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There is a lot going on right now! For example;
1.) The Federal Reserve has lowered interest rates to zero, purchased US Treasuries on the open market to further increase the money supply, and assumed ownership of some commercial debt.
2.) The Financial Accounting Standards Board, (FASB) caved by offering the banks reprieve from “mark to market” accounting by allowing U.S. companies to report net income figures that do not include unrealized market value losses. The change will provide banks more discretion valuing their assets, eliminate some write-offs that reduce capital and make it more difficult for investors to analyze bank financial statements.
3.) The Obama administration released the new bank rescue plan, which will provide private investors low cost financing to buy “troubled assets” from the banks.
4.) The stock market has been on a roll since March 9th led by the shares of Bank of America, Citigroup, JPMorgan and Wells Fargo! Some investor’s think bank shares are oversold and have confidence “credit problems” will be resolved, banks will begin lending again, and the economy will begin to get better in the second half.
5.) Congress is congress!
All of the subjects referenced above refer to debt, with the exception of congress, which is a liability. The point being there is too much of it. As a country we have tried to revalue, sell and collateralize our debt, to no avail; because the only proven methods to eliminate debt are to pay it off or write it off!
Think of it like this: Our economy has been going well since 1982 and our life styles have improved and debts and debt service have risen relative to income. Assets purchased at the top of the economic cycle are typically highly leveraged so the cash flow alone may not be enough to service the debt. Business plans usually assume good
economic times so when the economy stumbles, incomes fall, cash flow evaporates and the debtor defaults. The economy languishes because money is tied up in bad debt and not available to invest for growth. The story is not uncommon and not over until bankruptcy resets the debt to manageable levels; thus re-structuring the economy. Then, the story starts all over again!
Following are excerpts from an article in the March 23rd New York Times written by Paul Krugman, economist: “Right now our economy is being dragged down by a dysfunctional financial system, which has been crippled by huge losses on mortgage backed securities and other assets.
As economic historians can tell you, this is an old story, not that different from dozens of similar crisis over the centuries. And there’s a time honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time it takes temporary control of truly insolvent banks in order to clean up their books.
That’s what Sweden did in the early 1990’s. It’s also what we did after the savings and loan debacle of the Reagan years. And there is no reason we can’t do the same thing now.
But the Obama administration like the Bush administration wants an easier way out. The common element to the Paulson and Geithner plans is the insistence that the bad assets on the banks books are really worth much, much more than anyone is willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.
And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels. Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea says Mr. Obama’s top economic advisor is to use “the expertise of the market” to set the value of the toxic assets.
But the Geithner Scheme would offer a one-way bet: if asset values go up, the investor’s profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchase of bad assets.
But the real problem with the plan is that it won’t work. Yes troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus—for that is what the Geithner plan amounts to--will change that fact.”
You might say why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.”
As previously noted, the stock market appreciation over the past two weeks has been led by bank stocks. However, there is very little trading in bank bonds which continue to be priced at big discounts to the market. It’s as if bond investors, who look at bank balance sheets, are not convinced the story is over. Nor am I!
The press has done a pretty good job bringing attention to the lax loan underwriting, inflated ratings by the rating agencies and abuses of loan securitizations. I am confident these issues will be resolved favorably. I am hopeful the following issues will also be resolved favorably: I.) Strict enforcement of existing regulations, for example; the Office of Thrift Supervision which had but did not exercise it’s supervisory authority over the Financial Products unit of A.I.G., which sold credit default swaps,(CDS) without adequate reserves; and caused the technical bankruptcy of A.I.G. A CDS insures a bond from default. II.) The Security and Exchange Commission’s repeal of the “up tick rule” which allowed unfettered uncovered short selling runs on the stocks of Bear Stearns, Lehman Brothers, A.I.G. and others. I hope the “up tick rule” is re-instated. III.) Regulation of new products that are wide spread and involve significant amounts of money. It has been estimated the notational value of the CDS market, which is unregulated, is in the “trillions of dollars”. The ownership of a CDS should be restricted to the owner of the bond that is insured against default! Speculators, that did not own a bond, were able to buy a CDS and bet on rumored defaults of the bonds of Bear Stearns, Lehman Brothers, A.I.G. and others!
As a country we have some issues to work through as evidenced by the debates over economic strategy. In the meantime “patience’ is the investment strategy until after the economic issues get resolved. Buying stocks at that time will be a great move because in my opinion, stocks will be much less expensive and offer the buy of a lifetime!
Sincerely
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