What Financial Crisis?
I'm not sure why I have chosen to begin my financial blog on Friday 13th. I obviously do not suffer from triskaidekaphobia. Wondering what triskaidekaphobia is? Don't feel so bad. I just learned the word today, as I sipped my coffee, waiting in traffic and listening to a story about Friday the 13th this morning on National Public Radio. Triskaidekaphobia is the fear of the number 13 and the word paraskevidekatriaphobia is a fear of Friday the 13th.So what does Friday the 13th have to do with this blog and the financial markets? The answer is nothing. I just find it ironic that this is the day I have chosen to start writing my blog. I also find it ironic that we end this (ominous) week, of Friday the 13th, with the Dow Jones Industrial Average up 9.01%, the S&P 500 index up 10.71% and the NASDAQ 100 index up 9.75% for the week. Not too bad by most standards. Now, if we can only get the market to go up like that every week for the next few months.
I suspect that most started out this week, like I did, with the very pessimistic expectation that the equity markets would continue the seemingly never ending slide down to that next "floor" in the market indices. I am an optimist when it comes to the financial markets and the economy as a whole, but I have to admit this market has taken its toll on my optimistic outlook on the markets. This week was a breath of fresh air. I couldn't help but think that if you had taken a two year sabbatical to a remote, far-away, destination, where there were no links to the news, the economy, the markets, etc., and you came back on Sunday, March 8th (2009), you would have thought by just witnessing the moves in the equity market this week that our economy was doing very well.
Thank you Mr. Pandit
So is this jump in the market just going to be a short-lived bear market rally? Of course no one knows the answer. The market seems to be excited at the prospects of the major banks actually making money again. Citigroup's CEO, Vikram Pandit, announced that, “we are profitable through the first two months of 2009 and are having our best quarter-to-date performance since the third quarter of 2007". It is likely that this is an operational profit that Mr. Pandit is touting. It is also worth noting that there is still the month of March until the end of the first quarter. Things can change. Many banks, Citigroup included, may still have net losses for the first quarter, as a result of continued write downs on toxic assets. But if we do see operational profits, hidden inside the quarterly numbers, that is obviously a good sign. It is likely that the prices of bad assets on banks' balance sheets decreased in value so far this year, along with most other financial market asset prices. As these assets must be marked-to-market, they will likely cause more losses for financial institutions. It would be a great surprise if that is not the case.
Mark-Me-To-Market
Speaking of mark-to-market, on Thursday the House of Representatives financial services subcommittee met to discuss possible changes to the market-to-market accounting rules. In a speech on Tuesday, Federal Reserve Chairman Ben Bernanke mentioned that he did not support a suspension of market-to-market accounting rules. However, Mr. Bernanke did say that he supports "improvements" to the market-to-market accounting. Sounds to me like big Ben doesn't want to throw his political weight around too much. Come on Ben...you know we have to get rid of mark-to-market...at least temporarily.
Mark-to-market accounting was put into place with the best intentions. In normal market conditions, mark-to-market accounting provides a level of transparency that should exist. The problem is that many asset markets are completely frozen. In an environment where there are few or no buyers of the assets on banks' balance sheets, how do you appropriately value those assets?
The only reasonable way to value assets such as loans or securitized pools of loans is to use net present value of discounted cash flows. For example, if a bank has a pool of mortgages that has a total outstanding principal loan value of $100 million, that pool of mortgages should be worth whatever the net present value of the $100 million of future principal payments, plus the net present value of the interest that is being earned on those loans.
You also have to account for the fact that there are probably some delinquent loans in that pool of loans and there may even be some loans that are in default or have already defaulted. Since, you already know that these loans are delinquent or in default (i.e. non-performing), you would dramatically lower the valuation on that segment of the loan pool, using much higher discount rates and/or much lower repayment amounts of principal.
Finally, the most difficult task in accurately valuing these "bad loans" would be to account for the expectation that delinquencies and defaults are likely to increase for some time to come, given the state of the economy. There may be a lot of loans that currently are not delinquent or entering default, but may be delinquent/entering default within the next few months. Because of this, there would need to be a portion of the loan pool that uses a very high discount rate to calculate net present value. This would be necessary to compensate for the very likely event that delinquencies and defaults increase over the coming months.
All of that being said, some will still argue that if someone is only willing to pay $30 million for a pool of loans that has a principal value of $100 million, then that $30 million is the value at which the pool of loans should be listed as such for accounting purposes.
The reality is that our legislators in Washington D.C. need to make some sort of change to the accounting rules to more accurately reflect the true value of these assets. I agree that an asset is only worth what someone is willing to pay for, at any given point in time. But the true, long-term, value of an asset can be a much different value. For the purpose of listing these assets on financial institutions' balance sheets, the true, long-term values should be used.
Daily Show vs. Mad Money
If you haven't seen the head-to-head match up between John Stewart and Jim Cramer, you need to take about 15 minutes and watch the whole interview. It is entertaining to say the least. Take a look...
Way to go John Stewart! Thank you for calling out Jim Cramer for what he is. The sad fact is Stewart is absolutely correct. Cramer and many others in the financial "news" business are cohorts with market manipulating institutional investors on Wall Street.
A good example of the market manipulation was the price appreciation in crude oil in the year 2008. When crude oil went to $147/barrel, the price movement had nothing to do with the supply and demand of oil. Oil went to those sky high price levels because there is a very small population of institutional investors (i.e. hedge funds) on Wall Street that have the power to manipulate financial markets. When they decide they want oil prices to go to $150/barrel, they will make it happen. In the clip that John Stewart shows, Cramer even explains how this manipulation takes place and how he manipulated asset prices, when he was in the hedge fund business.
The entire market is currently in the midst of another major market manipulation. For months, hedge fund managers and sales representatives have been running around Wall Street, pitching the case for why the market MUST continue to go down. Why do they have this negative outlook? Hedge Funds and career bears argue that, because total credit market debt/GDP ratios are at about 350% (or higher), the massive deleveraging process must continue. Therefore, they argue investors should be "short" the market, in an effort to take advantage of this imminent drop in market value. Take a look a the charge below (source: Ned Davis Research Inc.):
This is a perfect example of how the hedge fund community uses misleading information to create erroneous arguments to support their portfolio positions. Hedge funds are short the market and they are very creative and manipulative in their efforts to make "the facts" appear in their favor.
The truth is that even the Federal Reserve, who publishes the data seen in this graph, has conceded that the data is flawed. Why is this chart misleading? The securitization process in the debt markets during the past two decades has dramatically inflated this "total credit market debt" statistic. Unlike previous generations, our debt is not simply held by banks and financial institutions. Over the past 20 years, as loans have been issued by financial institutions, those loans have not been held by banks, but rather loans are packaged into securities and sold off to investors. In fact, some loans have been packaged and re-packaged through the securitization process, making the statistic even more inflated and inaccurate.
Assume a home buyer took out a mortgage for $300,000 in 2004. That $300,000 will show up in the statistic as personal debt. The bank then decides to package your mortgage loan into a collateralized mortgage obligation (CMO) and sell that CMO to investors. Your $300,000 mortgage now is counted twice (for a total of $600,000) in the total credit market/GDP statistic. In 2005, if the borrower decided to refinance from that adjustable rate mortgage (ARM) to a 30-year fixed mortgage, that mortgage refinancing will cause the original $300,000 to now be represented three times in the total credit market/GDP statistic. A $300,000 mortgage is represented in this statistic at the inflated amount of $900,000. This is not the case for all loans and debt, but it certainly is the case for much of the debt that is outstanding. The hedge funds that use this statistic to sell their funds, know this data is flawed. But they use it anyway, because it paints the picture they want the investment community to see.
This is the "back room" market that John Stewart is referring to in his interview with Cramer. To some extent, Stewart's claim that there are two markets is true. It is also important not to overdue the conspiracy theory. While market manipulation does occur and there needs to be better regulation, surveillance and enforcement of this manipulation, the fact is that the world financial markets are still the best and most efficient mechanism to price assets.
Current asset prices in the financial markets (particularly in the equity markets), by most measures, are undervalued. Rational valuations will eventually return and the financial markets and asset prices will rebound.
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