Thursday, April 23, 2009

Now What?

Please accept my apologies, I have been in Chicago with my extended family the past few days.

On Friday the S&P closed at just about 870, just about the level it held before the fiasco of the original Geithner speech about TARP II. A lot has happened since then. After that first abortive attempt to explain what the government was going to do the markets fell and broke the November lows dropping to a closing low of 676 in the first weeks of March. Since then a number of things have happened which have added fuel to the fire and spurred on quite a rally. 1.) An internal memo from Vikram Pandit remarked on the improved earnings picture for Citibank. 2.) The Fed announced that it would buy treasury bonds outright. 3.) Geithner redeemed himself by actually announcing a plan involving stress testing and recapitalizing the weaker banks and providing equity and leverage to the private sector to buy assets off the bank balance sheets. 4.) The TALF began functioning. 5.) The G20 recapitalized the IMF. 6.) Economic data while dismal, was no more dismal than actually forecast. 7.) the FASB has relaxed the mark to market accounting rules 8.) earnings have come out for most of the largest TARP recipients verifying the sunny internal memo of Mr. Pandit which began the entire rally.

The S&P traded up almost 200 points in that time, erasing all the losses in the decline that came after the inauguration rally and the disappointment over the initial Geithner plan. There has been a hot debate between market professionals over whether this constituted a “Bear Market Rally” or whether the worm had turned and the market, which many consider to be a leading indicator, would lead the economy higher. With this rally the market has largely written off Q1 of 2009 as an extension of the panic in Q4 2008 and is looking to the future.

It seems to also have a lot of faith in the resolve of the government. Interestingly over the past several sessions gold and the market have been moving in opposite directions. You would think that market declines would be indications of more deflationary pressure in the economy and that would take down gold but the markets are so confident that the government will print its way out of this crisis that as earnings worsen gold rallies.

That said the market did drop 4% on Monday and has largely traded sideways since then. So what does this mean? Is the bear market rally over? Will the bear market resume? Will we pause and then continue to climb the wall of worry? There is a good case to be made for either side. The bears would argue that we have certainly not seen anything convincing in the data on the macro-economy that would lead us to believe the economy had turned. They also think the optimism over the financial sector may be overdone because their earnings will naturally be high when banks borrow at the risk free rate, lend to a credit starved economy and don’t have to mark their mistakes to market. Optimists can point to analyst estimates of 2010 S&P earnings of $76 per share and say the S&P is a steal at 11 times today’s closing value of 859.

My view of this is the following. I think the rally has done a lot of work and I think the market is fairly priced if you think the economy will recover but slowly. The current analyst estimate for S&P 2009 earnings is $59 or a 14.5 multiple to today’s close. I think the $76 number for 2010 is almost certainly too high, the $59 number for 2009 is itself $3 lower than two weeks ago. That said you cannot ignore all of the things that have happened over the past few weeks. The market may have gone up very quickly but not without reason. The fact that banks have more leeway in valuing their assets means we are likely to see fewer write-down shocks which have spooked the market in the past. I think we will trade mostly sideways until the macro-data give a better indication of where we are in the recession. The two things that could shock the market are a disorderly bankruptcy of the auto-sector or a serious problem in the release of the Bank stress tests. I will write tomorrow about how to approach those things.

Wednesday, April 15, 2009

Making volatility (the fear of other people) work for you

Despite the fact that there seems to be consensus building around the idea that the financial crisis is over there is still a lot of confusion about whether the economy is in recovery mode or not. There has been a powerful rally in the equity markets since the beginning of March but there still is quite a lot of debate about whether this is a “bear market rally” or the beginning of a real turnaround in the markets. There isn’t really enough data out yet to make a conclusive decision but there is enough to make a credible argument for either side.

The trouble is that as this argument plays itself out in the markets volatility is likely to remain elevated. Volatility, as measured by the CBOEs VIX index has come off quite a lot from its highs back in October but it remains high relative to where it has been for the past several years. It is easy to see why this is. You can think of the level of the S&P 500 as being the product of both its earnings and its PE ratio. Right now there is a lot of uncertainty about both. There is a lot of uncertainty about earnings because it is difficult to estimate what effect the constriction of credit markets and the pullback of consumer spending will have on corporate earnings. The PE is hard to guess as well because even if you believe that a recovery is around the corner the speed of the recovery is hard to gauge.

So is there a way to put all of this uncertainty to work for you? I think there is.

What if I made the following deal with you: If by mid December the S&P 500 was between 590 and 1010 I’ll pay you something and if its outside that range you pay me something? The index as I write this is about 845. More specifically, if the S&P is between $700 and $900 I’ll pay you $110, and I’ll pay you one dollar less per point its outside that range until it gets to 590 or 1010 at which point you have to start paying me? What do you say?

Well you might want to do some thinking about this. Let’s say you’re on the optimistic side of the argument. Let’s say you think that this is not a bear market rally but rather the beginning of a turnaround in the economy and you think that in 2010 the economy will grow at the average rate it has for the past 50 years. That is similar to saying that you agree with the average analyst estimate for S&P earnings and that you think the PE would be about 16, the long run average. According to the S&P website, the average estimate for S&P 500 earnings next year is about $62, multiply that by 16 and you get 992 in the index, with my bet you win $18.

Now let’s imagine that you are in the camp that says this is just a bear market rally and that we are destined to test the lows set back in March. The March closing low on the S&P was 676 set on March 9th. If we went back there you would win $86 with my bet. Let’s say you’re a pessimist and you think that the market will break those lows. Let’s say you think that we’ll go through them as much as we went through the November lows when we hit the March ones, about 10%. That would put the S&P at 609. Under this nightmare scenario you make $19.

So under either a scenario in which this is the end of the recession and the markets fully recover, or we retest the lows and break them you can make money with this deal. Not only can you make money in these extreme events, you stand to make even more money if, in the far more likely event, neither of them is played out fully. As I mentioned, if the S&P is between 700 and 900, you get $110. Or 14% of the average notional of 800, in 8 months for an annualize return around 21%. Sounds pretty good no? The question is, is anyone actually offering this deal? Yes they are.

The options markets on the S&P 500 ETF, the SPY are offering you this deal right now. The SPY is very much like the S&P 500 index divided by 10. What you have to do is sell the 70 Put and the 90 Call to form the equivalent of the 700-900 strangle in the S&P. As I write this that strangle is $11 bid (about $6.5 in the call and about $4.5 in the put, add 'em together and you get $11,) or $110 in S&P terms. If you sell those two options you take in $11 or 110 index points. If on the third Friday of December the S&P 500 is between 700 and 900. You get to keep the money. If it’s above 900 you have to sell the SPY at 90 to whoever bought the option from you but you took in $11 so its like being short from $101. Same thing on the downside, if the S&P is below 700, and thus the SPY is below you have to buy it for $70 but since you took in $11, its like buying it for $59 (or (590 in index terms.) Seems like a pretty good deal to me.

As with most good deals, I think its important to ask why am I getting such a good deal? What’s the catch? How is this possible?

The important thing to realize about what you are doing here is that you are taking advantage of the general level of fear in the markets. Because there has been so much volatility, there is a lot of demand for options. Options are kind of like stock insurance. Take the call for example, the right but not the obligation to buy the SPY for $90 is like owning the S&P above $90 but being insured against any losses below 90. Just like insurance companies charge more or less based on how risky the policy, options markets do the same thing. A house made of matchsticks is harder to insure against fire than a house made of cement for example and similarly options are more expensive when there is a lot of uncertainty.

The large amount of uncertainty in the earnings picture and the larger economy is making options very expensive. It is that fear of uncertainty which enables a thinking person to look at what he thinks the realistic outcomes for the market are over the next few months, recovery or recession, act accordingly, and make money in either case.

Monday, April 13, 2009

An Intuitive Understanding of P-E Ratios

One of the most common measures used to describe equity valuations is the Price-to-Earnings ratio. I have used it myself quite a lot on this blog and I think it gets thrown around so often that some people who may not fully grasp what it means or why its important may be hesitant to ask about it. I suppose it is also possible that the concept is so simple that it needs no further explication by me or anyone else. Still, I think it deserves some time.

The reason for that is that the price to earnings ratio is kind of an abstraction. What does it mean to have a stock be five times or three times or twenty times the annual earnings? People don’t really think about the number that much beyond thinking that a stock with a low price to earnings ratio is cheap and one with a high price to earnings ratio is expensive. Generally people can compare PE ratios to one another but don’t really think about what they intrinsically mean.

I think it’s easiest to think about a lot of things in the financial world in terms of an ordinary business and my favourite kind of business is a diner. So imagine that you and I are partners in a diner and we would like to retire to Florida. In order to do this we have to sell our diner. How would we decide what a fair price for it was? We would probably think about how much money we had invested in it over time. Maybe about how much it would cost someone to start from scratch like we did. Mostly we would have to think about what would be in the mind of the buyer.

What would be in the mind of the buyer would be how much money he would make if he bought it. Let’s say our diner makes $100,000 per year. Should we sell it for that? Probably not because all we would have to do is put off retirement for a year in order to get that. Additionally a single years earnings is probably far less than it would cost him to set up from scratch. It might be more reasonable for us to sell for several years worth of earnings. Let’s say we charge him years of earnings or $700,000 just to pick a number out of the air. This means that he would be buying our business for an effective price to earnings ratio of 7. You can think of PE as the number of years of earnings you would have to pay someone to take over their business.

What are the things that determine the number of years of earnings you would have to pay in order to buy a business? Well, probably the most important would be the rate of growth of those earnings. Let’s say for example that we knew that a factory was going to be built next to our diner. So we know that we can serve flapjacks and coffee up to hungry construction workers next year and the year after that we can serve them up to even more factory workers.
So let’s say this coming year we’ll make $100,000, the year after that $200,000 and the year after that 400,000. Are we still going to sell for $700,000 or a 7 PE? Probably not because we just have to stick around for three years to get that much. We’d probably hold out for more and our prospective buyer would probably be willing to pay more.

Another factor is how easy it is to borrow money generally. How much our buyer is willing to pay us is going to have a lot to do with how much of the money he has to put up himself. Let’s say our buyer can borrow $500,000 and agrees to pay us $700,000. So he has to put up $200,000 of his own money and if he’s making $100,000 a year that’s a 50% return on his investment. Not a bad deal. But if he has to put up all the money then he makes only $100,000 on his $700,000 investment, or 14% or so. He might be willing to pay a lot less if he has to put up all the money himself. Along the same lines the level of interest rates is an issue. If the bank is willing to lend him the money but is going to charge him a high rate of interest he’s going to be able to keep less of the $100,000 for himself, that lowers his returns and also increases his risk a little because the bank gets paid first and if he can’t pay them then they get the whole thing in default.

So some of the reasons why the stock market has been so volatile lately is that people are very uncertain both about the level of earnings and what the appropriate PE ratio is. As you can see, saying that there is a mystery about the PE ratio is really the same thing as saying that there is uncertainty about the rate of growth in the economy, the availability of credit, and the level of interest rates. This is what accounts for the very high levels of volatility in the markets these days.

Wednesday, April 8, 2009

How to protect yourself from inflation

In previous posts I have talked about how inflationary and deflationary forces are battling it out. In my most recent post I have spoken about how that while there is pretty massive uncertainty in the short run in the medium to long term the odds favour inflation. This is because inflationary policies are technically and politically easy to implement but technically and politically very difficult to unwind.

Inflation affects different people differently. You can think of it as a wealth transfer from creditors to debtors. Creditors are long cash, so they lend it out. Debtors are short cash so they borrow it. During inflation the value of cash goes down harming those who are long it (creditors) and helping those who are short it (debtors.)

Most people are some combination of debtor and creditor. Most people have some debt whether its a mortgage or a student loan or a credit card but most people also have some savings whether in a bank account or a 401k. Anyone with savings needs to be thinking about ways to protect themselves against inflation.
Traditional hedges for inflation are real assets: real estate, commodities, or precious metals. The current state of the economy and the nature of the crisis make them less useful this time around.

Real Estate:

Real estate does is an inflation hedge because it is a real asset. As the value of the dollar falls it takes more of them to buy the same house so the price should go up. If financed with a mortgage this is even better because the mortgage principal does not increase but its real value declines as the currency weakens. So if you already have a house with a mortgage on it don’t be in a hurry to pay it off, this is an excellent inflation hedge. If you don’t own a house you could get exposure to real estate in your investment portfolio through REITs.
That said, if you are looking to protect your savings against inflation buying more real estate on right now is probably not a good idea. It’s no secret that one of the reasons that for the crisis we are in now was that real estate prices became an asset bubble which is now deflating. Thus though inflationary pressures should drive up house prices the fact that we are coming off of a bubble and the correction seems to have further to run makes real estate a difficult choice as a pure inflation hedge.


Commodities are also real assets and also performed admirably during the 1970s. Today there are many easy ways to take get exposure to commodities with the advent of ETFs. DBA, USO, or UNG all allow a retail investor to get access to commodity price movements.

As with real estate, however some caution is warranted. In addition to their being inversely correlated with the dollar, commodities are also directly correlated to the level of economic activity in the world. Specifically in the past few years commodities have been driven by the substantial increase in the scale of world trade because China is a very large importer of commodities. These days, at the same time as the contraction in GDP, there is also a contraction in the scale of world trade. This means that if the economy gets worse before it gets better that commodity prices could still fall precipitously with economic activity and declining trade volumes making them a less effective hedge against inflation.

Precious Metals

Precious metals are a pure hedge against monetary devaluation because they are a substitute for currency but have a fixed supply. Precious metals are also easy to trade through ETFs such as GLD a share of which represents about a tenth of an ounce of gold so if gold is at $885 an ounce GLD is about $88.5.

Precious metals have not participated in an asset bubble like housing nor are they correlated as closely with world economic output and trade like industrial commodities. The problem is timing. If the TARP and the TALF don’t work or the stress tests show that the balance sheets of the banks are worse than the market thinks then there could be a further contraction and short term disinflation or deflation.

So if you simply went out and bought precious metals and then the economy took a turn for the worse you would be looking at losses on your gold but not necessarily a gain in the savings you were trying to protect. This isn’t too helpful either.
So what does this mean? Is it hopeless? Not at all but the solution is a little complicated.

Use all your options, including options.

What if I offered to make the following deal with you? In 2011 we would look at the price of gold. If, at that time the price of gold was above $1250/oz I would sell you gold for $1250/oz and if gold was below $750 you would have to buy it from me at $750? If the price of gold was between $750 and $1250 that is, neither inflation nor deflation occurred, we would do nothing.

Sounds like a good deal doesn’t it? You only want to own gold if there is inflation and the price of gold goes up a lot. If it does you get to buy it from me for $1250 no matter where it is. If we have deflation and the price of gold goes down below $750 then you have to buy it from me for $750. That’s not great but it is a lot better than buying it today at $885 an ounce where it is today. Keep in mind that we only transact if either inflation or deflation, as evidenced by the price of gold, has actually occurred. Sounds like an ideal hedge for an uncertain future.

So how do we accomplish this agreement? We use the option markets. What you want to do is buy a January 2011 $125 call on GLD which gives you the right to buy a share of GLD for $125 at any time between now and January 2011. At the same time you want to sell a January 2011 $75 put which obligates you to buy GLD for $75 anytime between now and January of 2011. You’ll notice that these options are roughly the same price so what are you really doing is selling the put, taking the cash and buying the call. If the prices are not exactly the same they won’t be off by much. Let’s say that the Call is $6 and the put is $7 then you take in an extra dollar if nothing happens or if you wind up buying the GLD you’ll effectively do it at $74 or $124 which is a little better for you anyway. Have a look at the prices with this link the 2011 options are down at the bottom.

Another nice thing about this trade is that you already know what is going to happen if gold goes to $750. If gold goes below $750 despite the fact that the government has announced all the plans it has print money you know what they will do next: print more money. This strategy which Ben Bernanke announced all the way back in his famous “helicopter money” speech back in 2002 will, sooner or later, raise the price level and with it gold. So in a lot of ways Ben Bernanke has already sold you the put that you are selling to finance your inflation hedge.

Thanks Uncle Ben.

Monday, April 6, 2009

"Good evening, I'm Ben Bernanke and I will be your waiter tonight.

There was a lot of focus on the employment report and the fact that the market, which seems to be forward looking shrugged it off. Perhaps more importantly, and certainly more so for long term investors, were some remarks by Ben Bernanke at a speech in Charlotte and by Donald Kohn in Ohio on Friday about actions the Federal Reserve is likely to take at the end of the current crisis.

The text of both speeches focused on the actions the Fed is taking to mitigate the current crisis with special reference to the programs which expand the Fed’s balance sheet. The short version is that as the credit markets froze up over the course of the past 18 months the Fed has stepped in and taken over some functions of the private financial system in order to prevent a liquidity crisis from causing a systemic collapse. The Fed has been aggressive and creative in the course of taking these actions and is at pains to point out that the vast majority of the assets it has taken onto its balance sheet expose the Fed to minimal risks.

These stories are more interesting for what they did not say than for what they did. The press reports that came out of their speeches were actually focused not on the Fed has done but how it intends to undo those things. Both men said that they were aware that the Fed would face challenges in unwinding these programs once the economy stabilises. I think it is telling that this came out in Q&A rather than in the text of their speeches. Especially Kohn’s as it included a section on policy risks.

Here is the difficulty: the Federal Reserve has stepped into the fray of lending to the private sector and of supporting the borrowing efforts of financial intermediaries as well. This is what has expanded the balance sheet. Some of this has been done through quantitative easing where the Fed simply creates money. Today the Fed and everyone else is primarily concerned with deflationary pressures on the economy in the form of lower wages, higher unemployment and very notably the disappearance of $30 trillion in financial asset values. I have spoke about the inflation/deflation conundrum in previous blog posts.

The Fed may well succeed in avoiding deflation now that they have signalled to the market the extent to which they are willing to go and how much money they are willing to print. The tricky thing will be how they avoid massive inflation once this is all over. In order to do that they will have to take actions to “soak up” all the liquidity they have created to avoid deflation. What that really means is shrinking the balance sheet of the Fed and withdrawing a lot of the guarantees they have made to various private sector players in the economy.

It is easy to say at a press conference years before the fact that this is what you intend to do but it is a different ball of wax when you have to actually do it. The trouble will be in the timing. If the Fed moves to early then the markets may not have enough liquidity to fully absorb the securities the fed sells and take over the funding obligations the Fed has assumed. This means that rates will rise in the economy and potentially kill the nascent economy in the crib.
If the Fed waits too long and inflation gets underway it will take a long time for the political will to form to do the things that are necessary to fight the inflation because those things would have the same effect of killing off the nascent recovery.

You can think of the problem as that of a waiter with a large tray filled with glasses of various sizes. During the course of the crisis they have been filling the glasses with water (money) and since is it them doing the filling and the placement they can adjust fairly easily. Now imagine that someone else (the market) comes and begins removing glasses from the tray but in ways that are unexpected. The fed will have to keep the tray balanced as it unwinds all these things under circumstances of extraordinary uncertainty. No easy task.

I think the most likely outcome is that the recovery we will get from this recession will be very aenemic and so the Fed will most likely wait too long. Inflation will begin and there will not be the political will at the Fed or at the Treasury to aggressively fight the inflation as that would put the economy right back into recession. For this reason I think we are likely to see pretty significant inflation 18 to 24 months from now. Deciding how to protect yourself from that will be a difficult challenge that I will address in my next post.

Friday, April 3, 2009

Unemployment at a 25 year high? Let's only rally them 1% then.

So the big news of today was the Labor Department release of the employment situation data. This showed that 663,000 jobs were lost in the US in March and an earlier number was revised higher to 741,000. This bring the total job loss in this recession to 5.1 million and the unemployment rate to 8.5%, it's highest rate since 1983 when the US was coming off the 1980-1981 recession.

This is generally pretty bad news for the economy but it was no worse than the markets expected so they traded up today. Generally investors think the economy is pretty bad. There is a lot of optimism out there around all of the programs that the government has put in place. It seems that investors are willing to give them time to work and so the markets tend to shrug off bad news about the present in anticipation of good news in the future.

So then you have to ask yourself is the market getting ahead of itself? Many pundits think that it is. The way to look at that is to ask yourself what you think the S&P 500 earnings will be and then ask yourself what price to earnings multiple you think is justified knowing that the historical average is 16. A PE higher than 16 would be appropriate if you felt earnings would grow faster than average and below 16 if you thought they would grow slower.

S&P has a handy spreadsheet of bottom up earnings estimates from Wall St. firms on thier website. From this you can see that the earnings estimates for 2009 are about $62 and given the current S&P level of 840 that implies a PE of about 13.5 a little less than the normal which you would expect in a weak recovery which is what economists generally think will happen.

Given that I don't think there is too much upside from here though I think the market may well trend higher. I also think the market will continue to ignore bad news unless it is far worse than expected. Earnings for Q1 are coming up in the next few weeks and I think the trend of ignoring bad news and rallying on mediocre news may continue as well. People are likely to be looking more closely at what guidance companies give than at the earnings themselves.

Thursday, April 2, 2009

"Nasty, brutish and short" or "Where's your Leviathan my G20 friends?"

In response to a comment I feel the need to publish this in order to give people a better understanding of what exactly we can expect from the G20 meeting.

Basically the G20 today released a communique about the outcome of its meetings. Much of it was a statement of an intention to do everything possible to restore the world economy to health and propserity both as individual nations and collectively. There was some reference to actions that have already been taken by governments. There were several items of interest those are:

1.) A commitment to increase the funding for the IMF by $750 billion. The IMF will also liquidate its gold reserves in order to improve its liquidity. Along with this they pledged to support multi-lateral development banks and trade finance.

2.) They agreed to reform banking regulation within thier own countries and to promote cooperation between thier various regulators in order to prevent "regulatory arbitrage."

3.) They pledged to refrain from increased protectionism and called on the WTO to monitor their adherence to this pledge.

Personally I think the only thing that has real meaning is item 1.) We don't know what horse trading went on behind the scenes and to what extent China's wishes for more influence over the IMF were granted and we won't know for a while. While it is helpful to know that the firemen at the IMF will now have plenty of water when needed it doesn't say too much about the fire itself. Countries which recieve IMF funds often nonetheless have wrenching adjustments to make even if they are smoothed over with IMF funding.

The other two points I think are mostly just for show. Recently there have been calls for a global regulator. On the subject of tax havens there was wide agreement that banking secrecy should come to an end and they seemed willing to threaten tax havens with sanctions. But with regard to banking regulaton the G20 stopped well short of global regulation and instead asked for their individual regulators to "cooperate."

Personally I think that cooperation is likely to be short lived. London made serious inroads against New York as the global hub for finance after the US passed the Sarbanes Oxley act and moved the international IPO business from the NYSE to the AIM. Most other budding financial centers learned the lesson of that and I think that there will be no shortage of would-be Londons from Dubai to Shanghai willing to take on the mantle of the easiest place to do business.

I think the trade issue is the same story. Almost immiediately after the last G20 meeting Russia placed tariffs on foreign cars. It is true that the world is made better off by free trade and it is true that the Smoot-Haley tarrif act in the 1930s made the depression deeper than it needed to be. But there is a fundamental problem with international cooperation under duress that the G20 is not designed to address.

The reason for this was best explained by Thomas Hobbes in his classic work Leviathan.

The premise of the book is that human beings live in a "state of nature" which is characterized by a war of all against all. Every man for himself and the devil take the hindmost. In order for civilization to flourish you need a "Leviathan" or a person with more power than any individual or most concievable collections of individuals in order to establish the rule of law. For this Hobbes had in mind the King of England because well, he worked for the King.

The international system is essentially a state of nature. There is no single state, not even the United States with the power to enforce rules on the whole system and the G20 certainly cannot do it. The real problem is that the governments are not responsible to one another, they are responsible to a domestic audience. An international financial regulator need the cooperation of all the domestic regulators in all the states because only they have the power to enforce the law within their states.

There will come a time when the interests of indidividual states conflict with those of the international regulators and in those cases the states will go their own way. Take for example the subprime lending crisis. Imagine that an international banking regulator had determined that subprime lending combined with securitization posed a systemic risk to the world financial system and as a result lower income Amercans should continue renting and be shut out of the American dream. Something tells me America would have sent the international regulator packing.

It's the same thing with trade. It's all well and good to put something down on paper about how trade is the best thing for everyone and we are not going to raise trade barriers. This neglects some basic facts. Right now international trade is somewhat one sided with America being responsible for the plurality of world imports and a number of mercantilist countries generating huge trade surpluses against the US and using them to run their countries and keep their currencies cheap to keep the game going.

Trouble is, the American consumer and soon the American government have taken in too much foreign capital and to pay it back we need to reverse the balance of payements. How do we do that? We need to export more and import less. But the rest of the world wants to do the same thing at the same time. It is easy to say that we don't want to embark on a protectionist spiral but what will the mood in the country be when we have 9% unemployment and are still shipping $500 billion a year abroad to pay for imports? How about 10%. 11% The voices of free trade are going to get quieter and quieter and the voices of protectionism are going to get louder and louder. And what will the G20 do to silence them? It will use all its enforcement powers....

....which is to say... nothing.

Mark to Market Relaxation

In other news the Financial Accounting Standards Board today voted to grant more freedom to financial institions to use fair value accounting for marking assets whos markets are thinly traded. Congress and some financial institutions have been asking for something like this for a long time.

The rules will be applied for the second quarter of 2009 but can be applied to the first quarter as well as long as both are done together. It allows the banks to ignore "distressed" sales of assets when considering their value. What precisely is a "distressed" sale is somewhat in the eye of the beholder.

The logical question to ask is, "Is this a good thing?" The answer to that depends on who you are.

If you are an executive or a current shareholder of a large financial institution with a lot of difficult to value assets....

...this is a good thing. It may not help you with the writedowns you have already done but it means that the pace with which you have to take losses in the future will be slower. This will allow the market to focus on the actual earnings of your bank. Given the fact that most banks are funding at the risk free rate and only making loans to the best possible credits at market distress rates it's probably a safe bet that they are pretty profitable.

If you are a hedge fund shark hoping to lever up with TARP II money and scoop the bottom make billions and retire to the Carribean...

...this is a bad thing. It means that the banks will be able to keep their better assets on the books longer rather than sell them to you at rock bottom prices. They may well be willing to sell you things which actually are worth zero however but you won't really know until several years after you bought them. It's not the end of the world though because the taxpayers take 85% of the loss but only 50% of the gains.

If you are an ordinary American who lends money to banks by depositing your money in them and therefore have a long term interest in the solvency of the banking system...'s a mixed bag. Changing the way in which something is valued on a day by day basis does not change the probability that the person will pay you back. It just means that banks are free to ignore or at least discount what the market believes that probability to be.

This is the heart of the matter. If you put your money in a bank either as a depositor or a shareholder the most important thing for you to know is whether or not the bank is going to ultimately be paid back the money it is lending out. The way market to market accounting works is that people use the markets to estimae the probability that a debtor will honor his debts to the bank.

The idea being that a market where a large number of people make decisions is kind of like a poll taken about the solvency of the debtor. If a loan for $100 to company XYZ is trading at $50 the market thinks there is a 50/50 chance that XYZ will default on the loan. If this happens to a client of a bank then the bank has to mark down the loans to reflect the lower chance that it will be paid back rather than wait until the loan defaults in the future.

The argument behind the FASB rule change today is that in times like these markets reflect the fact that people have to sell good securities to cover losses elsewhere rather than being a rational estimate of default proabilities. There is a case to be made for this but it begs the question: what is a better determinant of an assets value? A panicked market or a person with a material interest in the asset and who will suffer immiediately from having to mark it down.

Today FASB says the person with the has the material interest. Time will tell.

G20 Magic

As I write this the S&P 500 is up another 4% to 844. The reason for this seems to be optimism on the outcome of the G20 meeting as well as some follow through on a rally in Asia driven by, of all things, the news that Toyota sales fell 39% rather than the forecast 41%. Personally I'm not sure I would buy stocks on news like that but perhaps we were due for a rally.

The G20 has issued a communique. They are basically coming together to recapitalize the IMF and prepare it to deal with propping up emerging or recently emerged economies in the event that they at put to the wall by the global financial crisis. Additionally the IMF will sell some of its gold in order to help finance this.

The gold sale is what I find interesting. Around the world governments are printing money which is essentially debasing the worlds paper money. This should see a rise in the value of gold. So what do the worlds chief printers of money do to panic the gold bugs who are selling paper for metal? They sell the gold reserves of a multilateral institution which, in addition to helping with the recapitaization of the IMF also pushes up the relative value of the paper currencies being printed.

Smart guys these.