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March 13, 2009 Finally, Some Good News
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No doubt about it, the Canadian employment nosedive in February is bad news,
but it is bad news that is in lagged response to what has already been
happening around the world. It only proves that with one-third of our economy
in trade, we are no more immune to the global financial contagion than other
country. While we have gone from absolute denial last October to outright
calamitous prognostications, the real truth is that employment is a lagging
indicator, Canada is in a recession, things will get worse in the economy
before they get better, but progress is finally being made in setting the
financial crisis on a corrective course.
Far be it from me to be a Pollyanna, but the rally in stocks, especially
financials, in the past three days has some real fundamental underpinnings
coming from the initial source of the crisis—the U.S. These underpinnings
fall in two categories: economic and regulatory.
Encouraging Economic News
On the economic side, there is now evidence that the U.S. housing market,
while still weak and weakening in some regions, is bottoming in others. House
prices are falling sharply in Seattle and NYC, which have heretofore held up
reasonably well;, but in some areas of California and Florida, prices have
fallen so sharply and mortgage rates are down so much that existing home sales
increased in January and February. Housing affordability in the U.S. is at its
best level in decades. Housing starts have nosedived to such low levels that
they are far below even replacement rates. Meantime, household formation in the
U.S. is running at a meaningful pace as there are more than 96 million boomer
kids, at least 25 million of which are young adults. This compares to only 78
million boomers, most of whom are still in their late 40s and all are younger
than 63. House prices in regions of the sand states (California, Florida,
Arizona and Nevada) are below replacement value not including the land upon
which they sit. First-time buyers in the future will, will for the first time
in decades, be able to afford single-family homes and the number of those
first-time buyers is rising rapidly.
Existing homeowners are also about to get some help. Those with jobs are
slated to get assistance from the government to restructure the terms of their
mortgages to reduce monthly payments to a reasonable 31% of household income,
and the Fed is buying mortgage-related securities to drive mortgage rates down
further. The cost of capital for banks in the U.S. (not Canada) is so low
(thanks to government assistance) that even Citigroup and B of A are making
money this year (excluding potential further writedowns). The prospects for
great bank profits in the future remains bright, even in this deep and long
recession, as banks profit enormously from a steeply upward-sloping yield
curve.
The cost of capital for Canadian banks is relatively high as Canadian banks
are raising capital in the open markets (not from the government)—issuing
stock at extraordinarily low price-to-book ratios and paying roughly 10% on new
issues of specialized securities that qualify for innovative tier-1 capital.
While government funding of banks everywhere outside of Canada might put
Canadian banks at a competitive disadvantage, Canadian banking strength has
been has been recently well publicized. Relative to U.S. banks, Canadian bank
provisions for loan losses are lower and they are still growing their book.
Operating earnings at U.S. banks will be sharply reduced or eliminated by
writedowns (although this could be mitigated by adjustments in mark-to-market
accounting; more on that below).
While much has been made recently of rising delinquencies in credit card
loans and increases in nonperforming loans, these are normal manifestations of
economic recession in the cyclical banking business. Canada had not been in
recession for more than 16 years, so maybe we have forgotten what it is like.
Canadian banks have been through much worse, for example, the Mexican debt
losses, Dome Petroleum, the O&Y bankruptcy and very deep recessions in the
early 1980s and the early 1990s. Indeed, dividend yields, though certainly high
today, were higher in 1982 for the chartered banks, and not a single one cut
their dividend as earnings eventually. Today, tangible capital relative to
risk-weighted assets at the Canadian banks is much higher than at most banks in
the rest of the world.
Further, U.S. core retail sales (excluding automobiles) were
stronger-than-expected in February a follow up to the rise in January. Auto
sales have crashed in the U.S. and Canada, as households tighten their belts in
response to job losses, wealth destruction and outright fear. But, also
reducing sales is the lack of funding. The Big-Three no longer offer auto
leases in either Canada or the U.S. as their former financial arms are bust and
non-bank lenders are not making loans. Dealers report that more than half of
cars and light trucks sold in recent years have been leased. Banks in Canada
are not permitted to write auto leases and the monthly payments on auto loans
are generally much higher unless the loans are very long-term, roughly 72
months. Pent up demand for autos is rising. Another positive note is that car
sales rose in China and India in February.
Good Regulatory News
On the regulatory front, two pieces of good news have buoyed the markets.
One, it appears likely that the SEC will reinstate the uptick rule,
which requires that every short sale transaction be entered at a price
that is higher than the price of the previous trade. The uptick rule prevents
short sellers from adding to the downward momentum when the price of an asset
is already experiencing sharp declines. The rule was instated in 1934 (for
obvious reasons) and was eliminated on July 6, 2007, one month before the
credit crisis dramatically took hold of markets. Many believe that the removal
of this rule allowed short sellers to pile on, driving banking and other stocks
down mercilessly. On March 10, the SEC and Representative Barney Frank,
Chairman of the Financial Services Committee announced plans to restore the
uptick rule. The SEC stated it plans to hold a hearing as early as April. Frank
said he was hopeful that it would be restored within a month.
Two, and even more important, Chairman Bernanke and the Congress this week
called for Financial Accounting Standards Board (FASB) adjustment or
‘forbearance’ on the mark-to-market rule. U.S. accounting
rulemakers and regulators said they were pushing ahead with new guidance on
mark-to-market accounting that has forced banks to write down billions of
dollars in assets in the financial crisis. Aimed at giving an accurate view of
financial companies’ books, the rules have led to huge writedowns of
mortgage-related securities and other instruments at a time when markets are
thin or nonexistent for some assets. FASB Board member Lawrence Smith said on
Wednesday that the accounting-standards setter would include guidance on
whether a market is active or inactive and whether a transaction is distressed.
SEC Chair Mary Schapiro told Congress she was keeping the pressure on FASB to
act quickly. There will not be an all-out suspension of the rule.
Mark-to-market accounting rules were intended to bring transparency and order
to the bookkeeping at banks and other large businesses. In theory, the rules
are prudent. In practice, they have contributed to the meltdown in financial
markets.
Under mark-to-market rules, a bank must readjust the value of the assets it
is holding to reflect current market prices. For some kinds of
assets—especially mortgage-backed securities and other real-estate
products—those market prices have declined well past the point at which
the banks would agree to sell them. These assets generate income, and that
income makes them worth more to the banks than buyers on the market would
currently be willing to pay. Under the current rules, that doesn’t
matter, and the assets’ value has to be adjusted to account for what the
rules describe as a “hypothetical transaction at the measurement
date.”
Real market prices come from the interaction of a willing buyer and a
willing seller, but the current mark-to-market rules deform that arrangement
into “willing buyer, unwilling seller.” It doesn’t help that
for many mortgage-backed investments, there isn’t much of a market to
generate prices: Some of these securities simply are not widely traded and are
not intended to be; in other cases, the markets have been attenuated to the
extent that there are no willing buyers. Both of these conditions make the
calculation of “market prices” an exercise in fuzziness, which is
why the U.S. Treasury has had so much trouble arranging a system whereby the
toxic assets could be taken off of the books of the banks. The question
becomes, at what price are these assets bought?
Banks have had to treat losses on paper as though they were real economic
losses, accepting fire-sale valuations of securities that they may not intend
to sell. (The Bank of Canada has allowed Canadian banks some forbearance on
this score.) Because mark-to-market rules are used in assessing banks’
capital requirements, those paper losses can quickly become real losses when
banks are forced to sell assets, often at an enormous loss, to raise enough
capital to keep the regulators satisfied. Those pressured sales, in addition to
locking in losses, tend to drive down the prices of similar assets, creating a
vicious cycle of wealth destruction.
It is far from clear that mark-to-market rules are giving investors and
regulators the intended benefit. And while reforming mark-to-market will by no
means provide a magic bullet to end the financial crisis, it is clear that the
practice is having a harmful effect on many banks and institutional holders of
mortgage-backed assets like pension funds. This is amplifying what would
otherwise be more manageable problems and exacerbating the volatility in the
markets. Officials at FASB and the SEC promised Congress yesterday that an
‘improvement’ in mark-to-market rules can be put in place within
three weeks (“Frank:
Up-tick rule to be introduced in a month”. www.marketwatch.com, March
10, 2009).
Bottom Line: This is a major breakthrough in the financial crisis.
Oversold financials have rightly corrected a bit and if these developments pan
out and the economy continues to show positive signs, the enormous volume of
cash on the sidelines will lead to an explosive and sustainable rally in
undervalued stocks. Should this happen, the negative feedback loop would
reverse; asset values and economic activity would feed on each other moving up
instead of down.
One more positive thing: Fed Chairman Ben Bernanke will be on 60 Minutes
this Sunday night, CBS 7 PM EDT. He has the ability to move markets and he
has become quite polished in speaking to the issues surrounding the credit
crisis. Bernanke will assure the public that the economy and financial markets
are in good hands and that the crisis is under control. He will encourage
confidence in banks and suggest that the credit freeze is thawing and the
economy will strengthen. Fear has hampered the economy for 18 months. Anything
he can do to dampen fear and encourage confidence will be extremely helpful.
I’ll bet he will have a significant impact.
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June 19, 2010
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Unbelievable Complexity
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Quarterly Web Cast and Dividend Stock Screen
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Stock Market Applauds U.S. Government Plan
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The New Cold War
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Hedge Funds Face Shock Waves
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Fed Policy Tighter than Normal at 2% Fed Funds
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Obama Just Found His Middle-America Appeal
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A Global Presidential Campaign
What better evidence is there that globalization is real and permanent than the foreign trips of both presidential candidates? MOREJuly 15, 2008
Crisis Widens
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Next Shock: Currency Crisis?
The malaise of the U.S. economy is palpable MORE
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