being released for delivery, they will actually receive the specific wine contracted for, rather than some poorly made or inferior substitute.

Additionally, though, my friend faces a huge market exposure.

Namely, the vendor – who is said to have made some € 10 million of advance sales – is now exposed as were Bear Stearns or Merrill or Citi, who had sold highly-leveraged investments in hard-to-price slices of the subprime mortgage sector. Instead of locking in a contract with the vineyard for the necessary physical supply, at the time it took its customers’ deposits, the vendor reportedly chose to wait and play the fluctuating secondary market.

That is, like the bankers who sold the mortgage-based derivatives on the assumption that ever-rising housing prices would bail out all the dodgy mortgages, the wine-seller assumed an ability to cover its needs at delivery time, perhaps even hoping that a soft market might give it a windfall.

Here arises the problem of unexpected risk and uncontrollable price volatility in an underlying commodity. Holders of subprime paper were whacked by collapsing real estate values, unpredicted under their black-box pricing models. Just as with killing frost in the orange groves or warfare in the oil fields – serious re-pricing has hit the wines of 2005. With the publicists touting 2005 as a vintage for the century, the entire Bordeaux market took a major upward spike. Prices for my friend’s particular wine are up over 60%, and the very top wines have shot up 300% in less than a year.

Again as with the subprime sector, my friend has learned to his bewilderment that he is in an unraveling commodity hedging operation -- the vendor’s naked delivery problem being piled onto a whole structure of risks.

At a simple level, the vendor generated two years of float for itself, by immediately cashing its customers’ checks. And although dealing frequently with Anglo customers investing dollars and pounds, the vendor could easily hedge any currency fluctuation exposure.

But like Bear Stearns or New Century Financial or Northern Rock or UBS today – or others in recent memory such as Long Term Capital Management or Amaranth – the wine vendor is hostage to externally-delivered pricing shocks.

With the vendor facing a massive and expanding loss, my friend has the entirely legitimate anxiety that when the time comes, it may be unwilling or unable to deliver.

While he waits, it has been brought home – for both the bankers’ one-time valuation geniuses and their management who blithely assured that their controls were all in good Sarbanes/Oxley order -- that market reality has a stubborn unwillingness to behave according to unprovable mathematical models. And there is a lesson for central bankers: one-time bailouts have a terrible tendency to be under-calculated, insufficient, and fraught with unintended consequences.

Time will tell. Come this summer, while the Bordelaise prepare to press the grapes of 2008, my friend may be preparing to press his legal rights.   

Meanwhile, shareholders and investors in subprime funds have enlisted their lawyers to assess whether their glasses are half-full, half-empty or only holding the bitter dregs.

Accounting for Subprime -- Scoring the Scorekeepers

This audit season the skeletons just refuse to stay in the closets. Latest this month, but far from last, are AIG’s $4 billion loss estimate increase and Credit Suisse’s $2.85 billion write-down in its asset-backed securities.

Both examples read directly on a question put by a friend and regular reader -- a business school professor in Paris: “How much of the subprime thing is related to the accounting?”

Not that she needs my help with a lesson outline for her MBA students. But having been a guest in her classroom, I’m happy to offer. If I were teaching her class, I’d get there in three steps:

At the level of human behavior, subprime in its origins was first about the disconnect between incentives and risks: the mortgage originators took their fees immediately, but repackaged and laid off the future stream of payment obligations. Then the bankers, abetted by the ratings agencies, gamed the credit rating system by pushing untestable valuation models onto their credulous customers.

Second, as after-effect, subprime is now about legal responsibility. With the filing of new investor lawsuits back to Enron-era levels (for which, see the helpful running count being kept by the D&O Diary,here ),  the roster of defendants includes not only the banks and mortgage companies, but also the three dominant credit rating agencies and, at last count, three of the Big Four accounting firms.

But third, with the global harm extending from villages in the Norwegian Arctic to counties in rural Florida to bush hamlets in Australia, we should go back to basics: accounting principles and methods for the recording and reporting of transactions are as old and pervasive as trade itself.

As soon as commerce moved beyond one-to-one barter, conventions were required to quantify such inherently judgmental issues as the hazard of re-payment in future periods, the time value of money to change hands at a later time, or the transfer of performance to a third-party.

So viewed, subprime and the credit market turmoil are all about the accounting, and nothing else. Fundamentally flawed assessments were made – whether out of venality or ignorance – about the quantification, timing and transferability of the risks associated with uniquely complex financial derivatives, and the collapse in their values as knowledge and experience eventually caught up.

So the accounting for mortgage-based assets and their off-spring should be seen as a proxy for the reckoning of financial reality in all aspects:

For a family buying its first home with an adjustable-rate mortgage, the expense entry for housing cost changes from rent to mortgage payment. Its balance sheet now has an asset, the house, with the associated mortgage debt as a liability. When a depressed housing market erodes any equity, and the payment escalates beyond the family’s means, the accounting confirms the reality – red ink and foreclosure.

An investment bank that sponsored and sold exotic tranches of financial products now has the task of re-assuming them back onto its balance sheet and marking their value to a collapsing market rather than a discredited black-box model, which means filling the accounting holes. Costly new rescue capital, opportunistically supplied to the likes of Citi and Merrill, Northern Rock and the monoline insurers, may provide a lifeline but dilutes or even destroys the prior shareholders.

As for investors – whether an individual shareholder of the banks or a pension or retirement fund that bought the exotic products – their losses may not yet be realized for accounting purposes, unless they have sold out the positions, but they can plainly feel the real-world loss of wealth, and unsurprisingly are taking advice from the plaintiffs’ lawyers.

As shown already by AIG and Credit Suisse, the accounting challenges pinpointed by the professor are fraught both for the financial institutions and also for any investor who heard the siren song of higher rates and traded off for unknown future risks.

That’s because the more candor and rigor are brought to this year’s audit process, the more stark will be the ultimate concession that the valuation models on which subprime was built were creatures of myth and unreality. And therein lies a ghastly liability implication -- that the well-controlled and smoothly operating systems required under Section 404 of the looming Sarbanes-Oxley law simply weren’t there.

In the end, to wrap up for the good professor’s class, the quality of accounting is an effect, not a cause – the level of its virtue and integrity is observable in a mirror held up to commercial society.

Or as first put in the early 1970’s by cartoonist Walt Kelly’s swamp philosopher, Pogo the possum, “We have met the enemy, and he is us.”