Sunday Musings: Mark-To-Market Changes

Ulli Uncategorized Contact

Hat tip to reader Richard for pointing to “New Mark-To-Market Rules Coming.” Here are some highlights:

The House Financial Services Committee, led by Rep. Paul Kanjorski (D-PA), yesterday (Thursday) successfully browbeat the Financial Accounting Standards Board (FASB) into coming up with modifications of the mark-to-market rules for valuing bank assets. Wall Street, which over the last 10 years has invested over $5 billion in lobbying and campaign contributions, is seeing a nice payoff on their investment. Investors, not so much.

The claim is made that these “toxic” assets are not being truly valued by the market. Why would that be the case? Is this some little obscure asset that nobody has ever heard of? Hardly – there has been endless talk about them for months, not just in the financial press, but in the general press as well.
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The reason that these markets have dried up is not that there are no buyers. It is that the current holders cannot afford to sell. This is exactly like in the early days of the bursting of the housing bubble. In late 2006 and early 2007, inventories of houses for sale started to build up, and the number of houses sold started to fall sharply, yet the median price of an existing house held up very nicely.

The sellers were trying to hold out for what their house was “really worth” based on what the house down the street sold for six months earlier. So they held out, and now they really can’t afford to sell, since to do so would require them to bring there check book to the closing, and they don’t have anywhere close to that amount in the account. Does that fact make the house “really worth more”? Of course not!

Thus the idea is to let the banks make up the valuation for these assets. Oh sure – they will have some fancy black box model showing how much they are “really worth.” But anyone with three hours of experience with Excel can make up a spreadsheet that gets the answers they want if they manipulate the numbers and the assumptions that go into the spreadsheet.

There is a term for knowingly publishing financial statements with incorrect values in them, and that term is “securities fraud.” The very foundation of capitalism is that the “real value” for something is that which a willing buyer and a willing seller can mutually agree upon. That, folks, is the market price. That is the price at which these securities should be valued.

Supposedly, suspending mark-to-market rules is going to restore confidence in the banking system. This is nonsense. Why would you buy a bank, when it clearly says: “This book value belongs on the fiction shelf”! If a bank is insolvent, it should be taken into receivership. We do it all the time with small banks – 25 times it happened last year, and so far it has happened 19 times this year.
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Taking over the big banks, cleaning them up and then selling them off as quickly as possible has worked in the past, most notably in Sweden. We should go that route, rather than legitimizing securities fraud.

[Emphasis added]

As the author pointed out, changing mark-to-market accounting will be the equivalent of fraud. We all have to live with mark-to-market rules whether we realize it or not. If you sell anything in the open market place, be it via a garage sale, an ad in the paper to get rid of your old car or a vacant lot, a final price is established by an agreement between a willing buyer and a willing seller.

So why should banks be exempt? For the simple reason that, as many bloggers have posted before, mark to market accounting would render them insolvent. What arrogance. You make bad business decisions and instead of being punished, you simply change the law in your favor and come up with fancy models supporting your view point.

To demonstrate, I am thinking of selling one of my assets, which is a 3-year old Jeep Laredo, for $20,000. The problem I am having is that most buyers think the car is worth only $12,000. Adopting banking terminology, I insist that my pricing model is correct, and I firmly believe that they simply don’t understand this asset.

How is that for arrogance?

Higher Fees Ahead

Ulli Uncategorized Contact

Last Monday, I wrote about a lawsuit that may potentially cut mutual fund expenses for investors. Now Vanguard is in the news signaling that higher fees may be on the horizon. Here are some highlights:

As if the market crash hasn’t been painful enough, more mutual-fund firms are set to raise their fees in response to falling assets, leaving shareholders with even less money in their battered accounts.

The decision by low-cost stalwart Vanguard Group to raise expense ratios for many of its mutual funds is a clear sign to investors of a tough year ahead.

After a brutal 2008, with many stock funds down more than 30%, fund investors face the prospect of paying higher charges this year as fund firms scramble to make up for lower asset levels.

Mutual-fund charges are based on a percentage of assets, but some of their costs — such as customer service centers and mailing out fund literature — are fixed. After the dramatic plunge over the past year, which has seen the industry’s total assets under management fall to $9.5 trillion from $12 trillion, hiking expense ratios is likely to be a viable option for many firms.

“It’s a testament to the market environment that even a fund family [like Vanguard] that’s been taking in new money has seen its assets decline so much that it has to raise its expense ratios,” said Dan Culloton, associate director of fund analysis at Morningstar Inc.

Vanguard said it had $84 billion in net inflows across all its funds in 2008, and $25 billion in net inflows so far this year. But according to Culloton, from the end of 2007 through the end of February, total assets under management fell to just below $1 trillion from $1.3 trillion.

So far, 31 of Vanguard’s roughly 110 funds have said they are increasing their expense ratios. The average increase is 0.05%; last year, Vanguard’s average expense ratio was 0.2% per fund.

Vanguard is “not immune” to the poor market conditions, said John Woerth, a company spokesman. But, he added, on a relative basis Vanguard is “still the low-cost leader by far.”

Sure, Vanguard is still the low cost leader, no question about that. However, cutting costs and reducing staff maybe a better option because many investors may not return, or those who do, may do so only on a temporary basis.

Why?

Vanguard is the staunchest supporter of buy-and-hold and, despite 2 bear markets during this century, they have not adjusted their model to support changing conditions. Despite this recent feel-good rally, we’re still stuck in the midst of the worst economic downturn since the 1930s.

We’ve seen a huge market drop last year devastating most investors’ portfolios. This was followed by a 20% rally from the November lows to the end of 2008. 2009 saw a 25% drop in the S&P; 500 within the first 7 weeks, and now a 23% rebound in only 13 trading days; who knows what’s next.

What this all comes down to is that we are in an investment climate which simply does not justify a mindless buy and hold solution. Many investors (I hope tens of millions) had to learn this sobering fact the hard way and will hopefully from here on forward use a more intelligent approach to managing their investments.

If they do, that will not bode well for the buy-and-hold shops as investors are no longer willing to get stuck with a bullish investment in a bear market and subsequently paying for the privilege of seeing their portfolios getting another severe haircut again.

No Load Fund/ETF Tracker updated through 3/26/2009

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Up, up and away was the mantra as all major indexes gained for the third week in a row.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -5.14% thereby confirming the current bear market trend.



The international index now remains -11.39% below its own trend line, keeping us on the sidelines.

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

From TARP To GARP

Ulli Uncategorized Contact



Much has been written about the various bailout packages more recently referred to as TARP (Troubled Asset Relief Program), which should now be renamed to GARP (Geithner Asset Relief Program).

Both have one thing common in that enormous amounts of money are being spent without any certainty that positive results can be achieved. My confidence level in these programs, which was almost non-existent to begin with, was pulled down another notch yesterday, when Treasury Secretary Geithner uttered the words before congress that “it only requires will; it’s not about ability.” Yeah right.

To really understand how these plans work, take a look at a humorous description as submitted by reader Tom:

Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers – most of whom are unemployed alcoholics – to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of customers flood into Heidi’s bar. Taking advantage of her customers’ freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively. A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Heidi’s borrowing limit.

He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank’s corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed. Nevertheless, as their prices continuously climb, the securities become top-selling items.

One day, although the prices are still climbing, a risk manager (subsequently of course fired due his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Heidi’s bar.

However they cannot pay back the debts. Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKBOND drop in price by 95%. PUKEBOND performs better, stabilizing in price after dropping by 80%.

The suppliers of Heidi’s bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor. The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties. The funds required for this purpose are obtained by a tax levied on the non-drinkers.

There you have it. A perfect explanation how a useless asset is being securitized and sold, large amounts of money are being made in the process and, ultimately, innocent bystanders are being asked to ante up via tax dollars.

Timing The Hedge

Ulli Uncategorized Contact

Several readers have emailed over the past few days requesting some details about the execution of the hedge trades.

The issue is when setting up the hedge by purchasing SH for the short side and mutual funds for the long side, which order do you place first on days when the markets rally sharply?

This certainly was the case on Monday as all major indexes shot into the stratosphere. On Monday morning, you could have placed your (long) mutual fund orders to be filled at that day’s ending prices.

But what about SH? Entering the order and getting it filled early or at mid-day would have exposed you to losses as the market rallied on.

I was caught in that exact position. Due to a prior commitment, I had to leave the office about an hour before the markets closed. At that point, the rally was on and the Dow was up some 300 points and rising. My plan had been to simply enter the short position as close to closing time as possible to limit any adverse price action.

Since that was not possible, I simply postponed any action and will enter my long and short positions on a day when I will be around at closing time.

I suggest you follow a similar pattern so that you don’t enhance the odds of starting your hedge with a slight loss.

Feeding The Bulls

Ulli Uncategorized Contact

Treasury Secretary Geithner fed the bulls yesterday by announcing the details of his latest plan to stimulate the financial system.

Much already has been written about it as the particulars are being dissected in any possible way.

The markets took this as a positive development and off the races we went with all major indexes gaining sharply.

As always, Mish at Global Economics provided some valuable insights as to this new spending plan in “Geithner’s Galling (and Dangerous) Plan For Bad Bank Assets.” If you’re not interested in all the gory details, here’s a summary about five misconceptions:

* The trouble with the economy is that the banks aren’t lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it.
* The banks aren’t lending because their balance sheets are loaded with “bad assets” that the market has temporarily mispriced. The reality: The banks aren’t lending (much) because they have decided to stop making loans to people and companies who can’t pay them back.
* Bad assets are “bad” because the market doesn’t understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are.
* Once we get the “bad assets” off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they’ll sit there and say they are lending while waiting for the economy to bottom.
* Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they’ll be working it off for years.

What it comes down to is that another $1 trillion or so will be poured down this bottomless sinkhole for which the next few generations get to pay as the taxpayers are on the hook for 93% of this plan’s obligations.

Since we do not any influence over the outcome, we have to focus on the effects as far as the market is concerned. Over the next few days, we will see if there will be any follow through to the upside or if this rally is limited in scope.

While our domestic Trend Tracking Index (TTI) is still 5.09% away from signaling a new Buy, we nevertheless have to be prepared to act should this trend continue. Entering via our hedge position is only the first step to gaining market exposure conservatively. We will become more aggressive once the trend line has been crossed to the upside.