They’re Working on This in Washington, Right?

New Lows, and More New Lows

For the last few months, we’ve been saying in this column that the market has been trading in the range of 7,800 – 8,200 on the Dow. We’ve also been saying that the market could go either way; that it could break upward, past the upper end of the range, or down below the 7,800 level. And that, until we can be sure it’s going one way or the other, it’s a very risky place to be.

The last couple weeks of February has given us an answer. As of Monday, March 2, 2009, the Dow closed at 6,763.29, and the S&P finished barely above 700 at 700.82. Both indices are at multi-year lows. Here’s another way to look at it. Before this week, a lot of people were down 40% or so since this whole thing started. This week, I wouldn’t be surprised if people are now down 50-60%.

Unfortunately, I have to say that may not be the worst of it. The market is likely to continue declining. And how much further down can it go? From a technician’s point of view, Dow 6,000 is a first possible target. Beyond that, if we break below Dow 6,000 there is actually a possibility of Dow 4,000. Not something we want to talk about, but something that we have to put on the table.

How did we get here? And can this slide into the depths be stopped? There’s a long answer, but let me give you the short one first. Unless the Obama administration comes out with action that addresses the heart of the problem – the banks – we are headed steadily downward.

A strong statement. Now let me back it up.

I’ve said in previous articles that this all begins with banks, and I continue to believe that. We all know the story by now: the banks leveraged up nearly 40:1, many assets such as real estate were bought at bubble prices, derivatives were created and bought at high prices, and then the bubble burst. Now these “toxic” assets are sitting on the balance sheets of the banks, and as time goes by, their value decreases. Without a bottom, investors won’t step in and buy the stocks of the banks. Without buyers, these stocks, and the market, will just continue to decline.

They’re Working on This in Washington, Right?

And that’s where we are. The market is dropping, and there’s really no one left to stop it except for the government. And to date, there’s been a lot of legislation, a lot of announcements, and a lot of press conferences. But nothing’s been done to address the real problem: the decline in asset prices. Geithner, the newly anointed and much bally-hooed Treasury Secretary, has said nothing since his infamous speech a month ago, and Obama continues to issue vague proclamations. And you say to yourself, they must be, they have to be, working on this… right?

I would think so. But more than 1,000 points down on the Dow and not a word out of Geithner or Obama about the banks.

You might say, look at the huge stimulus package that was just passed. Look at the bailout of Citi and AIG. That’s a huge amount of money. Isn’t that enough?

Truth is, it’s not. The stimulus package, ginormous as it is, will take time to take effect. And the fact is, it won’t be enough to stop asset prices from going down. Consider real estate prices, for example. Nothing in the stimulus package will convince a buyer that the real estate market has bottomed and that it’s time to go buy a house.

What about the bailouts of Citi, AIG and all the other banks? Sadly, these are just bandages, patches that temporarily stem the tide. The government is just paying for the losses; it’s not stopping the losses from happening. It’s as if a hurricane hits, and the government pays for the damage. But the hurricane hasn’t died. It’s still running around causing more damage.

The Consequences of Mark-To-Market in a Down Cycle

So how do we stop the losses? I think one of the first steps would be to suspend the mark-to-market accounting rule. This rule was originally designed to protect us against more Enrons, situations where companies could hide losses and inflate values using accounting tricks. In this environment, I think that mark-to-market has disastrous consequences, and is a major contributor to the downward spiral in markets.

Let’s say that your company owns ten houses, all purchased for $800,000 each at the height of the bubble. The economy is weak, and you can’t pay the mortgage on a couple of them. You’re forced to sell two of your houses, but values have dropped 30%, so you only get $560,000 for the two that you sold. Now, you’re paying the mortgage payments on the other eight houses, but mark-to-market forces you to value your other eight houses at $560,000 each, taking a $240,000 loss on each of the ten houses.

Once your company is forced to write down the value of these ten houses, a whole new set of problems follow. Once the losses are reported, your stock tanks. This makes it almost impossible to raise capital from the stock market. So if you need to raise capital, you can’t get it by selling assets (because their value is dropping) and you can’t get it by issuing stock.

Banks are particularly vulnerable in this situation because government regulations require them to maintain certain capital ratios to protect against future losses. Current losses reduce existing capital, so as the economy turns south, banks get hit by losses on two fronts: first, operating losses from their day-to-day business; and second, losses that they have to take on the decline in asset values. As their capital gets depleted by losses, banks have to raise money to maintain their capital ratios. They can’t really get it from assets sales, and they can’t really get it from the stock market, so they’re forced to turn to the government.

If you think about it, mark-to-market also stops investors from buying assets in a downmarket. Once a price has been established for an asset, mark-to-market forces all other companies holding similar assets to set the same price for the asset. So let’s say we have another company, call it Company B, that also owns ten houses. Company B has not yet been forced to sell any of the houses, and is listing their value on its books as $800,000. Once Company A takes a 30% writedown on the houses and values them at $560,000, Company B must do the same. So if you think the economy is getting worse, and you’re looking to buy a house, there’s no reason for you to buy right away. You know that mark-to-market will quickly cut the price of any asset, so you’d rather wait then step in.

And there’s one more irony to keep in mind. As individuals, we think that if we own a house, and we make our mortgage payments, we’ll be okay. We might be under water on the value of the house; that is, the house might be worth less than the mortgage, but as long as we make the monthly payment, we might be able to hold through a downturn until the house is worth more than the mortgage. For corporations operating under mark-to-market accounting, this probably isn’t possible. In fact, in this environment, it’s likely that the company will have to sell the asset even if it is making all the mortgage payments. Let me ask this: if your house fell below the value of the mortgage, and you were forced to sell, even if you never missed a payment on the mortgage, would that be right?

Curbing the Shorts

Unfortunately, I think that suspending mark-to-market by itself is not enough. In my December article, “Attack of the Short Sellers”, I talked about how the short sellers were driving the financials off a cliff. They are still doing that today.

In my December article, I argued that the shorts put pressure on stock prices either by 1) creating a high short interest; or 2) manipulating quotes in the credit default swap CDS market. Just as a re-fresher, ramping up the short position sent a signal to others in the market that someone believed, very strongly, that a stock would go down. Likewise, driving up the price of credit default swaps sent the same sell signal to the market. Credit default swaps are basically insurance on securities. If the price of insurance rises substantially, you would want to sell the underlying asset.

Not long ago, there was an uptick rule that required a stock to go up before it could be shorted again. That was eliminated a few years ago, so the shorts could short continuously without interruption. That only increases the speed at which stock prices might decline.

I think there is a good argument for re-instating the uptick rule. I don’t really know why it’s not even on the table in Washington, but it seems logical to me that in this environment, where massive amounts of wealth is destroyed in minutes and hours, it’s worth looking at. Even Bernanke, in his testimony last week, said the same.

Given that selling momentum can also be created in the CDS market, the uptick rule may not be enough. Last fall, the SEC tried halting short selling for a month. Many stocks still went down substantially. It’s very possible that when short selling was halted, the short sellers used the CDS market to create selling momentum. The CDS market is more isolated, with no clear sense of pricing and volume; it’s not like the stock exchanges, where you can see prices and volumes with one look at at screen. Transactions in the CDS market are done person-to-person over the phone. As such, the CDS market lacks transparency and is more subject to manipulation (or call it “gaming the system” if you want a softer description). The bottom line is that re-instating the uptick rule might not be enough. You may also need transparency in the CDS market as well.

Nationalization?

There have been many who have argued, “just nationalize the banks.” Once the government has taken over the banks, they’ll be stabilized and we can move on.

For the life of me, I don’t understand this argument, not in the slightest. The first problem with nationalization is that the bank’s stock will be nearly wiped out. Now there are those that would say, “stockholders should be wiped out, they’re risk takers. They took the risk, it didn’t work out, and now they have to pay for it.” I think it’s nowhere near that simple, and that there are serious, serious consequences to wiping out the stockholders.

We’ll deal with those consequences in the next section. For the moment, let’s deal with a second order effect that no one seems to be talking about. The minute you wipe out the shareholders of, let’s say Citi, the shorts will start attacking the stock of all the other banks. All you have to do is look at the market to see this is true. Last week, the government converted their preferred shares in Citi to common stock. The government now owns a 36% stake in Citi, and this has seriously diluted the existing shareholders. So Citi’s stock tanked (again), and what happened to the other banks? Shares of Bank of America, Wells Fargo, JP Morgan and almost every other bank are down. This is because what happened to Citi could very well happen to the other banks. Many expect Bank of America and Wells to be the next to be seriously diluted. Some, such as JP Morgan, may very well weather the storm without Citi-like nationalization.

There’s a second problem with nationalization. Just because the government has taken over the bank doesn’t mean that the bleeding will stop. All you have to do is look at AIG, Freddie and Fannie as examples. This week, AIG had its third government bailout, and it’s likely that the government will take control of the company and force its breakup. The bleeding will continue; so far, all the government has done is pay for the collateral damage.

They’re Missing the Point

I would think that the last thing you want is for the market to keep dropping, and that the reasons to stop the market from dropping are obvious. But events are telling me otherwise.

First, the market is diving, and Washington isn’t really doing anything. You’ll remember that the most severe bloodletting occurred last October when Congress failed to pass the stimulus package. You’ll also notice that this month, the market broke past the 7,800 level on the Dow because Washington failed to do anything about the banks. That’s two for two, if anyone is counting. As much as I like Obama, I’m concerned, because this administration seems to say that it’s above the markets, that it’s actions are grander, and that it’s actions shouldn’t be determined by a downward-spiraling stock market.

Second, there’s the chorus of arguments that is probably causing paralysis in Washington. These debates include calls for:

• Nationalization
• Wipe out the weak banks, take the pain so that we can move on
• It’s about tax cuts, not spending (the Republican point of view)
• Let’s punish all the people who created this problem

I think that all these people are missing the point. The one and only thing that matters is the selling. Because the selling means real losses. It means the permanent destruction of wealth until it can be rebuilt again – and we know that can take a long time.

During the fall, I frequently ran into the question, “Where does it all go [when the stock market goes down]?” It took me a second to understand the question, because the question implied that the world is a zero sum gain. That is, if the market goes down, all that value must “go” somewhere else. And that’s wrong. That value disappears. If you buy a house for $800,000, and have to sell it for $500,000, the $300,000 difference doesn’t “go” anywhere. It’s destroyed. All that work or salary that led to the $300,000 is lost.

So as the market goes down, the more wealth that is destroyed. And it doesn’t come back. That’s the point.

One other way to think about this is to consider your friend who is in the market and is down, say 50%. As long as he doesn’t sell, it’s a paper loss. But when he’s forced to sell, that’s a real, unrecoverable loss. The only way to get it back is to build it again. And as the market continues to decline, the more people are forced to sell and realize that loss.

Now, you may not have money directly in the market, and you might say, “doesn’t affect me!” And you’d be dead wrong. Because more than likely, your retirement fund or your pension has money in the market. Or the company you work for sells to people who have money in the market. Or your company’s interest rate on their debt is determined by the market. Or your state or local municipality has money in the market. In other words, as those real losses in the market become more severe, you may lose your job, you may not get your tax refund, you’ll have to work harder for your retirement, and your taxes are going up. In fact, it’s not even a “may happen”, because all these things are happening.

When losses become real, it matters. There are those who say, “take the pain, get it over with!” To me that makes no sense. It’s like throwing leeches at a sick patient: the patient doesn’t get better after losing a few pints of blood; it takes a while for the body to build up the blood supply again. Likewise, the investor who is down 50%, and is forced to sell, doesn’t plunge happily back into life. He (or she) is shell-shocked, and has to work to make up the loss. That investor is going to be going to Walmart and McDonald’s for a long time before going back to hundred dollar meals at a chic California fusion restaurant.

And here’s the final kicker. When the market goes down, and the selling becomes more severe, its spurs another round of declines in asset prices. For example, with another downward leg in the stock market, more people lose their savings or their jobs. If they own houses, that means more foreclosures and writedowns at the banks. That means more losses at the banks, and more government bailouts. In other words, real losses in the market only accelerate the downward spiral. Yes, the stakes are high.

Of Policy and Practice

I don’t normally like to be political and call for policy directions in this column, but we’re at a point where I don’t think we have a choice. The economy is bad and there are no buyers. The only player that can do anything at all is the government.

The conservative idealogues would like to say, “less government” or “let the markets work”. Again, that just doesn’t make sense to me. We created today’s system, so why can’t we change it? And in fact, we instituted measures to grease the wheels of capitalism. We allowed 40:1 leverage, we eliminated the uptick rule, we created the CDS market to facilitate securitization, and we created the mark-to-market rule. All these things greased the markets, smoothed things. And we created a double-edged sword: by making the ramp up into the bubble sharp and speedy, we made sure that the crash was just as fast and vicious on the downside. Why, then, can’t we dismantle these things to soften the crash?

And Where Does That Leave the Investor?

Of course, this is the question we must always ask. Frankly, and unfortunately, things are out of our hands. I think it’s in the hands of Washington. Now that we have broken downward resistance, I would advise staying out of the market until we see clear signs that there is a bottom in banking. I’m normally pretty optimistic, but I don’t see much of a choice at this point.

The only people that will do well in this market are professional traders. They can be fast, nimble, and have much better access to the news. If you’re not a professional trader, I would say, stay out.

You might say, “There must be opportunity somewhere? Perhaps commodities? China?” The problem is, selling, aka real losses, destroy demand. So a major downward leg in the market takes everything down with it. The only people that can spend are governments, but as mentioned above, it could take a long time for government spending to have an effect. Moreover, the government spending may not be enough to counter all the losses.

As for international, we are now intertwined and decoupling is a myth. China can make some advances on it’s own, but I think that China remains mostly an export economy. It needs Japan, Europe and the United States to drive its growth. Europe is facing its own problems, and may have to contend with losses in Eastern Europe. Those problems could actually ripple through Europe and back across the Atlantic to the United States.

And what about that sharp, bear market rally that everyone’s been expecting? Well, I can’t tell you when it’s coming, or how much further down the market will go before that bear market rally comes. And so far, everyone who’s tried to invest in the market in advance of a rally has been wrong for the last year. Again, I would say, the surest sign of a rally is a change in the status of the banks. Without that, stay out – at least for now – and sleep better.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.