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Playing The Markets? Caution Is The Name Of The Game

Caution is not cowardly. Carelessness is not courage.

-Unknown

Here’s one for the traders and investors out there. I came across the following list of reasons yesterday from Bennet Sedacca (with Professor Rob Roy) of the financial website Minyanville.com as to why caution is a must in the markets these days:

1. Stocks are firmly in a downtrend.
2. Corporate spreads are rapidly widening.
3. Everyone I know is saying “All is well, buy America.”
4. European equities are taking out the lows of the year.
5. The capital-raising window is closed.
6. Earnings estimates are too high.
7. While much of the move in financials is done, it should spread to other industries.
8. If the “best of breed” are missing their numbers, what happens to the real dogs?
9. We are entering the worst part of the Presidential cycle.
10. We are at war. On multiple fronts.
11. The consumer is tapped out.
12. Corporate buybacks are gone.
13. Net equity issuance is very high.
14. Oil above $100 is very bearish.
15. The savings rate is 0.
16. The U.S. is actually one of the best performing markets in the world this year.
18. Level III assets continue to grow.
19. “Credit rot” is spreading from sub-prime to prime.
20. The dollar is sinking to new lows.
21. The Federal Reserve’s balance sheet is impaired.
22. Mutual fund equity cash remains low.
23. Individual investors are now taking money from their retirement accounts to survive.
24. The market is technically on the verge of breaking down.
25. We’ve broken the 200-week moving average in the Dow Jones for the first time since 2003.

Sedacca and Roy explained each reason in detail, and offered this advice:

Risks remain high and, as always, being cautious will only lose you opportunity - not capital.

Source:

“25 Reasons To Remain Cautious”
Bennet Sedacca, Professor Rob Roy
Minyanville.com, July 1, 2008

World’s Leading Banks React To Write-Down Pain

Rules. We’re all taught to follow them at a young age. You know how to spot someone who has real authority and influence? No, it’s not those chumps who break the rules. Rather, it’s those who change the rules of the game to fit their needs. And that’s what we are witnessing with the world’s leading banks as they confront escalating write-downs stemming from the ongoing housing and credit crisis. Earlier today I came across a post by Elizabeth MacDonald from FOXBusiness. In “Emac’s Stock Watch,” MacDonald wrote:

The world’s leading banks are demanding stock market and accounting regulators relax controversial accounting rules in order to stop the “downward spiral” of huge writedowns during the credit and housing crisis, $335b and counting…

The FT says the Institute of International Finance, an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank’s chairman, is promoting a plan that would let financial companies soften the blow of financial crises by valuing illiquid assets using historical, rather than market, prices.

The IIF says: “The writedowns required under current interpretations [of the accounting rules] may be substantially in excess of any actual or reasonably probable loss on many instruments.”

From what I understand, the issue here is the benchmark, the ABX market index, which might not accurately depict the values for bonds backed by subprime mortgages, as it’s a “thinly traded” index that is barely two years old, according to MacDonald. She explained:

The ABX is a synthetic credit derivative index, or a basket of credit default swaps that are basically high-priced gambling bets on where investors think the direction of the underlying bonds backed by subprime mortgages are headed.

I know this is complicated, but bear with me, it’s important. The swaps in the ABX are basically bets on the prices of the 20 supposedly most liquid (not saying much) subprime mortgage-backed bond deals. It’s an understatement to say booking prices based on this index is accounting that is more art than science…

Can an index based on values for just 20 bond deals legitimately be used for an asset class approaching $1.3tn in size? An index that historically undervalues the cash bonds it purportedly represents? An index noted for its negative sentiment and one that is routinely used by short sellers to attack these securities?

Okay, fair enough. So a new benchmark is needed (easier said than done, I’m guessing). Still, that’s not a good reason for permitting the valuation of illiquid assets using historical, rather than market, prices. But, as MacDonald said, “The bankers want the moon here.” Case in point:

The IIF plan would also let banks decide whether to hold asset-backed securities for as long as they want, freed from accounting rules that would force the banks to hold them to maturity. Instead, they would be able to book these securities on the balance sheet without taking the hit to profits, and then sell them after two years.

I’m not too surprised the banking industry wants to change the rules of the game. As Mayer Amschel Bauer Rothschild, founder of the Rothschild banking empire, once said:

Give me control of a nation’s money and I care not who makes its laws.

Source:

“Bankers Cry Uncle”
Elizabeth MacDonald
FOXBusiness, May 22, 2008

No Sympathy For Wall Street

“Shanna, they bought their tickets, they knew what they were getting into. I say, let ‘em crash.”

-Airplane! (American comedy film. 1980)

I have this strange feeling that Washington Post columnist Steven Pearlstein is not Wall Street’s biggest fan. Maybe it has something to do with his piece from this morning entitled “Time for Wall Street to Pay,” in which he wrote:

I’d be lying if I didn’t admit there’s part of me that takes some perverse satisfaction from the ever-widening crisis that has engulfed Wall Street, humbling its most powerful institutions and exposing its hypocrisy and corruption.

Pearlstein was just getting started:

Over the ensuing two decades, Wall Street has been brilliant at dreaming up other financial innovations that picked up where junk bonds left off. These included complex futures and derivatives contracts; loan syndication; securitization; credit default swaps; off-balance-sheet vehicles; collateralized debt obligations, or CDOs; and blank-check initial public offerings.

As the industry and its cheerleaders constantly remind us, these innovations have helped to lower the cost of capital and make the business sector more efficient and globally competitive. But what we are now discovering — or perhaps rediscovering — are all the ways in which all this glorious financial innovation has weakened the economy and the society it serves.

Pearlstein listed how Wall Street’s “innovations” have taken their toll on America and its economy:

For starters, these innovations have helped to create a cycle of financial booms and busts that have a tendency to spill over into the real economy, contributing to a heightened sense of insecurity.

They have shortened the time horizons of investors and corporate executives, who have responded by under-investing in research and the development of human capital.

They have contributed significantly to massive misallocation of capital to real estate, unproven technologies and unproductive financial manipulation.

They have made it easy and seemingly painless for businesses, households and even countries to take on dangerous levels of debt.

They have given traders a greater ability to secretly manipulate markets.

They have given corporations clever new tools to hide risks, liabilities and losses from investors.

And by giving banks the tools to circumvent reserve requirements and make more loans with less capital, they have enormously increased the leverage in the financial system and with it the risk of a financial meltdown.

But far and away the greatest damage from all this financial wizardry is the obscene levels of compensation it has generated for a select group of Wall Street executives and money managers.

Regarding this last point, Pearlstein warned that because “huge bonuses paid in the good years are never required to be paid back in the bad years,” this creates an “asymmetric compensation system that encourages excessive leverage and risk-taking.” Furthermore, he lamented at the fact that the prospect of earning untold wealth on Wall Street has attracted “an enormous amount of young talent that could have been more productively used in science, engineering, medicine, teaching, public service and businesses that generate genuine long-term value.” He asked:

Is it not fair to ask whether the United States can remain the world’s most prosperous and innovative economy when half of the seniors at the most prestigious colleges and universities now aspire to become “i-bankers” at Goldman Sachs?

At which point, Pearlstein went nuclear:

So I hope you’ll forgive me, dear readers, when I say that the best thing that could happen to our economy is for a dozen high-profile hedge funds to collapse; for investment banking to enter a long, deep freeze; for a major bank to fail; and for the price of a typical Park Avenue duplex to fall by 30 percent. For only then might we finally stop genuflecting before the altar of unregulated financial markets and insist that Wall Street serve the interest of Main Street, rather than the other way around.

Yes, I know it’s harsh and vengeful solution, and there will be lots of collateral damage. But as I look out over the destruction sweeping across the financial sector, I just can’t silence the small voice in my head that keeps repeating that old ‘60s expression, “Burn, baby, burn.”

Why Wall Street Bonuses Aren’t All That

On Wednesday, CNN Money, in conjunction with Fortune, talked about end-of-the-year Wall Street bonuses. Guess what? CNN Money is referring to the bonuses as “golden shackles,” with good reason. According to their report:

…bonus pay this year is going to come with a hitch: more stocks, less cash. The bigger the bonus, the more of it will be given in equity, say compensation experts at Armstrong International. The reason? Banks desperately need to hold on to their people; stock makes it tougher for their stars to take the money and run to, say, Goldman Sachs.

It’s ironic that as stocks are being doled out as holiday bonuses, Jim Rogers, legendary investor and founder of the Quantum Hedge Fund with billionaire George Soros, is betting hard against the sector.

Back on October 31, Rogers told Bloomberg that he was increasing his bets against U.S. securities firms because of salary “excesses” and money-losing investments. He increased his year-old short positions in U.S. investment banks in the 6 weeks prior to the interview.

Regarding salary excesses, Rogers told Bloomberg that:

You see 29-year-olds on Wall Street making $10 million to $20 million a year, and they think it’s normal. There have been lots of excesses.

The chairman of Beeland Interests also talked about the money-losing investments by the firms. Rogers said, “Who knows how bad the balance sheets are. They took on gigantic amounts of bad paper.” In a follow-up interview with Bloomberg on November 2, he added:

I am short the investment banks, as you know. I added more not too long ago. There’s a lot of phony bank bookkeeping going on. You should learn the word level 3 accounting, level 3 assets, because you’re going to hear a lot about it in the next 6 months.

In a bear market, the famous commodities investor predicted that stocks of U.S. investment banks could fall as much as 70%. So much for those bonuses…

Beware Of This One-Two Punch

Yesterday, MarketWatch talked about University of Maryland business professor Peter Morici, who won his second straight “Forecaster of the Month” award from the news service. Morici had the most accurate forecasts of any of his colleagues on 10 major U.S. economic indicators released in October, and capitalized on this notoriety to share the following:

• The Federal Reserve and U.S. Treasury Department are “naïve” about the global economy. Both Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson “look out of their league.”
• Wall Street is infected by “petty corruption.” Morici claims, “There’s a petty corruption that infects Wall Street firms. Everyone feels entitled to make $40 million a year.” The high salaries are justified by “lying to Americans about the value of their creations.”
• The capital markets, the mainspring of the U.S. economy, “are broken.”

Talk about no holds barred. Morici went on to say that, “If the U.S. economy melts down because of this stupidity, everyone will suffer.” In addition, “Whoever is president when that happens will be Herbert Hoover.”

A runner-up in the October contest was chief North American economist David Rosenberg of Merrill Lynch. The Wall Street Journal is reporting in their MarketBeat Blog post today that Rosenberg is saying the U.S. economy may already be in a recession. He is pointing out that the performance of the University of Michigan’s consumer sentiment index seems to mirror two other instances before the holiday shopping period, in 1990 and 2001, when “both times the economy was officially in recession.”

Credit Crunch May Cost Banks, Brokerages $500 Billion

Last Friday, legendary investor Jim Rogers told Bloomberg in an interview:

I am short the investment banks, as you know. I added more not too long ago. There’s a lot of phony bank bookkeeping going on. You should learn the word level 3 accounting, level 3 assets, because you’re going to hear a lot about it in the next 6 months.

Forget the 6 months. The Royal Bank of Scotland Group’s chief credit strategist Bob Janjuah put out a report yesterday that predicted the credit crunch will cause $250 billion to $500 billion of losses at banks and brokerages globally. According to Bloomberg, Janjuah said, “This credit crisis, when all is out, will see $250 billion to $500 billion of losses. The heat is on and it is inevitable that more players will have to revalue at least a decent portion” of assets they currently value using “mark-to-make believe.” He explained the significance of level 3 assets in his note. “The Financial Accounting Standards Board’s rule 157 makes it more difficult for companies to avoid putting market prices on their hardest-to-value securities, known as Level 3 assets,” Janjuah said. Rule 157 goes into effect on November 15.

What gives me nightmares is the staggering dollar amounts we’re talking about here. To date, the credit crunch has forced Wall Street banks and brokers to write down at least $40 billion as the result of record foreclosures. Yet, Bloomberg is reporting the following levels of exposure:

• Morgan Stanley, 251% of equity in level 3 assets
• Goldman Sachs, 185% of equity in level 3 assets
• Lehman Brothers, 159% of equity in level 3 assets
• Bear Stearns, 154% of equity in level 3 assets
• Citigroup, 105% of equity in level 3 assets
• Merrill Lynch, 38% of equity in level 3 assets

“If you look at the writedowns just at Citi and Merrill already it’s about $20 billion, so $100 billion may be on the conservative side globally,” Sajiv Vaid of Royal London Asset Management in London told Bloomberg yesterday. Janjuah said Merrill Lynch, with the least amount of exposure to level 3 assets, “may well come out of all of this in the best health.” Citigroup doesn’t look too bad either.

Wouldn’t it be something if Merrill Lynch’s ex-CEO Stan O’Neal ends up looking like a hero, and people stop calling Citigroup “Shitty-group,” after all is said and done?

Sunday Edition: November 4, 2007

Skeletons In The Vault
Last Friday, Bloomberg reporter Betty Liu interviewed Beeland Interests chairman Jim Rogers. Rogers, co-founder of the Quantum Hedge Fund with George Soros in the 1970s and well-known investment author, has been quite vocal lately regarding his negative outlook on the U.S. economy. However, this interview caught my attention as the legendary investor warned specifically about the dangers from something called level 3 assets held by investment banks. What are level 3 assets? Basically, it’s a classification given to assets that barely trade and whose values are largely the result of informed guesswork by a bank’s own employees. Level 3 assets may include mortgages (subprime included), securitized credit card obligations, leveraged buyout bridge loans, asset-backed commercial paper, complex derivatives contracts, and credit default swaps.

Here’s what Jim Rogers had to say in the interview:

Betty Liu: I want to get your take on the investment banks. Do you think we’re addressing the problems enough, the credit problems there?

Jim Rogers: I am short the investment banks, as you know. I added more not too long ago. There’s a lot of phony bank bookkeeping going on. You should learn the word level 3 accounting, level 3 assets, because you’re going to hear a lot about it in the next 6 months.

Rogers repeated his warning once again:

Betty Liu: So you think that the financial sector is not addressing the problems correctly? You think those problems are going to continue with us for quite some time?

Jim Rogers: Betty, listen to the words level 3 accounting, or level 3 assets. The government, or, accounting profession is now making these guys own up and next year they’re going to have to come up with the real thing. Huge numbers of assets are hidden away in level 3 assets which firms make up the numbers what they’re worth. They don’t have to put them into the market place. But starting next year, they have to. Listen to those terms, level 3 assets, because you’re going to see a lot of problems on Wall Street.

Under accounting standards SFAS 157 and 159, set by the Financial Accounting Standards Board (FASB), starting this November 15, banks will be required to divide their tradable assets into three “levels” according to how easy it is to get a market price, and according to a Dow Jones Newswire piece last Friday, it will be the auditors’ job to determine whether the right inputs to value level 3 assets were used. Because the valuations for these assets were performed by bank employees, and bonuses are paid out when the bank’s quarterly profit rises, there’s a very good chance these assets are grossly overvalued.

On October 29, Martin Hutchinson, a business and economics editor at United Press International and publisher of a weekly column of economic and market commentary called “The Bear’s Lair,” talked about what might happen once the shenanigans are uncovered:

Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman’s capital of $36 billion. In an extreme situation therefore, Goldman’s entire existence rests on the value of its Level 3 assets.

The same presumably applies to other major investment banks – since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital…

The capital underlying Wall Street, at the top, is not all that large – a matter of a few hundred billion. Given the piling of risk upon risk that has been engaged in over the last few years, and the size of the losses in the mortgage market alone that seem probable – my own estimate last spring of $980 billion looks increasingly likely to be somewhat below the final figure – it appears almost inevitable that in a bear market in which liquidity dries up and investors become skeptical, Wall Street’s capital will be wiped out.

Parting Shot
During his interview with Bloomberg on Friday, Jim Rogers had this to say about last week’s job data:

Well, first of all, they’re fraudulent numbers. The government’s making these numbers up… I don’t know why they keep doing it, because they’re losing all credibility, and we know that whatever numbers they publish will be revised dramatically next month. So, it’s a charade. I don’t know why they bother. I don’t know why anybody bothers. I know you have to report something, but it’s a charade.

Have a wonderful week,

Christopher E. Hill
Editor
editor@boom2bust.com