Our legal system depends on accurate assessments of fair market value in virtually every business-related matter that comes before a court. Distortions of fair market value, from whatever source, are problematic. Valuation issues materially affect everything from real estate values to stock and commodity values to more esoteric valuations involving crop prices for farmers.
Fair Market Value
As every business student learns, FMV is the price at which a willing seller and a willing buyer will close a transaction. Until about 2008, the centuries-old assumptions of fair market value more or less held throughout our economic system. After 2008, the validity of “fair market” value began to erode in certain securities markets supported by the various Congressional bailouts and Federal Reserve liquidity injections. After all, if the Federal Reserve is fully committed to supporting securities markets at any cost, that means the the Fed can, and does, unilaterally set the market price of assets it is willing to purchase. Invariably, this causes distortions of fair market value.
Once savvy traders figured out this reality, post-2008, the price of numerous securities skyrocketed, and has hardly looked back. “Buy the dip” has become the only rule for trading in certain securities today –meaning that if a (favored) stock price temporarily drops, buyers pile in with full expectation that the Federal Reserve will provide debt support for a stock buy-back spree to drive a V-shaped market recovery in that particular stock or set of stocks. From 2008 to today in May, 2020, the Fed has not disappointed. Bank bailouts and liquidity injections, sold to the public in 2008 as “temporary emergency measures,” are nowadays a permanent fixture in the Fed’s obvious (but not publicly admitted) goal to support and drive certain asset prices.
THE INCONVENIENT TRUTH ABOUT STOCK MARKET PRICE INCREASES SINCE 2008
Since the S&P 500 and DJIA components are heavily weighted to just a few high-performing stocks (such as Apple (AAPL), Amazon (AMZN), Netflix (NFLX), Microsoft (MSFT), Facebook (FB) and Google/Alphabet (GOOG), both of the broad equity indices tend to rise with price increases in these few stocks, irrespective of what is happening in the trading of other public securities. And since many derivative trades and ETF tracking stocks are based on these broad market indices, price increases in just these few stocks can give the appearance of a robust stock stock market–and by implication, a strong economy.
But this distortion in value weighting in the S&P 500 and DJIA tend to hide serious value problems in other publicly-traded companies that don’t have the good fortune of being Apple or Google or Facebook. But because the broader market indices are often used in valuation formulas, deceptive valuations can, and do, arise based on faulty assumptions of what is really going on in trading markets. This again causes distortions of fair market value.
It is worth emphasizing: the year-after-year rises in stock prices of the FAANG stocks have been driven largely by stock buy-backs; and these stock buy-backs have been driven largely by widely-available credit in the corporate credit markets. In effect, a company borrows to facilitate a stock buy-back; the stock-buyback drives its price higher; the higher stock price drives the S&P 500, DJIA and NASDAQ higher, which fuels higher collateral values that support yet higher levels of corporate borrowing. Up and up these values go in a cycle of borrowing based on higher collateral values that enable more borrowing. This cycle has repeated virtually non-stop since 2008 and is largely responsible for today’s perceived strong stock markets.
In fact, it was recently revealed that famed investor Warren Buffett’s massive value increases in recent years has come primarily from investments in companies that engage in aggressive stock buy-backs. Companies that have stopped buy-backs, such as United Airlines, Delta Airlines and IBM, have been dropped from Mr. Buffett’s holdings.
The point of diving down this stock market valuation rabbit hole is to draw attention to a very important element of valuation distortion in our current economy. To propose a valuation of virtually any asset in a public or private company, without considering this valuation distortion (manipulation) created for the overall economy is, in our view, unsupportable.
But discussion of stock market valuations just leads us to further, more opaque distortions of value that have a far more ominous impact on overall economic activity than just stock market valuations: the corporate credit market. If the residential mortgage market was the catalyst for the 2008 stock market crash, the corporate credit market threatens a similar, but far worse, trigger for economic difficulties in the years ahead. This is because of largely hidden trading activities in the central bank “repo” market and the derivative markets for corporate bonds and related credit products, most notably, credit default swaps. We first address the repo market in this discussion.
Sept. 16, 2019: the beginning of the end of FMV
The “repo market” is generally defined as a form of short-term borrowing for dealers in government securities. Investopedia says this: “In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price.”
Until Sept. 16, 2019, the repo rate of interest hovered below 2%. In practice, this meant that hedge funds and other financial entities could borrow from Wall Street banks for short term uses at a rate below 2%. But on Sept. 16, 2019, the repo rate skyrocketed to 10%–literally overnight. This meant that large banks–repo dealers–were not comfortable lending money to hedge funds and other financial entities without a huge interest rate premium.
What caused this overnight interest rate spike? Speculation centered around the then-imminent bankruptcy of the WeWork company, which threatened to collapse the global commercial real estate market, and related financial problems with WeWork’s principal investor, the Japanese company Softbank.
In any event, starting Sept. 16, 2019, the Federal Reserve crossed the proverbial “Rubicon” by beginning to inject trillions of dollars into the short-term repo market, and even lending directly to hedge funds and other financial institutions who were not dealers in government securities. This distortions of fair market value brought the repo market rate down to the desired range–below 2%–but marked the end of any notion that the repo market was actually priced at fair market value. Rather, obvious to all, the Federal Reserve was supporting the market at the policy-determined rate, which had nothing whatsoever to do with the price at which a willing seller would sell to a willing buyer.
Feb. 24, 2020: the Repo Market Collapse Threatened a Derivatives Market Collapse
By February 24, 2020, the Fed’s massive repo market injections were still not enough to calm fears in the dangerous derivatives markets. As news of the repo injections hit trading floors, share prices of the largest derivative traders and counter-party insurers dropped far faster, and farther, than the general market sell-off that continued that day. And, as AIG discovered in 2008, being a derivative counter-party is a disastrous position when capital markets show signs of distress. And yet, by Feb. 24, 2020, here we were again, with enormous derivative trades insured by large insurers, all in the face of increasingly-distressed capital markets.
DERIVATIVES MARKETS: THE LINK TO ALL OTHER ASSET MARKETS
So what’s the big deal if derivatives markets collapse? Actually, its an enormously big deal. Derivative trades (reference contracts to underlying assets) are typically leveraged up to 300 times the value of the underlying asset.
By March 12, 2020, the derivatives markets for corporate credit were about to collapse. This would have caused an economic collapse on the scale of 2008-if not much greater. By now, a huge part of the problem were the US shale oil companies who were massively leveraged. Just a few days earlier Saudi Arabia announced its “war on shale” by artificially cutting oil prices to an unsustainable level for US producers. The goal was to drive shale producers out of the market. This, of course, would have the spill-over effect of highly-leveraged US oil companies being unable to pay their corporate debt obligations.
If payments had stop on securitized collateral linked to the massive derivative trading markets, counter-party insurers would have collapsed, along with the largest derivative traders: JPMorgan, Citibank and Goldman Sachs. To not have another “Lehman Moment,” it was critical that hedge funds and other aggregators of securitized debt continue making payments–yet they were fast running out of money and the repo liquidity injections weren’t doing the job, since repo loans were short-term fixes.
The repo boat was sinking faster than the Fed could plug the holes created by the massive number of speculative derivative trades. Hedge funds had created a huge problem by borrowing short (in the repo market) and investing that money in long-term projects, like real estate. But the oil industry was now an even bigger catalyst for a derivatives unwind because of the global oil price collapse and the highly-leveraged US oil producers’ links to the derivatives trade.
MARCH 12, 2020: THE FED ANNOUNCES 1.5 TRILLION IN WALL STREET BAILOUT LOANS
Finally, with the Dow Jones Industrial Average plunging over 1,000 points per day, the Federal Reserve again stepped in to bail out Wall Street banks with $1.5 trillion in longer term loans. Terms of the loans have been kept secret. However, one can rather safely assume the loans, although clear distortions of fair market value, were intended to keep payments going on corporate debt, to prevent a derivatives market collapse. Keeping the party going, as it were.
our new world of unlimited BAILOUTS
By mid-march, Congress was getting into the bailout business due to the recently-appeared coronavirus concern. Small business lending was highlighted in the news, but less conspicuous was the additional money earmarked for Wall Street dealers and certain foreign banks (including Deutsche Bank)–presumably to keep payments up on the massive outstanding corporate debt default threats that had, by now, circled the globe. And this, in our view, to underpin the the Fed’s primary objective: to keep the speculative derivatives market from collapsing, which would bring the entire economy to a standstill–like 2008, only much worse. However laudable this policy goal, the result again has created massive distortions of fair market value.
Essentially, the Federal Reserve and Wall Street banks have created a true Frankenstein monster in the form of unregulated, speculative betting in financial derivatives. There is no easy way to undo this mess and return to an early 1990’s world where speculative derivatives were virtually unknown.
At the time of this writing, May 12, 2020, the bailout packages and liquidity injections to support Wall Street and large corporations are too many to count. Just today, Blackrock, the world’s largest asset manager, has begun buying junk bond ETFs at the Fed’s behest. (Blackrock was earlier appointed an agent for Federal Reserve open-market asset purchases.) Amazingly, none of these extreme, unprecedented efforts at disaster prevention have been publicly questioned or even discussed in wider conversations, outside a few sites dedicated to an in-depth analysis of Federal Reserve policy and global economic issues, such as Wall Street on Parade and ZeroHedge.
One thing is very clear at this point: the Federal Reserve and US Congress are determined to undertake any and all distortions of fair market value in asset prices to stop a wholesale stock market crash–and the ensuing economic collapse. Key questions are obvious:
–Is the Fed policy to support markets (at literally any cost) a laudable policy goal, or not?
–Is it even possible to support the multitude of markets ancillary to the corporate bond market?
–Most of all, how long can the Fed sustain this policy of widespread market support without a major breakage in some part of the financial system?
For now, these are all questions without clear answers, and are beyond the scope of this post. However, it is clearly the reality we currently live in. The Federal Reserve, through the Wall Street banks and hedge funds, will support the corporate bond market at any cost, for any duration of time, as long as possible.
RUNNING ON FAITH…
It has been said that “everyone has faith in something–the only variable is what that faith is placed in.” This statement seems profoundly true. For the time being, it appears that the general public has faith in Federal Reserve and governmental policy to continue doing “whatever it takes” to support and sustain the American way of life. The alternative is virtually unthinkable for everyone, and there is no agenda here to suggest otherwise.
One goal of this discussion–this series of blog posts–is to logically deconstruct the valuation issues that government policy has created in distortions of fair market value across virtually all asset classes. Importantly, in business litigation and bankruptcy cases, lawyers, other professionals and judges have a duty to involved parties to arrive at the most logically-correct valuation assessments possible. So this compels us to ask questions of our current environment.
The most important valuation question to grapple with is this: what effect will the Fed’s distortions of fair market value have on all other asset prices–what will become of the notion of “Fair Market Value” where market prices are now set by government regulators rather than by buyers and sellers? And what are the follow-on effects of this policy in relationship to the legal system in general, and the bankruptcy process in specific?
THESIS OF THIS BLOG SERIES ON VALUATION
The primary thesis of this blog series is that asset valuations in 2020 must now account more completely for global economic conditions than ever before, due to Federal Reserve’s distortions of fair market value and the unavoidable influence of global derivatives trading markets. In theory, the standard valuation models used in bankruptcy courts and other civil courts will continue to work just fine, even in times of asset value distortions, as long as a correct attention is placed on global economic conditions. This requires courts and valuation experts to account for the impact speculative derivatives may have on the value of an asset and asset class.
This ongoing discussion about asset valuation in 2020 continues in subsequent posts:
Part 2: The Impact of Derivatives and Securitizations
Part 3: The Standard Valuation Methods
Part 4: Modifying the Standard Methods