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With all the talk about swap regulation these days, we can’t help but ask, “what the heck are swaps?” Swaps are financial instruments used either to hedge against risk or to profit through speculation. Like other types of instruments of this sort, called derivatives, they are simply contracts between two parties, and their value is derived from the underlying security or market index on which the contract is based. Some are based on movements in interest rates, currency exchange rates or commodity prices.

A common swap is the interest rate swap. Consider a company that issued floating rate bonds - they have essentially borrowed money at a rate of interest tied to some interest rate benchmark such as LIBOR or prime. The company that issued the bonds is at risk of paying more to service its debt if interest rates were to rise. In order to protect itself, the company could structure a swap agreement allowing it to swap its floating rate payments for a higher fixed rate payment. It has removed the variability and risk of the floating rate bond. Essentially, the company has found a simple way to refinance its debt.

These days, there is a great deal of discussion on swaps because they have been virtually unregulated for many years. The concern is that without proper guidelines for valuation and disclosure, companies and the investing public are at great risk as corporations and investment houses use swaps on a regular basis. Stay tuned…

We hear about Silicon Valley executives who pocket millions when they leave their companies or Wall Street traders who make a killing when the stock market moves a few points. What alchemy creates such unbelievable returns? The answer: stock options. Stock options are essentially contracts to buy or sell shares of stock at a certain price, within a certain amount of time. Options to buy stock are known as call options and options to sell stock are known as put options. In this article, we’ll review the basics of the call option which allows an investor, trader or even the fortunate executive in a company to profit from the upward movement in a company’s stock price.

Suppose you are interested in investing in Bailout Industries. Their stock is currently trading at $10 per share and you believe it could go as high as $15 per share in the next year. In order to buy 100 shares of Bailout stock, you’ll need to shell out $1,000. If the stock were to reach $15, you could sell the stock for $1,500 and pocket a cool $500 profit. Now, consider what can be achieved if you buy the call options. The December 2010 $10 call option is currently selling for $1. In other words, a contract to buy one share of stock at $10 before December of 2010 is priced at $1. With $1,000, you could buy 1,000 call options. So what happens if you buy the call options and the stock does reach $15 next December? Your position is now worth $5,000! Not bad for a $1,000 investment. Sound too good to be true? Well, it can be.

The problem with call options is that they are simply contracts. When the terms of the contract are not met, they are essentially worthless. If Bailout stock falls below $10 and remains there at the time of expiration, the options are worthless and you’ve lost your $1,000. In future articles, we will take a look at put options and option valuation.

There are many ratios commonly used for the financial analysis of a company, and perhaps the best known is the Price/Earnings (PE) ratio. Ratios are powerful tools because rather than considering some number on its own, they allow us to evaluate a number in the context of another number. Let’s see how this works.

Imagine there are two companies, A and B. Both earned (i.e. made a profit of) $1 million last year - will they have the same value? Suppose A is in an industry that’s dying out and B is in a growth industry – (assuming that both companies have the same number of outstanding shares) which will have the higher stock price? B has the brighter future, the higher likelihood of providing long-term value, so it will have a higher stock price. So given the same earnings, B has the higher price and therefore the higher price/earnings ratio. Thus, the PE ratio is a measure of investors’ optimism about future growth.

Normally we wouldn’t compare companies in different industries. Since different industries have different growth prospects, we would not expect companies across those industries to necessarily have similar PE ratios. But companies within an industry are all subject to the same market forces, so we would generally expect them to have the same growth expectations, and therefore the same ratio of their current price relative to their current profits (earnings). What if we find a company that has a PE ratio that’s higher than the industry average? What might we wonder? This company’s price is higher relative to its earnings than everyone else in the industry (on average) so perhaps that price is too high and this company is overvalued. Or maybe there’s a good reason for investors to be more optimistic. And, of course, if a company has a PE ratio lower than the industry average, then maybe they’re undervalued and a good buy. Or maybe there’s a good reason why their price should be lower. Ratios such as this don’t provide a final decision; they’re just a potential flag to take a further look.

Speaking of taking a further look, next time we’ll take a different look at the PE ratio and how it might be used to determine a company’s value. Better yet, take one of our seminars to learn about many other powerful yet simple analytical ratios!

As the nation slips deeper into the depths of economic turmoil, virtually every media pundit and politician seems to have a theory as to why this happened and who is responsible. The newsrooms and congressional chambers are filled with banter about collateralized debt obligations, mark-to-market accounting and swap spreads. The problem is that invoking these terms in the context of such discussions is not the same as understanding them. As evidenced by recent congressional hearings, it is clear that our nation’s leaders have less than a basic understanding of finance and accounting. If they are truly committed to solving these problems, they will have to educate themselves as quickly as possible.

In the last several months, we have witnessed the former and current heads of the Federal Reserve Bank, US Treasury and some of the largest financial institutions testify before congress. In the standard questioning process, there seems to be a recurring theme. A question is asked by a member of congress that relates to some aspect of the financial crisis and as the response is offered, more confusion seems to arise. In a recent discussion between Fed Chairman Bernanke and a notable congressional leader, Mr. Bernanke was lambasted for injecting capital into several of our nation’s largest banks. The members of congress were irate over the fact that taxpayers are paying to bailout these institutions. Mr. Bernanke tried to explain that this was a capital injection and not an expenditure. Its intent was to solidify the company’s balance sheet and allow them to lend money. Exasperated by the puzzled looks from the congressional leaders, he sought to clarify the difference between capital injections and expenditures, something that fell on deaf ears. Former Fed chairman Greenspan also encountered widespread consternation recently when attempting to explain the complexities of derivative structures and their role in the crisis. Recognizing the daunting nature of this task, he too conceded limited understanding of these structures.

My professional experiences have taught me that even some of the most accomplished professionals have difficulty distinguishing between income and cash flow let alone recognizing derivative structures. Our leaders in Washington need to acknowledge their deficiencies in this area and do their best to correct them. Given the magnitude of the current crisis and the role our leaders play in maneuvering it, perhaps it is time we consider devoting a portion of the stimulus package to financial education for our leaders. We at Telestrat are prepared to heed the call.

Reuben Advani is a former investment banker, founder of Telestrat Education and author of The Wall Street MBA (McGraw-Hill). 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) inAccounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars inUnderstanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

Question: How does an obscure accounting rule find its way to the top of a new president’s agenda?

Answer: By creating the worst financial crisis in over 70 years.

Indeed, folks, a topic previously discussed by CPA’s and CFO’s is making front page headlines. Why? Well, to put it mildly, the fate of our banking system may depend on a method of accounting known as mark-to-market accounting. Mark-to-market is used to assign value to an asset based on its current market price. The idea came about in the 19^th century when future traders used it in an effort to mark their positions to the current market price. In other words, futures as well as other derivative instruments, are often traded on and off exchanges. While they may simply serve as contracts to buy or sell something at some point in the future, they maintain some value during their life. With mark-to-market accounting in place, the changes in value of these instruments are recorded on a regular basis on the financial statements of the company holding them. In other words, they are marked-to-market rather than listed at cost (what was paid for them).

To illustrate the way mark-to-market accounting has been applied in recent history, imagine this: you purchased a home for $100,000 ten years ago. Three years ago, in the height of the real estate boom, your home’s value was assessed to be $200,000. If you were to use mark-to-market accounting, you would list this increase in value on your personal financial statements and specifically, show an increase in your non-cash income. Did you benefit from this increase? Not directly. It doesn’t impact your household income or available cash as you have not sold the home. However, it does help your net worth on paper which means that in theory, you might be able to borrow more. In fact, you could likely obtain a larger home equity loan or line of credit based on this increase in net worth. Having access to this capital appears to place you in a stronger financial position.

Let’s consider another scenario: the home you purchased ten years ago for $100,000 is worth $70,000 today due to a major collapse in the housing market. Using mark-to-market accounting, your non-cash income would be reduced based on the drop in market value and more importantly, your net worth has dropped as a result. Although your household income is not affected and this represents no significant change to your lifestyle, your ability to borrow could be diminished. This may present some problems should you be in need of a home equity loan or some other source of capital.

Fortunately, we have little need for mark-to-market accounting in personal finance but what happens when some of the largest corporations in the world use this technique? That is what happened in 2007 when financial institutions were required by the Financial Accounting Standards Board (FASB) to use this method in an effort to disclose the values of various financial instruments. Some of these instruments, such as mortgage backed securities, were quite complex in that they were based on massive bundles of other instruments such as home mortgages. Quantifying their values became increasingly difficult when such instruments were not actively traded. In other words, when such instruments are actively traded, assigning a mark-to-market value is relatively simple. It becomes the price that buyers and sellers agree on. But what happens when these instruments are no longer traded? Then you have the makings of a major financial crisis at hand. As the appetite for these instruments waned in late 2007, financial institutions found it difficult to sell them. Without a liquid market, these institutions were forced to use broad based estimates to determine their values. In essence, they moved from mark-to-market accounting to mark-to-model accounting. The results were ugly. As the housing market collapsed, the values determined by these financial models were shockingly lower than in past quarters. As a result, major banks around the world were writing down these assets at a rapid pace while lowering their profits and eroding investor confidence. As investors lost confidence based on these massive write-downs, stock prices fell to reflect this.

Where does this leave us today? The world is divided on mark-to-market account. There are those in favor of it as it increases transparency in financial disclosure. As the argument goes, if something loses value the financial statements should reflect that. The opposing argument is based on the idea that trying to estimate market values can do more harm than good and ultimately prove misleading, especially in illiquid markets. Perhaps this dilemma is best summarized by the greatest punk band ever (and prescient market forecasters), The Clash. To paraphrase:

Should it stay or should it go? If it goes there will be trouble, and if it stays it will be double. So come on and let me know, should it stay or should it go.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues.

There is a great deal of discussion and speculation about the current stock market. “Where is it headed?” is the question most of us are asking. Well, don’t look to me for precise answers because if I knew, I wouldn’t be writing this entry or doing anything work related for that matter. In fact, the only thing I do know for certain is that no one can predict what will happen in the stock market at this point. Now, more than ever, this holds true.

In the last few years, analysts and investors were able to offer substantive predictions with relative ease. Why? Economic growth was strong, consistent and predictable. Based on macroeconomic data, companies could effectively predict demand increases for their products and services. And with solid demand forecasts, costs and expenses could be budgeted as well. Put them all together and what you have is a well defined profit forecast for the next year.

With credible profit projections, a company’s stock price generally adjusts to fall in line with the industry average PE multiple (price to earnings). The PE multiple for a company is its stock price divided by its earnings per share. PE multiples for an industry are based on an average of PE multiples for all companies in the industry. When a company offers a projected earnings number for the next year, the company’s stock price should adjust to align with the industry average multiple. So in theory, this allows one to not only predict where a company’s stock will be trading at in the future but where the entire market will be trading at. This is because the market is an aggregation of individual stocks. Consider the following example:

Company ABC projects its earnings for 2009 to be $2 per share. If the industry average PE multiple is 15, then ABC’s stock price should reach $30 by year end in order for it to be in line with the industry. So if the current stock price is $20, we can predict a 50 percent increase in stock price over the next year.

In 2009, stock market predictions will be as accurate as those pertaining to a Vegas craps table. There are two reasons for this. First, companies are having a difficult time projecting their earnings. Given that we will likely remain in the throes of the Great Recession, it will be difficult to determine how consumer and corporate spending patterns will react. This will make it challenging to forecast earnings and, consequently, stock prices. Second, investors large and small have been scared away by the recent market tumult and may very likely keep their cash tucked securely under the mattress. It’s unclear when their confidence will be restored and more specifically, when their funds will return to the market.

What we are facing is a paradigm unlike any we have seen in a very long time, if ever. Therefore my prediction for the stock market in 2009 is as follows: it may go up or it may go down.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation, or one of our On-Demand programs (available 24/7) including our Financial Markets Update, which explains what brought on our current market issues. 

As I write this, stock markets around the world are teetering on the verge of major collapse. What only a few weeks ago was a topic of interest for Wall Street bankers and academics has become a global contagion affecting everyone. In previous blog postings, I discussed several topics including mark-to-market accounting and short selling, each of which has played a role in this crisis. But what is now at the forefront of both the diagnosis and treatment of this malady stems from simple human psychology: confidence. Few deny that the overriding lack of confidence in our financial system and leaders exacerbates the current economic crisis. But how has this lack of confidence brought us to where we are today?

Let’s recap what we know so far: banks loaned money to borrowers under very aggressive terms predicated on the notion that housing prices always go up. New home construction reached unprecedented levels causing an excess of inventory. As home values started to decline due to this buildup of inventory, home values started to decline. This created problems for home owners who financed their mortgages with nominal down payments. As interest rates started to rise, it became even more difficult to make the required mortgage payments. At this point, confidence started to erode in the housing market driving down home values in most markets.

What about the banks? With the banks buying and selling complex financial instruments that are based on home prices, concerns started to mount that perhaps the banks would soon feel the pressures of the housing market decline. Sure enough, thanks in part to an obscure accounting rule known as FAS 157, major financial institutions were forced to estimate the loss of value on these financial instruments and record any drop as a charge against earnings. This raised bigger questions: how were they determining these values and more importantly, were they underestimating them. This created a further crisis of confidence among the clients of these banks as well as the investors in these banks. As clients started to close accounts, investors started to sell shares of stock in these companies. These factors worked in tandem to literally collapse several major banks in a matter of days as they no longer had the ability to meet their required capital obligations.

With housing collapsing and the banks collapsing, equity investors grew fearful that businesses would no longer have access to capital. Furthermore, consumers would curb spending out of fear that their most valued tangible asset, their home, wasn’t worth what they thought it was. And more importantly, businesses in turn would curb spending out of fear that consumers would buy few products. Most of all, businesses would have difficulty gaining access to capital due to problems with the banks. All of this ultimately stems from a lack of confidence in the spending ability of institutions as well as individuals.

So here we are in the midst of one major crisis of confidence. How do we fix it? Simple, restore confidence. To do that, the government (Congress, the Treasury and the Fed) has:

1.) passed the $700 billion rescue package which will, among other things, allow financial institutions to sell their distressed mortgage-based instruments to the government and
2.) agreed to loan money directly to companies by purchasing their commercial paper.

Unfortunately, these steps have done little but further undermine confidence in our financial system and leaders. What happens next? Stay tuned. I have a feeling another blog entry will be posted sooner rather than later.

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.

One week ago, the stock market surged, Wall Street was dominated by four large investment banks, and the largest insurance company in the world was enjoying a spike in stock price.

What a difference a week makes. One week later, the market saw its worst day in eight years, Wall Street is left with only two stand-alone investment banks, and the once largest insurance company in the world is fighting for its life. If you fell asleep at your desk last week and just awoke, I’ve got some news for you: the world has changed.

So what happened? Well among other things, companies have now been thrown to the market wolves, or bears in this case, and left to fend for themselves. Essentially, short sellers have taken hold of financials and continue to drive the market lower. How did so few become so powerful? Let’s consider the dynamics of short selling.

Short sellers make a bet that the price of a company’s stock will fall. To do that, they borrow shares of a traded stock (usually held by a brokerage house), and sell it with the intent of buying it back at a lower price. When the price drops, the short seller can buy the stock back and earn a profit on the difference between the sale price and the purchase price. Of course, if the price of the stock goes up, the short seller may have to close the position by buying shares of the stock to replace the borrowed shares at a higher price thus recognizing a loss. For example, a short seller sells shares of Lehman, the most recent market casualty, short at $4 per share. When the share drops to $.10 after the bank declares bankruptcy, the short-seller buys the shares to replace the borrowed ones at $.10 earning a $3.90 profit. Of course, had the stock gone up to say $10, the short seller may close the position by purchasing the shares at that price suffering a $6 loss.

Short-sellers are as much a part of an efficient market as the people who buy and hold shares of stock for an extended period of time. Unfortunately, the rules governing short-selling allow for short-sellers to push a stock to unprecedented lows in a very short period of time. This has created two contentious points:

1.)   The SEC’s standards for enforcement of “naked” short-selling are lax. Naked short selling means someone can sell short without even borrowing shares. In theory, it can allow a large short sale order to be placed which in and of itself, could push the stock price lower. As more, larger sell orders are placed, a stock price will collapse.

2.)   The uptick rule required that a short sale must be entered at a price higher than the last trade. The idea behind this is that it prevents the compounding downward pressure of progressively lower sell orders. The uptick rule was eliminated in 2007.

Short selling adversaries argue that there is a lack of regulation allowing for short sellers to essentially gang up and beat a stock down to nothing. Unfortunately, a falling stock price, while a technical problem, can easily become a fundamental problem in sectors such as financial services and insurance. In these sectors, a drop in stock price can trigger a ratings downgrade which can prompt liquidity concerns. If these issues are not checked, a complete collapse of a company can occur. 

To explore these and related issues, join us for one of our in-person courses (in major U.S. cities) in Accounting and Financial Statements or Corporate Finance and Valuation, or one of our webinars in Understanding Financial Statements, Financial Analysis, Stocks, Bonds, Options Online - Securities Basics for Lawyer, or Valuation.

In the midst of record high oil prices, a near meltdown of the banking sector, a loss of confidence in the stock market, a mortgage crisis and rising inflation, we find ourselves feeling rather helpless. As the overall economy suffers, business activity will likely slow leaving a dearth of opportunities for most of us in the business and legal community. So what can an able bodied professional like you do to manage this crisis? Educate yourself. That’s right. Knowledge is power and taking advantage of any downtime to build up your personal balance sheet will help you understand the current situation and, hopefully, allow you to add more value when opportunities present themselves. To start you out, here is a quick guide to what any professional should know about the current economy:

Where to begin? To understand the current situation, it’s important to consider the following process:

Bad mortgages weak banking sector weak stock market high commodity prices inflation weaker stock market higher commodity prices higher inflation job losses economic collapse.

Of course, the above chain of events paints a rather bleak picture of the future and for the most part, is a worst-case-scenario assessment. Where we go from here is something I’ll leave to the economic prognosticators (who, by the way, are usually wrong). Rather, I’ll simply attempt to clarify the forces at work and you can predict what might happen next.

Mortgage crisis—Basically, too many loans were issued to individuals who at any other point in time would not have qualified for these loans. These loans were packaged and sold to other investors who were virtually unaware of the risks associated with them. These bundled loans were termed collateralized debt obligations (CDO’s) and valued based on their future expected payments. This method of valuation, often termed mark-to-market accounting, creates innumerable accounting problems but most importantly, can mislead the investor because what you see may not be what you get. So when a company such as Citigroup states $30 billion worth of these loans on their balance sheet (what you see), what you get in 2008 is more like $5 billion.

Bank failures—The traditional economic belief is that when the banks fall, so do other aspects of the economy. Banks serve as an engine for growth providing consumers and corporations with the capital needed to expand. As the banks continue to report bad news including write downs of mortgage backed assets and worse, overall liquidity problems, investors lose faith in the sector. And as investors lose faith in the sector, they lose faith in the economy. When investors lose faith in the economy, what do they do? They sell stock. If companies are expected to suffer, their stock will be worth less. So if investors sell their stock, where do they invest their money? These days, oil!
Oil crisis—Investors, and more specifically commodities speculators, have invested heavily in oil futures due to a shortage of other compelling investment opportunities. Combine this with increasing demand for oil in emerging markets and tensions in the Middle East, and you have the perfect formula for sizeable gains in black gold. Real estate values have fallen and the stock market has fallen leaving investors with few other investment opportunities. Few will dispute the fact that the surge in oil, as well as other commodities, is creating a bubble. Nonetheless, the impact of this momentum is widespread. Specifically, higher fuel costs leads to higher costs in just about everything else. And overall higher costs lead to inflation. If inflation is prolonged, it impacts not only the consumer, who buys less, but the corporation, who may earn less. And if corporations suffer, job losses will mount.

That’s it in a nutshell. Clearly there’s much more happening behind the scenes but this should be enough to get you through your next water cooler discussion. And as bad as it sounds, signs of hope are emerging. Banks are beginning to show better than expected earnings (which isn’t saying much), oil prices are coming down, speculators are facing possible restrictions on their trading activities, and the government has pledged its support for some of the largest financial institutions. So stay tuned, it may or may not get better from here but it will most definitely get more interesting.

(For valuable, understandable, and interesting courses on accounting and financial statements, corporate finance and valuation, or other business topics, in your city or online, visit www.OneDayMBA.org.)

What a week it has been. The collapse of Bear Stearns stirred up memories of another corporate collapse not too long ago. Does the name Enron ring a bell? I remember Bruce Willis’s character remark in Die Hard II, “How can the same thing happen to the same guy twice?” How can the same guy find himself rescuing hostages on two separate occasions and how can two multibillion dollar corporations collapse due to financial instruments that are not what they appear to be? The first part of this is easy: Hollywood doesn’t have to explain anything. The second part is somewhat more complex.

Enron and Bear were both involved in valuing financial instruments using mark-to-market accounting. What that means is each company would list items on its balance sheet based on estimates of value. A general rule in the finance world is that valuation is more art than science and ultimately the only true value of anything is what a buyer and seller agree on. So what happens when you do not have a buyer and seller? You estimate the value using one of several methods of valuation. More often than not, the method employs a technique whereby the returns of the asset are projected many years into the future. Basically, they look at what will be earned or what cash will be generated each year over the course of many years. Then, they use a discount factor to assess what these projected funds would be worth in today’s dollars. The total of these discounted projections forms the value of the asset. In the case of Enron, they were estimating returns from oil and gas rights over many years and in the case of Bear, they were estimating returns from mortgage based derivatives. Well guess what? When the projections appear overly aggressive, the overall value is called into question as is the entire capital structure of the company. This can cause creditors, vendors, customers and shareholders to panic. And what starts as a debate over accounting estimates turns into an entire company collapse.

To be fair, Enron was doing things far more insidious than misstating values which is why the company not only collapsed but several of the individuals responsible for this are now in jail. At this point, Bear can only be accused of not truly understanding what it did and did not have. But there are some striking similarities in that both companies were presenting a picture of their financial performance based on some very aggressive assumptions. So Hollywood does not have to explain anything and it would appear that neither does corporate America.