January 12

"Illusory Prosperity" - Ludwig von Mises on Monetary Policy. John Hussman.


Hussman: The Anti-Tepper Makes an Apology (kind of). The Reformed Broker.

The manager's January 10th commentary reads as part admission of wrongheadedness, part bitter cartoon villain fist-shaking (you'll see!) and part doubling down on his bear case thesis. He admits that it's his job to generate returns in all environments but then pulls the fiduciary card to excuse his excess caution. Oh yeah, he also basically calls us all idiots. I guess we'll have to make do with only our profits as consolation for the insult.

Bearish John Hussman Is Sounding Like Someone Desperate To Keep His Clients. Clusterstock.


The market is a heartless beast. Pragmatic Capitalism.

The equity market is priced based on future profit expectations that are often right, but more often than not prove to be wrong. As we saw in 2007 those expectations were high, investors believed economic downturn would be thwarted and the environment ultimately surprised substantially to the downside. As the waterfall decline ensued we experienced the inverse reaction in 2009. Markets and expectations overshot to the downside. Expectations for profit growth became far too low and classic mean reversion ensued. As the economy stabilized in 2009 the economy remained stagnant at best. But the economy’s loss had become corporate America’s gain. The massive cost cuts made these corporations lean and mean. Corporate America’s diverse revenue stream kicked in as the global economy strengthened and leveraged up these lean balance sheets. Despite persistent weakness in the US economy profits continued to rebound through 2009 & 2010 even as US unemployment continued to climb. That heartless bitch did not care about the unemployed, stagnant wages or l-shaped recoveries. She cared only for the bottom line and the bottom line was robust – particularly when compared to expectations....

If I have made one mistake in recent years it has been focusing on what should be good for an economy (job growth, fair markets, organic growth, etc) as opposed to what the market desires (higher profits no matter how they come).... Ultimately, the purpose of research is to generate investment profits.  Connecting the dots between this research and actionable ideas is vital to success.  If you allow the emotion of a macro outlook to infect your work your results will suffer.   Remember, the market is not the economy.

Which country prints more and runs bigger government deficits: Canada or the US? Rebecca Wilder at Angry Bear.

Is inflation about to burst the Chinese bubble? naked capitalism.

China's lending quota? Michael Pettis.

would I have taken seriously a quota on new lending? Not really. It seems to me that if Beijing wants GDP growth in 2011 to come in at the expected 9%, the amount of new investment in China – which is determined in large part by the banking system – is really not something they can decide today. It is going to be whatever it needs to be given developments in household consumption growth and the trade surplus.


This is why I argued a few weeks ago that at whatever level the new loan quota was set, I was not going to think of it as constraining new lending in any way. Either the loan quota would be adjusted (upwards, almost inevitably) or more new lending would occur outside the banks’ balance sheets, as it did in 2009 and 2010.

Investment this year I suspect is going to be extremely high, as high as in 2009 and 2010, because it is only with very high levels of investment that we are likely to manage GDP growth rates high enough to keep Beijing happy. So my guess is that 2011 will be yet another year in this increasingly strained investment-driven party. Chinese GDP growth will continue to be the envy of the world, while those of us who worry about the sustainability and quality of the growth will worry more than ever.

Economic forecasting delusions. FT Alphaville.

So economists who tend to predict near the consensus are, by definition, unlikely to anticipate extreme events, while those who correctly predict the occasional Black Swan tend to get everything else wrong... Generally we agree with the standard defence that it’s not the forecast part of forecasts that matters, but rather their underlying information and logical coherence. And indeed, sometimes these are extremely helpful regardless of the outcome.

Predictions (in prep for next forecast meeting)

"Low-probability" events that I currently predict:

- U.S. is experiencing a balance sheet recession, much like the Japanese did, which leads to very different outcomes than do typical inventory-led recessions, meaning that this will be a bump-along, virtually no-growth era, albeit with lots of volatility

- the wide output gap will persist; economic slack will continue to be disinflationary

- U.S. housing STILL has not bottomed; houses remain overvalued and with the excess supply of homes, even ignoring shadow inventory, (months supply of existing homes now at 12.5 months), pressure on prices will resume

- the U.S. household balance sheet continues to have very much more debt than can be serviced given incomes and nonexistent income growth (median household income adjusted for inflation has not grown since 1997); there will be many more write-offs, loan loss provisions need to increase, which will hit earnings, and deleveraging will persist for a LONG time

- as households delever, deflation picks up (deflation is the contraction of money and credit; though prices as calculated in the CPI are not yet falling, M3 IS, thus deflation)

- with excess capacity and no demand growth, there's no impetus for production growth (other than very short-term inventory cycles), so there is no impetus for employment growth

- waning of inventory rebound and of federal fiscal stimulus will not just no longer add to growth, but will detract from growth, as will the state & local budget cut-backs

- if the U.S. does not double-dip, it will only be because the NBER decides the recession starting December 2007 hasn't actually ended yet (a mid-recession bounce off the lows that does not reclaim the old peak before the down-trend resumes may not justify an end-of-recession call)

- Canada will not decouple from the U.S. going forward any more than it did in 2008/09

- Canada has its own internal imbalances (consumer credit, household debt, housing activity & prices) which makes it not just vulnerable via external shocks, but vulnerable too to unsustainable domestic demand

- China does not just contribute to global imbalances, but has its own severe internal imbalances, which are unsustainable and thus won't be sustained, and China will suffer the same fate as Japan in the 1990s and the U.S. now in the aftermath of the crash of an asset bubble (though many believe the Chinese government has plenty of ability to fine-tune the economy and keep growth near double-digit range, there is not much precedent for successful central planning economies)

- stocks remain in a secular bear market, despite the cyclical swings; stocks will fall below 800 as current very rich valuations (based on cyclically-adjusted P/E ratio and Q-ratio, as opposed to forward P/E) are predicated on robust earnings growth due to robust economic growth, neither of which will materialize; in fact, if fair value is 850ish, and given that stock markets always over-react in each direction, a revisiting of the 600s is not out of the question

- investors will shun stocks and continue to restock the fixed income holdings on their balance sheets, which, for households, remain very low, particulary given the aging baby boomer demographic situation

- Fed will be on hold at least until 2014, likely longer

- BoC will get its overnight rate no higher than 1% while Fed remains at 0%, and I believe it will cut rates again once the shxt hxts the fan again (i.e. once the fact that there's no recovery to speak of becomes obvious)

- the secular bull market in bonds that began in the 1980s has not been broken yet and will not be in the next few years; bond yields will break through the 2009 lows, getting closer to Japanese levels in 2011; US10s will get below 2%, Canada 10s under 2.5% and long bonds to 3%







Context: "Low probability" events that I have previously predicted:

- in late 2006, anticipated not just U.S. housing stalling, but crashing; a recession in 2007; an S&L-type financial crisis

- in Q1/2007, I thought the economy would be in recession in Q2, if it was not already (wrong; but it was by the end of the year)

- in Q2/2007, I predicted a Minsky moment, that the debt bubble would burst (and though I sold most of my non-bank ABCP, I foolishly rationalized not selling my one last piece as it was just a 2-month maturity)

- and that the S&P would fall below 1000 (I was the only in-house predictor of negative stock returns in 2008; however, I was also the only predictor of negative stock returns for the rest of 2007, which was incorrect; early again, like with the recession)

- it was in Q3/2007 that I first started predicting that the U.S. would likely, due to a cratering asset bubble and large private sector debt burden, have an outlook similar to Japan in the 1990s
- in late 2007/early 2008, I predicted that the Fed would drop rates to the old low of 1%

- and, at that time, I believed it was too early to be buying credit (but I did not advocate for selling credit, and I certainly did not foresee spreads widening anywhere near as much as they ultimately did)

- in early 2008 I noted that economic growth since the 1980s had been driven by debt growth, with more and more debt required over time to buy each unit of GDP growth, and therefore that in the absence of debt growth there would be no economic growth; and that though the government could fill the void for awhile and offset private sector deleveraging for a time, it could not do so indefinitely, so economy-wide deleveraging would happen

- in 2008 I agreed that subprime was contained --- to planet Earth

- and I predicted, when losses so far were under $400 billion, that credit writedowns would easily exceed $1 trillion

- I also suggested in mid-2008 that the Fed was in a liquidity trap and that monetary policy, though easy, would not be effective (pushing on a string)

- in Sept 2008, when the S&P was at 1200, I expected stocks to go down a further 14% in 2008 and be down 8% in 2009 (down to 800 then up to 1000) (wrong -- they went lower than I anticipated (to 666), then recovered much more than I anticipated (to 1150))

- in late 2008 I predicted that global decoupling was an optimistic myth, that the global economy relied on the U.S. consumer and would be dragged down by it

- in 2008 and 2009 (and still in 2010) I believed that U.S. housing was not yet in a sustainable recovery

- in early 2009 I predicted that unemployment, then at 8.1%, would exceed 10%; I predicted that the Fed would be on hold for quite some time as, though an overnight rate of 0% seemed very accomodative, relative to a Taylor Rule approximation, it wasn't easy enough, and, because it NEEDED to be very easy, it would STAY very easy; I remained in the deflationary camp; that Fed's so-called printing of money through QE was ineffective as it wasn't a helicopter drop into the hands of consumers, but was instead sitting in banks' excess reserves (effectively just an asset swap), so though the Fed could expand the monetary base, as the money multiplier and velocity fell, monetary base expansion would have no effect on P*Q

- in spring 2009, I removed my hedges, assuming stocks would get back to 900 (at which point I started hedging part of my equity exposure again) or 1000 (at which point I became fully hedged); I did not expect the S&P to get above 1000, and did actually expect much lower stock prices in H2/2009 (below the March low --- wrong) (so I became net short equities as stocks got to 1100 and further at 1200)

- in Sept 2009 I predicted that the Universe bond index would return over 6% and the long index around 10% in 2010

- in late 2009, I predicted that bond yields would head higher in the first half of 2010, along with stock prices, as investors assumed the recovery was underway and entrenched, but that yields and stocks would fall in the second half of 2010 as it became obvious that the stimulus-induced and inventory-led recovery was temporary and not sustainable and that underlying demand remained anaemic and the recovery was really no recovery at all


in other words, just b/c a type of event in a normal economic environment might be of "low probability", in a different type of environment, all bets are off, and probabilities need to be significantly re-appraised

Bubble Bubble Toil and Trouble?

Lots of talk out there these days about bonds being in a bubble.

Notable example: Mr. Stocks for the Long Run, Jeremy Siegel, thinks bonds are in a bubble.

In fact, he thinks that those "who are now crowding into bonds and bond funds are courting disaster". His version of disaster is that bonds could lose 3x their current yield, or about 8% or 9%.

Never mind that if you hold to maturity, you will not lose money (like you can when an equity market bubble bursts), you will receive your coupon payments and get your full principal back.

Siegel is the guy who in January said:

I don't see it being a good year [for bonds] in 2010, because the Fed will be forced to raise interest rates sooner rather than later. We will see bond rates move higher.

Well, he was right... for a time. The 10-year yield did indeed move higher from just above 3.6% at the time of his interview to nearly 4% in April.... but have now rallied to under 2.6%.

Nor will he will be right about the Fed.

And he thinks that the p/e multiple should be at around 20 times normalized earnings "because of efficiencies in the market".

At no time in history when the stock market has had a 20x normalized P/E did you end up with an attractive long-term return on a going-forward basis. Normalized P/Es have exceeded 20 in the 1900s, the late 1920s, the 1960s and the 1990s; and we know how the following decade turned out in each case.

Consider the following chart, which shows what average and median price returns were 10-years forward from experiencing a normalized P/E in each range (using data going back to 1900)

anything over 18 has been hazardous to your wealth; would you accept a (nominal) return on stocks of just 1-4%?

by the by, the normalized P/E on the S&P right now is at about 22

so, he thinks bonds could lose as much as 10% if yields go higher; what does he think stocks might lose?

well, he doesn't say; but the normalized P/E of its high level currently of 22 compares unfavourably to a historically average level of 17 or 18, implying that stocks are currently 25% to 35% over-valued

which perhaps explains why investors are willing to bid bonds up to current levels

I'd rather take on the relatively low probability (given the economic environment and the likely course of monetary policy, both traditional and unconventional/quantitative) of a potential 10% loss on bonds as opposed to the (in my estimation) higher probability of as much as a 30% loss on stocks.

Or, as Felix Salmon says,

Most bond investors would love nothing more than for the Jeremys to be proved right and for stocks to start rising impressively as the economy recovers — even if that means losing money on their bond investments. But if the economy gets worse, having your money in safe Treasury bonds is going to help you sleep a lot better than having it in risky and volatile stocks

but let's say that maybe Siegel is right in a sense; maybe the current level of yields IS unsustainable in the long run, and, as such, bonds ARE in a bubble; but perhaps its a VERY long run (Japan's bonds have been in a bubble for 15+ years, I guess, with no signs of it abating yet), and bonds are in an unpoppable bubble, as per Colin Barr of Fortune.

Or, as per the Pragmatic Capitalist, the great bond "bubble" is a myth.

Updated Interest Rate Forecast

At the beginning of the year, I had penciled ranges of:

US10s 1.5-3.0
US30s 2.0-3.5

Can10s 2.25-3.35
Can30s 2.95-3.95

With the high yields in Q1 and the low yields in H2

My low yields were framed in the context of the Japanese experience under ZIRP and QE and deflation, whereby the whole Japanese curve traded under 1% in 2003, and even before that in 1998 their 10s got to 0.8% and their 20s to 1.3%

Obviously I didn’t foresee US longs backing up 130 bps from their December low of 2.50 (I thought up to 100)

I’m sticking with my US 10s forecasted range, though my US longs ceiling needs raising to 3.70

And I’d stick with my low yields for Canada (though I think there’s a risk we go even lower --- US10s went to 2.05 in December; now that Canada is likely to also go to ZIRP and to QE, and given that I think Canadian GDP and other economic data will be at least as horrid as the US), but would drop my highs to 2.95 on 10s and 3.70 on longs (given that economic data has deteriorated even faster in Canada than I would have anticipated, increasingly the likelihood of Canadian QE)

As such, the relative duration bets I’d advocate, pending further consideration and debate, would be:

2.25 – 0.2 short
2.35 – 0.1
2.45 - neutral
2.55 +0.10
2.65 +0.20
2.75 +0.30
2.85 +0.40
2.95 +0.50 long

QE comes to the US

Well, the Fed decided to pull the trigger on Quantitative Easing (QE) to augment its on-going, and now-expanded, campaign of Credit Easing (CE) --- and the bond market loves it.

US 10yr bonds have rallied 50bps from 3% to 2.5% and long bonds have rallied 44bps to 3.4% --- but the process of price-discovery is on-going here only 15 minutes after the announcement. Traders simply don't know yet where this will settle out.

Canadian bonds have of course rallied as well. 10-year yields have fallen to 2.7% and longs to 3.5%. We'll have to wait and see, probably until April 23, whether active QE programs in Japan, the UK, Switzerland and now the U.S. have any bearing on the Bank of Canada's decision about when to launch their own program.

The Fed statement follows:


Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession. Although the near-term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Donald L. Kohn; Jeffrey M. Lacker; Dennis P. Lockhart; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.


As dramatic an impact as the Fed has had on the market today with its announcement, the impact is borne of psychology. Ultimately, the Fed's purchase programs are relatively small compared to the size of the total credit markets and money supply. So, while it does go to show that betting against the Fed can be a painful trade, its not yet clear how much buying the Fed will have to do in order to offset the deleveraging going on in the broader economy (total US credit market debt of over $52 trillion). But there's no doubt that the lower yields will help.

Balance Sheet or Income Statement?

I was asked today what I thought the repercussions would be of the government forcing bondholders to take a hit, as suggested by Barry Ritholtz, among others. After all, unintended consequences have been a staple of the last year's ad hoc government actions. And if bondholders feel the pain, what might that do to ratify the worst fears of the bond market and scare off that source of funding for financial institutions for a very long time.

I intend to discuss that further in a following post, but in the meantime, I thought that the following two pieces, one by Yves Smith from naked capitalism, Will Banks Start to Walk Their Talk? Don't Hold Your Breath (Mark to Market Edition), and the other by Roger Ehrenberg at Information Arbitrage, Entrenched Managements: Yet One More Reason Why TARP = CRAP, sets the stage by discussing some very relevant points.



The new meme from big embattled banks, starting with Citigroup's leaked Pandit memo yesterday and Bank of America CEO Ken Lewis' declaration that the bank will be profitable in 2009, is that things will be OK and all this talk of nationalization is unwarranted.

I'll reserve judgement till the fat lady sings. The record of financial crises suggests the housing market has lower to go (which is consistent with the notion that prices need to revert to historical norms relative to incomes and rents) and that unemployment is far from its peak (the Reinhart/Rogoff historical comparisions suggest US unemployment will reach 12%).

The flip side is the point made by John Hempton: US banks earn fat spreads, so their earnings power is good (for those who read his detailed post, note some have raised objections to some of his assumptions). That has been enhanced by the Fed's near zero Fed Funds rate. And as we have noted, the fat interest spreads that are good for banks are not so good for borrowers. Yes, some have raised concerns about the requirement that banks participate in various "get the housing market going" programs may work to their detriment, but frankly, we are skeptical that these programs will come close to reaching the number of homeowners Team Obama bandied about.

So the 2009 picture boils down to how much the big banks have in the way of writeoffs, AND let us not forget, how well they do in their trading operations. Ken Lewis seems to still be depicting BofA as a conventional bank, and ignoring that Merrill could deliver losses and further writedowns.

Ah, but relief is coming on that front too. I must confess that I did not watch the Senate hearings, but mark to market looks to be dead. From Bloomberg "Lawmakers Tell FASB to Change Fair-Value ‘Quickly’ ":

U.S. Representative Paul Kanjorski said regulators must act “quickly” to give companies more leeway in applying the fair-value accounting rule that banks blame for exacerbating the financial crisis.

“If the regulators and standard setters do not act now to improve the standards, then the Congress will have no other option than to act itself,” Kanjorski, the Pennsylvania Democrat who leads a House Financial Services capital markets subcommittee, said at a hearing today. Fair-value, which requires companies to mark assets to reflect market prices, has “produced numerous unintended consequences,” he said....

Kanjorski said he isn’t advocating suspending the rule, because such a move would bring back “the very kind of subjectivity and sleight of hand that made mark-to-market necessary in the first place.”

Eliminating fair-value “would diminish the quality and transparency of reporting, and could adversely affect investors’ confidence in the markets,” Herz said. The rule “can help to more promptly reveal underlying problems at financial institutions.”

Guidance being prepared by Norwalk, Connecticut-based FASB will encourage companies and auditors to use their own judgments in valuing assets, Herz said.

You cannot have it both ways. The Senate is trying to pretend it is going to keep fair value accounting in a somehow friendlier form, but friendlier to the industry means the financial statements are no longer reliable. They cannot be trusted. Anyone who thinks so needs to recall the example I keep harping on, Lehman. Even with mark to market accounting, Lehman delivered $100 billion in losses to unsecured creditors on a $600 billion and change balance sheet. That level of misvaluation should be impossible (absent exempted categories like Level 3 assets, which are openly phony baloney). If this wasn't accounting fraud (and I am inclined to believe it was) then the existing rules were so loose you could steer a supertanker through them. Lehman says there is ALREADY too much play in the existing rules, not too little.

You cannot be half pregnant here. Either you have objective standards or you don't. The notion that subjective valuations will be permitted and they won't be abused is utter fantasy.

The reason fair value was implemented, was, to paraphrase Churchill, it is the worst way to value financial assets except all the others that have been tried. Historical cost is misleading in an environment where interest rates can move significantly over the life of the asset. Banks also tended to avoid writing down or reserving against assets until they were clearly impaired. Hold to maturity (which is what is used for loans, and presumably some variant will be the new fair value compromise) has considerable subjectivity.

One bad feature of mark to market is that it it pro-cyclical. That is, as market values in general go up, the value of assets on financial firm balance sheets go up. Say assets formerly valued at 100 are now worth 120. Oh, and guess what? That gain in value increases your equity by 20. If you are a Wall Street firm, you'll pay some to yourself, but you'll lever up the portion you retain. So firms take on more risk even thought their holdings have not changed, merely their valuation. No one had any problems with mark to market when it was making everyone look good. The process operates in reverse on the way down (except those employees still keep paying themselves, funny how that works). Of course, there is another solution, which is to have procyclical capital requirements (higher when prevailing asset prices rise, lower when they fall) and some have been worked out in considerable detail. But that is far too sensible and offers no quick relief to banks desperate to slather lipstick on the pig of their balance sheets.

Some have contended that the death of mark to market is no biggie, such as David Reilly of Bloomberg, who argues that, based on his analysis, it applies only 29% of assets the 12 biggest banks in the KBW Bank index.

First, if you look at the index, it excludes Goldman and Morgan Stanley. Second, Merrill was purchased by BofA AFTER its latest report date, so its inclusion might boost the total a tad. Looking at mark to market and reaching conclusions based on figures that exclude many of the systemically important global trading firms is silly.

Second, 29% is still vastly in excess of their equity. If the elimination of mark to market allows banks to make their valuations of these assets more flattering by, say, 10%, that would exaggerate their assets by roughly 3%, which goes straight to their net worth. For instance, on a quick and dirty pass, Citi's balance sheet (conveniently excluding its roughly $1 trillion in SIVs) is $1.9 trillion and shareholders' equity is $142 billion, or 7.3%. An additional 3% would be an over 41% increase.

So yes, the banks may look just ducky soon. They are going to continue to get plenty of subsidies from the authorities, via super low interest rates. the fancy new facilities that will boost their profits, such as the new $1 trillion asset backed facility (I think TABSF, but I can no longer keep them all straight, which is no doubt part of the point).

In the meantime, the taxpayer will continue to subsidize banks, the banks will get to keep the upside, and (as in credit cards) charge fat spreads. Ain't capitalism wonderful?

If the banks were really doing as well as their PR suggests, they would not need to use the to be launched public private garbage barge operation. Do you think there is a snowball's chance in hell of that happening?

We are going straight down the Japan path: propping up banks rather than forcing them to recognize losses, and providing the same sort of accommodative accounting to boot. All it did for them was kick the can down the road a few years, at considerable cost to its society. But that's what you get when the executive and regulators are unwilling to challenge the primacy of the banking class.

Update 3/13. 12:30 AM: You gotta love Floyd Norris:

If mark-to-market accounting is to blame for the current financial crisis, then the National Weather Service is to blame for Hurricane Katrina; if it hadn’t told us the hurricane hit New Orleans, the city would never have flooded....

Sadly, a victory for the bankers would not help them much. Even if it were true that banks would be held in higher regard now if they had not been forced to write down the value of their bad assets — and that is, at best, debatable — changing the rules now would be counterproductive. Would you trust banks more? Would other banks be more inclined to trust banks?...

Although you would not know it from the angry complaints, the accounting board’s Statement 157 did not require mark-to-market accounting. That was already required under earlier rules. What it did do was clarify how such values should be determined. That stopped banks from defining “market value” as meaning whatever they chose it to mean.

Conrad Hewitt, who was chief accountant at the Securities and Exchange Commission when it conducted a Congressionally mandated review of the issue late last year, said at a recent Pace University accounting forum that he asked all the complainers if they had a better way to determine market value than the one prescribed by Statement 157. None did

Now for the second post:

Citigroup is up almost 80% over the past few days, while Bank of America has nearly doubled. Each CEO has come out with a bullish statement, Citi to the effect of "We're raking it in" while B of A has defiantly exhorted "We don't need no more stinkin' money." These words helped set off a frantic rally, as market sentiment has, almost overnight, been flipped on its head. Could things have looked more bleak last week? I don't think so. But today's feeling was downright optimistic. Did we get a plethora of new data to cause this reassessment? Not that I saw. Have we seen credit spreads dramatically tighten in line with the equity markets bullish rampage of the past few days? Nope. So what gives? At least as it relates to the financials, the key message is this: TARP has turned big-time CEOs into traders with losing books swinging for the fences. Not exactly what Congress or the Treasury had in mind when they decided to bail out the biggest, most complicated financial institutions. With our money.

Clearly much of the price appreciation is due to a vicious short-covering rally that Messrs. Pandit and Lewis kicked off. But the fact is, what do they have to lose? If they can fool us long enough, credit spreads will come in and recovery will become a self-fulfilling prophecy. Otherwise, Congress (read: the US taxpayer) will bail them out once again. Citi, B of A and AIG have each had multiple bites of the bailout apple, so what's another bite among friends? They are inclined to do this because their reputations are already severly damaged; in essence, short of outright fraud, they can't get any worse. Therefore, they are motivated to throw caution to the wind, be super-positive and hope for the best. If new management with fresh reputations were on the scene, the would be much less inclined to release bullish statements without empirical data to back it up. This is a major flaw of TARP: letting incumbent managements stay around. It has created perverse motives that serve neither the troubled institutions nor its shareholders very well.

How are buyers of Citi going to feel if they enter at $2, think it's going to $5 because of Vik's words and then see it crater to $0.80 based on deteriorating fundamentals and the need for additional dilutive equity issuances? i'll tell you how - pissed off. Now you can say "caveat emptor," and you'd be right. But wouldn't you rather have new managements with motivations aligned with those of shareholders, instead of old managements motivated to rehabilitate their reputations? Rather than be so focused on capping pay, how about insisting that a new slate of managers take over as well as some new independent directors? I think this would yield far better outcomes for everyone involved. Congress and Treasury have taken their eye off the ball. Time for a little less populist BS and a little more common sense reform.

p.s. the title of the post, if that wasn't clear, refers to the point made also by the Motley Fool, among others, that its all well and good that the banks are generating some nice income right now from some juicy spreads, but the real issue is the value of the legacy assets on their books and whether or not they are solvent

Bond Bubble?

From RGE: Will U.S. Treasuries Be the Next Bubble to Burst?

In 2008, the Treasury market had its best annual rally in more than 25 years on fears of global credit crisis, recession, deflation. 10yr and 30yr Treasury yields fell to all-time lows and T-bill yields even dipped into negative territory for the first time since the Great Depression. The total return of the 30-year bond was c. 45%, its best year since 1982. Treasuries in general returned 14%, outperforming S&P 500 by 53 percentage points

In 2009, any signs of a less than dire economic outcome as deflation may burst the bubble in Treasuries. With the U.S. government expected to issue between $1.5 trillion to $2 trillion of debt into the $5 trillion Treasury market to finance its rescues of the financial system, the risk of a sudden drop in prices is growing. 10yr and 30yr Treasuries are still yielding between 2-3%, 2yr notes less than 1%, T-bills near zero. The TIPS market is anticipating less than 0.5% annual inflation for the next 10 years (ML)

Bubble Origins

This bubble is motivated by fear rather than greed. Investors are seeking to protect themselves against deflation and declining stock markets by blindly acquiring "risk-free" government bonds (FT)

Institutional investors also contributed to the bond bubble. Pension funds, insurers and others have sold off toxic securitized triple-A rated bonds and replaced them with Treasuries. Government bonds are attractive for diversification purposes since they have held up while just about everything else in their investment portfolios has collapsed (FT)

The Federal Reserve's signals that it might buy longer U.S. government maturities added momentum to the epic rally (FT)

How Bad Will the Crash Be?

The median forecast of 19 primary dealers is that 10yr bond yields will rise to 3% and 2yr yields will rise to 1.2% in 2009 (Bloomberg)

Because of the low income on Treasury securities, it would take only a small rise in yields for total returns on Treasuries to turn negative (Merrill)

Given the level of extension in yields, it would not be difficult to generate losses of say 10% in the 10-year Treasury bond, and as much as 20-25% in the 30-year Treasury bond over a very short period of time (Hussman)

The last time investors lost money on U.S. government bonds was the year after the 1998 bailout of LTCM and Russia's default sent investors rushing to Treasuries. Yields on 10-year notes rose to 6.44% in 1999 from 4.65%

Timing the Crash

If the dollar holds steady, Treasury bond prices are likely to plunge; if Treasury prices hold steady, the value of the dollar is likely to plunge. Either way, foreign holders of Treasury securities are facing probable losses, and they know it (Hussman)

The specter of deflation and Japan's experience in the 1990s suggest bond yields could fall significantly further – 10yr JGB yields went on to find a low of 0.45%despite massive fiscal stimulus. Ironically, it was the start of quantitative easing in March 2001 when yields ticked up (JPMorgan)