Playing Catch Up

Last Friday, the Public Company Accounting Oversight Board (PCAOB) came out with the warning that auditors should be on the lookout for potential stock options backdating abuses:

WASHINGTON (Dow Jones/AP) -- The Public Company Accounting Oversight Board on Friday issued its first-ever ``audit practice alert,'' warning auditors to be on the lookout for problems in the timing and accounting of stock-option grants.

``Auditors planning or performing an audit should be alert to the risk that the issuer may not have properly accounted for stock options, and as a result, may have materially misstated its financial statements,'' the alert cautioned. It told auditors to assess such risks in the course of an audit and use professional judgment in deciding whether additional scrutiny is warranted.

The oversight board's alert comes on the heels of Securities and Exchange Commission rules approved Wednesday intended to crack down on backdating and other abuses in granting executive stock options.

Huh? Can someone please tell me what's new here? Isn't this what auditors are supposed to do in the first place - that is, uh, audit? Stock option terms and policies would seem to be right in the sweet spot of their perview. "It (PCAOB) told auditors to assess such risks in the course of an audit and use professional judgment in deciding whether additional scrutiny is warranted." What? Use professional judgement? Now I believe a clear, robust public accounting system is critical for the integrity of the financial markets, and also believe that a group like PCAOB has an important place in this process, but these pronouncements are truly embarrassing. It basically sends the message that all that money spent on audit services - and let me tell you firsthand that these services are not cheap - yields questionable results and doesn't serve those for whom it was designed, namely, the public. That such language is used implies to me that the "profession" of public accounting has truly lost its luster, and that the integrity and objectivity which is the supposed currency of the trade has depreciated markedly.

As noted in a previous post, I believe those in the position of responsibility on which others rely, i.e., fiduciaries such as pension funds, accountants, lawyers, etc., must be held accountable for their actions (or their lack of action as the case may be). Once the integrity of these players falls into question, the underpinnings of the marketplace they are supposed to serve weakens considerably. My hope is that "bold" pronouncements like those made by the PCAOB on Friday are few and far between, because if fundamental issues like those discussed above require comment a wholesale review of the public accounting profession may be in order.

Colliding of Worlds - Blogs vs. Traditional Media

So it just came across CNN.com that Ana Marie Cox a/k/a Wonkette, is trading her sword for a pen and moving from Nick Denton's edgy Gawker Media to the far more buttoned-down Time Warner-owned Time.com. Ms. Cox is assuming the new role of Washington editor, which seems pretty cool yet pretty mainstream to me. Congratulations to her. I do find it interesting, however, that someone of her status and success in the blogosphere (in terms of clicks, eyeballs - namely, her following) would be pursued for (and accept) such a seemingly conventional position with such an old-guard publication. Clearly those executives at Time Warner believe that her appeal and following as the ascerbic and witty Wonkette will translate into increased readership on their Time.com site. I wonder what the demographic profile of the Wonkette reader is relative to the Time.com reader? If these demographic profiles are materially different, will Ms. Cox be successful in drawing new readers to Time.com? And if, in fact, she writes in a more, shall we say, toned-down manner as necessitated by the editorial policies of her new employer, will some of her appeal be diluted? I have no idea and I am completely unqualified to answer such questions, but they intrigue me nonetheless.

But I am fascinated by the growing crossover between traditional and non-traditional media, and this is only the latest and highest-profile example of this phenomenon. Bottom line - Wonkette has interesting stuff to say and people eat it up. This is news. If she can bring a little of her joie de vivre (not to mention her rolodex) and character to Time.com I have no doubt she will be able to deliver terrific value for Time Warner's investment. I am also confident that this move is only the beginning of an oscillation back-and-forth across the new media-traditional media divide that will ultimately lead to a single word to describe sites like Wonkette and Time.com - media.

Do Hedge Funds Give Rise to Externalities?

As mentioned in several earlier blog posts, I have very strong opinions on the issue of hedge fund regulation. As discussed in Wednesday's New York Times, Christopher Cox, Chairman of the SEC, made several particularly interesting comments during Tuesday's Senate hearings:

“I am concerned that the current definition, which is decades old, is not only out of date but wholly inadequate to protect unsophisticated investors from the complex risks of investment in most hedge funds,” he[Cox] said.

...

The commission has the authority to investigate any kind of fraud it suspects, but the court’s decision to throw out the registration requirement limits its ability to conduct routine exams and improve its understanding of the industry.

...

The Treasury Department, meanwhile, has formed a group to examine potential risks in the industry, including the exposure that many large banks could have to certain trades. The group, which first met a few weeks ago, will work with members of the hedge fund industry and the banks who manage their accounts. 

...

[Randal K. Quarles, under secretary for domestic finance at the Treasury Department] said one risk he saw was embedded leverage, or bets that hedge funds have taken with derivatives that are less apparent on the balance sheet. 

Now I could sit here and address Mr. Cox's comments one by one, but I think the entire issue here can be addressed through a single word, a powerful economic concept called externalities. Per Wikipedia:

In economics, an externality is the effect of a transaction between two parties on a third party who is not involved in the carrying out of that transaction. Externalities can be either positive, when an external benefit is generated, or negative, when an external cost is generated from a market transaction.

An externality occurs when a decision causes costs or benefits to stakeholders other than the person making the decision, often, though not necessarily, from the use of common goods (for example, a decision which results in pollution of the atmosphere would involve an externality). In other words, the decision-maker does not bear all of the costs or reap all of the gains from his or her action. As a result, in a competitive market too much or too little of the good will be consumed from the point of view of society. If the world around the person making the decision benefits more than he does, such as in areas of education, or safety, then the good will be underprovided; if the costs to the world exceed the costs to the individual making the choice in areas such as pollution or crime then the good will be overprovided from society's point of view.

So, to me the real question is - "Does the hedge fund industry give rise to externalities that warrant government regulation?" Tom Evslin, himself a free-marketeer, recently had a great post on externalities and provided classic economic arguments for where government regulation might be warranted (even for those in favor of free markets).

For externalities to be present in the hedge fund industry, the crux of the argument has to revolve around those who are impacted by hedge funds but themselves are not directly involved in hedge funds. This would seem to break down into two core constituencies:

1. non-accredited investors who are indirectly invested in hedge funds through pension plans and other pooled investment vehicles; and


2. market participants of all types who are potentially effected by the trading activities of hedge funds and its impact on the global financial markets.

Interestingly enough, I would say that these two constituencies are generally the focus of the more rational arguments I’ve seen for regulating hedge funds, and I’ll briefly explain my views on each.

Non-accredited investors : Chairman Cox raises the issue of protecting the individual (read: unsophisticated and non-accredited) investor. I buy this argument as long as we are talking about what constitutes an unsophisticated investor. The accreditation requirements go a long way towards separating those for whom investing in hedge funds is appropriate and those for whom it is not, and it probably does make sense to raise the net worth and income thresholds. Ok, now what? Most of the arguments I've seen have to do with non-accredited investors indirectly investing in hedge funds through their holdings in pension plans, which themselves invest in hedge funds.

Ah, now we're getting somewhere. This could be an externality, right? But wait, pensions fund managers, they are, what is that word, fiduciaries. Hmmm, maybe it is their responsibility to make sure that their investments are being managed properly and their constituencies are being protected. And they are sophisticated, right? They either have large in-house investment teams or smaller teams that leverage the work of “skilled” pension consultants like Mercer, Hewitt, Hennessee, Cambridge Associates, etc.

So is there really an externality here? My answer - NO. Why use regulation to protect people who themselves are protected through the accreditation standards, and whose agency involvement (via indirect investment through pension funds) is being represented by those who are legally responsible for looking after their best interests? Seems like overkill to me.

Market participants: The above article addresses a number of issues relating to hedge funds’ impact on the financial markets, which clearly effects investors everywhere whether or not they are invested in hedge funds. The article mentions the SEC’s power to investigate fraud (and, in fact, other concerns) in the absence of explicit regulation, as well as the Treasury Department’s newly-formed group “… to examine potential risks in the industry, including the exposure that many large banks could have to certain trades.” This group will also include hedge funds. I saw this first-hand in my earlier career in derivatives and trading, where both the SEC and Treasury interviewed myself and several of my colleagues (in trading, structuring and prime brokerage) to ask questions, investigate issues and collect data on hot-button issues, i.e., concentration of risk, number of unconfirmed trades, KYC/AML procedures, etc. Let me tell you, this kind of tacit regulation and review works like a charm. It is not “check the box” regulation – it is sitting eye-to-eye with someone who has the power to make your life very, very painful. When your internal counsel gets a call from the SEC, Treasury or the OCC, you hop to it, get your ducks in a row and prepare to be grilled. This is a healthy process and keeps people on their toes, knowing that they can get a call at any time.

And the interesting thing is that while hedge funds themselves might not be “regulated” in the classic sense (though in my earlier post about regulation, I argue that hedge funds are, in fact, effectively regulated), their key trading counterparties and liquidity providers – the banks and prime brokers – are. Further, the principal engine of growth in hedge fund AUM – pension funds and endowments – are fiduciaries, who themselves are legally on the hook for protecting their constituencies. So I really don’t see how those with the power, authority and responsibility for protecting and preserving the integrity of U.S.-based institutions’ impact on the financial markets don’t already have the requisite tools at their disposal. So is this a true externality? I don’t think so.

One final comment on this issue of regulation to protect investors from bad behavior: Through legislation, the SEC filing process and coordination with the FASB (the body which promulgates financial accounting rules), the government has already taken extensive steps to regulate public companies and mutual funds (presumably, the argument being that individual investors themselves can't influence what happens inside a corporation or a mutual fund and, therefore, needs to be protected). Let's take a quick look at their record in using regulation to address perceived externalities in the financial markets: (1) Enron; (2) WorldCom; (3) Cendant; (4) Every company ensnared in the options-backdating scandal; (5) and about 5,000 other examples.

Oh, and let's not forget the issues with Directors' conflicts in mutual funds, the mutual fund market timing scandal, just to name a few. How often have we read statements to the effect of, "Hedge funds have an unfair advantage over mutual funds because they are less transparent."  I'll tell you - a lot, and this contention is a bunch of baloney. Time and time again it has been proven that "regulation by filling in forms" works poorly. The simple act of filling in a form doesn't ensure honesty, integrity or presentation of substance over form.

It is time that people both inside and outside the Beltway wake up to the fact that regulations, while appropriate where externalities exist, are not a panacea and should not be solely relied upon to ensure good behavior. Investors themselves need to do their homework, and those in the position of fiduciary responsibility need to be held accountable for doing the homework on behalf of their less sophisticated constituents. Further, the government already has very powerful and effective tools at their disposal outside of formal regulation, and from personal experience I can tell you that this process – periodic meetings with members from the SEC and Treasury, similar to that used by the FSA in the UK – is very effective. Let’s focus on the goal here, folks, and not simply create another opportunity for ill-conceived and costly legislation to dampen an essential and vibrant marketplace.

Fred's Got It

In Fred Wilson's post today, titled Transparency, Markets and the Internet, he gets right to the point of how the dissemination of information has evolved and how the playing field will never be the same:

So that’s a quick trip through my journey toward the land of transparency in financial markets. The days of schmoozing the CFO so you can get the call before the other analysts is over. Put to its grave by the cleanup of wall street in the aftermath of the last bubble. So you have to get the facts some other way. It’s good that we have this thing called the Internet that is ideally suited to out every secret, fast forward every rumor, and route it to the very people who need that information to trade on it.

Schmoozing is out. Crawling is in. MBAs with a spreadsheet are a dime a dozen. But the kid who knows how to mashup 1000 rss feeds, tag them on the fly, and cross index them with the crawler he hacked the other night at three in the morning is in high demand.

While Fred focuses on the issue of increasing transparency and its great leap forward over the past decade, I'd like to comment on the other trend that mirrors this - the great leap forward in technology. Think about what we've seen since the late 1990s - the advent of advanced search, RSS, massive harvesting and ping aggregation and notification, advanced visualization and analysis tools for getting a handle on seemingly unmanageable amounts of data, tagging, social networks - the list goes on.

As mentioned in a prior post about the internet and investment, I make the point that we are witnessing a tectonic change in the way investors will seek to discover, analyze and act upon web data. Technology has now run so far, so fast that tools previously available only to governments and large corporations are available to all. This does, as Fred notes, increase transparency, and, in fact, the democratization of the investment landscape. The gap between the haves and the have nots is shrinking by the day, and the day will come in the not-too-distant future when true alpha - one created through investment skill and better ideas and analysis, be it human or computer-driven, and not through insider tips or cozy conversations off-the-record - is readily observable. This will be a great day for all.

Waking up to Risk

I don't know how many of you caught it, but there was an interesting little piece in the Gulf Times (the Qatar gulf, not the Mexico gulf) yesterday concerning the inherent weakness of the Sharpe Ratio as a measure of risk. Who was the star of this article? None other than Mr. Fooled by Randomness himself, Nassim Nicholas Taleb. Now Mr. Taleb is a very opinionated (not to  mention an extremely bright) man, make no mistake about it. I personally view this as a strength, since his views are provactive, grounded in math and statistics and often buck conventional wisdom. Among other things, he seems to think that investors are generally a bunch of dumb sheep who irrationally attribute investment skill to what is really only chance. I have to say I am pretty much a buyer of his theories. That said, his topic du jour is that of how the Sharpe Ratio doesn't properly reflect risk-adjusted returns since financial markets returns in specific (and social phenomena, in general) don't conform to a normal distribution, and that this measure is being used as a justification for investing in hedge funds.

The Sharpe ratio is a measure of risk-adjusted return. It is the difference between returns and a risk-free interest rate - often the yield on US Treasury bills - divided by the volatility or range of possible returns. It has been used in recent years to persuade investors such as pension funds that it is less risky to invest in hedge funds than equities. “It’s used for marketing. It looks sophisticated, but the volatility part is not a good measure of risk,” said Nassim Nicholas Taleb, a hedge fund investor and a professor in the sciences of uncertainty at the University of Massachusetts Amherst. 

“The Sharpe ratio is like a horoscope ... A startlingly high number of people rely on this bogus theory ... It’s a big scam by finance professors ... Finance is a craft not a science...” It (a normal distribution) cannot be applied to exceptional extreme events in finance such as large losses or gains that will continue to dominate the picture no matter how large the sample gets. “If the exception doesn’t matter in the long-run, then the law of averages applies ... If the exception continues to dominate the sample even if the sample becomes very large, you can’t use the normal distribution,” Taleb said. “It can’t be applied to socio-economic variables ... An example is stock market returns ... In the last 50 years, 10 days represented more than half of stock market returns.”

Now this is a very complicated issue that would take many posts to delve into, but Taleb hits on one of the key points that is often missed when discussing optimal portfolio construction including hedge funds. Two others are:

• Hedge fund returns generally exhibit negative skewness (akin to selling options, collecting premium, but being exposed to tail risk)
• Hedge fund returns generally exhibit high kurtosis (fat tails, meaning a higher incidence of "bust" than what would be considered normal)

There has been some excellent academic work in this area which I can dig up for readers, if they are interested. But I think the key point here is that a single statistic, even one as famous as the Sharpe Ratio, cannot begin to capture the risk/return characteristics inherent in hedge fund strategies. It is for the same reason that VaR (Value at Risk) is a flawed measure of a bank's riskiness, again given the assumptions that risks are normally distributed. What the banks themselves do internally and what sophisticated investors do is run a wide variety of stress tests, incorporating events that would show up as many, many standard deviations from the mean (and thereby having an expected occurrence of once in an eon, notwithstanding the fact that we seem to have an eon every few years) but which could well transpire. It is only by flexing the variables impacting a portfolio across a broad array of outcomes (including correlation) that a fair assessment of risk and return can be made.

Thanks, Mr. Taleb, for reminding us that investing is a serious business and calls for serious and thoughtful analysis, and that relying on a statistic to get comfortable with an investment is, in short, a fool's game.

Me and Bernanke

As noted in today's Hedge Fund Daily, I am pleased to say that Ben and I see eye-to-eye on the issue of hedge fund regulation, preferring a market-based approach:

Like his predecessor, Federal Reserve Chairman Ben Bernanke is cool to the idea of hedge fund regulation. Speaking before a House Financial Services Committee, Bernanke said, “The best way to make sure hedge funds are not taking excessive risks or excessive leverage is through market discipline” and bank regulation. He argued that the Securities and Exchange Commission does have a role in hedge funds, but not as a regulator, saying he would support actions that would give the agency the authority to make sure that “the information that hedge funds to provide their investors is accurate.” He noted that the commission has made “very strong efforts to ensure that those banks and investment banks are carefully monitoring the risks” of HFs with which they work. Bernanke cautioned that hedge funds should remain in the “realm of sophisticated investors.” The former Fed chief, Alan Greenspan, may have warned of a hedge fund meltdown in his time, but he also opposed the regs.

Thanks, Ben. Have a great weekend.

Broadening the Multi-Strategy Mandate - Where do Hedge Funds end and Private Equity Funds begin?

I don't think it's any secret that larger, multi-strategy hedge funds are investing in an increasingly broad (and unusual) array of assets - loans for leveraged buyouts, PIPES and convertible structures for later-stage venture-backed companies, purchase of life insurance payouts and even financing for litigation. Hedge funds are even battling directly in the buyout world, as evidenced by the recent scrap between Fortress and Polygon over the UK-based telecom equipment provider Telent. I wonder what Alfred Jones, the father of the hedge fund industry, would think of these gymnastics. From my vantage point it appears that two principal motivations are driving this phenomenon: (1) reaching for returns in a very crowded and difficult market; and (2) trying to create increasingly non-correlated (read: alpha generating) portfolios when most public-market asset classes, regardless of geography or place in the capital structure, are moving more in lock-step than they have in years. Oh, and by the way, it is also true that private equity complexes are spending more time in hedge-fund land than ever before, whether it is the build-up of Blackstone Group's highly successful alternative asset management group or Texas Pacific Group's hedge fund venture with Dinakar Singh in the formation of TPG-Axon. This, in addition to Eric Mindich's mega-launch of his Eton Park hedge fund, whose offering document I am told provided that up to 30% of the fund's assets could be invested in illiquid securities. To say that a blurring of the lines between hedge funds and private equity has occurred (and one, might argue, banks themselves, given the increasing role both private equity and hedge fund firms are playing in the first-loan market) is the understatement of the century.

While this is kind of interesting, I think what is more interesting is to look at the structural differences between hedge fund firms and private equity firms and how this might impact performance-based compensation, disclosure and regulation. Private equity firms generally collect commitments for investment, draw on those commitments, make investments, and get paid performance fees as those investments become liquid over time, e.g., perform. Seems to make sense - match the payment for success with the successes themselves. Hedge funds, interestingly enough, grew up differently, as the concept of a "hedge fund" generally meant buying good stuff (long) and selling bad stuff (short) in an effort to minimize the impact of the broad market on performance (beta) and isolating the manager's skill (alpha). Since this buying and selling, by necessity, took place in the public markets, there were readily ascertainable values for the hedge fund's positions at each reporting period. It was these values that were used to compute the payment of performance fees (the net asset value or NAV). As long as the portfolio is liquid, fair values are readily observable and, in theory, the entire book could be liquidated at the NAV (absent bid-offer spread). But as I mentioned above the world has changed - a lot. Hedge funds now have portfolios that are a mish-mash of liquid assets, somewhat liquid assets (where one could go and get bids from 5 dealers and obtain a fair value) and totally illiquid assets (where the value is highly subjective a dealer would not be willing to provide a 2-way quote). So how have hedge fund compensation customs changed to reflect these altered portfolio characteristics? Not much.

Now, I am firmly convinced that this trend - hedge funds and private equity firms looking more and more alike - will not stop, and I am also a strong believer in market-based regulation (as opposed to ill-conceived legislation developed by bureaucrats who don't understand the investment business). But this issue - getting paid on NAV when NAV itself is highly questionable - is a real problem. It looks bad. Real bad. The implications extend beyond compensation. For instance, if you can't arrive at a fair value for an asset, a "thumb in the air" method is used like book value minus an illiquidity haircut. This approach dear friends, is not very scientific and is extremely prone to error. Beyond error, once an approach is used for a particular asset that approach tends to be used again and again and again. This has two potentially adverse effects upon disclosure and compensation: (1) compensation may be overstated because NAV might be much lower that the level reflected in the NAV calculation; and (2) volatility of returns will be understated since this asset, whose value invariably is moving up and down but whose value is difficult to measure, is being valued in the same way quarter after quarter after quarter. This is called autocorrelation. This skews the analysis of fund returns and makes a fair comparision across different firms and different strategies nearly impossible. Does any of this sound good?

And if the industry doesn't take steps to address this issue, my sense is that the issue will be dealt with for them by constituencies they'd rather not deal with (read: the SEC or Congress). It is just too big a problem to be ignored, and the problem is growing every day as more funds pile into less liquid assets for the reasons mentioned above. One way to possibly deal with this is to create a fund with two share classes - one which tracks the liquid assets (and therefore has a calculable NAV) and another which captures the illiquid assets (which does not have a readily calculable NAV). The liquid asset class could attract performance compensation in the same way hedge funds are paid today, which is generally quarterly. The illiquid asset class, however, could be treated much the way private equity compensation is handled today, based upon realization of the value of the illiquid investments. A manager could then report two NAVs, one for each share class. This would seem to restore the original intention of hedge fund compensation model, while providing for a better matching of performance generation and performance payment. This would also be a great PR move for the industry, proactively dealing with an issue before it becomes a PR nightmare.

Hedge fund managers are generally super smart and excellent asset allocators. But today's changed world calls for a new model - a fairer model, a more sensible model. Just as the most innovative managers have been pushing the edge of new and different asset classes, they should aggressively lead the charge in pushing best practices on this rapidly growing and influential industry.

India Backs Off

I am happy to report that the DoT has backed off the website ban and that bloggers across India are once again in business. Free speech wins. Good news - and we all can use a little bit of that these days.

Et tu, India?

The blogosphere has been afire the past two days with the word that India's Department of Telecommunications (DoT) has created a list of "offensive" websites and caused the major ISPs to block these sites. There was no advisory to this effect, no public communication as to the DoT's intentions and rationale, nothing of the sort. This would have been bad enough. Interestingly, however, whether due to technical incompetence or intent, not only were single pages blocked but entire blogger platforms such as blogspot.com, TypePad.com and Geocities.com were shut down. Now the government had gone too far. And this in the wake of the positive role played by bloggers during the recent bombings in Mumbai. A furor instantly erupted both within and without India, and sites such as Blogging Without Censorship emerged to take a leadership role in helping native bloggers deal with the ban. We'll see how long the DoT can hold out under relentless pressure from the angry, infantalized masses that don't want to suffer the same fate as their peers in China and Pakistan.

An interesting implication of these draconian steps to control citizen journalism is that the material being published is either (a) impactful, (b) newsworthy or (c) both. India is a democratic nation, yet is clearly concerned about the free flow of ideas across the internet. China, for all its economic might, is deeply afraid of losing control of its transition from an isolated, socialist state to a leader in the global economy and a true diplomatic superpower. While the steps taken by these countries to control free speech and the free flow of ideas are deeply unfortunate, it is a powerful validation of the blogger as a vehicle for idea creation, dissemination and change. It is also amazing to witness how people within these countries adapt to restrictions unthinkable in the U.S., whether using offshore means to create and distribute content, understanding the way the censors operate and getting "borderline" content posted on bulletin boards like the Chinese BBS or starting a censorship blog with a "how to" list to work-around the ban in India.

Governments can try and use regulation to keep people and ideas down for a time, but inevitably fissures will form, cracks will emerge and people will be heard. Just like the unstoppable trend of more and better content being made available on the internet, people who want a voice will have a voice and, if others want to hear them, will be heard.

Stock Options, Accounting and Monkey-Business - Pass the Tums

I have been sitting back and watching the fireworks around the options backdating "scandal" and feeling, quite frankly, pretty bored. What's new here? We've got poorly-worded (read: vague) accounting rules, corporate boards who have not internalized the fiduciary duty owed to shareholders, weak (read: non-existent) financial disclosure, and not enough really juicy news to go around in summertime. Clearly Boards and Managements all across the U.S. were playing fast-and-loose with the rules, no question. This was certainly not a unique phenomenon in the 1999-2002 time period, and the stock option scandal is merely the latest in a rash of fiduciary and communications breakdowns that plagued U.S. corporations during this period. We know the problems. Those who knowingly played with shareholders' money without telling them so will pay, some people may go to jail, earnings will be restated across corporate America, and we'll move on.

But this is all in the past. What about the future? I have seen some press recently around the issue of option expensing, and how the volatility assumptions can be "adjusted" to reflect changes in market conditions. I personally find this topic much more interesting. For example, Intel recently lowered the volatility assumption in their option pricing model from 50% to 26%, lopping off $519 million in expenses to be reflected over the life of the options (according to an estimate by analyst David Zion of Credit Suisse). Certainly Intel's implied volatility has dropped as it has gotten bigger - this is not an unusual phenomenon - but does today's 26% represent a drop fueled by company-specific or market-driven factors? Should, maybe, 10-year trailing historical volatility be used in order to create an objective set of rules that can be consistently applied across corporate America, and heavily dilute the effects of overall market volatility on single-stock volatility? Does anyone see what's going on here?

THIS IS THE PENSION INCOME RECOGNITION GAME ALL OVER AGAIN! Say the stock market has risen and your pension is (temporarily) overfunded. But operations haven't been so good and you are going to whiff at your next earnings release. Simply goose the expected return on plan assets and let some of this non-cash income flow into the corporation's financial statements! Makes the bottom line look good, that's for sure. But is this sustainable? Of course not. It's total BS. So what happens? Market returns revert to normal, the overfunding drops and maybe switches to underfunding, and all of a sudden instead of pension income gains we have actual (not just accounting) losses. Yet another example of manufacturing short-term results for fame and personal profit which does nothing to benefit the long-term investor.

Now let's look at this with respect to our options example. Let's say that stock market volatility falls and single stock volatilities reflect this drop. Ok, this is a point in time. But options are generally 10 years. Do implied volatilities (and the resulting historical) volatilities really remain at rock-bottom levels for 10 years? It hasn't in my lifetime. So why re-price option expenses to historically low levels when, if you believe in mean-reversion, things will eventually snap back? I can think of only one answer - to make today's results look artificially good. Now I don't mean to be picking on Intel - they are playing by the rules (and, let me tell you, they know the rules and the math behind options pricing very, very well) - but this is a fundamental issue with accounting rule-making that simply has to be addressed.

This gets into the concept of rules-based versus concepts-based accounting regulation, and is not a topic I wish to delve into in this blog. But I think a little common sense is warranted here. If the companies themselves continue to fully avail themselves of the inherent weaknesses of the current accounting regime, then it is incumbent upon both analysts and investors to model economic reality - which often means not what we are getting from corporate America.