Saturday, April 11, 2009

Recklessness Fought With More Recklessness

from John Hussman, Phd.-

Last week saw a continuation of the impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place. The U.S. Treasury's toxic assets plan, for instance, looks to "leverage" public funds (with the FDIC providing the "6-to-1 leverage") in order to defend the bondholders of mismanaged financials who took excessive leverage. At the same time, the Treasury plans to limit the "competitive bidding" to a few hand-picked "managers" who will be encouraged to overpay thanks to put options granted at public expense. This is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC's balance sheet, which exists to protect ordinary depositors, not bank bondholders.

On Thursday, the stock market cheered a move by the Financial Accounting Standards Board (FASB) to relax FAS-157 (the "mark-to-market" accounting rule), allowing nearly insolvent financial companies to use more discretion in the models they use to assess fair value. Of course, the irresponsibly rosy assumptions built into these models have been a large contributor to this near-insolvency, because they virtually ignored foreclosure risks.

Notably, the one thing policy-makers have not done is to address foreclosure abatement in any serious way. The only way to get through this crisis without enormous collateral damage to ordinary Americans is by restructuring mortgage obligations (ideally using property appreciation rights), restructuring the debt obligations of distressed financial companies (ideally by requiring bondholders to swap a portion of their debt for equity), and abandoning the idea of using public funds to purchase un-restructurable mortgage debt ("toxic assets").

Look. You can play hot potato with the toxic assets all day long, and only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders. You can tinker with the accounting rules all you want, and it won't make the banks solvent. It may improve "reported" earnings for a spell, but as investors who care about the stream of future cash flows that will actually be delivered to us over time, it is clear that modifying the accounting rules doesn't create value. It simply increases the likelihood that financial institutions will quietly go insolvent. I recognize that the accounting changes may reduce the immediate need for regulatory action, since banks will be able to pad their Tier 1 capital with false hope. But we have done nothing to abate foreclosures, and we are just about to begin a huge reset cycle for Alt-A's and option-ARMs. As the underlying mortgages go into foreclosure, it will ultimately become impossible to argue that the toxic assets would be worth much even in an "orderly transaction."

Meanwhile, in a bizarre convolution of reality reminiscent of Alice in Wonderland, the Financial Times reported last week: "US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury's $1,000bn plan to revive the financial system." And why not? They can put up a few percent of their own money, and swap each other's toxic assets financed by a bewildered public suddenly bearing more than 90% of the downside risk. The "investors" in this happy "public-private partnership" keep half the upside while ordinary Americans take the downside off of their hands. Some partnership.

John Mauldin Economic Musings

Frightening excerpts from John Mauldin's newsletter:

Earnings Estimates
Earnings may drop 31% in the second quarter and 18% in the next before gaining 74 % in the last three months of the year, analysts predict. Banks are projected to account for all of the rebound in the final quarter. Without financial companies, the gain turns into a 5% decline, the data show.
The above estimates are based on operating earnings, not as reported earnings. Long time readers know that operating earnings are actually earnings before interest and Bad Stuff. As reported earnings are what companies actually report on their tax reports, as a gauge of profitability they are much more reliable. Before the mid-90s the difference between operating and as reported earnings was typically quite small. Then companies found that they could play the market if they played games with their operating earnings.
Operating earnings are earnings which typically do not take into account one time, non-recurring events. The number of items which get classified as “non-recurring” has mushroomed to the point where projected operating earnings for 2009 are more than double the estimates of as reported earnings. Operating earnings for 2008 was almost three times actual or as reported earnings.

Housing Mess -- Will Deepen in 2010-2011
They contend that much of the bad news in the subprime and housing market has been written off. And one would have to admit that a lot has been, and with the relaxation of mark-to-market, there may indeed be some truth to that suggestion. But there are still some issues that remain in the future for housing problems. Take a look at the graph below. (Not sure where it is from as it was sent to me, but I have seen the same data elsewhere.) Notice that monthly mortgage rate resets declined markedly in 2009 from 2008, only to rise once again in 2010 and 2011.

Shadow Inventory of Foreclosed Homes
We are seeing what some call a “shadow inventory” of foreclosed homes. “We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market,” said Rick Sharga, vice president of RealtyTrac, which compiles nationwide statistics on foreclosures.
Realty Trac in a survey found that only 30% of foreclosures were listed for sale... Add in homes that people would like to sell but simply can’t find buyers and must either hold or rent, and the unsold inventory numbers that are public are likely far below actual available homes.
Might some homes in foreclosure be held off the market as banks eventually want to negotiate with the homeowner? Possibly, but other surveys show that anywhere from 30-40% of homes in the foreclosure process in many areas are actually already vacant. There is no one with whom to negotiate.
Typically a foreclosed home sells within a few weeks as banks take the first “reasonable” offer. Again, it normally takes about three months from foreclosure to where the home is sold. It takes a few months to get a home ready. But surveys show it is taking a lot longer, and many homes have not made it onto the market, even as more homes are being foreclosed each month. There are just so many homes it is hard to get them onto the market and sold. Normally there are about 160,000 homes are year in foreclosures sales. We are now seeing 80,000 a month, or six times normal levels and rising.
Second, lenders could be deferring sales to put off having to acknowledge the actual extent of their loss. "With banks in the stress they're in, I don't think they're anxious to show losses in assets on their balance sheets," one observer said.
Finally, banks may not want to flood the market with foreclosures, driving prices down even more. They are simply managing their assets so as to recover the most capital they can.
Given that the graph above says that there will be more mortgage misery as so many mortgages reset in the next two years, and given the unknowable nature of the losses, it is somewhat optimistic to think financial profits will rise by 74% in the fourth quarter. But it gets worse.

Commercial Real Estate
We are now starting to see some real deterioration in traditional bank lending. Delinquencies on home equity loans are rising rapidly. The American Banking Association released a composite index of eight different types of consumer loans and the delinquency rate on this 35 year old composite jumped to a record high of 3.22%.
The above data reflects 4th quarter data. As unemployment is up 2% since then and is rising, it is more than reasonable to assume that we will see another record rise in delinquencies this quarter. With unemployment headed to over 10% and maybe 11% from today’s 8.5%, delinquencies are likely to continue to rise for the entire year.
Commercial mortgages are in trouble. S&P has warned they may cut ratings on $97 billion in commercial mortgage asset backed debt. The country’s 10 biggest banks have $327.6 billion in commercial mortgages, according to regulatory filings. A projected tripling in the default rate would result in losses of about 7% of total unpaid balances,according to estimates from analysts at research firm Reis Inc. (Bloomberg)

P/E Ratios Go Negative
The P/E ratio for the end of the second quarter is 1944 (not a typo). The losses of the 4th quarter almost wipe out all earnings for the 12 months ending June 30. But by the end of the 3rd quarter, the P/E ratio has dropped to a negative -467.That has never happened. We have never seen negative earnings over a 12 month period since WW2. (I don’t have data for the Depression era.)

“…Much of the excitement in the stock market – at least that is related to the current performance of the economy - seems to be centered on an economy that is performing less badly than expected. The risks here seem to be that if the trends in data surprises change, so could investor's attitudes toward stocks that are currently overbought on a number of measures.
“…If the high correlation between stock prices and data surprises holds, the recent rally in stocks might be tested. Even if the economy has bottomed, it's very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven. During these periods, the risks to stocks will be greatest when the market is overbought and investors have priced in high expectations of positive data surprises continuing.”
The projections of many market analysts assume that we will have something that will look like a normal recovery. I have objected that that could be a very bad assumption, as we are not having a normal recession. This is already a very lengthy recession, and is just going to get longer. As I will note below, there are reasons to think we could see a mild recovery late this year only to dip back into recession next year.
Even ignoring the disastrous 4th quarter of 2008, what if earnings drop by 80% or more, which is quite possible? That means they have to rise by 400% to get back to new highs. That could take some time. Even if they could rise at an unlikely 24% a year, it would take six years to see new highs. Look at what a mountain corporate earnings must climb.
Further, the Democratic Congress and the Obama administration are going to enact the largest tax increase in history in 2010, just as the economy is barely recovering, as the Bush tax cuts go away because the Republicans could not make them permanent when they had the chance. We are going to pay for that with a likely dip back into a recession in 2010, or at the very least a prolonged weak economy.

Social Security -- About to Implode
And then there is the last piece of data I want to bring to your attention, which is the most troubling of all. Everyone knows that the government spends the Social Security surpluses on current spending, “borrowing” the money and putting it into a “Social Security Trust Fund” which is basically just US debt we owe to the trust fund. In other words, there is no trust fund with anything other than paper debt. It is accounting legerdemain.
Everyone assumed that the real problem was some time later next decade when there would no longer be surpluses. In 2008, the Congressional Budget Office (CBO) projected that there would be $703 billion in surpluses from 2009-18. Recently, the CBO has revised those estimates downward. It now projects surpluses to be on $83 billion.

Trillion Dollar Deficits
But there is a limit to continued $2 trillion deficits without an appreciable rise in interest rates that will be needed to attract buyers of treasury bonds, which of course increases interest rate payments on the national debt, while also crowding out corporate and personal borrowing. This is not going to end well, and the end game is getting a lot closer.
All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.
The original question was “Is that recovery we see?” I think the answer is no.

All Short-Term Traders Need to Know This

from Dr. Brett-
The one thing short-term traders should know is that size matters. It is of vital importance at all times to know whether the traders in size are leaning to the buy or sell side. Because volatility is intimately connected to volume, the presence or absence of large traders will determine the amount of movement in the market. The degree to which large traders are hitting bids or lifting offers will determine the market's tendency to sustain directional moves (i.e., trend).

(IMO, understanding--really understanding--those last two sentences will keep many traders out of bad trades and bad markets).

Let's take the opening period of Friday's trade as an example. I'm looking at the time period just before the NYSE open to the end of the first half hour of trade (9:25 AM - 10:00 AM ET) in the S&P 500 e-mini (ES) market. During that period, we had 13,954 trades that included 212,684 contracts.

Of these trades, 5148--almost 40%--were one-lots. Those one-lots accounted for about 2-1/2% of all market volume during the opening period.

Conversely, 431 trades--only about 3% of the total--were trades of 100 contracts or more. This group of large traders, however, accounted for 82,127 contracts traded, or nearly 40% of the total.

So there you have it. Give or take a bit, the smallest 40% of trades account for 3% of the volume, and the 3% of largest trades control 40% of the volume.

A number of excellent short-term trading guides can arise from these observations. For instance, we can compare the number of large trades occuring during a time period and compare it to the average number of large trades that occur during that time period, and we'll have a rough idea of the degree to which large players are dominant and volatility can be expected.

We can also parcel out the large trades that occur at the bid price (meaning a large seller is anxious to exit the market) vs. the large trades that occur at the offer (a large buyer is eager to get into the market) as a way of tracking the moment-to-moment sentiment of large traders.

Trade by trade analyses of market action that capture the sequencing of large trades at market tops and bottoms are also quite revealing, as they display how one-sided markets (those dominated by buyers or sellers) become two-sided when other timeframe participants perceive that the market has moved too far from value. That period on Friday from just before the open to the end of the first half-hour of trade neatly caught such a sequence.

There's value in looking at charts of markets that cover many days. That's viewing the market through a telescope. The short-term trader, however, can also benefit from observing the teeming life under the microscope. What moves the market in the short run is not what fundamentally moves the market over the long haul. Taking advantage of the data appropriate for your timeframe is all-important.

Tonight, I'll post a chart to the Trading Psychology Weblog that illustrates some of these ideas.

Recharing the Emotional Batteries

from Dr. Brett -
I'm writing this from the oceanfront (literally) in Virgina Beach; it's early enough that there aren't too many people around. Just the wind and the waves: ocean as far and wide as I can see.

Something about sitting by the ocean on an empty beach is quieting. There are few distractions; eventually, it's as if you adopt the rhythm of the waves and are just left at peace with yourself. It's at those times that I often have my best and biggest thoughts: fresh inspirations and insights.

Following my sophomore year at Duke, I sat on a Florida beach early in the morning reading a book called The Fountainhead by Ayn Rand. Looking over the water, I was suddenly seized with the recognition that this was what I was meant to do with my life: use psychology to help people find their greatness--not to fight mental illness.

That was almost a quarter century ago. The memory of that morning on the beach--and the mission I felt at that occasion--is as strong today as it was when I returned to school and reorganized my life.

We could not survive without life's routines. Routine helps us perform repetitive tasks automatically, so that we can direct our attention elsewhere. As Colin Wilson emphasized, however, we become so caught in routine that there is no "elsewhere". Life becomes a series of routines, our work and relationships become stale, and suddenly we find ourselves growing old before our time.

Not everyone will find their break from routines in travel and the ocean. Some find it in spiritual pursuits; others in the adventure of hiking or sports. Sitting with the ocean reminds me of the need to escape the mundane and recharge mind and body. At those moments, our most productive times--those that can shape a lifetime--can be our moments away from work.

How ETF's Can Provide Valuable Information

from Dr. Brett-
A very nice set of ETF resources can be found on the Morningstar site, which tracks the returns of ETFs over 1 month, 3 month, 1 year, 3 year, and year-to-date time frames and ranks the ETFs by trading volume. A particularly unique feature identifies ETFs relative to their "fair value", so that investors can identify undervalued opportunities. A screener also helps traders identify ETFs by their investment style, returns, and expense ratios.

When we look at ETF performance and volume, we can gain some insight into hot market themes. Not surprisingly, ETF daily volume is dominated by the SPY and QQQQ instruments for the S&P 500 Index and NASDAQ 100 Index, respectively. After that, it gets interesting. The third most popular ETF as of Thursday's trade was the S&P 500 Index financial stock sector ETF, XLF. It is down over 11% over the past month, compared to SPY, which is only down 2.58% over that same period. The high volume decline suggests widespread pessimism about this sector, despite Fed (and sovereign wealth fund) attempts at relief.

Fourth and sixth in volume are the UltraShort vehicles for the QQQQ (QID) and SPY (SDS). These enable traders to take double-size short positions on the indexes, and thus are instruments favored by very bearish participants. Since the start of 2007, 20-day volume in QID, for example, has expanded over 10 times. Once again this speaks to the pessimism of market participants--and their desire for leverage, a theme I'll be touching upon in my next post.

Significantly, we have ETFs representing market indexes from Japan (EWJ), Emerging Markets (EEM), Brazil (EWZ), EAFE (EFA), and Taiwan (EWT), and Hong Kong (EWH) in the top 20 volume list--a strong indication of the degree to which investors and traders are taking a global perspective on markets and diversifying beyond the U.S. It is interesting to see the Brazil ETF at #9 in volume, given that it is up over 9% in the past month--a clear outperformer relative to U.S., Asian, and European bourses.

Finally, also within the top 20 ETFs for volume are instruments for S&P 500 energy stocks (XLE), S&P 500 materials stocks (XLB), and gold (GLD). This is a clear reflection of the flow of money into commodities and commodity-related issues. All three are up on a one-month basis, a notable contrast to the broad indexes, which are all lower over that period.

The above, of course, is a static view of volume and performance. It is the flow of funds in and out of ETFs that help us identify sectors and themes gaining favor. By tracking these statistics over time, we can follow in the footsteps of institutional investors and ride important market trends.


Tracking the Stock Market's Largest Traders

Friday, April 10, 2009

Deficit Quadruples -- In One Year!

from AP:

The Treasury Department said Friday that the budget deficit increased by $192.3 billion in March, and is near $1 trillion just halfway through the budget year, as costs of the financial bailout and recession mount.

Last month's deficit, a record for March, was significantly higher than the $150 billion that economists expected.

The deficit already totals $956.8 billion for the first six months of the budget year, also a record for that period. The Obama administration projects the deficit for the entire year will hit $1.75 trillion.

A deficit at that level would nearly quadruple the previous annual record of $454.8 billion set last year. The March deficit was nearly four times the size of the imbalance in the same month last year.

Thursday, April 9, 2009

Moody's Issues Warning On ALL Local Muni Bonds -- for First Time EVER!

Moody's today issued a negative watch for the first time every -- on ALL muni bonds for local governments. Unbelievable! Why didn't this make the news?

China Sells More Cars Than the U.S. 3 Months Running

from AP:
Preliminary figures show auto sales in China reached about 1.03 million in March, exceeding U.S. sales for the third month in a row, state media reports said Wednesday.

Wednesday, April 8, 2009

Delayed: Bank Stress Test Could Stress Financial System

from Reuters:
The U.S. Treasury Department is planning to delay the release of any completed bank stress test results until after the first-quarter earnings season to avoid complicating stock market reaction, a source familiar with Treasury's discussions said on Tuesday.

The Treasury is still talking about how results of the regulatory stress tests on the 19 largest U.S. banks will be released, and may disclose them as summary results that are not institution-specific, the source said.

The government is testing how the largest banks would fare under more adverse economic conditions than are expected in an attempt to assess the firms' capital needs. The tests are due to be completed by the end of April, but Treasury has said they may be finished before then.

The source, speaking anonymously because the Treasury has not made a final decision on what to disclose, said officials do not want any test results released before the earnings season wraps up for most U.S. banks on April 24.

Treasury did not immediately respond to a request for comment.

TARP Panel Says Crisis Far From Over

from ABC News:

Though some economic measures are improving, the financial crisis "is far from over" and "appears to be taking root in the larger economy."

This, despite the government's commitment to spend trillions of taxpayer dollars on a massive bailout of the financial system.

These were the findings released in a report today by the Congressional Oversight Panel, the body charged with overseeing the government's Troubled Asset Relief Program, the $700 billion plan aimed at bailing out the country's financial sector.

"We still have a long way to go. A very long way," Elizabeth Warren, the Harvard Law School professor who chairs the panel, said in an interview today with Bloomberg News.

The panel reported that the government has spent, lent or set aside more than $4 trillion through the Troubled Asset Relief Program, the Federal Reserve and the Federal Deposit Insurance Corporation.

Today, the "credit markets no longer face an acute systemic crisis in confidence that threatens the functioning of the economy," the report said.

But, it said, the economy now faces an "apparently prolonged period of weakness" with regard to financial firms and lending.

It noted, for instance, that Citigroup and Bank of America received multiple injections of capital from the government while borrowing costs remain high for businesses and individuals. The panel also cited increasing numbers of home foreclosures and lower home prices as reasons for concern.

The panel criticized the Treasury Department for failing to identify what measurements it will use to determine whether its rescue programs are working.

"If you don't articulate what the metrics are going out ... you can't know if anything succeeded or failed," Warren said.

Not Enough Spending Transparency?

Warren also criticized the Treasury for its lack of openness on its rescue efforts as it first began the TARP program last year.

"As Treasury started this program," she said, "they really had the notion that they would spend the money the way they wanted, and not only were they not going to tell the public, I don't think they were going to tell the Congressional Oversight Panel."

The Treasury Department recently unveiled a Web site dedicated to detailing the government's financial stability efforts. On the site, the department promises that the government's financial stability plan "will institute a new era of accountability, transparency and conditions on the financial institutions receiving funds."

Tuesday, April 7, 2009

Russian, Chinese Spies Penetrate U.S. Electrical Grid, Exploit Vulnerabilities

from the Wall Street Journal:
Cyberspies have penetrated the U.S. electrical grid and left behind software programs that could be used to disrupt the system, according to current and former national-security officials.

The spies came from China, Russia and other countries, these officials said, and were believed to be on a mission to navigate the U.S. electrical system and its controls. The intruders haven't sought to damage the power grid or other key infrastructure, but officials warned they could try during a crisis or war.

"The Chinese have attempted to map our infrastructure, such as the electrical grid," said a senior intelligence official. "So have the Russians."

The espionage appeared pervasive across the U.S. and doesn't target a particular company or region, said a former Department of Homeland Security official. "There are intrusions, and they are growing," the former official said, referring to electrical systems. "There were a lot last year."

Many of the intrusions were detected not by the companies in charge of the infrastructure but by U.S. intelligence agencies, officials said. Intelligence officials worry about cyber attackers taking control of electrical facilities, a nuclear power plant or financial networks via the Internet.

Authorities investigating the intrusions have found software tools left behind that could be used to destroy infrastructure components, the senior intelligence official said. He added, "If we go to war with them, they will try to turn them on."

Officials said water, sewage and other infrastructure systems also were at risk.

"Over the past several years, we have seen cyberattacks against critical infrastructures abroad, and many of our own infrastructures are as vulnerable as their foreign counterparts, " Director of National Intelligence Dennis Blair recently told lawmakers. "A number of nations, including Russia and China, can disrupt elements of the U.S. information infrastructure."

Fed's TALF Meets Tepid Interest, May Not Work!

from Marketwatch:
A new Federal Reserve program to encourage more consumer lending hit a speed bump Tuesday, with investor demand for cheap Fed financing to buy bonds backed by credit-card and auto-loan payments sinking more than 60% from the program's initial round last month.

Investors applied for $1.7 billion in loans to purchase asset-backed securities under the second installment of the Term Asset-Backed Securities Loan Facility, or TALF, the Federal Reserve Bank of New York said in an update to its Web site late Tuesday.
That's down from $4.7 billion in requests during the program's first round last month. It also falls short of the $3.3 billion in TALF-eligible bonds companies brought to market Tuesday.
The gap between the amount of bonds sold and requests for Fed financing for these bonds suggests some investors chose not to use the Fed's attractive loan rates to purchase asset-backed securities.
That reluctance may stem from fears the federal government would impose restrictions on institutions that use bailout programs -- concerns bond underwriters and investors were hashing out in legal documents, analysts said.

Natural Gas Dips to Nearly $3.50 mmBtu

Natural gas today dipped ever lower to reach about $3.55/mmBtu.

Techniques for Overcoming Performance Anxiety in Trading

from Dr. Brett-

A little while back I made the observation that performance anxiety is the most common psychological problem that I encounter among traders. It occurs in many forms--during slumps, at times when traders attempt to raise their size/risk, when life's financial needs add pressure to trading outcomes--but the common element is that a concern with the results of trading interferes with the process of trading itself.

I thought that both the comments of readers and their emailed suggestions offered very useful ideas regarding the handling of performance pressures in trading. In this post, I'll add two suggestions of my own.

* Self-hypnosis - This builds on the ideas from my first trading book, The Psychology of Trading. When a trader is responding to a trading situation with anxiety, I ask the trader to close his eyes, breathe deeply and slowly, fix his attention on a musical selection, and hold his hands in front of him with palms facing each other a couple feet apart. The music, taken from Philip Glass' early works, has a highly repetitive structure and serves as an object of focus. After an extended period of the slow, rhythmical breathing and focus on the music, I then suggest to the trader to imagine that there is a magnet between his hands, pulling them slowly and steadily together. As his hands are drawn closer and closer, I suggest, he will find himself feeling more and more relaxed, calm, and confident. The exercise is brought to a close when the palms finally touch. Altogether the exercise lasts at least 15 minutes.

The exercise becomes a self-hypnosis routine when traders give themselves suggestions during the time that the hands are moving together. For example, they might suggest to themselves (internally or even via a self-made audio tape) that, as their hands move together, they will feel increasingly accepting of a recent loss and able to put it behind them. The key is to enter a highly focused and relaxed state prior to the self-suggestions and to perform the exercise thoroughly and regularly on a daily basis. Over time, traders find it easier to enter the focused state of relaxation and invoke their own suggestions. Eventually it's possible to get back to that state (and activate the suggestions) by merely taking a couple of deep breaths and bringing one's hands together. This makes the technique very practical for real-time trading situations, when all you have time for is perhaps a few deep breaths and a simple gesture. Repetition is essential to such mastery.

* Reprogramming Anxiety Through Biofeedback - Regular readers know that I consider biofeedback to be a best practice in trading, with broad application to a variety of emotional situations that affect performance. Of late, I've been making use of heart rate variability feedback through the Freeze-Framer program, which offers a nice graphical interface to help users track their progress and visually determine whether or not they're in "the zone". In the first step of biofeedback training, I simply teach traders how to enter the zone, as above, by regulating their breathing and sustaining a tight cognitive focus. This, by itself, is a very useful skill that can serve as a preventive measure regarding performance stress.

Once the trader becomes adept at this, I then add a second component to the exercise: The trader must vividly visualize a mildly anxiety-producing trading situation while hooked up to the biofeedback and maintaining the calm focus. Once the trader can repeatedly visualize this low-anxiety situation and sustain "the zone" on the biofeedback readout, we then move to a second, higher-level anxiety scenario. Often it's helpful to vividly imagine variations of the same scenario in separate biofeedback sessions. Eventually we move to the most anxiety-producing situations, repeating them over and over in variations, until the trader can sustain the calm focus even in the worst case scenarios. The added benefit of this method is that it teaches traders what they need to do to get their minds and bodies under control. This awareness can then filter down to real time, when all the trader needs to do is focus attention and regulate breathing during stressful market periods. A variation of the biofeedback work that is quite effective involves practicing constructive self-talk while staying in the zone.

Notice that both of these methods involve shifting one's state--physically, cognitively, and emotionally--as a way of dealing with performance pressure. By enhancing our control over our states, we can place ourselves in modes of thinking and feeling that are incompatible with performance anxiety. My experience is that traders can learn this competency on their own or with only a minimum of coaching intervention. With steady practice, one develops a degree of self-mastery that carries over to other areas of life. I believe I'm much more able to deal with life's various stresses as a result of what I've learned from managing my trades--and my reactions to those trades!

Drama Creates Trauma: Risk Management

from Dr. Brett-

I recently received an email from a trader who was going through difficult emotional swings as a result of swings in his portfolio. He assured me that he was a knowledgeable, experienced trader and that he limited his risk to 5% per trade.

I didn't need to read any further to know the problem.

So let's return to Henry Carstens' P&L Forecaster to see what's gone wrong.

In the top chart above, we're looking at forecasted returns for a $100,000 portfolio in which the standard deviation of returns per trade is 1% or $1000 and the trader has entered a period of flat performance (average zero return per trade). That might represent the scenario in which a trader risks 1% of portfolio per trade with moderate discipline. Over the course of 100 trades, that trader shows an equity peak of about $9000 (up 9%) and trough about -$3000 (down 3%), for a peak-to-trough drawdown of 12%.

In the world of professional money management, such a swing would merit the attention of risk managers. I don't know too many portfolio managers who would feel good about going from up 9% on the year to down 3% within the span of 100 trades. It wouldn't be a catastrophe, but it would be a concern.

Now, in the bottom chart, let's take a look at the performance of the trader who ramps up risk to a 5% standard deviation per trade, like our correspondent. That again might represent a scenario of risking 5% of the portfolio per trade with moderate discipline. Over the course of 100 trades, that trader displays an equity peak of about $15,000 (up 15%) and trough of almost -$30,000 (down 30%) for a gut-wrenching peak-to-trough drawdown of 45%.

In the world of professional money management, that would be wholly unacceptable.

We all hit periods of flat performance; during those times, note how risk levels affect *psychological stress*. In one scenario, we swing from 9% up to 3% down. Raising the risk per trade by a factor of five swings up from 15% up to 30% down. Note that the order of the gains and losses could just as easily have been reversed: in the first scenario, we could have first gone from 9% down to 3% up; in the second scenario, we could have gone from 30% up to 15% down.

It's the swings that are important--and the effect of those swings on the psyche.

When we trade size that is too large for our account size, we subject ourselves to drastic swings in P/L, and that subjects us to drastic swings in mood. In turn, we then make trading mistakes that bring a negative expectancy to each trade, and the size eventually blows us up.

My advice to the gentleman? Think of the charts above as measuring risk per day instead of risk per trade, so that the equity curves represent 100 days of trading. You can see that a 1% standard deviation of returns still generates peak-to-trough drawdowns of over 10%. I would cut risk below that level--risking less than 1% per day, and thus significantly less than 1% per trade--for at least a month of consistent, disciplined trading before considering a *modest* rise in size (which, in turn, would need to be accompanied by a full month of consistent, disciplined trading).

Only such a sustained period of trading without large swings will counteract the emotional fallout created by the large equity swings. In trading, if you create drama in your returns, you'll create trauma--and that's how trading careers end. The links below explain this in detail.


The Psychology of Risk and Return

Risk Management and Human Biology

Inside the Trader's Brain

Psychology Resources for Traders

from Dr. Brett--
The Trading Coach blog is becoming my main archive of material on trading psychology and the psychology of markets. Here are a few recent resources that you might find helpful:

* Trading Techniques Linkfest - Links to recent articles on trading patterns and techniques

* Developing Yourself as a Trader - Links to psychology-related posts

* Collected Readings in Trading Psychology - A large PDF of my early writings

I will be adding items to the archive periodically, including supplemental material to my new book.

Trading Scared is Trading Scarred

from Dr. Brett-
A trader dropped me an email today to explain that he was "trading scared": missing out on opportunities because he was overly risk averse. As luck (or Freudian psychology) would have it, he spelled "scared" as "scarred". That little slip revealed considerable psychological insight.

Most traders who trade scared are also trading scarred. Normal losing trades and periods of drawdown are processed normally, as expectable--if somewhat disappointing--events. When losses are substantial, however, they can be processed as traumatic events. Instead of being processed through normal, explicit, verbal channels, they activate the flight/fight emergency mechanisms of mind and body, leaving their emotional imprint. Later, events similar to the traumatic losses--even normal ones--can trigger the emotional and physical reactions of emergency, including paralyzing anxiety.

Interestingly, our trader had an excellent March after losses in December - February. During those losses, he explains, "I basically got pretty close to running out of money in my bank account." He feels that he should increase his size after the good month, but instead he's trading even more scared than he did before the winning month. As he recognizes, the making of money in March has restimulated his experience of losing money in December through February following a profitable fall season. Because the earlier losses nearly bankrupted him, they weren't experienced as normal losses. They scarred him in a traumatic way, and now he's trading scared.

When traders need profits to make the next paycheck that will put bread on the table, that is too much performance pressure. I've commented in the past that the smartest thing I ever did when learning trading was to begin with a trading stake that I could afford to lose in its entirety without affecting my family's lifestyle. Having the cushion of a second income and/or a secure savings account as backup means that normal slumps don't have to turn into career-threatening events. I've worked with traders who felt that, if they didn't make money in the current month, they would not be able to cover their mortgage payments. Normal losing trades became extreme threats, and the traders traded scared as a result.

It's when the desire to profit becomes an acute need for profits that performance anxiety is likely to overcome efforts at prudent risk-taking. Any business, when it gets off the ground, has to be adequately capitalized, so that it can weather initial adversity. The lack of adequate capitalization leads many traders to take large risks (to make enough money to support themselves), but also to trade with large fear (due to the absence of any cushion in the event of loss). Our trader should not be thinking of ramping up size after only a month in the black. Rather, he should work on achieving consistency with the kind of trading that worked in March.

That will build his cash cushion, his confidence, and ultimately his ability to take risk in a secure manner. The links below outline methods that are quite useful in addressing psych issues related to trauma.


Drama Creates Trauma

Favorite Techniques for Overcoming Performance Anxiety

Expose Yourself

China Will Not Participate in Global Energy Taxation

Platts reported today that China has officially declared that even if the United States participates in cap and trade taxation, China won't. This is a great way for the U.S. to ensure that companies will send even more jobs to other countries -- like China -- rather than bear the astronomical cost of the cap and trade tax. Perhaps it should more appropriately be called, "The Job Exportation Assurance Tax", because that's precisely what it will do!

Obama Wants Control of Our Financial System

from the Wall Street Journal opinion page:

I must be naive. I really thought the administration would welcome the return of bank bailout money. Some $340 million in TARP cash flowed back this week from four small banks in Louisiana, New York, Indiana and California. This isn't much when we routinely talk in trillions, but clearly that money has not been wasted or otherwise sunk down Wall Street's black hole. So why no cheering as the cash comes back?

My answer: The government wants to control the banks, just as it now controls GM and Chrysler, and will surely control the health industry in the not-too-distant future. Keeping them TARP-stuffed is the key to control. And for this intensely political president, mere influence is not enough. The White House wants to tell 'em what to do. Control. Direct. Command.

It is not for nothing that rage has been turned on those wicked financiers. The banks are at the core of the administration's thrust: By managing the money, government can steer the whole economy even more firmly down the left fork in the road.

If the banks are forced to keep TARP cash -- which was often forced on them in the first place -- the Obama team can work its will on the financial system to unprecedented degree. That's what's happening right now.

Here's a true story first reported by my Fox News colleague Andrew Napolitano (with the names and some details obscured to prevent retaliation). Under the Bush team a prominent and profitable bank, under threat of a damaging public audit, was forced to accept less than $1 billion of TARP money. The government insisted on buying a new class of preferred stock which gave it a tiny, minority position. The money flowed to the bank. Arguably, back then, the Bush administration was acting for purely economic reasons. It wanted to recapitalize the banks to halt a financial panic.

Fast forward to today, and that same bank is begging to give the money back. The chairman offers to write a check, now, with interest. He's been sitting on the cash for months and has felt the dead hand of government threatening to run his business and dictate pay scales. He sees the writing on the wall and he wants out. But the Obama team says no, since unlike the smaller banks that gave their TARP money back, this bank is far more prominent. The bank has also been threatened with "adverse" consequences if its chairman persists. That's politics talking, not economics.

Think about it: If Rick Wagoner can be fired and compact cars can be mandated, why can't a bank with a vault full of TARP money be told where to lend? And since politics drives this administration, why can't special loans and terms be offered to favored constituents, favored industries, or even favored regions? Our prosperity has never been based on the political allocation of credit -- until now.

Which brings me to the Pay for Performance Act, just passed by the House. This is an outstanding example of class warfare. I'm an Englishman. We invented class warfare, and I know it when I see it. This legislation allows the administration to dictate pay for anyone working in any company that takes a dime of TARP money. This is a whip with which to thrash the unpopular bankers, a tool to advance the Obama administration's goal of controlling the financial system.

After 35 years in America, I never thought I would see this. I still can't quite believe we will sit by as this crisis is used to hand control of our economy over to government. But here we are, on the brink. Clearly, I have been naive.

Mr. Varney is a host on the Fox Business Network.

IMF Increases Assessment of Bank Losses to $4 Trillion

from the Times Online:

Toxic debts racked up by banks and insurers could spiral to $4 trillion (£2.7 trillion), new forecasts from the International Monetary Fund (IMF) are set to suggest.

The IMF said in January that it expected the deterioration in US-originated assets to reach $2.2 trillion by the end of next year, but it is understood to be looking at raising that to $3.1 trillion in its next assessment of the global economy, due to be published on April 21. In addition, it is likely to boost that total by $900 billion for toxic assets originated in Europe and Asia.

Banks and insurers, which so far have owned up to $1.29 trillion in toxic assets, are facing increasing losses as the deepening recession takes a toll, adding to the debts racked up from sub-prime mortgages. The IMF's new forecast, which could be revised again before the end of the month, will come as a blow to governments that have already pumped billions into the banking system.

Paul Ashworth, senior US economist at Capital Economics, said: “The first losses were asset writedowns based on sub-prime mortgages and associated instruments. But now, banks are selling ‘plain vanilla' losses from mortgages, commercial loans and credit cards. For this reason, the housing market will play a crucial part in how big the bad debt toll is over the next year or two.”

It looks like we may be poised for the next leg down.

Soybeans Back to Flat, Other Grains Slide Deep Into the Red

Pressure from outside financial markets pushed grains traders over the edge before the 5:00 am closing time. Soybeans have given up all their gains, and both corn and wheat are deep into the red. With the stock markets sliding fast, grain traders have liquidated their positions in defensiveness. This chart for corn is symbolic of the sector and show significant selling overnight, with wheat appearing similar. Soybeans, since my last post, have declined to breakeven (see chart below). If stocks drop forcefully, no one will want to hold onto grains over fear of slackening demand.

Dow Futures Decline By Triple Digits

The overnight futures have now resumed the downward trend and the Dow is down in excess of 100 points. Anything could happen if the trading day reverses itself, but this appears to be a very ill omen. If this decline holds, and extends itself through to tomorrow, I will likely get a sell signal tomorrow. The rally ride was nice while it lasted!

Weakness in Outside Markets Affect Grains

Despite strong fundamentals, weakness in outside markets may be affecting grains. If the stock market begins to fall again, I expect that commodities will also decline again based upon perceived weak demand. As the stock market has fallen overnight, grains are also reflecting that worry. Crude oil is also showing signs of sagging.

Back to Perceived Safe Havens of USD, Treasuries, Gold

All three charts look about the same, so I'll only show one.

Stocks Show Another Day of Weakness Overnight

This tumble looks significant. Now that earnings season for the first quarter is upon us, there is fear that the financial chickens are coming home to roost, and that they are going to look even more ugly than expected.

Soros Says Its a Bear Market Rally

It is amazing to me that despite the terrible performance of the financial markets, Soros still give Obama high marks. Nevertheless, I think his assessment of the situation bears wisdom. His solutions, on the other hand, are more of what has created the crisis. From Bloomberg:
George Soros, the billionaire hedge- fund manager who made money last year while most peers suffered losses, said the four-week rally in U.S. stocks isn’t the start of a bull market because the economy is still shrinking.

“It’s a bear-market rally because we have not yet turned the economy around,” Soros, 78, said in an interview yesterday with Bloomberg Television, referring to the recent rebound in stock prices. “This isn’t a financial crisis like all the other financial crises that we have experienced in our lifetime.”

The Standard & Poor’s 500 Index of largest U.S. companies has climbed 24 percent since March 9 on optimism the worst of the 16-month U.S. recession is over. The economy continues to contract, and there’s a risk the U.S. falls into a depression, Soros said.

‘Zombie’ Banks

Soros said the banking system is “seriously under water” with banks on “life support.”

“They are weighed down by a lot of bad assets, which are still declining in value,” he said in the interview in his New York office. “The amount is difficult to estimate, but I think it’s in the region of maybe a trillion-and-a-half dollars.”

Soros said the change to fair-value accounting rules will keep troubled banks in business, stalling a U.S. recovery.

“This is part of the muddling-through scenario where we are going to keep zombie banks alive,” Soros said. “It’s going to sap the energies of the economy.”

The Financial Accounting Standards Board relaxed so-called mark-to-market rules last week, allowing banks to use “significant” judgment in gauging prices of some investments on their books. While analysts said the measure may reduce writedowns and boost net income, investor advocates and accounting-industry groups said it will help financial institutions hide their true health.

Monday, April 6, 2009

Short Primer on VIX

from Steven Sears at Barrons:

The fear gauge has fallen, but it may be time to build up hedges.

ON THE CUSP OF FIRST-QUARTER-EARNINGS SEASON, the options market is percolating with talk about what to expect from Corporate America.

No one seems to expect that the majority of companies will report great results, though high are the hopes, which spring eternal on Wall Street as well as Main Street, that corporate executives will reveal on post-earnings conference calls that they see signs of an improving business conditions in the future.

For insights into how the Standard & Poor's 500 index could behave in the next 30 days, many investors reflexively turn to the Chicago Board Options Exchange's Market Volatility Index (VIX). The fear gauge, as the VIX is commonly called, is comprised of a strip of Standard & Poor's 500 puts and calls that is intended to give investors a sense of how options traders view the market during the next 30 days.

VIX closed Friday at 39.70, its lowest level since Jan. 28, while the Standard & Poor's 500 index closed at 842.50, the highest close for the market since Feb. 2.

Michael McCarty, chief equity and options strategist at Meridian Equity Partners, says, "While it is tempting to conclude that the drop below 40 for the VIX is cause for joy, it is important both to not over interpret the VIX and to recall what followed the last close below 40, specifically a significant sell-off in the market."

Many of Monday's pre-open trading notes cautioned investors to remain wary and wily despite the drop in the VIX and the gain in stock prices. Many strategists and traders advise investors to use the lull in options volatility as an opportunity to hedge stocks and portfolios against stock-market declines -- and to position for advances.

McCarty likes using VIX "call spreads" to hedge against an increase in volatility. VIX often rises when stock prices decrease. This could happen if earnings reports, and corporate outlooks, are particularly negative.

VIX was recently up about 6.5% at 42.31.

McCarty noted that April VIX futures, which reflect only May SPX options, closed at 41.70 on Friday, down only 1.25, while July VIX futures trade at a premium to "spot VIX," indicating that traders expect a volatility increase.

Krag "Buzz" Gregory, a Goldman Sachs' derivatives strategist who is widely respected for his volatility analysis, told clients Monday that Standard & Poor's 500 index implied volatility -- essentially, future expectations -- are priced below realized -- past results -- for virtually every strike price and expiration.

"Whether you are hedging or positioning for more upside, implied volatility looks cheap relative to potential realized in our view." Gregory told clients.

For example, Standard & Poor's 500 index call options that are 5% out-of-the-money are trading at 8.5 volatility points below one-month realized volatility. One lesson many traders have profitably learned is that it pays to own far-out-of-the-money options in volatile trending markets. On March 9, for example, May 900 calls were 33% out-of-the-money and could be bought for $1. Gregory said the calls are now worth $17.80.

At this crossroads in the stock market, there's something for bulls and bears in the options market, which is proof yet again of our favored old saw that options gives investors options.

FHLB Chair Resigns over Refusal to Sign Off On Bad Bank Accounting Practices

from Zero Hedge:
When the man in charge of the second largest borrower in the U.S. is willing to lose his job due to his discomfort with the FASB's shift in accounting rules, you can bet that the tragic fallout of all the "market buoying" recent events is only a matter of time.

Somehow this noteworthy event, which happened over a week ago, passed substantially unnoticed until Zero Hedge friend Jonathan Weil at Bloomberg dug it up. Charles Bowsher, who was most recently Chairman of the Federal Home Loan Bank System's Office of Finance and previously served as U.S. comptroller general may be the only truly honorable man in the socialist nexus of politics and finance. The reason for his departure from this critical post - his discomfort in vouching for the banks' combined financial statements. And as Weil puts it succinctly: "Now the question for taxpayers is this: If Charles Bowsher can’t get comfortable with these banks’ financial statements, why should anybody else be?" Why indeed.
If Bowsher was merely involved with some marginal organization, this could be perceived as a hypocritical attempt to score populist brownie points. However, the FHLB is among the governmental entities at the heart of the current problem. Zero Hedge has written previously about the FHLB and its critical role in the ongoing housing crisis, but in a nutshell "The Office of Finance issues and services all the debt for the 12 regional Federal Home Loan Banks. That’s a lot of debt -- $1.26 trillion as of Dec. 31, making the FHLBank System the largest U.S. borrower after the federal government. The government-chartered banks, which operate independently, in turn supply low-cost loans to their 8,100 member banks and finance companies. If any of the FHLBanks were to fail, taxpayers could be on the hook."

Ah, the poor taxpayer about to get duped one last time. And the immediate reason for Bowsher's decisions: his concern with the methods used for determining when losses on hard-to-value securities should be included in banks’ earnings and regulatory capital. And it gets much worse:

For the fourth quarter of 2008, the FHLBanks said their total preliminary net loss was $672 million. It would have been many times larger, had they included all their red ink.

The year-end balance sheet at the FHLBank of Seattle, for example, showed $5.6 billion of non-government mortgage-backed securities that it says it will hold until maturity. Yet the estimated value of those securities was just $3.6 billion. The bank, which reported a $199.4 million net loss for 2008, said the declines were only temporary. They’ve been anything but fleeting, though. Most of those securities have been worth less than they cost for more than a year.

The FASB’s rules on this subject, which have never been well defined, are now in flux. Today, after caving in to pressure by the banking industry and members of Congress, the Financial Accounting Standards Board is set to vote on a plan to relax its rules on mark-to-market accounting, so that companies can disregard market prices and ignore losses on their securities indefinitely.
Bowsher is not new to taking hard political stands:

As comptroller general, he was in charge of the General Accountability Office, the investigative arm of Congress. At his direction, the GAO was among the first to warn the public about the brewing savings-and- loan crisis during the 1980s. He testified before Congress in 1994 that there was an “immediate need” for “federal regulation of the safety and soundness” of all major U.S. derivatives dealers. (How’s that for prescient?)

Most recently, in 2007, he led an independent committee that issued a blistering report on financial missteps at the Smithsonian Institution, whose board of regents included U.S. Chief Justice John Roberts.
And how does the FHLB spin this event?

"Mr. Bowsher has expressed his concerns to me around the complexity of valuing mortgage-backed securities and the process of producing combined financial statements from the 12 home loan banks. I don’t think it’s appropriate for us to speak for Mr. Bowsher."
So: to paraphrase - one of the men who knows the ins and outs of the financials of banks involved in the mortgage crisis more intimately than even Bernanke and Geithner, let alone Obama, is saying that the newly implemented changes by the FASB will throw the whole system into tailspin and he want none of it.

If this isn't the most damning condemnation of the Kool Aid the administration, the Treasury, the Fed, the FASB, the FDIC, and all the other alphabet soups are trying to make the common U.S. citizen drink and have seconds, then nothing else possibly could be.... of course until Bowsher is proven right and everything collapses into the smoldering heap of defaulted MBS still marked at par on various liquidating banks' balance sheets...

Oh and yes, let's hold a moment of silence for Lehman which held billions of mortgage backed securities that it too was "holding until maturity." Well, Lehman is no more, and all these securities now trade, in the form of the company's general unsecured claims, at the generous price of 12 cents on the dollar... Furthermore, one can't say the market is illiquid - the bid-ask spread is only 1 cent. And as there are over $150 billion of these claims floating around, one can't say the market is in any way limited from a price discovery standpoint.

Maybe if more honest people follow in Bowsher's unique example, the general population will finally start seeing though the everyday lies and misinformation coming out of D.C. Sphere: Related Content

The Ominous Lesson We Learn from the FDIC's Largest Bidder

from Zero Hedge:
For all those who feel like punching their monitor or TV every time the administration says that the legacy loan program is fair and equitable at a transaction price in the 80-90 cent ballpark, we have some news for you (that will likely make the half life of said monitor or TV even shorter).

But first, there has been a lot of speculation about where banks have marked their commercial loan portfolios. Zero Hedge had previously discovered and disclosed interpretative data from Goldman, which concluded that the major banks were still stuck in a fairytale world where these loans were marked in the 90+ ballpark, a far, far cry from where comparable loans would clear in the market. Of course, FDIC's head Sheila Bair (who many WaMu shareholders lately do not feel too hot about) had some interpretative voodoo of her own, claiming the bid offer disconnect is purely due to a lack of liquidity and access to financing:

"It has been clear for some time that troubled loans and securities have depressed market perceptions of banks and impeded new lending. Difficult market conditions have complicated efforts to sell these troubled assets because potential buyers have not had access to financing. The Legacy Loans Program aligns the interests of the government with private investors to provide financing and market-based pricing, and is a critical step forward in the process of restoring clarity to the markets. While there are inherent challenges to implementing a program of this magnitude quickly, the framework announced today provides the foundation upon which the FDIC will begin to build immediately."

So it came as a big surprise that none other than the FDIC keeps a track of where commercial loans clear in its own internal auctions. In a relatively obscure part of the FDIC's website, there lies a little gem of disclosure, which exposes all the rhetoric by Sheila Bair and by other members of the administration as hypocrisy on steroids. We bring you: FDIC's closed loan sales database. Zero Hedge took the liberty of compiling some of the data for the benefit of our readers: we picked a data sort of all closed commercial loan auctions from January 1, 2009 to February 28, 2009, to see just at what level these would close. Of course, we highly recommend our readers recreate these results.
|The results: 43 commercial loan auctions, of which 39 were for exclusively performing (so not non-performing, or lower quality auctions, and by implication free cash generating), consisting of 331 total loans, representing $206 million in face value, ended up clearing for a $103 million price, a 49.3% discount, or a 50.7% clearing price! That's right, the FDIC itself clears performing commercial loans at 50 cents on the dollar on average in its own regulated, orderly auctions. One would assume the chairman of the very agency that conducts these loan auctions would be aware of them and would at least reference or mention these results in her numerous public appearances.

Curiously, the FDIC also discloses the winning bidders. The surprising recurring result: a little known (but deserving much greater attention) company known as Beal Bank (and its LNV Corporation subsidiary). In the first two months of the year alone, Beal Bank, and more specifically its owner Andy Beal, has won $73 million face value of auctions, for a price of $43 million- a clearing price of 59%. Another way of looking at it is that Beal accounts for 35% of all FDIC auctions.

Just who is Andy Beal, aside from a prolific and profitable poker-playing, college-dropout of course? A great question, which Forbes goes into great detail answering this weekend. We paraphrase the key points from Forbes:

Standing outside the glass-domed headquarters of his Plano, Texas, bank in March, D. Andrew Beal presses a cellphone to his ear. He's discussing a deal to buy mortgage securities. In just a few minutes, the deal's done: His Beal Bank will buy $15 million of face value for $5 million. A few hours earlier he reviewed details on a $500 million loan his bank is making to a company heading into bankruptcy--the biggest he's ever done. A few floors above, workers are bent over computer screens preparing bids for chunks of $600 million in assets dumped by two imploded financial firms. In the last 15 months, Beal has purchased $800 million of loans from failed banks, probably more than anyone else.

It is amusing that Beal Bank, which is not large enough to qualify for the FDIC's zombie bank life-support program known as TLGP, is beating the FDIC at its own game, gobbling up assets (at fair market prices, which is what auction outcomes are by definition). Beal is such a non-mainstream individual that Project Zero will hold a honorary bunk in his favor, (he will have to decide who gets top with Chuck Bowsher) until such time as he decides to stand outside ZH headquarters for 24 hours to gain admission:

It's hard to imagine Beal fitting in at a bankers' convention. He walked into the Las Vegas Bellagio in 2001 and challenged the world's best poker players to games with $2 million pots--the highest stakes ever. Donning large sunglasses and earphones, Beal held his own against the poker stars, once winning $11 million in a single day, although he shrugs that he lost more than he won. At the track he'll drive one of his nine race cars (costing as much as $100,000 each) at 150 mph. On city streets he cruises in a huge Ford Excursion, the vehicle that has made him feel safe since a drunk driver punctured his lungs in 2000.

However, the main reason why Beal is prophetic beyond his years is the following:

He thinks the government is going to be "disappointed" by its various programs to revive lending. He says Treasury Secretary Timothy Geithner's new plan to guarantee loans to buyers of toxic assets won't lead to many sales because the problem isn't liquidity but price. They are not low enough. Half the country's banks--4,000 in all--would be bust, he says, if they marked their loans to what the loans would fetch in an auction. He says banks are fooling themselves by refusing to mark busted assets down.

"Banks are on a prayer mission that somehow prices will come back and they won't have to face reality," Beal says. And that reality, according to Beal, is going to get a lot worse. "Unemployment is going over 10%, commercial real estate hasn't even begun collapsing and corporate credit defaults are just getting started," he says. His prediction: depression, without bread lines this time, thanks to the government safety net, but with equal cost to society.

It is a fitting conclusion that Beal himself is the winning bidder in FDIC's commercial loan auctions (which no other major bank with a $ trillion+ balance sheet has any interest in participating in - why is this if the loans are worth 90 cents as Citi et al have them market internally?), and thus the true market test of what all these toxic legacy loans are really worth. Zero Hedge wholeheartedly agrees with Beal that the CRE situation is headed for a cliff at 120 mph, and that no matter how much hypocritical posturing and rhetoric the administration spouts, or how many more trillions in debt the U.S. incurs to revive the financial zombie on the morgue dissection table, there is nothing at this point that can be done to change the final outcome.

Harvard, Princeton Economists Suggest Toxic Bank Assets Really Are Toxic, and that Gethner's Plan is Making Things WORSE!

These two guys are suggesting that Geithner is dead wrong, and that the consequences will be costly. From Clusterstock:
The government's official view that toxic assets are incorrectly priced due to illiquidity "fire sales" is wrong, a new study by Harvard and Princeton finance professors suggests.

You can read the whole paper by Harvard's Joshua Coval and Erik Stafford and Princeton's Jakub Jurek below. The striking conclusion is that the low prices of toxic assets actually reflect the fundamentals, rather than being driven by an illiquidity discount.

"The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing."

This contrasts sharply with the analysis that underlies most of the financial rescue programs launched by the Federal Reserve and the Treasury Department. The white paper released to support the Private-Public Investment Partnerships, the program that seeks to encourage private firms to buy toxic assets with government subsidized loans, took the opposite point of view.

"Troubled real estate-related assets comprised of legacy loans and securities, are at the center of the problems currently impacting the U.S. financial system...The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales," the Treasury and the Fed claimed.

Many prominent economists--including such diverse types as Anna Schwartz and Paul Krugman--have taken with this official view, saying the government was mistaking a solvency crisis for a liquidity crisis. This latest paper effectively demolishes the "fire sale" view. It draws three important conclusions.

* Many banks are now insolvent. "...many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities."

* Supporting markets in toxic assets has no purpose other than transfering money from taxpayers to banks. "...any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities."

* We're making it worse. "...policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning."

In short, the government cannot save the banks by improving liquidity or changing mark to market rules because the problem isn't illiquidity or accounting. The problem is that highly leveraged financial firms own assets that are worth far less than they thought they would be, and the firms are insolvent as a result. This is why the latest bailout plans secretly give huge subsidies to banks--because the only way to keep the insolvent zombies afloat is to transfer billions of dollars to banks, bank stockholders, and bank creditors. The alternative--allowing the insolvent banks to fail, seizing the assets, wiping our shareholders, giving bond holders a serious haircut--is still not on the official agenda.

Mike Mayo, Meredith Whitney: Worse Yet to Come

from Bloomberg:
CLSA analyst Mike Mayo assigned an “underweight” rating to U.S. banks, saying loan losses may exceed Great Depression levels and the government may be forced to take over large lenders.

Financial shares and major U.S. stock indexes dropped after Mayo advised clients to sell banks including Winston-Salem, North Carolina-based BB&T Corp. and Cincinnati’s Fifth Third Bancorp. Mayo said in a report today that he assigned “underperform” ratings to Bank of America Corp. and JPMorgan Chase & Co., the two biggest U.S. banks by assets.

“While certain mortgage problems are farther along, other areas are likely to accelerate, reflecting a rolling recession by asset class,” said Mayo, who joined CLSA from Deutsche Bank AG last month. “New government actions might not help as much as expected, especially given that loans have been marked down to only 98 cents on the dollar, on average.”

Seven Deadly Sins

Mayo said banks engaged in “seven deadly sins”: greedy loan growth, gluttony of real estate, lust for high yields, sloth-like risk management, pride of low capital, envy of exotic fees, and anger of regulators. Mayo’s “underweight” rating applies to the entire sector.

Meredith Whitney, who left Oppenheimer & Co. in February to found Meredith Whitney Advisory Group LLC, said in a Forbes interview that banks will continue to write down their mortgage assets as home prices decline further than lenders expected. Home prices are not done falling and will ultimately drop 50 percent from their peak, Whitney said today in a CNBC interview.

The unemployment rate also has exceeded banks’ projections and could lead to further loan losses, Whitney told Forbes. Banks “by and large” will show profits in the first quarter before provisions for loan losses, Whitney said on CNBC.

BLS Birth/Death Model Grossly Understating Unemployment

from Market Oracle:
Month after month, with the exception of January, the BLS is assuming more jobs were created by new businesses than lost by businesses closing shop. The BLS model is horribly wrong.

BLS Black Box

For those unfamiliar with the birth/death model, monthly jobs adjustments are made by the BLS based on economic assumptions about the birth and death of businesses (not individuals). Those assumptions are made according to estimates of where the BLS thinks we are in the economic cycle.

The BLS has admitted however, that their model will be wrong at economic turning points. And there is no doubt we are long past an economic turning point.

Here is the pertinent snip from the BLS on Birth/Death Methodology.

* The net birth/death model component figures are unique to each month and exhibit a seasonal pattern that can result in negative adjustments in some months. These models do not attempt to correct for any other potential error sources in the CES estimates such as sampling error or design limitations.
* Note that the net birth/death figures are not seasonally adjusted, and are applied to not seasonally adjusted monthly employment links to determine the final estimate.
* The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend.

Household Data
In March, the number of persons working part time for economic reasons (sometimes referred to as involuntary part-time workers) climbed by 423,000 to 9.0 million. This category includes persons who would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs.

Persons Not in the Labor Force

About 2.1 million persons (not seasonally adjusted) were marginally attached to the labor force in March, 754,000 more than a year earlier. These individuals wanted and were available for work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

Among the marginally attached, there were 685,000 discouraged workers in March, up by 284,000 from a year earlier. Discouraged workers are persons not currently looking for work because they believe no jobs are available for them. The other 1.4 million persons marginally attached to the labor force in March had not searched for work in the 4 weeks preceding the survey for reasons such as school attendance or family responsibilities...

Grim Statistics

The official unemployment rate is 8.5% and rising sharply. However, if you start counting all the people that want a job but gave up, all the people with part-time jobs that want a full-time job, all the people who dropped off the unemployment rolls because their unemployment benefits ran out, etc., you get a closer picture of what the unemployment rate is. That number is in the last row labeled U-6.

It reflects how unemployment feels to the average Joe on the street. U-6 is 15.6%. Both U-6 and U-3 (the so called "official" unemployment number) are poised to rise further.

Looking ahead, I expect the service sector to continue to weaken. Mall vacancy rates are rising and a huge contraction in commercial real estate is finally started. There is no driver for jobs and states in forced cutback mode are making matters far worse.

Mark to Market Suspended -- Turning the Clock Back to NON-Transparency

from Market Oracle:
Mark to Market Accounting Mess Shows That Congress, Bankers Just Don't Get It …

This week, the Financial Accounting Standards Board (FASB) caved on the mark-to-market accounting front. Members of the board agreed to give financial institutions more flexibility in valuing assets, including the “toxic” ones that have given investors so much agita.

You could see this coming a mile away because Congress has essentially been browbeating the group into submission. Recent hearings and commentary from legislators made it clear that if FASB didn't kowtow to the banking lobby and amend mark-to-market standards, Congress would find a way to make it happen.

Where do I stand on this? I made my position abundantly clear on March 13, when I wrote the following in my Money and Markets column:

“Look, the problem isn't that there's NO market for these bad securities. The problem isn't that the prices are “artificially” low. The problem isn't how we account for these assets. The problem is that the industry doesn't want to acknowledge that today's prices are the REAL prices .

There are tons of bidders out there for this crappy paper … at the RIGHT price. Vulture funds, hedge funds, private equity investors: They're all raising billions and billions of dollars to scoop up cheap real estate, inexpensive bundles of mortgage backed securities, and distressed buyout loans.

But sellers don't want to admit reality. They're not hitting the buyer's bids. They're hanging on to the garbage securities, hoping against hope that they won't have to sell at the true market prices. And the government is busy trying to figure out ways to prop up the price of the garbage rather than forcing banks to take their medicine now, even if it means the result is that they have to temporarily be nationalized or put into receivership.”

Nothing has changed my opinion since then. The banking lobby argues that because many of these assets are still spinning off principal and interest payments, they should be able to carry them at full value or close to it — not the supposedly distressed, “false” market prices.

But look at the performance of the asset markets underlying the toxic paper! Those markets aren't getting better. They're getting worse...
from a damning New York Times op-ed piece by Joseph Stiglitz, a Nobel prize-winning economist and professor at Columbia University. He added:

“The Obama administration's $500 billion or more proposal to deal with America's ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: The banks win, investors win — and taxpayers lose.

“Treasury hopes to get us out of the mess by replicating the flawed system that the private sector used to bring the world crashing down, with a proposal marked by overleveraging in the public sector, excessive complexity, poor incentives and a lack of transparency.”

If you're not outraged that we're bailing out the banks in this fashion, you should be.

George Soros Sees Rough Waters Ahead

I am no fan of George Soros. He's a monster, in my opinion. However, I think he is absolutely right on this. From CNBC:
The U.S. economy is in for a "lasting slowdown" and could face a Japan-style period of relatively low growth coupled with high inflation, billionaire investor George Soros said on Monday.

Soros, speaking to Reuters Financial Television, also warned that rescuing U.S. banks could turn them into "zombies" that draw the lifeblood of the economy, prolonging the economic slowdown.
"I don't expect the U.S. economy to recover in the third or fourth quarter so I think we are in for a pretty lasting slowdown," Soros said, adding that in 2010 there might be "something" in terms of U.S. growth.
Soros' view contrasts with the majority of economists, who expect the U.S. economy to stop contracting in the third quarter and resume growing in the fourth quarter, according to the latest monthly poll of forecasts conducted by Reuters.
The recovery will look like "an inverted square root sign," Soros said. "You hit bottom and you automatically rebound some, but then you don't come out of it in a V-shape recovery or anything like that. You settle down—step down." The healing of the banking system and housing markets is crucial to recovery. "The banking system, as a whole, is basically insolvent," Soros said. What's more, the Treasury's Public-Private Investment Fund is going to work but it won't be enough to recapitalize the banks in a way that they are able to or willing to provide credit.
"What we have created now is a situation where the banks who will be able to earn their way out of a hole, but by doing that, they are going to weigh on the economy," he said. "Instead of stimulating the economy, they will draw the lifeblood, so to speak, of profits away from the real economy in order to keep themselves alive. This is the zombie bank situation."
The stress tests being conducted by Treasury could be a precursor to a more successful recapitalization of the banks, he added.

Interest Rates Rising Despite Fed Purchases

from Marketwatch:
NEW YORK (MarketWatch) -- Treasury prices declined Monday, with longer-term debt reversing earlier strength, as investors remained wary of buying before the Treasury Department auctions $59 billion in new debt this week.
Earlier support dissipated after the Federal Reserve purchased $2.53 billion in Treasurys maturing between 2019 and 2026, less than some had expected.
Ten-year note yields rose 4 basis points, or 0.04%, to 2.93%. Yields move in the opposite direction of prices.
Shorter-term notes were little changed, as declines in U.S. equities hinted at skepticism among investors that may keep them in the relative safety of government debt and away from riskier assets.
The Fed was expected to buy between $7 billion and $10 billion in the operation, in line with amounts in its most recent buybacks, said analysts at Morgan Stanley. Last week, the market was very disappointed it only bought $2.5 billion of longer-dated debt, they said.
The Fed's next purchases will take place on Wednesday when it will buy shorter-term securities maturing in 2010 and 2011.
The Treasury also announced it will auction $35 billion in 3-year on Wednesday and $18 billion in 10-year notes on Thursday. It previously said it would sell $6 billion in inflation-linked securities on Tuesday.
The amounts are roughly in line with estimates from Wrightson ICAP, a research firm specializing in government finance.
Analysts also noted that trading volume was low ahead of upcoming holidays. Passover starts Wednesday and markets are closed for Good Friday.
Fed purchases last week did little to keep Treasury yields down, as equity gains and data revived some optimism among investors. A dismal monthly payrolls report on Friday was better than the even grimmer report some investors had braced for.
Ten-year note yields increased 15 basis points last week, pushing back towards levels last seen before the Fed surprised markets after its last policy meeting by announcing it would purchase $300 billion in Treasurys in the following six months.
"The Fed's problem is that the market realizes that $300 billion in Treasury buybacks is just a drop in the bucket compared to $2.5 trillion in estimated net Treasury issuance this fiscal year," said strategists at UBS Securities. The fiscal year ends in September.

Apparently, the Fed's purchases are insufficient to affect interest rates. The size of even the Fed's balance sheet is too small for the gargantuan size of the U.S. government's debt.

Fed Opens New Credit Lines

from the AP:


WASHINGTON (AP) - The Federal Reserve said Monday it has expanded credit lines with the central banks of Japan, Switzerland, the United Kingdom and European Union that will provide foreign currency to U.S. banks - if needed.

Under currency swap arrangements, which were common last fall when the credit crisis intensified, the Fed provides dollars in exchange for reserves of the other nations' currencies.

"Should the need arise, euro, yen, sterling and Swiss francs would be provided to the Federal Reserve via these additional swap agreements with the relevant central banks," according to the Fed release. "Central banks continue to work together and are taking steps as appropriate to foster stability in global financial markets."

The Fed said the expanded credit lines, authorized through Oct. 30, are worth the equivalent of up to $45 billion with the Bank of England, $108 billion with the European Central Bank, $99 billion with the Bank of Japan and $35 billion with the Swiss National Bank

Separately, the Fed said it will auction off $150 billion in short-term loans to nonbanks and other financial institutions under a program that began last year. The auctions provide loans to those institutions on similar terms that the central bank provides to banks, and are intended to stabilize the U.S. financial system.