One of top questions I've heard (over and over) lately has been:

What about buying Citibank down here?

As little as two weeks ago, the financial services giant was trading at one dollar (in fact it dipped briefly to 97 cents).

So?   How can we miss, right?

Well, I can think of few reasons why this may not be such a hot deal.   But before we get to that, did you ever read the first post I wrote about Citibank?  It was back in November 2007.

First, "word on the street" is the uptick rule may be reinstated.

If you were relentlessly selling short Citibank, the announcement of the return of the uptick rule ought to be enough to get you to cover your short (buy back the stock you sold short).   And while it's impossible to tell, it's my guess we saw a lot of short covering this week.

Next, the CEO of Citibank, Vikram Pandit, circulated an internal memo to employees that stated Citi actually made a profit in January and February.  That's good, right?

Maybe.

After all, the same company managed to lose $28 billion in the previous quarter.  Twenty-eight-billion-dollars!  How can a company manage (mis-manage?) to do that — in just a 3-month period?  Mark-to-market had much to do with the write-downs they took in the previous quarter.  And that rule is still in place, it has not been suspended.  So, the company may still lose money for the entire quarter.  Yikes.

What else? There are millions of new shares coming onto the market.  Citibank is converting many of their preferreds into common stock.  This dilutes the value of common shares already in the market.

Anything else? Well, yes, maybe the worst of all.  The company announced they are contemplating a reverse stock split.  A study completed in 2008 showed companies that did reverse splits found these reverse splits underperformed the market by 50% (on a risk-adjusted basis) during the three-year period after the action. “Reverse stock splits are a strong indicator the company is going to be a significant underperformer during the near future,” says Jim Rosenfeld, co-author of the study and an associate professor of finance at Emory University’s Goizueta Business School in Atlanta.

Many companies consider pulling a reverse stock split to avoid getting delisted.  But many wind up taking that path eventually anyway.  Can you imagine Citibank getting delisted from the New York Stock Exchange?

I am not a big fan of Comedy Central or Jon Stewart, I've watched the show a few times.  But on Thursday March 13, 2009 Stewart interviewed Jim Cramer on his show.  And for the first time (at least that I can remember), someone actually tried to hold Cramer responsible for some of the advice he has given, and also for the fact that CNBC has "morphed" into an entertainment channel.  The thrust of the conversation was more toward exposing CNBC (and to some extent Cramer) as shills for Wall Street and no investigative work is done on that channel.

Bravo.  It is truly an excellent piece to watch and encourage you to do so now.

I expect Yahoo and Hulu will chop up this video shortly. So, don't delay, see this video as soon as possible.  It's nearly 20 minutes, so take some time and watch this, it will be worth it.  Here is the link: http://tv.yahoo.com/blog/stewart-vs-cramer-winner-take-all–183

Stewart said "CNBC could be this great financial tool…especially for people who believe there are two financial markets…the people who are told to invest in 401ks and just leave it there…invest for the long term…don't worry about it."  And the other market — that occurs in a back room.  Where giant piles of money are going in and out…" "But you go on TV and pretend (that market) isn't happening."

By the way, if you have not checked out Hulu (http://www.hulu.com) you really should.  Full-length TV shows (and even some movies) are shown online.  Free.  Since they have no business plan to make money, I don't expect them to be around very long.  But worth a look.

How mark to the market accounting helped kill Wall Street

Mark-to-market accounting is what's used in your brokerage account — your margin account at a Wall Street firm.  To understand mark to market accounting, let's look at what happens in a retail brokerage account that trades on margin:

Suppose you invest $80,000 in cash in a brokerage account.  You sign up for margin capability.  Before you place a trade in your account, you have the ability to buy up to $160,000 worth of securities with only $80,000.  You will pay margin interest on any outstanding balances, and your "margin maintenance" is recalculated every night – based on the gain or loss in value of the securities in the account.  This is how a margin account works.

Using the above illustration, you have 50% equity in the account, and have an outstanding margin (or debit) balance of $80,000.

Suppose the value of the assets in the account drop from $160,000 to $145,000.  You now have 45% equity in your account.  You still have buying power and seem to be in no imminent danger of a margin call.  Remember, you still owe $80,000.  If you were to close the account now, you would sell the assets for $145,000.  The margin debit balance of $80,000 would be paid (margin interest would also be included).  The securities dropped almost 10% in value (from $160,000 down to $145,000) but you lost nearly twice that percentage, because you leveraged the trade.  You would be left with the remainder… approximately $65,000.

But suppose the value of the assets in the account dropped from $160,000 to $100,000.  You now have 20% equity in your account.  Remember, you still owe $80,000.  At this stage, you have no more "buying power."   This means you cannot take money from the account, nor can you buy any additional investments.  In fact, at 20% equity you have a "margin call" and your broker would be contacting you requiring you to deposit more money (or other securities) to boost the equity in the account.

Margin works wonderfully when the assets in your account are rising in value.  But margin will wipe you out when the assets in your account are falling in value.

The assets in the account are repriced every single night in a margin account.  And the equity is calculated every day and the amount needed for "margin maintenance" is also calculated every day.  And when your account gets upside down, you have a margin call, and it needs to be rectified right away.

Margin accounts are calculated using mark to the market accounting.

Banks (and brokerage firms) that own mortgage backed securities have been required — since November 2007 — to use mark to market accounting on these securities.  Coincidentally, this was just around the time these mortgage securities started dropping precipitously in value.  2007 saw many mortgage firms get wiped out, and brokerage firms and banks holding these assets started realizing the volatility of these assets.

Remember banks and brokerage firms were required to employ mark to market accounting beginning in November 2007 for mortgage backed securities.  As real estate values collapsed, and foreclosures began to rise, banks and brokerage firms no longer wanted to hold the securities as investments on their books.  It is no wonder then, that six months later (March 2008) that one of the biggest holders of mortgage backed securities — Bear Stearns — was caught in a massive credit squeeze.  The assets that they regularly borrowed against were no longer "borrow-able."

Bear Stearns — which had traded at well over $100 per share months before, agreed to sell themselves to J.P. Morgan Chase for two dollars per share.  This figure was ultimately increased to $10 per share.

By mid– 2008, Merrill Lynch had decided to unload a $31 billion pool of mortgage backed securities that they owned, and essentially announced they would take the best offer.  These mortgage backed securities had been held on the books (it's estimated) at $.80 on the dollar.  This pool was sold for $.22 on the dollar in July, only after Merrill Lynch agreed to subsidize part of the losses that might be incurred by the buyer.

These are anecdotes and examples using vast over-simplification and are being used to illustrate how mark-to-market accounting works.
While not directly connected, mark to market accounting required that other banks and brokers investing in similar type investments market their own similar assets down to similar levels.  Thus, the entire mortgage backed market froze. Trades were no longer taking place, because every time a trade would take place, it would require the values of similar securities to be repriced everywhere.  These securities could no longer find a value and could not be borrowed against, hampering most lending capabilities at these firms.

What is left in the governments bag of tricks to get the banks back on track?  One topic that I wrote about — 5 months ago — has popped up this past week with more and more frequency.  We are finally starting to hear more and more chatter about relaxing "Mark to the market" regulations.

What is mark to the market?

Suppose a house on your street went into foreclosure.  Previously, that home — and every other home on the street had a value of $600,000.  But the foreclosed property went through a sheriff's sale and was sold for $250,000.  Does it mean every home on the street must suffer the same price cut?  Events like this can "dent" prices up and down the street.  But following market to the market regulations, every home on that street would now be worth $250,000.

Is that fair, or even realistic?

This is what banks and brokerage firms have been dealing with.  It's absolutely glorious when prices are moving up.  But it is a nasty, vicious, life threatening downward spiral when prices are going down.  Let me explain:

In summer of 2008, Merrill Lynch desperately wanted to get out of a large investment ($31 billion) of mortgage backed securities.  Merrill, and many other brokerage firms were still carrying these bonds on their books at approximately $.80 on the dollar (80% of the face amount).  They received an offer of $.22 on the dollar, only a fraction of what they were carrying them on their books.  When Merrill completed the sale, all other similar investments — at Merrill Lynch and every other firm — had to be marked down to those kind of levels.

Here's where bad news gets worse. Most banks and brokerage firms were choking on debt like this.  After all, Standard & Poor's and Moody's had rated these mortgage backed securities as high-quality investments.  This allowed banks and brokerage firms to hold these investments instead of treasury bonds (which had much lower interest rates), and these high credit ratings also gave them the opportunity to borrow against them. The benefit to the banks was easy to see.  But everyone else benefited too: somewhat higher rates were paid on CD's and bonds, loans were available to many, and mortgages were created at lower rates.  We all drank from the well.  Some more than others.

Here's where worse news becomes a catastrophe. Many banks and brokerage firms were leveraged 30:1 or 40:1.  Meaning, if the value of these bonds dropped by 5%, they had a serious problem.  This is why they started creating, buying and selling these additional "bets" or "side contracts" known as credit default swaps.   Most of these mortgage backed investments had already been marked down to about 80%.  But the bar was brought down to 22 with that Merrill deal.  Yikes.

I am completely against bailing out incompetent management.  Wall Street and the banks have taken some really dumb risks and made terrible decisions.  Indeed, some of these executives need to be shot.  But the problem is that the banks provide "the grease" that keeps the economy moving.  So something needs to be done.  Mark to the market needs to be modified.  Yes, it means changing the rules in the middle of the game, which really isn't fair.

There's more (much more), but that's enough for now.

The federal, state and local governments are co–losers with Madoff investors.

Lots of questions are starting to surface regarding Bernard Madoff, and the scam that he's been running — apparently, for years.

I'm starting to read questions like "not charging an advisory fee, only working for the commissions…isn't that a conflict of interest?" Of course it is — and no investment advisor would ever (or should ever) work under terms like that.

Another question that's being asked is "when did this actually stop being an investment program and start becoming a Ponzi scheme?" Until all the details are in, I think people need to assume this has been a Ponzi scheme…all along… from the very beginning.

One more question being asked (which I addressed earlier) is "how can one person run a scheme like this — on this magnitude, and for this length of time — without anyone else being involved, or aware of it?" Of course.  We should all be skeptical.

Another red flag (and how could so many smart people miss this one?): how was it that no dividends were ever reported?  Sometimes you wind up holding a stock through the dividend — by accident!  And not one dividend was reported…ever? The topic I raised on several blog posts elsewhere, took a different slant from the "shock and surprise" many commenters posted.  My point was this: it's probably a safe assumption that people paid ordinary income and capital gains on fictitious transactions — in many cases, for years.  We're talking about a tremendous amount of taxes being recouped by investors who can file amended returns.

Taking that concept one step further: let's assume that everything was fictitious — the statements, the trades, the returns — everything.  What we're really looking at is not losses, but… theft.

I've heard that theft losses can be written off entirely against your income.  I'm not an accountant, and don't give tax advice.  Let's put this in perspective: if you lose money in the stock market, you "net" your gains and losses and can take a maximum of $3000 capital loss each year.  The remainder gets carried forward into the future, until it is completely used up.

However, if you lost $1 million, due to theft, you can write off the entire $1 million as a loss against your income.  And if that wipes out your entire net income for the current year, you can go back the last three years and amend those tax returns — and then carry the remainder forward — until is used up.

Will investors be made whole?  No.  No chance.

Under this scenario, the federal, state and local governments are the co–losers with Madoff investors.  And who will make up the deficit caused by this?

You got it.

Quick history lesson: Mark-to-the-Market was a practice originally begun by futures and commodity traders in the 19th century.  Essentially, mark-to-the-market means your holdings must be "priced" every night…at the price they can be sold at.

For years, many bank and investment companies carried investments at cost, or even sometimes at the face value.  This never gave an accurate picture of gain or loss.

Today, many balance sheets are filled with untraditional investments, like derivatives (for example, interest-rate swaps).  Harder to price, since these derivatives don't trade every day or carried listed prices (like stocks).  So, most companies that own derivatives would come up values on a monthly or quarterly basis…not daily.  What happened was companies would come up with a "model" and these assets were "marked to the model" instead of marked to the market.

Fast forward to November 2007.

Financial Accounting Standards Board (FASB) Statement #157 "Fair Value Measurements" became effective in November 2007.  This statement was created, partly in response to the Enron scandal.

The bottom line: firms had to value the assets at the price you could sell them for — if you sold them right now on the open market.  That's what something is worth.

And within six months, Bear Stearns checked out.  Within one year, Lehman, AIG, Washington Mutual, Wachovia had all succumbed.  Merrill Lynch cut a deal.

There is no market for investments like subprime loans.  Where there is no information available, the SEC has declared companies can make their own assumption.  Which is why may banks and firms may have been extremely slow to write down these assets.

Understand these bank and brokers are not falling apart because your neighbor is in foreclosure.   Do you realize that there is good cash flow from mortgage-backed securities…even subprime mortgages?

Under FAS 157, many companies had been forced to deeply mark down (reduce) the value of mortgage-backed securities due to their inability to sell them.  This resulted in margin calls everywhere.

In margin-call scenarios, better valued assets get sold, leaving the lousy assets behind.  So the lousy equity remains…not fixing the problem.

The SEC is now acknowledging the market for mortgage-backed securities is simply "not orderly" and fair value standards (FAS 157) should be more liberally applied to reflect the expected value.

Suspending mark-to the-market (FAS 157) doesn't "suspend reality" for the financial sector.  The Paulson proposal would replace mark-to-the-market with net operating losses, which would be a very powerful way to help get banks back on their feet…quickly.

Pretty sad story reported recently…but sad, as in pathetic.

Guy Wyser-Pratte, who is known on Wall Street as a shareholder activist and runs a $500 million hedge fund, recently reported that the private banking operation of J.P. Morgan Chase had "somehow" allowed many small electronic transfers out of his personal account, over a period of time (15 months). Each transaction represented only several thousand dollars. However, the total of these withdrawals was more than $300,000. But these electronic transfers were not authorized.

Did he get all of his money back?

No. The end result of his saga, apparently will be a recovery of just $50,000.

Why?

Apparently, Mr. Hotshot Wall Streeter never bothered looking at his monthly bank statement. Look…if you don't contact your bank or broker within 60 days from the date the statement is printed… you are essentially saying "I agree" with everything printed on that statement. And you probably won't have a leg to stand on if you come back six months (or a year), later announcing some discrepancies found on your statement. The responsibility is yours.

Now, Wyser-Pratte claims that since he opened that account "years and years ago" he doesn't recall signing a document agreeing to that "60 day" stipulation.

He's right…he probably didn't sign anything like that. But maybe he should look on the back of his bank statement! It's usually written there…every single month. It ticks me off that some big shot takes his eye off the ball and tries to put the blame on someone else.

If you get a statement from a bank or broker — and you don't do anything regarding a possible discrepancy you may find within 60 days from the date of this statement, you are accepting the statement as it's printed. Essentially, you are out of luck. Please don't tell me you are as careless as Mr. Hotshot Wall Streeter.

Didn't this guy have someone reconciling his bank statements? Scary! Additionally, Wyser-Pratte states that the monthly statements have become so complicated he had trouble deciphering them. Wow! And he manages money for a living?

This is just one of the reasons why I encourage new clients to review their first few monthly statements with me. It's important that you understand what's happening inside your account. The first step is understanding how to read your monthly statement. Look, more and more transactions are taking place electronically. You supply your routing number and account number over the phone and you are giving the keys to your bank account to someone. It's a little scary, but it's 2008. We will have to exercise a little more diligence than we did yesterday, and it comes down to having a certain level of trust.

Or — is it giving away a certain level of trust? What are your thoughts?

In one of my most recent posts I discussed the "ready to explode" product issued by brokerage firms called "auction rate preferred securities."

Well, that didn't take long.

In this past week UBS (the parent company of PaineWebber), announced they are spending $19 billion (yes, billion with a B) to buy back auction rate preferred securities their brokers had sold to their clients. Citigroup (which owns Smith Barney), announced they are doing the same — for $7.5 billion. Merrill Lynch announced that they will buy back $10 billion of these securities sold by their brokers over the next few months.

That is $36 billion these brokerage firms have whipped out their checkbooks for… and we haven't even heard from Wachovia or Morgan Stanley yet!

Understand that the auction rate preferred market is a $300 billion market. It's a lot bigger than people realize. And it's been around longer than most people know. I went on sales calls in the 1980s and marketed these investments as alternatives to commercial paper to universities and small publicly traded corporations.

So everyone is feeling the heat from these brokers walking away from this market… individuals can't get out of these investments, which were sold to them as money market alternatives. Some publicly traded corporations have had to show losses on their books along with anyone else who listened to their broker and used these products as an alternative to short-term investments like treasury bills and commercial paper.

One of the best questions you can ask whenever considering an investment you are unfamiliar with, is this: "OK, sounds good. Now how do we get out of these things?"

The line heard in every economic recession, and every single stock market pullback is: this time it's different.

Which is usually one of the single best indicators to tell you that the market is putting a bottom in place, and we can only expect the market to move up from here.

And best of all, this time around it comes from Jim Cramer.

His actual quote, on July 9 was "but this time is different; it's doom itself. In 25 years on Wall Street, I have never seen things this bad." He even went on to write, "sell everything. Nothing's working. Revisit when the prices are adjusted for a big recession, soaring inflation, and a crushed consumer. Sell at 12,000 and come back at 10,000. Even better: short it."

Here's the link to the article

This is the problem when you have to predict the weather (or stocks), for a living. You have a pretty good chance of being wrong. Most of the time.

Cramer is usually optimistic, but says he'll be bullish again after a big recession, when inflation is tamed and the consumer feels better about the economy. I'm sorry to report that if Jim Cramer waits that long he will miss a pretty good move in the market.

These charts that I keep talking about tell you very clearly which sectors are in demand (and therefore seeing a rise in prices) in which sectors and stocks are in supply (which means they're seeing a decline in their prices). They have successfully kept us in energy for the past five years and out of financial stocks nearly 18 months ago.

I won't hang my hat on predictions, company earnings, news of a new product or any other rumors. Don't forget: everything written on Wall Street was written with an agenda behind it.

That agenda usually doesn't include you.

All these firms hold the same investments.
There is STILL considerable risk in the group.

Why did this happen to just Bear Stearns?

One of the first things I learned about investments was when it comes to bonds, think chocolate and vanilla, super simple: when interest rates rise, bond prices (values) go down.

And when interest rates drop, the price of your bond (the value of your existing bond) goes up. It’s called an inverse relationship…think of a seesaw in the playground. When one side goes up (rates), the other side goes down (prices).

It always works.Well, it always works, until it doesn’t work.

Ask Bear Stearns. And Goldman Sachs. And Lehman Brothers.

(and Merrill Lynch, Citibank, Morgan Stanley, UBS, JP Morgan, and many more)

See, while the Federal Reserve has been busy lowering rates lately, the bonds held by these brokerage firms were also dropping (apparently dropping by the hour!) in price.

Bond prices going down — while rates are going down? That never happens, right?

Stay with me on this, ok?
According to the Wall Street Journal and Dorsey Wright, firms like Bear Stearns and Goldman Sachs have been leveraging (borrowing against the assets they hold, using margin) by a factor of 25 to 1. Wow!

I scratch my head wondering why they would leverage their balance sheet by a factor of 25. Imagine you and me only needing to put up 4 cents to invest $1.00. Or another way of looking at it, your $1 can buy you $25 worth of securities. Pretty good, eh?

Still with me? Ok, now go another step: Goldman Sachs reported earnings this week. Their return on equity (what they earned on their own capital) for the past 12 months has been 29.5%. If the math is right, they’re really earning about 1.1% on their capital, but then “goosing” the numbers (through 25 to 1 margin) to get to 29.5%.

That doesn’t sound so good, does it?

Let's talk about MARGIN

Now how can they borrow so much money? When you borrow (margin) against stocks, you can start by borrowing 50% of the current value. Since stocks go up and down, you are permitted to see that “equity percentage” drop to 30% before running into danger of a margin call (where you either need to add money, to increase your equity percentage closer to 50%, or start selling).

So if you had $50,000 in a margin account, you could actually withdraw $25,000 in cash (borrow against the stock). Or, instead, you could not take any cash out, but buy $100,000 worth of stock, putting up just the $50,000. And the net value can drop to near $30,000 before you face a margin call.

But when you borrow against bonds, you can borrow significantly more. Unlike stocks, where you can initially borrow 50%, with bonds you can borrow 80% and sometimes 90%. That’s a lot more leverage!

And when the Fed starts lowering rates (like they are now), well, we already discussed how prices of bonds rise. Right?

What happened to Bear Stearns, and every other brokerage firm (and lots of banks) is the values of the bonds they hold have been dropping. They hold a lot of these sub-prime mortgages and loans…which have been very toxic. Additionally, every firm apparently has bushels and bushels of these cancerous bonds on their hands. They can’t sell to anyone, since everyone they deal with has the same toxic stuff on their books.

So if you try to sell, and there is no demand, what happens to the price?

You already know – if there is no demand for you what you’re selling, prices start dropping – drastically.

So, the next question is — how can you borrow — when no one wants your stuff? The real problem became trying to accurately value what all these toxic bonds were worth. That was difficult, because no one was willing to buy.

Here’s another way of looking at it: what happens when there are no sales of homes on your street — for a year? Have home prices really dropped? Maybe. But the price of your home will drop like a rock the minute your neighbor sells for a lot less than you expect. Every home on the street just got marked down, right?

What happened at Bear Stearns can happen at Goldman Sachs, Lehman Brothers and lots of banks conducting the same business in bonds. And since all these firms consistently trade securities among each other all the time, they may sometimes feel compelled to extend an offer to buy some toxic bond. But they will offer prices so far below the current market no one would ever accept.

But then the offer is accepted! And the whole neighborhood gets "marked down."

And that marks down the price of every other bond just like it. It’s a negative downward spiral. Think of it as playing musical chairs on the Titanic. All the players in the game are muttering: "Pretty soon the music will stop, I hope I have a chair, but the end result is we’re all in trouble."

UPDATE: Sunday evening, 03/16/2008: Bear Stearns to be acquired by JPMorgan Chase for $2.00 in stock swap deal.
That is NOT a typo!
The stock closed at $30 on Friday. On Thursday, it was $57.00.
And yes, it was $150 last summer.

This, essentially became a giant margin call on Bear Stearns. Apparently, cash — and customers — were leaving in droves the last few days. And when the firm needed to raise more cash, they found no buyers for all of the sub-prime investments they held.

All the brokerage firms and banks dealing in these same illiquid investments may get painted with the same brush. If Bear Stearns is worth $2, what is Citibank worth? What about Goldman Sachs, Merrill Lynch, Morgan Stanley…what are they worth now?

Since these are all widely-held stocks (and Citibank and JPMorgan are stocks in the Dow Jones Industrial Average), it would not be a big surprise to see a massive sell-off tomorrow.

We remain interested in currency and commodities, and cash. Call the office if you have ANY questions or concerns, or just need a gut-check.

The news surrounding Bear Stearns on Friday morning was not good! There are several important elements to this story.

The first element is the most important one: Bear Stearns appears to be out of cash. If you've ever traded on margin (or know someone that does), running out of cash happens from time to time. The problem is it usually happens at the worst time! This "credit squeeze" apparently sapped all the available cash Bear Stearns had at their disposal.
The Federal Reserve stepped in overnight and was able to provide 28 days of liquidity — through an arrangement with J.P. Morgan Chase. Bear Stearns will be able to function for the next four weeks, but beyond that is unclear.

No one knows what the outcome will be at this time.
The second important element in the Bear Stearns story is that subprime mortgages, problem loans and credit markets drying up — are a bigger problem than many people won't accept. They are still in denial! It's extremely unusual to see headlines like we saw with Bear Stearns. The long-term viability of the company is in question.
The third important element in the Bear Stearns story is credibility. Management at many of these financial institutions may not hold an accurate view/perspective of what's really happening. Alan Schwartz, the chief executive of Bear Stearns, said the company was not facing liquidity problems — as recently as Monday. By the end of the week the firm was facing many calls for cash from their clients and other firms that they do business with on Wall Street.
That last point is crucial. Credibility of management. Most investors still use only fundamental analysis to determine whether they should buy or sell a stock. Company fundamentals: the history, their earnings, management, products, revenues, market share, etc.
The flaw in fundamental analysis is that it's human driven — sometimes management changes, sometimes the direction of the firm changes, sometimes companies will go back and restate earnings (essentially rewriting the past!).
In a sense, fundamental analysis relies on what management of the company tells you (and tells the analysts that follow the company) what's going on. As an investor, you rely on them to be honest and open…after all, you OWN the company when you own the stock.
Early on in my career, I'd been burned so many times by misleading statements, inaccurate earnings reports, and all sorts of problems. I learned to check out the charts — in addition to listening to the company. The point and figure chart for Bear Stearns shows sell signal after sell signal, and an important support line break months ago.
Clearly, there were many people who did not feel comfortable owning the stock over the past year and had decided to sell it — well before the news came out on Friday. There is only one thing that matters when it comes to stocks: the PRICE. Not the future, not the grand 85-year history, not their terrific market share or their wonderful products. The only thing that matters is price.
Today's lesson: if you wait for the news, you are too late.

I've labeled this “the yikes spiral” because typically this happens when certain markets are in free fall. The most often example occurs when a company runs into trouble and may need to contemplate bankruptcy.

It's a sad event, because people are losing money, and jobs may also be lost in the process, but it's also interesting to watch what happens to the bonds of a particular company when things start to spiral out of control — the yikes spiral. I'll try and stitch this all together at the end to show you the comparisons between bankrupt companies and the current mortgage mess.

The process “might” go like this: a company will continue to expand, and borrow money (often for as long as the bankers will lend them money), and expand to a point where they can no longer manage or effectively grow. After a period of time the company will begin to disappoint Wall Street because their revenue growth (or the rate of earnings growth) will flatten, and then eventually slow down…or drop.

The stock begins to tank, and analysts begin to wonder how "all that money" that was lent to this company (coincidentally by Wall Street firms and banks) will ever be repaid.

At this point, the price, or value, of the bonds (representing what the company owes) also drops. Stories circulate that the company will begin to "explore alternative means of raising capital and/or refinancing." Throughout this period, the bonds continue to drop in value.

Next, someone may write an article discussing the (at that time) far-fetched concept that this company could ultimately file for bankruptcy if the situation does not improve. As soon as the "B" word is mentioned (bankruptcy), the bonds begin an immediate, sharp nosedive in value. Keep in mind that the price of the bonds represents the market's assessment of their ability to re-pay the loans. Lots of talk and rumors begin to swirl. At some point, the rating agencies for the bonds (examples of rating agencies include Moody's, Fitch’s, and Standard & Poor's) will announce that they are beginning "a review of the financials and bond ratings of this company." The bonds fall even further in price.

If you are a portfolio manager who happens to own bonds issued by this company, you don't want to get stuck holding a bankrupt bond, so you call around and see what kind of price you will get…if you can find a buyer.

The bond market is still mostly a “negotiated” market – there are very few listed bonds that trade on an exchange. The other firms you call around to (that you do business with) honestly do not want to buy this bond, but do not want to appear as if they are "stiffing" someone they often do business with. So they will offer an abnormally low price to buy the bonds from their counterpart — with no serious intention of buying. You might see a price that's far below the last traded price, or even 30 or 40 cents on the dollar…or lower.

The surprise comes when that really low offer is accepted. Yikes!

Just like a real estate transaction, (when a home on your street is sold, the "bar" is reset for your neighborhood), the bar has now been reset for the bonds of this company. In practically no time at all the company's bonds indicate they're trading at a level that indicates severe problems are happening with the company, to the point where the company must at least contemplate filing for bankruptcy.

It's usually only at this point that the company publicly discusses some serious financial problems…and the company officially announces there "may be issues.” The stock and the bonds of the company are already trading at fire sale prices.

Now…as a reminder…if you've been hanging around, waiting for the “news” …you have lost…big.

The problem with the scenario above is that no one really knows the value of these bonds — until they are sold. It's easy to see how a "somewhat normal" situation can spiral out of control… quickly. So Wall Street firms never really know "for certain" with the value of their bonds are on their books.

Why go through this long presentation?

Take the above example (what happens to the value of one company's bonds), and then multiply it by millions upon millions of homeowners. Every time a mortgage is created (or refinanced), a new loan is created. This loan is then repackaged by the mortgage originator and sold to a bank. The bank then often turns around and sells this same package of loans to Fannie Mae, or to a bank or a Wall Street firm. These firms are then sold as a package, often in what's called a “collateralized debt obligation,” or CDO. These investments could be found in bond funds, mutual funds, and with hedge funds.

There is no way of knowing what these mortgages are actually worth for two reasons:

1. The underlying asset beneath the mortgage (the value of your home) continues to drop. And since real estate sales have been grinding to a halt, there's no accurate way to value the asset which is being borrowed against. There is a huge vacuum of information between the "most recent" sale on your street and the next closing. They could be months apart.

2. There's no way to forecast what percentage of these loans are in trouble…or…more importantly…what percentage of loans will become troubled over the next six to 12 months.

So there is no real way to accurately value these investments.

Which is why you are seeing financial firms take multi-billion-dollar write-offs… just months AFTER taking billion dollar write-offs! There's just no way to accurately reflect the value of these assets. Additionally, mortgage departments are shuttering. These departments have been an enormous part of the financial sector's growth over the last 10 years. This "leg" of the business has dried up — and gone away.

So, not only are you having a write-down of assets, entire divisions of businesses are going away overnight. Compared to a year ago, all of these financial firms are now smaller in size (because their assets have shrunk) their revenue streams are smaller — because large divisions of the business have gone away.

This is why many people are finally realizing that you cannot stay in the stocks of these financial companies. It is nearly impossible to accurately value many of the investments they hold.

The stock market has been discounting (marking down the price) of Wall Street brokers and banks since May. The charts of all of these stocks began to turn down in the spring. We really didn't have any news why this was happening! The sector became unfavored, and sell signals were appearing on every chart in the group.

However, it's only been the past few weeks (in late September and into October) when we learned the extent of the damage subprime mortgages caused at these firms.

And the damage has run into the billions at several firms.

But yet, during the past two weeks we've begun to see the stocks of banks and brokers begin to RISE.

How can they be rising with all this bad news?
Are they going up because all the bad news is out?
Maybe it's because interest rates seem to be going lower?
Is there another reason why these stocks are climbing?

Again, different story from the previous message, but the moral of this story is still the same: don't rely on the media for investment advice. The unemotional point and figure charts only track what's in demand and what's in supply. This gives us an extremely accurate picture of where our money should be invested today.

Tom

Thomas Mullooly
Mullooly Asset Management LLC
Our Only Business Is Fee-Only Investment Advice
www.mullooly.net
support@mullooly.net

Friday morning, October 5, the Vice Chairman of the Federal Reserve Board (Donald Kohn) was quoted as saying "a one half point rate cut may be enough."

That headline sent the bond market into a tailspin. But wait, here's the entire quote:

"But pending further evidence, a 50 basis point easing was not an unreasonable first approximation of what might be required to keep the economy on a sustainable growth path. It would be better to respond too much or too rapidly to the turmoil in financial markets rather than acting too little or too slowly." Kohn said.

"it would be better to respond too much or too rapidly…"

Why is it Wall Street traders, the media, CNBC (and anyone else) latch on to half a story? It's the same as saying the Yankees lost on Friday night because Joba Chamberlain was bothered by the gnats in the eighth inning. Has the media overlooked the fact the Yankees only managed three hits on Friday?

The truth is the "market" hates indecision and uncertainty. But that's what we've got! Look, no one knows what the Fed will do next…not even the Fed!

The moral of this story is not to rely on the media for your investment advice. The unemotional point and figure charts only track what's in demand and what's in supply. This gives us an extremely accurate picture of where our money should be invested today.

Tom

Thomas Mullooly
Mullooly Asset Management LLC
Our Only Business Is Fee-Only Investment Advice
www.mullooly.net
support@mullooly.net