Mark to Market

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 It was repealed and we had a functioning financial system for 60 years.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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Summary of ETF’s That Don’t Work*

*As Advertised.

An insightful piece from Seeking Alpha prompted this post, as I’ve noticed deficiencies in the use of certain types of ETF’s:

1. “USO” – which tracks the spot price of Crude Oil
2. Any of the Proshares Leveraged ETF’s (short or long – SKF, UYG, SDS, SSO, DXD, DDM…)

I am certainly late to the party of pointing out the leveraged ETF’s, but nonetheless have a few things to say.

First, the explanation on USO from Seeking Alpha:

Here are the current prices for oil contracts with expirations in the next six months. Notice how every contract is more expensive than the one that preceded it. USO follows a simple strategy of buying the current contract and then rolling into the next contract before the current one expires.

March 2009	$40.42
April 2009	$46.22
May 2009	$48.88
June 2009	$50.45
July 2009	$51.28
August 2009	$52.70
Source: NYMEX. Data as of 2/9/08.

Until last Friday, USO owned the March 2009 contract. Specifically, it owned 84,378 March contracts, entitling it to 84.4 million barrels of oil.

But on Friday, it sold all those contracts and bought the April contract instead. But because the April contract cost $6/barrel more than the March contract, it couldn’t afford as many contracts. In fact, if you exclude new inflows into the fund, it could only buy 73,444 April contracts.

Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil. They now control less oil. If the spot price stays near $40/barrel, the value of those April contracts will decay back to $40/barrel over the next month and investors will lose their shirts. If the price of oil jumps 15% in the next month—before USO rolls again into the May contract—investors will only break even.

Basically, because the price of Oil is upward sloping, the parent fund has to cost average-up at the beginning of every month – they have to reinvest all of the money from expiring contracts at a higher price – meaning there is less firepower behind the investment.

(The author makes reference to “contango,” which may sound complicated but isn’t…it’s just when the Oil futures price is above the spot (current) price).

The Leveraged ETF’s, on the other hand, aren’t flawed per se; it is our perception of how they should work which is flawed.

This concept was well covered by the Wall Street Journal, and by Jim Cramer, who through the powers of cognitive dissonance decided that the Ultrashort Financials ETF (SKF) brought down the bank stocks in January (The author of the Proshares article from thestreet.com provides analysis on how this is somewhat true).

Here’s the WSJ excerpt:

The issue is that these funds are designed to double the index’s return — or double the inverse of that return — on a daily basis. The compounding of those daily moves can result in longer-term returns that have a very different relationship to the longer-term returns of the underlying index.

For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further — 12%.

Here’s why: On the first day, doubling the index’s 5% gain pushes the fund’s NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88.

The funds themselves are tricky, but if you understand that making 10% is different than losing 10%, then this should make perfect sense.

End Lesson: These are instruments made for day traders, not long term investors.

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Paulson’s Plan For 2009

Of course I’m referring to John Paulson (since Hank no longer matters), the guy who turned $500 million into $3.5 billion in a single year (2007) by shorting sub-prime mortgage backed securities through buying credit default swaps.

The New York Times received a copy of his year end letter, which gives his guidance for 2009…the NYT website won’t allow me to embed the letter, so here’s the link if you’re curious.

Since the report is 28 pages long, here’s some abridged analysis via Paul Kedrosky:

Looking forward to 2009, Paulson remains highly bearish. Here is his general strategy, he says, for the first half:

• Slight short exposure to equity markets
• Remain short financials
• Focus on long distressed opportunity
  • Mortgages
  • Bankrupt debt
  • Distressed
  • Capital restructurings
• Focus on strategic merger deals
• Maintain short focus on financials, with the belief that we only perhaps half-way thru

To remain short financials, he must believe on some level that a nationalization is in the cards to wipe out the equity of troubled banks. That’s not to say that nationalization is the only shoe left to drop, since rising unemployment is likely to go hand in hand with continued mortgage defaults, along with the potential for more trouble in commercial real-estate.

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GE’s Inevitable Downgrade

From Bloomberg:

General Electric Co.’s and General Electric Capital Corp.’s Aaa ratings may be downgraded by Moody’s Investors Service. The ratings agency revealed its plans in a statement today.

It’s about time…One would think that the next step is a dividend cut, since they’re already having trouble justifying a $1.24 per share payout when their earning $1.32 (cash outflows almost equal their current inflows – and GE doesn’t give guidance anymore, so we can’t necessarily assume their earnings will get better). GE’s AAA credit rating has historically allowed them to finance their operations at a much cheaper rate than other blue-chip mainstays, such as IBM, which Moody’s has deemed an “A1”. To add some color to how this affects the cost of their debt, we can look at the coupons on GE and IBM bonds:

These aren’t perfect substitutes, but it’s clear that GE can issue debt at a cheaper rate than IBM. What’s interesting when comparing these 2 bonds is that IBM trades at a premium, while GE’s AAA rating appears to have a reverse effect on their demand for bonds (they’re actually trading at a discount to IBM despite the better credit rating); As an investor, do we really need to compromise the better return from IBM’s bonds for the small level of added security on GE’s? Clearly not – they’ve both been around forever.

(Here’s a table which displays/translates the ratings hierarchy).

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“Why Banks Still Won’t Lend”

Despite the flood of cash from the government, Banks are still hoarding cash…What could explain this phenomenon?

From BusinessWeek:

They (Banks Chiefs) argue that the government funds are designed to shore up capital and support lending, but that they have no obligation to make new loans. “It’s not a one-to-one relationship,” says BofA CEO Kenneth D. Lewis. “We don’t write $15 billion in loans because we got $15 billion from the government.”

So there’s a disagreement on what the TARP money should be used for…But some may ask why banks won’t make new loans? The answer, as always, is dependent on money:

Right now there’s little financial incentive to make fresh loans. In the current unease, new corporate loans are immediately marked down to between 60¢ and 80¢ on the dollar, forcing banks to take a hit on the debt. It’s more lucrative, then, for them to buy old loans that are discounted already.

Just when you think all of the side effects of repealing Glass-Steagall were out of the system. Now banks won’t even make new loans; since there are so many discounted securitized mortgages on the market, they’re using the TARP money to buy outstanding mortgages…

Since the TARP was so Ad hoc by nature,  The government didn’t  force them to do otherwise, so you can’t blame banks for cutting the best deals.

The most important point regards their capital requirements:

Under federal rules, banks are required to maintain a certain level of capital based on their assets. When they incur losses, they either have to raise more capital or sell assets to keep those ratios in check.

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Crescenzi: Banks Sitting on $1 Trillion Cash

From Tony Crescenzi’s blog, via CNBC:

In Friday’s release, cash balances held by commercial banks topped $1 trillion for the first time, reflecting cash balances held at the Fed. Pre-Lehman, cash balances tended to hover around $300 billion, with an annual growth rate of less than 1% per year. The Federal Reserve’s curse on cash, hexed as it was last week with the Federal Reserve’s Zero Interest Rate Policy (ZIRP), will eventually pressure banks to use the cash, as net interest margins on loans are far more attractive than the return on cash.

A good point. Banks won’t be earning there way out of this mess by having their money sit at the Federal Reserve, so one has to think that 2009 will be a big year for lending – albeit there is increasing risk of default – since that is the obvious way a commercial bank earns money (opening savings accounts and making loans). Of course some banks have investment arms, but we know what can happen if we rely too heavily on those for profits…

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Could ‘Glass-Steagall’ Have Stopped this Mess?

First, here’s a little history about the Glass-Steagall act, courtesy of PBS‘s Frontline:

Following the Great Crash of 1929, one of every five banks in America failed. In 1933, Senator Carter Glass (D-Va.) and Congressman Henry Steagall (D-Ala.) introduced historic legislation which sought to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds.

The new law banned commercial banks from underwriting securities, forcing them to choose between being a simple lender or an underwriter (brokerage). The act also established the Federal Deposit Insurance Corporation (FDIC), insuring bank deposits, and strengthened the Federal Reserve’s control over credit.

In retrospect, this ideology was the right prognosis for America; we had just had a nasty stock market crash, and were in the midst of the great depression. Years later, we would exit the depression only to achieve the greatest period of economic growth in our history…yet in 1986, we weren’t so sure:

In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argued that three “outside checks” on corporate misbehavior had emerged since 1933: “a very effective” SEC; knowledgeable investors, and “very sophisticated” rating agencies. Volcker was unconvinced, and expressed his fear that lenders would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public.

Sorry, I can’t help myself…the very argument for repealing Glass-Steagall is monumentally flawed – let’s review each of the three “outside checks” one-by-one, since we have the benefit of hindsight being 20/20:

1. Was the SEC “effective” in granting Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers permission to exceed the market mandated level of leverage from 10:1 to 40:1? (Notice 3 of these brokers no longer exist, and 2 of them have become holding banks)
2. “Knowledgeable investors”…not exactly true. Collateralized Debt Obligations, Credit Default Swaps, Mortgage Backed Securities, Credit Linked Notes….we could spend a day running off all of the instruments of structured finance, which is esoteric by nature – and understood by very few.
3. “Sophisticated Rating Agencies” might be the most laughable of all; not only did they incorrectly gauge the health of the components in our financial system, but they were also stubbornly late in making adjustments to their ratings. In recent months they have only exacerbated problems in the credit markets, because by downgrading a company’s debt in the peak of a credit crisis, they are causing investors to demand a higher yield at the very point when the company is most vulnerable; if the damage is done, they shouldn’t push companies to the edge of bankruptcy – if you disagree or don’t know what I’m talking about, click the link above for more about this point (it’s actually really funny to watch the CNBC anchor rip apart S&P’s head of financial institution’s ratings).

Greenspan, who was appointed FED chairman in 1987, favored the repeal because he felt that deregulation would help U.S. banks compete with big foreign institutions. Leaving the lack of truth aside, his agenda is what developed our financial system into what it is today; Citigroup immediately merged with Travelers Corp., something which never could have happened under Glass-Steagall; a combination of insurance underwriting, securities underwriting, and commercial banking.

So to answer the question above, I say yes.

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Who Has Rights to the Worst Balance Sheet?

The answer: I don’t know. If I had to guess, I’d say Bank of America since they bought Countrywide and Merrill Lynch (One would think they could have gotten both for free – the JP Morgan way).

From Citi’s town hall presentation:

Notice that even with Wachovia, Wells Fargo has by far the smallest balance sheet. This chart is by no means useful in describing the underlying assets of each company, as the arbitrary nature of “other loans” dominates a portion of every bank’s balance sheet (if we were really curious and did some research, we would probably find that this section is comprised of Hybrid ARM’s, Alt-A mortgages, and maybe even some Sub-prime mortgages).

I guess we haven’t achieved adequate transparency quite yet…

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The New Center of Attention

This Wachovia episode is only getting more interesting. Before there is a resolution to this cat fight, I thought it would be worthwhile to point out the pros and cons of each outcome.

This deal is a no brainer for everyone but Citi;

1. Wells Fargo is using private money to buy Wachovia, meaning no tax dollars necessary
2. They will assume ALL of Wachovia’s operations, not just commercial banking
3. Wachovia shareholders get $7 instead of $1 per share.
4. The Citi deal requires the “good bank/bad bank” scenario, where they take only the good stuff, and leave the rest to the FDIC to take care of.

The bad part of this outcome is placed solely on Citi; they said on Monday that cutting their dividend in half was an action to shore up capital for the Wachovia deal, but now without the acquisition, that argument is out the window. Also, before Wells Fargo came in with the $15 billion deal, there wasn’t any relative basis to say that Citi’s $2 billion offer was too low. Wall Street initially applauded Citi’s move to buy Wachovia, because it signaled that they had a strong enough balance sheet to be expanding in this environment. For a brief time, they were moving into the tranche of Wells Fargo, JP Morgan, and Bank of America (As told by the stock price hitting a 3 month high).

In short, we already know that Wells Fargo was in better shape than the pack; but we cannot prove that Citi, the only bank left with anything close to their astonishing $51 billion in write downs, is improving. The Wachovia deal provides them with an opportunity to signal to Wall Street that they will make it through this mess, and they will not need another loan from Abu Dhabi, or Prince Al-Waleed.

Considering all of this, maybe we are seeing resistance from the Federal Courts (besides the legal ramifications) because this is the only viable acquisition left on the table for Citi to make, and it would be able to offset any bad news to come.

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Forced Short Squeeze: The Bear’s perspective

By now we’ve heard the concession: “How can people complain about market manipulation, when our government engages in manipulation themselves?”

There has been an angry outcry about the temporary ban on short selling of 799 financial institutions because of the potential implications:

• Besides the obvious parallels between socialism and a nationalized financial system, our markets are now artificially inflated (the gains we are witnessing would not be this dramatic if there were short selling). Unfortunately, we will be subject to more volatility once the ban expires on October 3rd. Gages such as the “VIX”, or volatility index, which traders often use to judge whether a market is overbought/oversold, will be obsolete for an indefinite time frame.
• The thing which I am most worried about, is that since the SEC has disclosed the exact date in which short selling will be reinstated, There could a widespread collusion opportunity amongst bearish Hedge funds (That day is definitely marked down on their calendar). The SEC has effectively advertised the very time we will not be watching the gate, and potentially created a platform for more severe market manipulation. There will be a gigantic buildup of vultures waiting to make their move…a flood of shorts could overwhelm the market due to this ban.

Once the short squeeze is over, there will be no more shorts to squeeze, and the market may realize that the “legs” of this rally were unfounded.

Finally, short sellers were not the root of destroying the financials; If there had been a glimmer of transparancy, Wall Street would not be in running for its life. One thing is for sure; this bailout will force a realization of the severity of our problems, and we will find out if the market has yet priced in the truth.

Here’s a link to two of Doug Kass’s articles…he is the ultimate short seller:

• Kass: RTC solution no cure at all
  
• Kass: Free Market Fraudsters

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