Enzio's Clock

Background

1. Pork inflation

Despite deflation elsewhere, the price of "pork" - the price of getting what you want pushed through on Capitol Hill - has risen. 

At stake was how to change an old accounting rule in order to not have to keep reporting massive losses on their sub-prime, etc., junk assets. 

According to the Wall Street Journal Asia  of 4th June 2009, p. 16f (WSJ), "The rules had required banks, securities firms and insurers to use market prices to help assign values to mortgage securities and other assets that don't trade on exchanges - to 'mark to market.'  But when markets went haywire last fall, financial firms complained that the rules forced them to slash the value of many assets based on fire-sale prices. That contributed to big losses that depleted their capital and left several of the nation's largest firms on the brink of failure...the rules became  a big problem in 2007."

All further quotations are from said erudite and eye-opening article.

The OLD rule was that "...valuations should reflect 'observable' input such as market prices whenever possible. They required banks to disclose extensive information about assets they were unable to value based on market prices. Financial firms last year reported losses or write-downs totaling roughly $175 billion, according to Michael Mayo, an analyst at the CLSA unit of Credit Agricole SA."

Financial services groups  did not like this rule that made them value their trashed assets "from the outside". So  "...earlier this year, financial services organizations put their lobbyists on the case. Thirty one financial firms and trade groups formed a coalition (the "Fair Value Coalition": your author)   and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues..They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of who pushed for the rule change..."

2. External valuation morphs into internal volition

Armed with such money, by April 2nd these pork barrel lobbyists introduced a draft proposal that changed the rules. Now, instead of using "observable" market values when valuing assets (the OLD rule mentioned above), financial firms  are allowed to "presume"  that markets were dysfunctional ...Then they could use internal models to set values, rather than market prices. Their models are not fully disclosed to investors. Given the opposition of many investor groups to this rule change, "In the final proposal, FASB deleted  ... 'presume'. It was a modest setback for the industry: financial firms couldn't use internal pricing models to value assets unless a series of conditions existed indicating that markets were dysfunctional."  The Fair Value Coalition now is training its sights on other parts of this FASB valuation rule...

3.  Lipstick on  pigs

Hearings in the House Finance Committee  peaked around 12th March; shortly thereafter, banks were told that they had to adopt the laxer valuation rules by 2nd April. "The change helped turned  around investor sentiment on banks." Indeed, the KBW Bank Index (BKX:IND) has doubled since its low point on 6th March.... Non wonder that banks have rocketed and my own recommendation to short the banks via SKF:US has been such a disaster: "Wells Fargo & Co. said the change increased its capital by $4.4 billion in the first quarter. Citigroup Inc. said the change added $413 million to first quarter earnings..."

Does it surprise you that shortly after the rule change was discounted in the markets, that banks went on a capital-raising spree?Hard to believe the absence of any insider dealing, is it not?

Of course, these accounting changes create "funny money": these  changes from previously "external" or market-driven valuations to  to "internal", or self-interested valuations are creating accounting profits - but not cash profits. Funny money abounds.

So the accounting rule change has put lipstick on pigs, but the pig - banks with dubious earnings - remains. With the Economic Time® worsening in America

• mortgage defaults have to rise, and
  
• credit card defaults have to rise, so
• banks will keep curtailing lending, and
• making losses on their other "assets".
  

Add to this our musings recently about the sell-off of long-dated bonds due to increasing fears about the sustainability of America's growing Federal debt, and the Economic Clock® has to tick ever more badly for

• home owners who find their mortgages rising, and
• companies, that cannot cut employees and costs any more, so their profits dwindle, and thus for
• banks that eventually have to recognize the reality of the terrible quality of their loan portfolios - not to mention of other long positions held by their props traders.. and
• those suckers owning U.S. Federal debt issues.

The bottom line is that whilst banks' profits may consist of funny money, non-financials' corporate losses will not consist of such funny money: banks won't lend to companies that are not making money.

So when does this merry-go-round stop veering towards disaster?

4. How to Make Money Off This Idea

1. Always consult your financial adviser first.
2. If you can afford to be a longer-term buyer, then I will doggedly cling to that ETF through which you can short the American financials, SKF:US.  I, too, am painfully aware that it is down a gut-wrenching 61.4% since we originally recommended it on 23rd March 2008. But I am hanging on, waiting for the next market crash to take banks down with it. So, f you buy into my weary wariness, then start preparing to buy into this story. My guess is that banks' second quarter profits will remain fat and ostensibly healthy, but come 3Q09, the lipstick will wear off, and we will see the same old mud-splattered pigs wallowing in their sties...
3. Might gold be another hedge against the loss in the store of value that banks ostensibly create? Our advice  on 15th November 2007 to buy the gold ETF, PHAU:LN has reaped 20% for our subscribers...
4. Finally, to repeat our warning about market perceptions of U.S. Treasuries heading south, buy the ETF, TBT:US