Much has been discussed and written about the “toxic assets” held by banks around the world (how is that for the understatement of the 21st century?) including in this blog on several occasions.
The recent debate, prior to the release of these silly “Stress Tests”, was FASB relaxing its “mark-to-market” accounting standard. This allowed the banks more flexibility in how they make up prices for assets they hold that have no open market price nor any broker willing to speculate with regard to what the price may be. As I discussed many weeks back in this blog, the sticky wicket for the banks were all the “Category 3″ securities they are stuck holding, which are those investments that they have to price themselves and that FASB (under government pressure) has given them increased latitude in creating fictional pricing. This relaxation is what enabled many of the banks to suddenly report some wonderful earnings recently.
What might be interesting for people to consider on the release of the “Stress Test” results is that securities make up a fairly minor percentage of the assets most banks hold. A much more vast holding of banks are “whole loans”, which are residential, commercial and other loans that have not been packaged into securities.
You see, it’s securities that are subject to “mark-to-market” accounting under FAS 157. Whole loans, conversely, are held at amortized cost (which is the cost of the loan plus or minus part of the premium or discount the bank paid for the loan), which is an enormously stable way to report value. As long as the loan is in “good standing” (meaning not 90 days or more delinquent) the bank can hold the loan at effectively the face value. Whole loans can make up as much as 80% of the holdings of many, many banks.
So what if the commercial real estate market gets anywhere near as bad as many people think? What if delinquencies and defaults begin to run rampant as 2009 goes forward? Clearly, many of these whole loans (commercial AND residential) being held by the banks will become 90 days or more late and the banks will then need to write them down to an actual market value since in accounting terms they’ve become “permanantly impaired”. One would suppose this could be a fairly substantial number when the wave of defaults begins to crest later this year. This is what many people and also the IMF are thinking when you hear them predict huge loss numbers (some are as high as another $4 trillion in further losses) in the financial system. To me, this stress testing has been a massive public relations success but is completely meaningless.
I don’t have a good answer for why the U.S. stock market has rallied over 30% since March. To me it seems as phony as a three dollar bill and I’ve taken some huge losses being short the S&P because I expected the market to test the lows of March again. Although I still do believe we will have a trip back to those levels before any true, meaningful move to the upside can be sustained. My God, earnings are being reported by companies that are tiny fractions of their results last year and the stocks rally because the results were better than “estimates”. Just this morning the markets seem to be peeing themselves because over 600,000 Americans lost their jobs last week and we’re working on 6,000,000 lost jobs in the U.S. during the past 18 months. But why are they peeing themselves? Because the country only lost 601,000 jobs instead of the 635,000 we lost the week prior. Wow! How fantastic. It’s like your doctor telling you that you lost 6.01 liters of blood yesterday but how that’s wonderful compared to the 6.35 liters you lost the day before. Frankly, I just don’t get it.
But I’ve watched the markets for going on 30 years and herd mentalities are tough to step in front of and the momentum is clearly to the upside in the stock and commodities markets right now. I don’t believe the fundamentals support these moves but I also know that the fundamentals often mean very little or nothing. Oil is nearly $58 this morning and every report during the last month shows that inventories are growing every single day, so go figure.
In the meantime I’ll just sit and watch and lose money in my S&P short position and wait until the event occurs (whatever it is) that makes people realize that happy days aren’t here again and that the economy is still in frightening condition. At that point, we’ll head back to 6,500 or less in the Dow Jones.