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.

I received a phone call this afternoon from someone who found my firm online.  The gentlemen has received no guidance regarding his 401k at work.  Last July, he had $286,000 in his plan.

Today he has $166,000.

I asked him what he had been doing lately.  He had moved his money in recent months from a "Growth and Income" fund.  Now he had 20% each in five different funds:

1. Growth and Income
2. Equity Growth
3. Blue Chip Growth
4. S&P 500
5. Large Cap Value

He also made changes to his new contributions.  So, 20% of each dollar went into each of these five funds listed above.  His primary concern was…

"should I keep contributing to my 401k?"

Sometimes it's a bit stunning when faced with an obvious question.   To his point, he felt he was throwing good money after bad.  But unless you need cash now, you should continue contributing.  This is your money that you will need to LIVE on when you retire.  And every dollar you contribute lowers your overall taxable income.

However, do you need to contribute new money into these same lousy funds?  NO! You can elect to have new contributions deposited into the money market fund, short term Treasury fund, stable value fund, stable income fund, etc.

Now.  How much was actually accomplished by moving the money from a "growth and income" to these other funds he chose?  Not really.  If you take a look at the top 25 positions in each fund, you will find these funds hold many similar names.   So it's really "rearranging the deck chairs on the Titanic."   In fact, it's been written that 70% of all money in equity mutual funds sit in the same 500 stocks…the names in the S&P 500.

To really avoid risk in a declining market, you have to move some money out of the market entirely…not just to another fund in the plan, and consider (if you have a self-directed brokerage option in your plan) using inverse funds and commodity choices (gold, other metals, grains and currencies).  Also, putting assets into long term bonds also invites risk of principal should interest rates move sharply higher.

One flaw that is "baked in" to many 401k plans is a recent change.  Many plans prohibit the amount — or restricting the number — of changes you can make in your account.  Getting "hamstrung" by limiting the amount of moves a participant can make is simply wrong.  Do not misunderstand — I don't condone active trading.  But being limited in the number of transactions you can make in your plan is simply bad policy.

If you would like a free look at your 401k account at work — or your 403b annuity, or section 457 deferred compensation plan at work — call us at 877-223-7300, or email us at support (at) mullooly (dot) net.

What limitations do you have in your plan at work?  Do you have a self-directed option in your plan?

Warren Buffett writes an annual letter to the shareholders of Berkshire Hathaway each year.  If you've never read them, you really ought to.  They are priceless gems.  Not a laugh a minute, but an interesting observation on what's happening.

This year's version is about 22 pages and he comments on Mark to the Market, derivatives, Bear Stearns and some of the other problems we've been exposed to the past year, thanks to our friends on Broad and Wall Streets.  The whole piece is worth your time if you care aout the markets, but I'd pay particular attention to pages 15-18.

I also found Buffett's "prediction" about the possible bubble in the Treasury market to be very interesting.  You should too.

You can find it here: http://www.berkshirehathaway.com/letters/2008ltr.pdf

Throwing good money after bad into these banks is not the answer.

Now, I don't like changing the rules in the middle of the game.  But I still believe the almost-immediate fix for this entire mess is suspending "mark to the market" regulations.

Read this statement from news sources today: Citigroup declined to comment on talks with the government, but in an email said its capital base is very strong, despite $28.5 billion of losses in the last five quarters.

How could Citigroup lose $28 billion — and say they are very strong?
Believe it or not, it is TRUE.

They HAVE to book these losses due to "mark to the market."  This is really important!  When a competitor has to mark down the value of bonds, mark-to-the-market means you must do the same thing on your books…whether you sell or not!

OK, true, these same banks made profits hand-over-fist when real estate was going up and they leveraged like crazy off it.  So, if you run your business that way, it's going to be painful…no…near suicidal…when things are bad.

And that's precisely whats happening now.

Now, a capitalist society says the weak will be extinguished.  OK.

So weak auto stocks should be wiped out.

Weak homebuilders have to go.

Weak retailers, see ya.

But banks provide the grease for the entire economy.  They should NOT be bailed out with cash.

Suspend mark-to-the-market.   Now.

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.

Clearly, investors are more concerned about return OF principal then return ON principal. Another important point to keep in mind is many money market mutual funds invest in short-term treasury bills as the primary component for their investment portfolio. If the current average rate on Treasury Bills is now 0%… what kind of rate should you expect to receive on money market funds over the next few months?

This is just another reminder that money markets are an unusual investment. They've been a terrific place to hide for most of 2008. But most of the time they are not — and should not be — considered an investment. Most times, money market mutual funds are merely short-term parking places while you are in between other investments.

The Treasury announced they will begin to inject capital (money) into banks, under terms created under the bailout bill.  This article will try to walk through, in English, what this all means.

As part of the bailout bill (or TARP: troubled asset recovery plan), one provision that was mostly overlooked during the congressional hearings and rollout was the feature that permitted the Treasury to inject capital directly into selected banks.

A general understanding that most people had of the bailout bill, was that "troubled assets" would, essentially be "traded" to the Treasury for treasury bills.  That feature still is in the bailout package, but is mired in the developmental stages.  Working out the details of which assets (and from which banks) to trade may take a long time to figure out.

And time is the one precious commodity that no one has.

So the Treasury is proposing to take an "ownership stake" in some banks.  They will "buy" part of some banks in return for preferred stock.  They will receive dividend income and be able to make money by selling those shares in the future.  Probably right back to the banks themselves.

What do the banks get?  Well, when you sell stock, you get cash.

Now…here's where the plan works: When a bank receives equity (cash) it can turn around and lend that money, practically overnight.  However, banks don't lend money on a dollar for dollar basis, it's always leveraged.  Not that 30:1 or 40:1 leverage like what sunk the fat cats. So, for illustrative purposes only, think in these terms: $700 billion could turn into $7 trillion worth of loans and financing.  If that doesn't get banks moving again, we are all dead.  For perspective, consider that the entire mortgage market in the United States is approximately $14 trillion.

This feature was widely overlooked by most folks when the bill was introduced and signed into legislation by President Bush.  But this feature may indeed be the "master stroke" (or "magic bullet") that gets the wheels turning again.  It's a dangerous precedent, and it IS risky (if it doesn't work, it is game OVER).

But understand THIS as well: getting the banks to lend money again, is not the end of a recession.  But it will certainly re-ignite the flame, and can very likely accelerate the economy.  So, while I'm not an economist by profession (but I am an optimist), in my humble opinion I feel this will be a short, but very severe recession… followed by recovery.

You truly are living in interesting times.  I don't believe we will see this kind of action again for years and years.  Maybe generations.  And this is a "magic bullet" (or atom bomb) that we need to insure we will never need to employ again.  Seriously…never again.

I've read many different reports about the mortgage mess.  No one really seems to have accurate data.  But if 80 or 90% of all mortgages are current, I have to believe the federal government has made a good investment with this bailout bill.  I believe the government will make money on these mortgages.  And now that they are injecting capital into selected banks, they will have "preferred stock" in these banks.  Meaning, as the banks get back on their feet, the government will make money on these investments as well.  They are negotiating great terms and getting in near the ground floor.

The immediate impact will be the re-opening of the banks, and the credit markets.   We'll see that right away in our local economy.  But the entire process may take several years to completely unwind.  But the Treasury has the deepest pockets in town.  Whoever is President of the United States in five or six years will certainly try to take credit for the "economic miracle" that occurred on "their watch."

You can count on that.

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.

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?"

"Mr. Valentine has set the price!"

Or, in this case Mr. Bernanke sets the price.

This week the Federal Reserve announced that the "open spigot" of money available to investment banks will be closing January 30, 2009. This is six months away.

What this means is that the access to cash will be closing. What this means to you is financial stocks — particularly the bigger banks and brokerage firms — might either be putting a bottom in place, or falling off the cliff in the coming weeks or months. And while we've avoided financial stocks for the past year-plus, the financial sector still remains one of the largest cogs in the S&P 500. So, it could be a turning point. We'll see.

Knowing that this window is soon closing, banks and brokerage firms will have the impetus to write off anything of a questionable nature. So it's very possible we can see massively larger write-downs an extremely large quarterly losses for some of these brokerage firms and banks, as they race to meet this new deadline in six months. They've had access to these funds to help provide liquidity and to help in avoiding a Bear Stearns-like collapse.

While I'm not going to predict the future, this could be the "end of the bad news" for some of these firms. There have been several times in the last 25 years with these kind of events have marked turning points for banks and brokers. The Latin America debt problem in the 80s, recessions, Long Term Capital Management, the currency crisis in 1998, etc.

Please understand, in no way does this event — or this deadline — lower the risk that comes with investing in this financial and Wall Street sector. It's like skating on thin ice: it's a great ride, until it's over. And then it's really over.

Why did I use the headline "Mr. Valentine has set the price"?

This is a line from the 1983 movie "Trading Places" with Dan Aykroyd and Eddie Murphy. As Billy Ray Valentine, Eddie Murphy explains — on his first day on the job — why he's picked a price to buy pork bellies. And Mortimer and Randolph Duke advise their clients interested in purchasing pork bellies to buy at the price Valentine has set.

Likewise, Ben Bernanke has essentially told Wall Street that his "free lunch" will be ending January 30, 2009.

You may not have heard of the term "auction rate preferred securities."

Yet.

If you have not, you probably will soon. Essentially, these are longer-term investments but they have an unusual feature: an interest rate that resets – usually every 7, 14, 28 or 45 days.

The "trick" to making this work is having multiple broker-dealers maintaining an orderly auction market. This provides liquidity for sellers to get out (raise cash) and allow buyers to move in. If the broker-dealers walk away from the market, the whole thing collapses like a house of cards.

Even though you may never have owned auction rate preferred securities, why should this be important to you?

The answer is, you may have owned them… but just never knew. If you had money invested in a closed end mutual fund — like a closed end bond fund, there's a very good chance that a portion of your money was invested in these auction rate preferred securities. In fact, most leveraged closed end bond funds gain their leverage by issuing auction rate preferred securities.

But here is what makes this debacle even more curious: these investments are often highly rated (even AAA rated at times) and backed by 1 1/2 — or sometimes two times the investment. And they continue to pay interest.

So these investments actually ARE working — they're just not working the way they were marketed.

And that's where the problem lies… a failure to disclose. In many cases, these auction rate preferred securities were marketed to investors as cash equivalents. They were marketed as alternatives to CDs, money markets and other short-term parking places for cash. The brokerage firms will deny they were marketed as alternatives to short-term cash investments. The investors (sometimes called plaintiffs) will demand justice because they will claim they weren’t told of the risks involved, or the possibility for illiquid markets to emerge at any time.

In the never-ending game of musical chairs, when broker-dealers stopped actively participating in this market, the bids can dry up and disappear. What this means is you had "no way out" of these investments after 7, 14, or 28 days… you owned it.

This is the "disconnect" between investors and Wall Street firms. Over the years, so many "institutional type" products have filtered down to the retail level for individual investors. The problem is that they are not marketed properly. If individual investors knew everything that "could" go wrong with some of these exotic investments, they would probably not touch them with a 10 foot pole. After all, if clients want risk they can turn to the stock market. This was supposedly alternatives for short-term cash. So this can be a very painful message to hear… money you thought would be available every few weeks, is now tied up in a long-term investment.

The problem with liquidity and spotty disclosure was a lesson I learned nearly 25 years ago with oil and gas and real estate limited partnerships. The first question you need to ask when considering an investment is: "OK, sounds good. Now how do we get out of these things?"

If there’s no clear exit path, run. Keep it simple.

Bank Failures in Nevada and California

The headlines this past weekend showed that US regulators took over two banks Friday afternoon and sold them both to Mutual of Omaha bank. This was the sixth and seventh bank failures this year.

Before becoming a broker, over 25 years ago, I spent some time working at Anchor Savings Bank in New York. I worked in their main office in Hewlett. I was fortunate to work very close enough to observe the President of the bank, who also starred in the commercials, Donald L. Thomas. His tagline was "Your Anchor Banker: He Understands."

But what Thomas really understood was how to buy banks.

I watched him cut deals to buy branches and other banks in trouble over a cup of coffee and a doughnut in the cafeteria. He was a master of working with the FDIC, and the FSLIC which was the Federal Savings-And-Loan Insurance Corporation.

While news of the bank failure certainly makes for good headlines, it should be noted that many of these "transactions" are negotiated behind closed doors — and most banking depositors hardly notice any change at all.

In fact the FDIC ought to be complimented for the way they handle these transactions. In most cases regulators will "seize" the bank on a Friday afternoon, and re-open at 9 a.m. Monday morning under either a newly chartered Bank, or as part of another bank in a prearranged sale of assets. This was the case with First National Bank of Nevada and First Heritage Bank of California is past weekend.

For all practical purposes, on the surface, it appears to be business as usual at banks that go through this process. However, business drastically changes in several ways. These banks will usually be restricted in the manner and amount in which they can lend — if they can lend at all — while under receivership.

Additionally, assets that exceed the FDIC coverage will not be insured. It's just really careless and foolish for individuals to deposit more than $100,000 in one bank. In a true sign of the times, I had not had that "$100,000 FDIC limit discussion" with any clients since 1991. I've had it several times just the last few days.

Whenever there is an "intervention" by the FDIC, there is always a chance you can lose money. Your money may not be available on the day your CD was supposed to come due, and there is the possibility that you could lose interest — or have your rate on your CD reset. It's always best to contact the bank, or the broker or investment adviser and get the details. Don't assume things will work out by themselves.

The "Bailey Building and Loan scenario" in the movie "It's a Wonderful Life" — where the depositors make a run on the bank, really doesn't come into play unless Chuck Schumer is writing a letter. In fact, the FDIC announced that customers of the two banks taken over this weekend can access their money by writing checks, using ATM machines and debit cards. In case you had not heard, Senator Charles Schumer from New York wrote a letter a few weeks ago requesting an investigation into the business practices at Indy Mac Bank. Within a two-week period nearly all of the liquid assets were withdrawn from the bank, in a classic "Bailey Building and Loan" bank run. Thanks Chucky.

In summary, failed banks get lots of headlines and instill fear — where there really doesn't need to be any. The FDIC — one government agency that really does a great job — make sure that individual depositors don't run into problems. During every recession, some banks will fail. The FDIC is there to make sure your money doesn't go down the drain along with it.

P.S. The image nearby is from http://tellingtimenyc.blogspot.com/. It's a little tough to read, but check out the rates on those CD's!!!

Anchor Savings Bank

Let's talk about Fannie Mae and Freddie Mac.

How could these two companies be "OK" a week ago — and now this week they seem on the brink of disaster? If you've heard of these two companies, but you're not really sure who they are and what they do, just understand — these two companies underwrite, back up or guarantee nearly half of the mortgages in the United States today.

Here is the news from this past week…

The Financial Accounting Standards Board (FASB) is drafting a rule that will force all corporations to account for financial risks. They (FASB) would like to make it harder for corporations to keep things off their balance sheet. In theory, that "sounds" good.

Years ago, Fannie Mae and Freddie Mac used to be government agencies. They are now publicly traded companies. Remember in the 1980's, the "era of big government" was ending. The mortgage business was something the Fed's didn't realy want to be in. And since this was a pretty profitable business (well, at the time, right?) these two businesses were sold off, went public. In theory, THAT "sounds" good, too…right?

Today they are considered GSE's (government-sponsored enterprises). Since they are publicly traded corporations, they have to abide by the same rules as all corporations, no exceptions.

Now stay with me, because this is where things get a little complicated.

If this new rule is adopted, it would trigger a need for about $46 billion in new capital at Fannie Mae and $29 billion in new capital needed at Freddie Mac. Ummm, that looks like $75 billion with a "b."

See, government-sponsored entities are required — by law — to hold more than five times the amount of capital for investments held in portfolio then for all of balance sheet assets. This would also force Freddie Mac and Fannie Mae to put assets back on their books that total somewhere between $3.5 and $4 trillion.

You read that right, between $3.5 and $4.0 trillion.
All kidding aside, that is a lot of money.

Still with me?

Remember, this is a proposed rule… and rules get proposed, and then shot down, all the time. And it also takes a very long time to get rules passed, and even longer still for rules to be implemented.

But you know Wall Street. When shareholders hear bad news, they run for the exits. Even if the show is still in the opening act.

Don't get me wrong, I'm not recommending purchasing either of these stocks. Both charts look like they're on life support. But the action this week in the stock market for these two stocks really appears to be an overreaction — at least temporarily. They could still go to zero someday.

But the news headlines this has created are making everyone freak out. The news media has taken the ball and is running with it, milking this for all the drama they can. And drama sells, mister.

Fannie Mae has raised about $14 billion the last few months to offset write-downs on mortgages that it guarantees. Freddie Mac has already raised about $6 billion in the same period. The thought of these two organizations needing to raise another $75 billion — just to meet some accounting regulations — just blew everyone away. That $75 billion doesn't even bring into play any potential future losses or write offs that Fannie Mae and Freddie Mac could have.

Have you seen the Bruce Willis movie, "Die Hard"?

When the police officer starts to drive away, Willis sends him a message…throwing one of the bad guys on the hood of the car.

And Willis yells "Welcome to the party, pal!"

Well, the stock market screamed that to Ben Bernanke this week.

On Tuesday Bernanke seemd optimistic things might improve later this year. But he also mentioned that the falling dollar has contributed to an "unwelcome rise" in inflation.

No kidding.

I wonder how much of the rise in gold, silver, oil and other commodities the past 12 months is directly because of the falling value of the US Dollar?

What do you think?

So…it seems Bernanke may be putting the pieces in place for an eventual rise in rates — possibly later this year or early next year — if, as he said this week, "inflation were to flash signs of getting dangerously out of hand."

Wait.
Did he say "dangerously out of hand?"
Let's see…oil has gone from $30 to $130.
Gold has gone from $300 to $1000.

Huh?

Oh…welcome to the party. Pal.

Most Wall Street recommendations to buy are based on projected future revenues and/or projected future earnings. Projected. Or you could say, "predicted".

Ever notice that a stock will begin to drop (many times without any news), and people will begin to ask "why is XYZ dropping?" Then rumors begin to swirl that something might be wrong, and the stock drops even further. In fact, it slides quite a bit until the actual news is released.

And by then, it's often TOO late to sell the stock.

This makes some folks jumpy…and with good reason. I'm sure you know someone who makes a point or two in a stock and then flips it. Why is it that some folks just seem so thirsty for a profit? Probably because they rarely make money in stocks. And yet, these same folks will ride XYZ down 50% because "it's not a loss until you sell it."

Yeah, right! People in my line of work always preach cutting your losses short and let the winners run. The problem is most folks don't know whether to sell — or hold on, and they wind up making a mistake.

Look, this is where the charts can give you guidance. They don't predict the future, they just tell you if a mutual or a stock is fund is going down because of the market or because there is something actually wrong.

If a fund or stock is in a strong sector, has good relative strength compared to it's peers and the market overall, and is on a buy signal…then stick it out. If a mutual fund or your stock is giving multiple sell signals, breaks the support line, is on a relative strength sell signal, then it's a loser, and it's time to go.

Point and figure lets you know if the move today in your stock was just a wiggle with the rest of the market, or a change in trend. And trends REALLY matter. And the charts don't care if there was a big seller of shares, or if someone has inside information about the company.

When enough sellers show up to change the trend of the stock (from a stock in demand to a stock that everyone is selling — supply), we will see that very plainly on the chart. Plain as the nose on your face. These point and figure charts are unbiased – they do not care if you have owned XYZ for 44 days or 44 years – when it's time to go, it is time to GO.

The charts are very clear. There's no ambiguity. Buy, sell, or hold on. Simple.

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.

Look At The Bond Market

Hate being the party pooper, but I think it's important to remind people that when interest rates start to creep up, that's usually a sign that the party in the stock market may be taking a pause, or even coming to a close.

Look at what's happening in the bond market right now.

The projected yield on the five-year Treasury note has jumped from 4.4% in March (just three months ago) to 4.9% today. Most of this move has happened in the last two weeks.

The yield on the 10 year Treasury note has made a significant leap from 4.25% six months ago and has shot up to 4.95%.

The 30 year Treasury bond has followed nearly the same path. Yields have moved from 4.6% three months ago to 5.05% today.

So short-term — and long-term — interest rates are moving up. It doesn’t matter why. Economists will come up with dozens of reasons and explanations. What matters is that we know what’s happening, and how it can affect us.

When rates rise, like we are seeing right now, we start to see money drift OUT of the stock market and back into fixed income investments like CDs and bonds. That is because these fixed income investments can now start to offer higher rates, with somewhat less risk than the stock market.

This kind of wave usually starts as a dribble, then a gush and finally a tsunami.

So we will continue to ladder our fixed income dollars in short term CDs (3, 6, 9 and 12 months) and pick up higher and higher rates. When rates finally begin to crest, then we’ll consider investing in longer-term bonds. Not before then.

Tom

Thomas Mullooly
Mullooly Asset Management LLC
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