Will the financial overhaul bill fix what's wrong with banks?

On Friday, congressional conference committee members announced that they had reached agreement on the final contours of the financial overhaul bill. The bill is expected to be put to a final vote in the next week and perhaps be ready to be signed into law by July 4. Knowing the speed with which Congress completes tasks, I will not hold my breath, but it is time to examine what's in the bill and whether it will accomplish its stated objective: to put financial services firms (and especially banks) on a firmer footing and to prevent another banking crisis.

The bill is almost 2000 pages long, which scares the daylights out of me, but it supposedly contains the following ingredients (I will admit that I have not read whole chunks of this bill and what I have read is mind numbingly boring):
Regulatory framework: In addition to allowing regulators to seize and break up troubled financial service firms, the bill allows regulators to recoup the costs of the bailout by making other financial service firms with more than $50 billion in assets pay a fee. In tandem, it reduces the Fed's emergency lending powers and prevents bankers from having a say in who gets to be a Fed president. The Office of Thrift Supervision will cease to exist and the Fed will retain oversight of community banks.
The Volcker Rule: The rule restricts banks from trading with their proprietary capital and from investing more than 3% of the capital in hedge or private equity funds. It also limits banks from bailing out hedge funds that they have invested their capital in.
Derivatives: Standard derivatives (on foreign currency, interest rates etc.) have to be traded on exchanges and backed up by clearing houses, with standardized capital and margin requirements. Banks can still create customized derivatives for clients, but only in restricted circumstances. Banks have to create separate entities for their swap business.
Consumer Agency: There is a new federal agency (Consumer Financial Protection Bureau) that is supposed to protect consumers from fraud/misinformation in financial service company products (including mortgages) by regulating these products and enforcing the regulations.
Investor protection/ power: The SEC can set standards for brokers who give investment advice and hold them to the same fiduciary duty requirements already governing investment advisers. Hedge funds and private equity funds have to register as investment advisers and provide information on trades.
Securitization: Banks that package assets and securitize them are required to hold 5% of the credit risk on their balance sheets.
Credit Rating firms: Allows investors to sue ratings firms for "knowing or reckless" failure in assigning ratings.

The reviews are already coming in. On the one hand, there are some who believe that this reform is too little, too late and that it will do nothing to prevent the next crisis. These critics feel that Congress should have returned Glass-Steagall to the books and broken up big banks. At the other extreme, there are some who believe that the heavy hand of regulation will destroy the competitiveness of US banks, by making them less profitable and valuable, and move the derivatives and swaps businesses to offshore locales. Strange though it may seem, I think that both sides are right on some issues and wrong on others.

Focusing just on the bank-related portion of the bill, there are three questions that I would like to address:
1. Will this bill prevent financial service firms from becoming "too big to fail"?
I don't see how this bill will reduce the likelihood that banks will become "too big to fail". While the bill doles out some punishment to larger banks - the fees on banks with more than $ 50 billion in assets and the exemption of smaller banks from some of the regulations - there is nothing in the bill that will prevent banks from becoming larger. In fact, given that a ton of regulation is going to emerge from this bill, I will predict that the largest banks will have a competitive advantage when it comes to playing the "rules" game and get even larger. I will also predict that the requirement that banks carve out the swap business and other risky businesses will make them more complex and less transparent. From a valuation standpoint, I am not looking forward to valuing either JP Morgan or Bank of America in a couple of years.

2. Will it reduce "bad" risk taking at banks?
The focus of this bill is clearly directed at trying to prevent "bad risk taking" by banks, where "bad risks" are defined as very large risks, which if they pay off, deliver large profits to the bank, but if they fail, become systemic risk that taxpayers are called upon to cover. The separation of the swap businesses at banks, the restrictions on derivatives and the limits on investing proprietary capital in hedge funds seem to be directed at this bad risk taking. On all counts, the lawmakers are reflecting the conventional wisdom of both academics and practitioners on the roots of the 2008 banking crisis and the legislation is written to prevent a re-occurrence. Having watched investment banks operate for 30 years, I believe that they will find new and never-before-seen ways of taking large risks. I will predict that the next crisis will look nothing like the last one, and that this legislation will not only do little to prevent it but will actually contribute to it (by driving risks underground and away from the regulatory eye). Until we deal with the compensation structures at these institutions, where decision makers profit from upside risk and are relatively unaffected by downside risk, we are designed to repeat our mistakes over and over again: "Groundhog Day" in financial markets.


3. Will it make banks less profitable?
Interesting question. At first sight, the answer seems to be yes, since there are restrictions on banks investing in hedge funds and limitations on their derivatives and swaps businesses. On a pure return on equity basis, these are some of the highest return businesses for banks but they are also the highest risk businesses. As an investor in banks, I have always looked at these businesses with a jaundiced eye: they earned high returns but I am unconvinced that they earned high excess returns (over and above the risk-adjusted cost of equity). My prediction is that, if this legislation is passed and put into effect, the returns on equity at banks will decrease, as they return to safer businesses, but their excess returns may very well increase, as the regulations scare away new entrants. Bottom line: Banks may become less profitable (if you define it in terms of return on equity) but in the process become more valuable.

Like all legislation, this one is written with the best of intentions. I hope it succeeds but I don't think it will.

South African Business and Arts Grants announced

Recipients of the first cycle of Business and Arts South Africa Supporting Grants for the 2010/2011 financial year have been announced.


A total of 15 business plans and projects were given project-specific grants – a significant boost for South Africa’s cultural landscape. The grants cover a broad scope of arts projects – from visual arts to dance; theatre; music; and more.

The 2010/2011 Business and Arts South Africa Supporting Grants are awarded five times in the financial year after deliberation by the organisation’s board. In a carefully designed and monitored process, both the arts applicant and the sponsor complete application forms.

Available on www.basa.co.za, these forms are designed to encourage the two partners to work together and identify areas of potential benefit. Business and Arts South Africa allocates funds to the project once it has assessed how the partnership benefits both the sponsor and the recipient. This is in keeping with the organisation’s belief in taking arts projects from “seed to strength to sustainability.”

The full list of recipients and sponsors (see below) is an impressive one and covers a range of different-sized arts projects being mounted across the country.

Applications for the second cycle of Business and Arts South Africa Supporting Grant s are now open. The closing date for this next cycle is 7 July, with recipients being notified on 4 August.

Details of the next cycles are available on the Business and Arts South Africa website, www.basa.co.za.

Supporting Grants: 2010

Organisation: Big Time Dance Troupe
Project: Queen E and her Entourage
Sponsor: Ellies (Pty) Ltd

Organisation: Rotary Club of Kloof
Project: Art and Music in the Hills
Sponsor: TBWA Hunt Lascaris – Durban

Organisation: New Music SA
Project: eMusic Indaba
Sponsor: SAMRO

Organisation: Cosmos Productions
Project: Theatre for Change Tour
Sponsor: Protea Hotels

Organisation: Africa Ignite
Project: Showcasing Kwa-Zulu Natal proud art, craft and heritage at the King Shaka International Airport
Sponsor: Airport Company South Africa Limited

Organisation: Aid to Artisans South Africa Trust (ATASA)
Project: South Africa Handcraft Exhibition featuring the women artists of the Ndebele
Sponsor: Nando’s Chickenland (Pty) Ltd

Organisation: Tshwane Leadership Foundation
Project: Feast of the Clowns
Sponsor: City Property Administration (Pty) Ltd.

Organisation: Ifa Lethu Foundation
Project: Home and Away – A return to the south
Sponsor: G&D Apparel

Organisation: Field Band Foundation
Project: Field Band Foundation
Sponsor: Ogilvy (Pty) Ltd Durban

Organisation: Johannesburg Art Gallery
Project : My Private Universe
Sponsor: Stokvel Cellular (Pty) Ltd.

Organisation: Baxter Theatre Centre
Project: Remix Dance Company: Loveaffair
Sponsor: Red Lake Trading 10 (Pty) Ltd

Organisation: Kearsney College
Project: Kearsney Choir Tour to World Olympics Game (July 2010) – Return upbeat Festival (August 2010)
Sponsor: The Jonsson Group (Pty) Ltd.

Organisation: University of Witwatersrand
Project: Drama for Life Progr amme
Sponsor: German Technical Co-operation (GTZ)

Organisation: Individual (Dr Fred Scott)
Project: Eleven Soccer and Art South Africa 2010 Project
Sponsor: Commerzbank South Africa

Organisation: Buntuzim Media Production
Project: Maboneng – Alex Multi Arts Experience
Sponsor: Santam Ltd

Small Business Grants For Women

If you've got an excellent business plan but you just don't have the finances to get it off the ground then you need to have to think about applying for some small business grants for women. But having a good thought is only part in the battle. Here are some factors you'll need to have to take into account when applying for small business grants for ladies.

Your credit history – The difference between applying for a grant and applying to borrow money is that you'll eventually need to pay the loan back – with interest – but you won't have to repay the grant. Even so, when applying for modest enterprise grants for ladies it's very best that you have a spotless credit rating. If you could have negative reports on your credit report take steps to clear them up before you start applying for grants.

Your business enterprise idea – You can find various kinds of grants – federal grants, local government grants and even grants from private enterprises or individuals. Each organization looks for something various in the enterprises they decide to award grants to. For example, the Federal government likes to grant funding for companies that will help your community including a medical center or arts center or childcare facility. You'll have far more success as qualifying for grants if you match your organization to the requirements in the provider.

Your organization strategy – No matter which kind you apply for you are going to need to submit a detailed company program. This must consist of the amount of dollars you have to have, what you intend to spend the cash on, how you expect that income to assist your organization, what form of return you assume to see on the investment. Including pie charts and graphs will make your presentation look far more expert. If you've never prepared a organization program before you might want to consult with a professional to ensure much better response on your applications.

Your application – It is perfectly acceptable for you personally to apply for additional than 1 kind of grant. But no matter how numerous you apply for your application has to be filled out in it is entirety. Again, if you're not familiar with, or comfortable with, this step in the course of action it may well be ideal in case you consult a specialist.

These small company grants for women are a wonderful opportunity to suit your needs to create your mark and burst via that glass ceiling. And that grant money is readily offered for anyone who wants to utilize. And that's generally the problem – too a lot of females aren't familiar with writing a company strategy or cleaning up their credit report.

But you DO know how to run a business and you DO know you have a fantastic idea. Do not let your unfamiliarity with the grant process stand in your way of owning your own business enterprise. Most grants that you simply apply for will be really specific about the details that they want. Answer all of their questions and get creative wherever possible to make your application stand out above the rest. You'll find hundreds of small business grants for women and there's one that's just appropriate for you!

Learn more about small business grants for women. Stop by Catherine Yeatts's site where you can find out all about women's business grants and what it can do for you.

Valuation Approaches...

I have always believed that valuation is simple at its core and that we choose to make it complex. Furthermore, the determinants of value have not changed through the ages; all that has changed are the estimation practices. One of my pet peeves relating to valuation is when an entity (usually a consultant, academic or an appraiser) takes a standard valuation equation, does some algebra, moves terms around and then claims to have discovered a new and "better" valuation model.

Each consulting firm has its own proprietary value measure, with a fancy name and acronym (Economic value added (EVA), Cash Flow Return on Investment (CFROI), Cash Return on Capital Invested (CROCI) etc.) that it markets to its clients as the magic bullet for value creation. To make themselves indispensable, consultants usually add computational twists that require their presence. To get a sense of how these measures are marketed, you can check out books on each (usually written by the measure's developers):
CFROI
EVA
CROCI
All of these models share two themes. First, they relate the value of a business to excess returns (returns earned over and above the cost of capital or equity). Second, each claims to be easier to use, more intuitive and better than the other models out there.

With analysts, the search for a better valuation approach usually takes the form of concocting new multiples or modifying existing ones. Consider the PEG ratio, a favored tool of analysts following high tech (and growth) companies. The PEG ratio is obtained by dividing the PE ratio by the expected growth rate in earnings per share, and companies that trade at low PEG ratios are considered cheap. It is viewed as a less time-intensive and assumption-free substitute for intrinsic valuation.

As analysts and consultants push their favored approaches to the forefront, it is no surprise that most of us feel overwhelmed by the choices that we face. Which of these dozens of approaches will yield the right value? How do I pick? At the risk of being simplistic, let me offer a solution. Pick the approach that you feel most comfortable with and use it correctly. The value you obtain will be identical to the value you would have obtained using any alternate approach. I have an extended survey paper that I wrote on valuation approaches (and their history) in 2005 that can be downloaded online, if you are interested:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1625010
Valuation is not rocket science. Valuing companies may not be easy but the challenges we face are not in valuation theory but in estimation practice. Put another way, we know exactly how to value companies. What we do not have a handle on is how best to estimate growth, risk and cash flows. So, let's stop concocting new models and theories and start thinking more seriously about how best to estimate cash flows for a cyclical firm, risk for a regulated company and growth for young start-up firm. The second edition of one of my books, The Dark Side of Valuation, is dedicated to this concept. You may not like or agree with some of the solutions that I have to estimation challenges, but I hope it will start you thinking about how best to deal with these challenges.

What is "fair value"?

What is the fair value of an asset? Sounds like a simple question but the question has taken on a life of its own, given recent changes in both accounting and legal standards. In both contexts, the rule makers contend that their objective is to ensure that assets are recorded at fair value and have created rules to ensure that this happens.

Let us start with accounting. The push towards fair value accounting has now become an article of faith for accounting standards boards. In the United States, FAS 157 (the very fact that we are at rule number 157 tells you something about how accountants think - the more rules the better) provides a synopsis of what the accounting definition of fair value. I have expressed my skepticism about fair value accounting before on this blog and made my case for why this is not only a good idea. 

In legal circles, the hypocrisy about fair value is even greater. Appraisers are supposedly unbiased and fair in their estimates in value, no matter who they work for or which side of the legal divide pays them. The Internal Revenue Service has made this requirement explicit in its guidelines for appraisers. All of the valuation appraiser organizations - The National Association of Certified Valuation Analysts (NACVA), American Institute of Certified Public Accountants (AICPA), American Society of Appraisers (ASA), Institute of Business Appraisers (IBA)- argue that their members provide fair, unbiased estimates of the values of businesses.

I have a simple definition (and test) of fair value. If an asset is valued at fair value, the appraiser (or his client) should be indifferent to being either  a buyer or a seller at that value. If you are an appraiser valuing your business for tax purposes, would you really be willing to sell your business at the appraised value? If the answer is yes, you have stayed true the notion of fair value. If the answer is no, the talk about fair value is just talk... If you are the tax authority valuing the same business (for tax purposes), would you be willing to buy the business at the appraised value? If the answer is no, you too are guilty of hypocrisy.

Let's be honest. Asking "biased" appraisers to estimate fair value is a hopeless task; the bias comes from the way appraisers get compensated/ paid.  Either change the way that we hire/pay appraisers or accept that each side's appraisers are going to come up with valuations that reflect which side of the divide they are coming from.

Parent versus Consolidated financial statements

My last post on valuing the Tata companies, all of which have significant holdings in other companies, has raised a natural follow up question. When valuing a company, is it better to use stand-alone parent company financial statements or should we use consolidated financial statements?  More generally, which of these two should you focus on as an investor/manager/regulator?

Accounting Background
The question of whether to use parent-company or consolidated statements becomes an issue only when a company has cross holdings in other companies. To illustrate the difference, consider a simple example, where company A owns 60% of company B. Company A can report its financial results in a parent company statement or in a consolidated statement.
a. If it chooses to report the financial results in a parent company statement, the operating income statement will center on just company A's operating results. The revenues and operating income will reflect only company A's operations. However, there will be a line item on the income statement, below the operating income line, which will include 60% of the net income of company B.
On the balance sheet, only the operating assets and liabilities of company A will be recorded. However, there will be a line item on the asset side of the balance sheet that reflects the accountant's estimate of the value of the 60% of company B; the rules on how to estimate this value and how often it has to be updated can vary from country to country.
b. If the financial results are in a consolidated statement, the operations of company A and B will be combined. As a result, the revenues, operating income and other operating numbers (depreciation, cost of goods sold) will reflect the sum of those numbers for companies A and B. In a similar vein, the assets and liabilities on the balance sheet will reflect the combined values of companies A &B, notwithstanding the fact that company A owns only 60% of company B. The accounting adjustment for the 40% of company B's equity that does not belong to company A takes the form of minority interest, shown on the liability side of the consolidated balance sheet. Again, the rules on how to estimate this value and how often it gets updated varies across countries.

A final note on consolidation. Consolidated statements exclude intra company transactions. Thus, if company A sells $ 100 million in products to company B, the parent company financials will show revenues of $100 million for company A and costs of $ 100 million for company B, but the consolidated statements will net them out and show nothing.

Why would a company choose to use one versus the other?
It is not always a choice. In the United States, companies are required to consolidate financial statements, if they own a controlling stake of a subsidiary (defined as >50% of the outstanding equity). They do not have to consolidate minority holdings in companies. In general, US companies are required to report only consolidated statements and do not have to provide parent company financials, but these consolidated statements represent a mix of consolidation (for majority stakes) and parent company rules (for minority stakes).

The rules for consolidation are similar in international accounting standards. In much of Europe and in many emerging markets, companies will report both parent company and consolidated statements in the same annual report, with wildly different results. What does add to the confusion is that the rules on consolidation still vary across markets.

All of the Tata companies that I valued had both parent company and consolidated financial statements in their annual reports. Tata Steel, for instance, had a parent company statement, where its holding of equity in Corus Steel was shown as an asset on the balance sheet and a consolidated statement, which reflected the combined revenues and operating results of the companies, with a minority interest item reflecting the portion of Corus Steel that is not owned by Tata Steel.

Valuation fundamentals
 In theory, you can value a company using either parent company or consolidated statements, with the following key differences:
a. Parent company financials: If you value a firm, using parent company financials, you are using the operating income and cash flows (cap ex, depreciation, working capital) of just the parent company. Consequently, discounting the cash flows at the cost of capital yields a value for just the parent company. To value the equity in this company, you will have to subtract out net debt in the parent company and add the value of equity in cross holdings, using either the book value of these holdings as a base or through an intrinsic value of the subsidiaries.
b. Consolidated financials: If you value a firm, using consolidated financials, you have valued the parent firm and its consolidated subsidiaries together, since your earnings and cash flows reflect the combined earnings and cash flows of the companies. To get to the value of equity in the company, you will have to subtract out the net debt of the combined companies and the estimated value of the portion of the equity in the subsidiary that does not belong to the parent company. Again, this estimate can be based upon the book value of minority interest or on the intrinsic value of the subsidaries.

Which set of statements for valuation?
If I had access to full information on both the parent and the subsidiaries, I would value a company based upon its parent company financials and then value every one of its subsidiaries, using their individual financial statements. I have two reasons for this bias:
1. This would give me the maximum flexibility in terms of valuation inputs - the cash flows, growth and risk can be very different across parent companies and subsidiaries. The final value of equity in the company would then be the summation of the values of equity holdings in the parent company and all subsidiaries.
2. It allows me to avoid the two items in consolidated financial statements that give me headaches - goodwill (and whatever accountants choose to do with that cursed item) and minority interests (where I have trust an accountant to estimate the value of a holding)


In practice, though, this ideal is not easy to reach. In many cases, there will be incomplete or no financial statements available for subsidiaries. In this case, it becomes a choice between two imperfect estimates of value, the book value of the holdings in subsidiaries in parent company statements or the minority interests in consolidated statements.  The more homogeneity there is between the parent company (same business, same growth and profitability trends), the greater the argument for using consolidated financial statements, valuing the combined company and subtracting out the estimated value of the minority interests in the subsidiary. As

In the case of Tata Steel, for instance, I chose to value Tata Steel as a stand alone company in 2009 and added the book value of the Corus holding to arrive at the value of equity in Tata Steel overall. I could have valued the company using consolidated statements and subtracted out the value of minority interests. The choice ultimately was driven by the fact that Tata's Steel's consolidated statements were still in a state of flux in 2008-09, two years after the acquisition of Corus. As Corus is integrated in Tata Steel, the consolidated statements should become more informative. In fact, the 2009-10 consolidated statement looks far more settled and I may try to value the company based upon these numbers now.


More generally, which statements should you use to assess a company?
While the answer I have given is valuation focused, there are many constituent groups that use financial statements. Bankers and ratings agencies look at them, so that they can assess default risk. Portfolio managers and investors use the numbers from financial statements to compute ratios and multiples (PE, EV/EBITDA..) Since the rating is for a company, with its cross holdings, and the multiple is for the equity in the consolidated company, there is an argument to be made that we should be looking a consolidated statements. However. this makes sense if and only if the parent company has holdings in subsidiaries with very similar fundamentals - risk, growth and cash flows. If not, it would make more sense to judge the parent company and its subsidiaries separately and to make comparisons to different peer groups.