Valuation 101: How Warren Buffet Does It; And Brooksley Born Wanted It Done
Stock-Markets / Stock Market Valuations Oct 26, 2009 - 01:21 PMBy: Andrew_Butter
A while back I caught a clip of Warren Buffet being interviewed by a rather tiresome over-bubbly television star; who brightly asked him a really-really profound question that the scriptwriter had obviously spent all night dreaming up:
“So Mr. Buffet, how do you know if something’s a good investment or not?”
He replied somewhat testily, “I know how to do a valuation”.
So that’s why he’s a billionaire then? Evidently he knows how to do a valuation, he know when something is on sale for less than what it’s really worth, and he know when to sell something when that scenario starts to change.
Now try asking any investment guru, “Financial Stability Expert”, genius Nobel-prize-winning economist, hot-shot Big Four auditor, ratings rubber-stamp-Rambo, or Wall Street hack, whether they know how to do a valuation. Most likely they will tell you, “Sure I do”.
Try asking them this question, “so did you ever read International Valuation Standards”
“You know the book on how to do a valuation that was first published in 2000 and was written over about ten years by the best valuation professionals in the world and is approved and recognized by every valuation institute of any consequence in the world, including those in USA?”
Like all 462 pages?
If the answer you get is “Uh...Duh”, which is what you will probably get 99% of the time, well you are on the right path to figuring out why there was a credit crunch.
International Valuation Standards:
IVS are very different from the Voodoo Valuation Standards (VVS) that are so beloved by FASB, IAS, and the purveyors of the deliciously un-stressful Stress Tests; they recognise just two values (a) Market Value and (b) Other Than Market Value.
This is the thing, when you do a valuation in accordance with IVS (i.e. for example when someone pays you money to do a valuation they can rely on, and when you hold Professional Indemnity Insurance so that if you give them a totally misleading answer they can sue you and expect to get paid damages (what a notion!)), you are supposed to start off asking the question.
Q1: Is the market (for the thing or service you are valuing), in disequilibrium or not?
In other words is the market suffering from a bust of “illiquidity” for example what happened to the market for toxic assets in September last year, or is it suffering from a burst of “over-liquidity”, which was what happened to the market for toxic assets (and housing that securitized those toxic assets), in the preceding years.
If the answer to that question is “No”, then a valuation is easy, you just look up the price in the market, that’s called “mark-to-market”, and the reason that approach is so beloved by the geniuses who created the credit crunch is that it’s easy and cheap to do and requires absolutely no intelligence at all.
If the answer is “Yes” then according to IVS the person doing the valuation is supposed to do two things:
1: Flag that fact to the client.
2: Make an estimate of what the value would be (in their opinion), if the market was not in disequilibrium, and report that value, the Other than Market Value to the client.
Example:
In July 2006, any competent valuation professional would have seen that the housing market in USA was in a state of disequilibrium due primarily to “over-liquidity”. That was not a secret; the IMF was saying that, Professor Shiller was saying that.
The extent of the over-pricing could of course have been a matter of debate, although in my opinion (that’s what you pay for when you buy a valuation, an opinion), a valuation done strictly in accordance with International Valuation Standards would have remarked that the market in general was 40% over-priced (as is shown in http://www.marketoracle.co.uk/Article6250.html ).
A second opinion might well have given a different result, two valuation professionals can always end up with a different answer, then it’s up to the client to decide what to do, although that is made easier under IVS because you are supposed to:
(a) Explain how you did the valuation in plain English (or Dutch, or Swahili, as appropriate (interestingly I recently reviewed a very competent valuation done by a firm in Kenya, lots of people know how to do a valuation properly, although evidently the news did not yet trickle down from River Road in Nairobi to Wall Street)).
(b) The valuation is supposed to be based on “sufficient” market-derived (historical) data.
(c) The data should be properly analysed.
Personally, I have only been doing valuations for twenty years; perhaps I was wrong, (one’s standards do tend to get a bit “relaxed” sometimes when one is working pro-bono). Although, I have yet to see anyone else do a valuation of housing in USA using IVS, and even though nearly 20,000 people read that article, no one has yet challenged my valuation approach.
In my defence, I do have a habit of getting it right (never got sued for professional incompetence yet – touch wood), for example “S&P 500 675” (that was a valuation) http://www.marketoracle.co.uk/Article14368.html .
The other thing is that IVS is very prescriptive about how you do a valuation; I suspect that a second opinion would be in the same ball-park, if everything is out on the table, well it’s easy to do an audit.
The point:
- Until you do a valuation like that, you have no clue what’s going on.
- Unless you ask for a valuation done according to IVS, well you are not going to get one.
- According to IVS the LTV of those 100% mortgages written at the peak were not that, they were 140%.
Thus if the valuations of housing done for the purposes of assessing the likely value of the collateral that had been put up (at the point in time that you might want to liquidate it), starting 2000, well Alan Greenspan’s grand utopian dreams of destroying the fabric of the United States economy, might well have been thwarted.
Same thing for toxic assets and derivatives, the way you value those is exactly the same as how you value a second-hand bottling plant (at least according to IVS). The only problem right now is that it’s impossible to value those instruments at the moment, because there is not enough “market-derived-data” in the public domain or available to a potential buyer, to do that.
I know, I tried, I told my client, “sorry, this is impossible”.
That explains why the likes of Henry Paulson and Tim Geithner have been scratching their heads for over a year trying to figure out how much to pay for toxic assets, first under the TARP scheme and second under PPIP.
The reason for that is thanks to the sterling efforts of Alan Greenspan, Bob Rubin, Lawrence Summers, Timothy Geithner and others of the guilded “Working Group” that “Saved The World”, ten years ago, ten years before Gordon Brown even thought about that.
It’s the same formula for growing mushrooms, “keep them in the dark and feed them on horse manure”.
The Warning:
There is a superb documentary doing the rounds these days about the geniuses to whom we owe the current catastrophe (with sterling walk-on performances by a very youthful looking Tim Geithner and a much slimmed-down Lawrence Summers). It’s called “The Warning” http://www.marketoracle.co.uk/Article14485.html .
It documents how in 1997 Brooksley Born tried to put in place regulation of the Over The Counter (OTC) Derivatives, so that there would be transparency both for buyers, so that government regulators could understand whether there was systemic risk, and so that market participants could be protected from fraud, for example when counter-parties put up the same collateral to more than one creditor (like taking out a mortgage on your house with ten mortgage providers – so that when you run away there are ten people fighting over the same house – in most countries that’s called fraud, in USA that’s called “free-markets”).
She met with a storm of resistance from the Rubin/Greenspan mandarins, the “Working Group”, ably assisted by their lieutenants, (their apprentice sorcerers who are now trying to recreate the magic of their mentor and master-wizard), Garry Summers and Timothy Geithner.
They quickly mobilised Congress to shut down this “dangerous person” who might derail the bubble that they were cooking; and Congress was only to happy to oblige the “leader of the pack”, the man that President Bush called “one of the most admired and influential economists in our nations history”.
In 1997 a Congressional Special Committee was convened to warn her off, in that hearing one interrogator asked, “What are you trying to protect”?
Born: “We are trying to protect the money of the American People”.
Can’t have that, someone who w3ants to protect the money of American people from fraud.
Shortly after that there was the dress rehearsal of the Long Term Capital Management collapse, which started in 1998. But that was “only” $4.2 billion, and Wall Street was standing-by to clean up the mess, so that was quietly brushed under the carpet. It was a “blip”, it wouldn’t happen again.
And then just to be sure that it did, they shut her up and shut her down, they obtained from Congress an order telling her to desist, and she resigned. By 2008 the derivatives market exceeded $500 trillion.
What did she want that was so dangerous?
What she wanted was that market participants (and people who were directly and indirectly exposed financially to what Alan Greenspan called “the dumb mistakes” of the gamblers, for example the US taxpayers), to be provided as a matter of law with sufficient information to be able to make rational investment decisions (i.e. so that they could hire a competent valuation expert to do a valuation).
They succeeded, and their triumph is $11 trillion or so losses, one loses track of the estimates, a bit like the civilian casualties in Iraq, no one is counting.
And guess what? Tim Geithner and Larry Summers, are setting things up so that can happen again.
Do the math, in 1998 LTCM lost $4.2 billion, in 2008 the shadow banks lost (themselves, we won’t talk about what the people who bought their melanin tainted milk lost), at least $4.2 trillion and counting.
So what are the newly qualified “wizards” cooking up this time? That’s something to look forwards to in 2018, like $4,200 trillion.
Whoopee, I can hardly wait!
By Andrew Butter
Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( hbutter@eim.ae ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.
© 2009 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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