Tuesday, March 10, 2009

Goodbye Mark, Hello Zombie

We finished the day today with one of the biggest one day bear market rallies in stock market history. Up 5.8% for the day. The biggest gainers for the afternoon were financial stocks.

What caused this violent upward move? Well, there was news released from Citigroup's CEO Vikram Pandit that the company has been profitable the first two months of this year. Anyone with any sort of sense knows that comment is ridiculous in every way. The market cheered the news and bought their stock today.

There was also some positive words from our Treasury Secretary who announced today that our economy would recover in the second half of this year, one upping Pandit's comment with another of equal stupidity. The market surged on the news.

But the big, big news of the day came from our senator Barney Frank. He announced that progress was being made on the return of the uptick rule. What that means is that a stock is not allowed to be shorted until it ticks upward. This keeps shorts from attacking stocks and beating them down. They will do this to try and protect the stocks of our nationalized financial companies that short sellers have a fondness of feeding on, like blood thirsty sharks.

This comment, while cheered wildly from the trading floor, was only a warm up for his second announcement: They are working diligently on a plan to remove mark to market accounting for their nationalized financial institutions.

Mark to market means that you have to put a value of the assets on your balance sheet based on what they would sell for in the free market. It is the equivalent of an appraiser coming to your house and giving you a value for your home based on what it would sell for in the free market.

For example, let's say Citigroup loaded up on $1 trillion worth of mortgage securities in 2006. Then in 2009, the underlying homes that the loans were made on have fallen by 50% in value. The mortgage securities are now worth $500 billion because that is what they would sell for if the companies put them on the market today. (In real life most of the debt is worth far less because there are currently no buyers for mortgage CDO's, other than our Federal Reserve)

The banks have to keep a certain capital ratio in order to keep their door open. So based on our example above, if they had $100 billion in capital (cash) and they had to write off $500 billion then they are under water and have to declare bankruptcy. (Unless they can raise $400 billion in cash) This is why the government has been stepping in and giving the banks trillions in cash. It is to allow them to keep their doors open after they are forced to write down this debt.

Barney Frank's plan to remove mark to market means that the banks would not have to declare what their assets are worth so they would not have to mark them down and be forced to take the losses. Seems like a brilliant idea right?

Japan tried this in the 1990's. Their actions are what coined the now popular term "zombie" banks. Their banks carried on for years and years with the worthless assets on their books, and investors never knew what the value of the banks were. This gave investors no confidence to invest in the banks or the country for a full ten year period known now as the "lost decade."

To remove mark to market would be an unmitigated disaster. In fact, the one bright spot I've seen during this whole nightmare has been the government's will not to remove it. They have done something you could say is equally horrific by forcing the tax payers to pay for the losses, but at least that concept has an ending. At some point the losses will be cleaned. With zombie banks, the losses are never cleaned, and we become zombie America forever. (Just like the Japanese who are still recovering today from this mistake, 20 years later)

How long will the rally last? Who knows? Maybe months. Its fun to see people get excited about a market rising that has only changed fundamentally for the worse. A market rally means that expensive stocks just become more overpriced. For some reason this makes people want to buy. I guess that's why a market can stay irrational for a very long time.

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