Scrap Mark to Market Valuation

The key to unfreezing the credit markets is the scrapping of Mark to Market Valuation. Because of the U.S. Generally Accepted Accounting Principles (GAAP) bank assets are valued at Mark to Market.  Many of these assets, Mortgage Backed Securities (MBS) and other derivatives have drastically dropped in value because of this method of valuation.  The Treasury Department and the SEC have branded these types of assets as toxic.  However, the reality is that many of these so-called toxic assets are still earning the same return as when they were first bought by the financial institutions.  Therefore, even if a bank is very profitable it may not pass the Feds’ stress test, and the Feds may opt to re-capitalize it with bail out money thereby subjecting it to compensation and bonus restrictions.  A bank may be considered by the Feds as a troubled institution even if it is drowning in money.

An alternative method of valuation which many economists are now advocating is the Cash Flow Method.  As a simple explanation, the Cash Flow Method of valuation takes into consideration how much income the company receives from the so-called toxic assets rather than how much those toxic assets are presently worth.  If this valuation method is used, financial institutions will start lending again because they will show a stronger balance sheet, presumably taking them off the government hit list of troubled financial institutions.

Geithner’s “plan” which was revealed yesterday is a hybrid of the solution I proposed in DidoSpin 03/08/09.  It appears that the government will indeed create an entity to buy toxic assets (MBS).  The difference is that the government will solicit investors from the private sector to partner with in buying the assets.  With $1.25 trillion to spend, the government, in partnership with private investors hopes to acquire the assets at close to their toxic asset prices.  Obviously the banks will try to get as much money as they can for them.   This is a win-win situation because the banks’ stocks will increase in value as soon as the toxic assets are sold and when the housing market recovers as it always does the government’s holdings will increase in value and the government will make a hefty profit.  If Wall Street is in favor of the “plan” and liberals are against it, then I am for it.

Any opinions and views herein are the sole responsibility of the writer.

 

Bank Stress Tests & Other Terms

The political talk shows this past weekend generated lots of economic, financial and accounting terms such as Bank Stress Tests, Mark to Market Valuation, Cash Flow Valuation, Positive Yield Curve and 3rd Tier (Capital) Assets to name a few.  I wonder how many viewers understood those terms.  I would like to take this opportunity to simplify them for the reader.

The bank stress test is what the Treasury Department will conduct on banks and other financial institutions to determine which institutions are undercapitalized and whether they have enough reserves to weather adverse scenarios such as the rise and fall of the stock market, interest rates and currency fluctuations and exposure to undisclosed risks.  Initially the Obama Administration indicated that the stress test would only apply to financial institutions with over $100 billion in assets, but due to the worsening economic outlook, all bets are off.

Mark to market valuation is the current FASB (Financial Accounting Standards Board) and SEC (Securities and Exchange Commission) standard of valuation of bank assets.  As an example, if Citibank is holding a mortgage derivative which was valued at $600,000 before the bubble burst, but is now only $200,000, regulations require the bank to report this asset (Capital) at Mark to Market which is $200,000.  If the bank is holding many of these derivatives, Geithner’s office may declare the bank as “in distressed” and force it to take additional capital from the government in bail out money.  Many economists such as Larry Kudlow and Lou Dobbs now advocate the Cash Flow Valuation instead of  Mark to Market on the ground that the $600,000 asset still yields the same return for the bank although it is now only valued at $200,000.

The Positive Yield (interest rate) Curve is the normal yield of investments.  Longer term maturities usually have a higher yield than shorter term.  When the yield becomes negative or inverted, it spells trouble for the banking system as what started happening in late 2006.  The incentive for depositors to leave their money with the bank for longer periods of time, say 5 to 10 years is to earn a higher interest rate.  If the interest rate is the same for 5 years as it is for 1 year, this incentive is gone.  Geithner’s job now is to classify banks’ assets into tier 1, 2 or 3.  If Geithner’s agents reclassify too many of a particular bank’s assets from tier 1 to tier 3, that bank may be classified as a distressed bank and may be forced to take bail out money as additional capital.  Tier 3 assets or capital are the most risky investments the bank holds.  Examples of these are uncollateralized debts such as credit card debts and unsecured personal and business loans.

What we have seen from Bush and Paulson to Obama, Geithner and Pelosi is that our government tends to overreach in its desire to restore stability.  The Obama administration goes one step further by taking advantage of the crisis to put through its social agenda.  As Rham Emmanuel clearly stated, “we should not let a crisis go to waste.”   As recently as a week ago, many banks including Citibank and Bank of America announced that they are not in bad shape; that they are actually making money; and that they don’t need any more government bailout money.  I hope, for our own good, that such announcements and the positive yield curve will prompt investors to pull their cash out of their mattresses and home safes and hand it over to their friendly neighborhood bank.

Any opinions and views herein are the sole responsibility of the writer.

How We Got Here, Market Crash of 2008, Housing Bubble

I am worried just like many investors that Obama and his cabinet members do not know how to fix our present economic problems.  That is the reason, many investors have been continuing to dump stocks and pretty much keep their cash underneath their mattresses.  What is worse is that Obama and crew as well as many legislators do not seem to know how we got here.  If we do not know how we got here, how will we know how to get out?

Obama: Well, first of all, I don't think it's accurate to say that consumer spending got us into this mess.  What got us into this mess initially were banks taking exorbitant, wild risks with other people's monies based on shaky assets and because of the enormous leverage, where they had one dollar's worth of assets and they were betting thirty dollars on that one dollar, what we had was a crisis in the financial system….. My bottom line is to make sure that we are saving or creating 4 million jobs, we are making sure that the financial system is working again, that homeowners are getting some relief…..

Question: Thank you, Mr. President.  Many experts, from Nouriel Roubini to Sen. [Chuck] Schumer, have said that it will cost the government more than $1 trillion to really fix the financial system. During the campaign, you promised the American people that you won't just tell them what they want to hear, but what they need to hear.

Won't the government need far more than the $350 billion that's remaining in the financial rescue funds to really solve the credit crisis?

Obama: Well, the credit crisis is real, and it's not over.  We averted catastrophe by passing the TARP legislation.  But, as I said before, because of a lack of clarity and consistency in how it was applied, a lack of oversight in -- in how the money went out, we didn't get as big of a bang for the buck as we should have.

-end of news conference-

If I go by Obama’s first news conference, it is clear that he is not sure how we got HERE and how we are going to get out.  This is very reminiscent of the Carter Administration.

First, let us make it clear that Republicans tried to fix this problem (banking crisis) which the Democrats helped create through the creation of the CRA, Community Reinvestment Act.  In 2005 Republicans tried to reign in Fannie and Freddie.  The Senate Banking Committee passed a serious Fannie and Freddie reform bill, S.190, that would have required Fannie and Freddie to eliminate their investments in risky assets.  (See http://www.govtrack.us/congress/billtext.xpd?bill=s109-190).  As co-sponsor of S.190, Senator John McCain warned of the forthcoming economic crisis.  But the bill failed in the senate.

Foreclosures started increasing in 2005 due to the fact that sub-prime mortgage borrowers could no longer afford their monthly payments.  Many of these loans were NINJA (no income, no job, no asset) loans offered by banks to under-qualified borrowers who were willing to pay a premium interest rate and mortgage insurance to qualify.  Some were balloon mortgages with no interest for the first few years.  When mortgage rates went up from a low of approx 3.5% in May 2003 to more than double that in mid 2006, many homeowners just abandoned their houses.  This was the primary cause of the banking crisis, the “financial meltdown” as Obama refers to it.

The recession accelerated sharply due to the energy crisis of 2007-2008 with $4 per gallon gas and $140 per barrel oil.  This energy crisis like the specter of death reached all across America strangling many businesses.  The recession increased foreclosures and bailout mania followed.

It is interesting to note that Obama and Geithner do not seem to know where the first part of the bailout (TARP) money went.  It is like this Mr. President:  Let’s say BANKONE takes in a one year time deposit of $1000 from John promising to pay him 3% interest per annum.  Then BANKONE lends $1000 to Peter for a period of one year at 7% interest rate.  Nice profit.  But at the end of one year, Peter has lost his job and can only pay $500.  But now John wants his full $1000 plus interest.  The bank does not have the money.  Where will he get it?  From the government.  That is how the first part of the bailout money is being used.  The banks simply deposited the money and entered it on their balance sheet, i.e. debit cash and credit loan from the government.  They are being over cautious and prudent as well they should be in their lending practices because the opposite is what got them into this mess in the first place.  Now Obama, Geithner and the democrats are asking where did the TARP money go?  Why are the banks not lending money?  Where is the help for the homeowners?

Finally, another interesting observation is that bailout mania appears to have pervaded our free market system and even our entire society seemingly making us ripe for a transition into something like European socialism.  Bailout for the auto industry, health care industry, the states, auto rental companies, adult entertainment industry, etc.  A woman during one of Obama’s town hall meetings even wanted a personal bailout….a new kitchen, a new car.

My neighbors and I, about 8 of us, are getting together this weekend so we can put together a plan for a bailout of our own from our banks which hold our home mortgages in our subdivision.  We found out that the bank reduced the principal owed by one of our neighbors from $795,000 to $400,000 because he had been 6 months late on his mortgage payments and he can only afford amortization payment on $400k.  Meanwhile, the 8 of us who have about the same mortgage balances have been paying our mortgages on time.  The bank says, “no bailout for you unless you are delinquent on your mortgage payment”.  Well, we do not want to be delinquent but we want some of that bailout money!