Just Share Discussion Threads

[edwardt] 10/9/2018 15:05

indeed . i have totally read this one wrong. mea culpa.

[nav_mike] 10/9/2018 14:18

Well the market is now in full on panic mode....you must be very proud

[eumaeus] 10/9/2018 13:05

Kevin has a discussion out today on that very slide, if you are interested.

hxxp://eumaeus.org/wordp/index.php/2018/09/09/i-just-dont-believe-it/

[eumaeus] 10/9/2018 13:02

OK let me 'restructure' my FTSE portfolio by securitising the cashflows. I will sell you the senior *and* the junior tranche for the same made up price, i.e. £12,000. Will you buy now?

[dasv] 10/9/2018 12:27

Your argument is that the valuation approach applied to ERM's should not factor-in future projected cash flows at all? But aren't ERM's bond-like? The valuation model for corporate bonds, gilts, treasuries is based on projecting future cash flows (e.g. coupons) so why not value restructured notes based on an ERM on this basis?

If the life co. should not project future cash flows of the ERM's, then how should they be valued?

The ERM appears on the balance sheet as a restructured note, with a lower valuation (yield) than the ERM and further valuation reductions due to SII (volatility, dilapidation, further SII capital requirements for property risk) (there was a presentation slide on this - page 18, top right

Nobody is being asked to buy the ERM's Now (as in your portfolio example) when they buy shares in a life company, and it's a simplification to claim they are.

The investor is not simply buying the backing assets, they are buying a future discounted view of the asset/ liability mix of the insurer, along with its potential for growth. A life company has liabilities stretching out 20+ years: as you know, the profitability of a policy is determined by a combination of future factors (including longevity, interest rates, asset prices, yields, cost of capital). Obviously this makes valuing a life co's stock tricky. It does remind me somewhat of a growth stock: you aren't buying last year's cash flows you are buying the next five to ten years of cash-flows (e.g. FAANG valuations).

Further, there is a deep and liquid market in FTSE stock but no market in ERM's. I.e. it's simple to see the arbitrage argument you are trying to make: why would I buy your portfolio at a premium when I could buy it from another market participant at today's value? Try doing the same thing with ERM's. There is no arbitrage possibility.

So I still don't see the applicability of your analogy (buying your FTSE portfolio for greater than market value being analogous to buying stock in a company selling ERM's):-

1. ERM's are already discounted by life co's (under SII and via restructured notes)
2. Share prices don't just reflect book value of assets
3. No arbitrage opportunities exist for ERM's

In short, the thought experiment doesn't work because the analogy isn't analogous.

[eumaeus] 10/9/2018 10:58

@dasv, OK then will you buy my FTSE portfolio, current market value £10,000, at say £12,000? The latter is the discounted value of my forecast. You have just rejected my argument that the latter would be an overvaluation so why wouldn’t you buy it at that level, or any other level > £1,0000, right now?
I agree that an OTM call option might well expire ITM. The question is whether you would pay me the strike price *now*. Of course you wouldn’t.
Re IFRS, what is outlawed is any subjective estimate of future cashflows which when discounted at risk free does not calibrate to current fair value. Such as e.g. forecasting the FTSE level at some future point, discounting back at risk free to get a higher than market value, then selling it on to gullible investors at the higher value, on the grounds that ‘FTSE always goes up in the long run’.

[dasv] 10/9/2018 10:02

As for the "outlawing discounting of projected cash flows" - doesn't the forthcoming IFRS17 standard demand that discounted best estimate cash flows are used for the valuation of assets? (as per IFRS4)?

[dasv] 10/9/2018 09:56

If you are selling me a currently out-of-the-money portfolio option in 10 years time with a strike of 10,000 then yes it's out of the money now, but considering past performance of the stock market, global economy, correlation with GDP growth, it doesn't sound like an unreasonable proposition.

[dasv] 10/9/2018 09:52

“It can only be known whether ERMs are overpriced post hoc after experience.” Completely wrong. If I sell you my FTSE portfolio at 10,000, then you know it’s overpriced now. You don’t have to wait for it to reach 10,000 (or not) in order to know that.
---

No. Completely right. I think you are very confused. The accuracy of an estimation of future value can only be determined after it ceases to be an estimate, i.e. after the event, after experience, post hoc.

[topvest] 08/9/2018 19:57

Yes, absolutely...leverage is low. So at inception the debt is recognised at origination value being the amount advanced. Thinking about it there shouldn't be a day 1 profit on origination. The interest is then added at the interest rate in force (adjusted for the assumptions set out, but possibly mis-pricing the NNEG option depending on views). Aren't we just we talking about the difference between accreting 4% (say some NNEG shortfall) or 5% (say fully performing) interest?

[eumaeus] 08/9/2018 19:48

£7bn LTM, yes. Also about £9bn of A/BBB corp bonds, though recently shifted more to gilts. On the liability side the enhanced annuities+DB schemes, plus of course the equity.

[topvest] 08/9/2018 19:41

Hmm - JUST only has £480m of gross debt and £7bn of lifetime annuities.

[nav_mike] 08/9/2018 19:35

Couldnt possibly comment eh? Well at least we can deduce what your stance is, and following that link only reinforces that thought.

If the PRA all think like you then JUST dont have a prayer.

[eumaeus] 08/9/2018 19:25

'Flim flam operation'? Couldn't possibly comment. On the £1bn, look at my EUMAEUS post on that very subject hxxp://eumaeus.org/wordp/index.php/2018/08/10/hidden-in-plain-view/

[eumaeus] 08/9/2018 19:24

Here is a simple example. Borrow £1bn at 1.5% to repay as a bullet payment in 10Y. Invest the £1bn in risky assets that you believe can achieve 4% over that period. Then discount the future value of the £1bn (£1,162m) by 4%, giving £779m, which is the new book value of the debt. Since a balance sheet must balance (that’s why it’s called a balance sheet), this creates £221m of equity. Now get the auditor to sign off, and sell the company for the £221m. ‘Charlie’; was claiming there are no risk free profits, but haven’t I just made one? The only risk is the shareholders claiming their money back once they have seen what I have done. Fortunately they will strenuously defend me and attack anyone who tries to point out exactly what has been going on.

[nav_mike] 08/9/2018 19:22

eumaeus

There is currently a near £1 billion difference between JUSTs balance sheet and mcap values? Are you saying the PRA will be looking for an adjustmet/capital raise of that size or greater?

The tone of your last comment suggests you view JUST as a flim flam operation, ie creating value where none exists

[topvest] 08/9/2018 19:10

Is that the same? Depends on how they derive the origination value. If they are using the projections, to spread the interest then that sounds OK to me and the impact of changing the assumptions is fairly marginal. What is unclear is how much profit they book on day 1 (as new business) as no split by product is given.

[eumaeus] 08/9/2018 18:51

@Topvest, in fact they are marking assets at origination value, but the using the projection spread to discount the debt. This amounts to roughly the same thing. @nav_mike, no that is not the PRA's position. You are welcome to buy shares in my new company with book value at the £100m I suggested.

[topvest] 08/9/2018 18:36

Yes, agreed. You have a point. Depends what discount rate they are using I suppose. It’s not disclosed. Are you saying companies are discounting at a risk free rate?

Why are most companies doing it then and having their auditors sign it off?

[nav_mike] 08/9/2018 18:31

Well hopefully when JUST have been ruined by an onerous fundraising and pensioners can no longer get products they want at a decent price, then all these technically brilliant mathematicians can sit back, pour themselves a brandy and congratulate themselves on a job well done.

The tone of eumaeus' posts suggests the PRA have a dislike of JUSTs business model and will pay only lip service to any proposals from them.

[dasv] 08/9/2018 18:27

Charlie, I just read your blog. Great points and very interesting.

[eumaeus] 08/9/2018 18:18

So, let me borrow £1bn long term at close to risk free, then purchase £1bn of risky assets at market value. Then project forward the value at the risky rate, and discount at risk free. This gives me a present value for the asset of more than £1bn, say £1.1bn (or discount the debt at more than risk free, it’s roughly the same thing). So you have magically created equity worth £100m. Now sell to some investor who believes all that stuff. You have made £100m almost risk free. Of course the new investor has overpaid by exactly £100m. He or she will never get the risky excess return, because it’s already been paid to me! Work it out. This is nothing to do with fair value.

[topvest] 08/9/2018 18:06

Its a discounted cash flow forecast to determine the fair value, using an assumption that house prices will increase by more than inflation. Why is that different to other actuarial valuations where you assume equity returns at 6 or 7% etc? I acknowledge that it is bringing forward projected good news into the valuation.

[eumaeus] 08/9/2018 17:52

It's not fair value, quite the opposite. Fair value principles require the accountant to value assets and liabilities as a market participant would. There is no way a market participant would value assets using discount-projection methods. The discount-projection method was supposed to have been outlawed many years ago, but it clearly still persists.