Archive for March, 2009

Adding up the Bailout

From CNN Money:


I encourage you to follow the link, since there’s a nice interactive chart. According to CNN’s calculations, we’ve spent $2.6 trillion of the $10.5 trillion we’ve allocated to the bailout. This now dwarfs one of my earlier posts on the cumulative cost of the Iraq War.


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Finally! This issue has been neglected by the media…to think it only took George Soros to speak up about it.

from Bloomberg:

Billionaire investor George Soros said U.S. commercial real estate will probably drop at least 30 percent in value, causing further strains on banks.

“Commercial real estate has not yet fallen in value,” Soros, 78, speaking at a forum in Washington, said. “It is inevitable, it is written, everybody knows it, there are already some transactions which reflect and anticipate it, so we know, they will drop at least 30 percent.”

Soros said the risk of further declines in property prices is reason for the administration of President Barack Obama to move quickly to recapitalize banks. Soros said Obama acted too slowly on a banking overhaul and should have moved immediately upon taking office.

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I just looked through my archives and discovered that I engage in some sort of market prognostication about every three months…The most recent one from January is a good place to pick up for this edition (if at all curious, here’s September and August).

US Treasury debt is an unreasonably low yielding investment, meaning this is where everyone is hiding from risk – which is a misconception, since the principal investment on a 10-year note is only protected by a 2.10% interest rate, meaning any indication of a sell off could drastically hurt a US debt holder. Should treasuries sell off, certain sectors within equities would be a logical home for this capital – the question is always when.

Well to answer this issue 3 months late, when could be now.

But first, some background on the FED’s role in buying treasuries.

The FED has been overreaching the bounds of their traditional policy tools i.e. setting interest rates through buying short-term government debt (1-3 month T-bills), and has entered the business of buying 5, 10, and even 30 year bonds in an effort to drive down the Mortgage Backed Securities pegged to government debt of longer maturities, which should lower the prices of adjustable rate mortgages and allow people to refinance a fixed mortgage.

Due to this agenda, the Federal Reserve has been a huge buyer at all of the recent treasury auctions (the same ones which finance our $1.5 trillion deficit), and have successfully suppressed bond yields…until today:

From Bloomberg:

Benchmark indexes turned negative at about 2 p.m. after an auction of $34 billion in five-year Treasury notes drew a larger-than-forecast yield of 1.849 percent, spurring concern that government attempts to lower interest rates won’t work.

Treasuries declined for a fifth day following the auction and the failure of a U.K. government debt sale. The last time the U.K. was unable to attract enough investors was in 2002.

This situation is paradoxical; on one hand, as I wrote in January, the disinterest in treasuries could be a indication that investors are beginning to trust equities again – a notion which is supported by the 1,200 point rally in the past 10 days.


On the other, we could have a situation where the free markets counter the aims of the FED by selling off treasuries – when buyers cease to exist, yields will go up, and so will rates on mortgages indirectly pegged to treasuries.

With that, here’s the rest of what I’ve been thinking:

Reasons to be Positive:

  • I think the Dow has temporarily bottomed at 6,500 – for different reasons than Doug Kass – because we will need to see if the effects of the recent government action actually work. More specifically, in order to drop below 6,500 we would need a scenario discernibly worse than a nationalization of our financial system, since that was what a DJIA of 6,500 was pricing in. Besides that, all of the logistics which traders look for are coming into favor: there’s heavier volume to the upside on up days, oil has rebounded (which suggests an antipication of increasing global demand), investor confidence is rising, and home prices/sales are looking more optimistic.

Reasons to be Negative:

  • Citi, BofA, and JP Morgan have all indicated that they were profitable for the first 2 months of 2009, but this was accomplished in a system with free money. What will happen to profitability when Bernanke inevitably raises rates?
  • Do I need to worry about the omnipotence of vacant stores, or is commercial real estate implicitly apart of the same set of issues we’ve been dealing with for the past 2 years?

I never thought I’d run out of negative things to say…I may add in some other points if nothing else interesting happens in the meantime.

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This is priceless:

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There is a good editorial out of thestreet.com regarding mark t0 market accounting. Until recently, there have been plenty of people who criticized applying fair value accounting principles to an illiquid asset class, but no one really explained how badly it hurts the financial sector.

From the article:

Here’s the problem. Let’s say a bank has purchased a series of geographically diversified securitized mortgage backed securities. How do we value them? Let’s say that within that mortgage series, 20% of those mortgages have defaulted and the prices of those defaulted houses have declined and can be sold at roughly 50% below what they were valued at when the securities were originally issued. What is the intrinsic (theoretical) value of the security? The answer is approximately 90 cents on the dollar. 100 – (0.20 x 0.50).

Here’s a more realistic example:

Now let’s look at the absurd situation we now find ourselves in. Some of the banks are forced to sell these long-term securities, but because of extreme credit market conditions they can only get 20 cents on the dollar. Now FASB 157 kicks in and says that this is the fair market value of these securities. Now we have an 80% ($1.00-$0.20) real loss on these bank-held assets instead of the 10% intrinsic (theoretical) decline, which means at a 20 times levered ratio, the holder has suffered a catastrophic 1600% total loss on their investment.

Rumor has it that congress will have a meeting next Thursday (March 12th) about suspending M2M.

Here’s something to consider: mark to market was used during the Great Depression. It was repealed and we had a functioning financial system for 60 years. It was reinstated on November 15th 2007 (13 months before the “official” recession began). This may be an unobtrusive measure, but that’s pretty shocking.

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