Tuesday, March 10, 2009

We want to believe

The markets are up huge today, the S&P is up 6.4% today. While this is indeed a huge intraday move and in normal market times might take an entire year this time around all it is really doing is taking us back to where we were last Wednesday. Many people have been calling for a bear market rally and this may well be the start of it. That may well be the case, especially if Geithner lets the market build on this with an announcement about the public-private partnership or some other batch of details about what will be done with the remainder of the TARP funds.

Still, I am inclined to be a but skeptical personally. This rally is built on comments by the CEO of Citibank saying that they are thus far having the best quarter since 2007. To be frank this is not really saying a lot given what has happened to Citibank since then. I find the power of this rally somewhat surprising as I would have thought that the credibility of Bank CEOs had been so damaged that it would never recover, but here people are taking the market up as much as it moved in 2006 in a single day.

Personally I think this may have to do as much with the incentives of the bonus cycle as with the actual performance of the Citi business. Imagine a world in which you manage a $2 billion book of illiquid or long dated assets where you are allowed some discretion as to how precisely it is marked. Not a lot of discretion but some.

Now imagine that it is mid December 2008. Your book is down $200 million, people consider you to have done a good job because given your risk people were expecting you to lose $400 million and you made $600 million last year. You may not have been fired but your bonus will certainly be zero. What is the difference to you between loosing $200 million and $240 million in 2008? None. Your bonus is still zero. But what is the difference to your bonus in 2009 if you start with a $40 million safety net in January of 2009? Probably a lot. Can you see where this is going?

If the notional value of your book is $2 billion, a $40 million mark adjustment will not set off any serious flags so you might be tempted to make such a mark adjustment "just to be conservative," thereby enabling yourself to make the opposite mark adjustment in 2009 and thereby transferring a loss no one will notice in 2008 into a profit everyone will in 2009. And so across Citibank many of these decisions have had to be made. Some people probably chose to mark things fair, other may have chosen to mark them conservative, and now the marks are "coming back." This leads Mr. Pandit to issue an "internal" memo which is promptly leaked and takes the market up 5%.

Rally's have been started on flimsier things in the past but it remains to be seen if this has legs. I think it will need an assist from some economic data or our man Geithner to have any. You can see however how earnestly people want this to be over by how aggressively they take the market higher on this.

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