Tuesday, September 30, 2008

"The Recession Train Has Already Left The Station"



Professor Nouriel Roubini spoke to Bloomberg this morning. He provides his take on the failed bailout bill as well as discussing the current state of the economic crisis and alternative measures that may help to begin to heal the banking system and the wider economy (click on video above and listen carefully).

I know stocks surged today as investors grew optimistic that some sort of a rescue plan will come through by week's end:

The Dow Jones Index put on 485 points or 4.7 per cent to end at 10,851.

The tech-heavy Nasdaq gained almost 5 per cent.

The Standard and Poor's 500 rose slightly more.

Investors were optimistic that the bailout plan would eventually be passed as US President, George W Bush, again appealed for legislators to give it the go ahead.

Meanwhile, the White House has strongly urged the media not to describe the rescue effort as a bailout.

White House spokesman, Tony Fratto, says that is a loaded term used by critics to defeat the plan.

Don't you just love this political spin doctors? Had they done this plan properly from the get-go and explained it to the public thoroughly, we probably would have had some package on the table by now.

But in this world of non-transparency, which permeates Wall Street, Washington and yes, public pension funds, nobody is willing to own up their mistakes and admit they screwed up.

Anyways, I am not going to get into why stocks surged today, but I will refer you to Tim Knight's blog, Slope of Hope. Tim does an outstanding job of explaining the technical signals of the market. This is a technical rally, not the start of another bull market (the trend remains down).

Regardless of the surge in stocks, the story remains the turbulence in credit markets:

The London interbank offered rate, a key measure of banks' willingness to lend, has surged in recent days and Tuesday was no different. Overnight Libor spiked to 6.88, from 2.56%, while three-month Libor was up to 4.05%, from 3.89%. The closely-watched Ted spread -- the difference between Libor and the yield on a three-month U.S. Treasury bill -- actually narrowed somewhat Tuesday as the three-month T-bill yield rose to 0.92%, from 0.51%. Short-term Treasury yields had been dropping of late as traders sought a safe place to park their money, regardless of the return, particularly during Monday's plunge. (See "Banks Are Squeezed, Credit Is Crushed.") The wider the Ted spread, the more fear in the credit markets.

In addition to interbank lending, problems are also lurking in other corners of the credit markets like derivatives and commercial paper. Many companies use commercial paper, basically short-term IOUs, to fund daily operations like payroll.

On Wednesday, the Federal Reserve shares its latest data on the commercial paper market, with another decline expected after the Sept. 24 report showed the market shrank by $113.0 billion over the previous two weeks.

Another decrease would indicate companies have struggled to find buyers and roll over existing commercial paper, and that they may need to turn to tap more expensive bank credit lines or issue bonds to raise cash.

This is the credit crunch in action. If companies start tapping more expensive credit lines or issuing bonds to raise cash, their cost of financing goes up and they will have to shed costs elsewhere.

The bond market sold off today. Treasuries plummeted as speculation lawmakers will salvage financial-rescue legislation eased concern that capital markets will deteriorate further:

Traders pushed up 10-year note yields by the most in more than a week, erasing the bulk of yesterday's rally, as an advance in stocks damped demand for government debt. A gauge of expectations for Treasury volatility surged to the highest in at least 20 years. Senate leaders vowed to act this week on the $700 billion rescue package, which the House rejected yesterday.

"It's just this manic reversal from yesterday,'' said William Hornbarger, a fixed-income strategist at Wachovia Securities in St. Louis. "Yesterday it felt like the world was ending; today it feels a bit better.''

I am willing to bet that this erratic volatility will persist for the next six to twelve months, but the big trend in stocks will remain down, not up.

One final important note on mark-to-market. A senior banker brought to my attention that the SEC announced today that they will give banks more leeway on the mark-to-market rule:

In the new guidance, first reported by Reuters, the U.S. Securities and Exchange Commission reminded financial services firms that they don't need to use fire sale prices when evaluating their hard to price assets.

"This is a significant first step and adds stability, confidence, and liquidity within the capital markets," said Steve Bartlett, president and chief executive of The Financial Services Roundtable. "By clarifying how to treat assets in an uncertain market, the SEC is continuing to provide transparency to investors and helping institutions to provide credit in periods of market stress."

U.S. accounting rule maker, the Financial Accounting Standards Board said on its Web site on Tuesday that it would change the agenda for its Wednesday meeting to focus on fair value accounting. The board is contemplating issuing additional guidance through a FASB staff position as soon as Wednesday, according to a person familiar with the matter.

...

The SEC's guidance says that sometimes the level 3 inputs may be more appropriate than the so-called level 2, or observable factors.

"In essence, the SEC wants to stop the avalanche of declining prices," said Tom Sowanick, chief investment officer at Clearbrook Financial. Sowanick said that the new guidance should allow banks to rely more on their own assumptions when they determine fair value rather than the distressed sale prices occurring in the markets.

But fair value accounting has been popular with many investors who said it greatly increased transparency about the risks banks are facing.

"This letter (SEC document) could be titled, pick a number, any number, as it gives bankers great leeway in choosing what numbers they will give to investors," said Lynn Turner, who served as chief accountant at the SEC from 1998 through 2001.

Others, however, said that the changes have not gone far enough.

"Fair value accounting is a utopian dream that ran into the reality of business and litigation," said Chris Whalen, co-founder of Institutional Risk Analytics, which provides ratings and analytical tools to investors.

"Equating an opinion with a market price is crazy," he continued. "It doesn't matter who gives the opinion -- the auditor is still going to say to the client, 'Why don't you write it down?'"

Under U.S. accounting rules, a "Level 1" asset can be marked-to-market based on a simple price quote in an active market. However, the price of a "Level 2" asset is "mark-to-model" and is estimated based on observable market prices and inputs. A "Level 3" asset is so illiquid that its value is based entirely on management's best estimate derived from complex mathematical models. The SEC release indicated that the agency does not believe distressed, or forced liquidation sales are orderly transactions.

Will this help shore up the banks' balance sheets during this critical time? Yes, loosening the mark-to-market rule will help, but it will not stop the deleveraging process, only slow it down a little.

Roubini is right, the recession train has already left the station.

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