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Posts Tagged ‘relaxation of mark to market’

FHLB-Chicago Skating on Very Thin Ice

Posted by Larry Doyle on August 5th, 2009 4:21 PM |

The Federal Home Loan Bank (FHLB) system represents significant risks within our financial system. The fact that you do not hear about this system does not mean the risks are shallow or insignificant. You do not hear about the FHLB system simply because the general media pays no attention to it. They should.

Thanks to a close friend for sharing a recent FHLB-Chicago Presentation. This overview provides the following:

1. market update
2. financial results
3. developments in products, credit, and collateral
4. future outlook

Based on my experience, the FHLB-Chicago was always one of the more conservatively managed banks within the FHLB system. That said, after reviewing their financials it is very apparent that this bank is skating on very thin ice and if not for the relaxation of the mark-to-market by the FASB would be well below regulatory capital standards.

For those intrigued by the inner workings of a FHLB, this review provides riveting details. If you are looking for the Cliff Notes, allow me to highlight:

Pages 27-28
The Net Income Statement for ytd 2009 and comparable period in 2008 displays the enormous benefit of the relaxation of the mark-to-market accounting standard as the bank swings from a $152 million loss in 2008 to a $64million gain for ytd 2009.

Pages 35-36
The regulatory capital ratios for FHLB-Chicago highlight that this entity has approximately a mere $200 million in excess capital above the minimum requirement. For an entity this size, $200 million is razor thin.

Page 39
Credit
impairment of this bank’s assets is truly mind boggling. As of year end 2007, the FHLB-Chicago viewed 100% of their assets as being AAA. Fast forward a mere 18 months, now 35% of these assets are rated CCC or worse. Please review the graph on this page for a hint as to the destructive nature of these ratings downgrades on this bank. FHLB-Chicago is representative of many financial entities in our banking system today. No surprise why so many are failing and will continue to fail. This graph is very powerful.  What do you think the bid is for that CCC bucket of assets right now? Zero or very close.

Page 40
The FHLB-Chicago highlights that they have taken writedowns of $263 million on their assets due to credit impairments while they still view potential writedowns of $1.213 billion on these assets due to market conditions.

Given that the FHLB-Chicago admittedly has a mere $200 million in excess capital to satisfy the minimum regulatory capital ratio, we can see that without the relaxation of the mark-to-market they would be woefully capital deficient.

Is the housing market going to improve markedly so that their assets will dramatically increase in value, especially that 35% in the CCC bucket? I would not bet on it.

. . . and the FHLB-Chicago is one of the better managed.

LD

Related Sense on Cents Commentary

Freddie Mac, Fannie Mae Deja Vu?; May 28, 2009

Basis Risks Will Lead to Future Financial Frauds

Posted by Larry Doyle on August 5th, 2009 8:24 AM |

How often have we heard from those involved in financial frauds that they never initially intended on perpetrating a fraud? Well then, what did they intend? Having personally witnessed more than a handful of ‘under the radar’ frauds in the form of intentional misrepresentations of investment values, the activity often centers on a financial term known as ‘basis risk.’ What is basis risk? Why do I think our current financial system has numerous financial frauds germinating?

Utilizing our friendly Investing primer (found in the right sidebar here at Sense on Cents), we learn that basis risk is defined as:

The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in a hedging strategy, thus adding risk to the position.

Or similarly,

Offsetting vehicles are generally similar in structure to the investments being hedged, but they are still different enough to cause concern. For example, in the attempt to hedge against a two-year bond with the purchase of Treasury bill futures, there is a risk that the Treasury bill and the bond will not fluctuate identically.

I have no doubt that a number of financial firms entered into hedging strategies over the last 9 months that present massive basis risk. While these financial firms own an array of individual investment positions (corporate, municipal, mortgage-backed, commercial mortgages, asset-backed, equities), the hedging vehicle utilized is often an index of some sort which is representative of an entire market segment or, in the case of a specific corporate entity, the CDS (credit derivative swap) for that company.

As financial firms move forward, they manage their investment positions and their hedges accordingly. Do not forget, however, that last Spring the FASB (Federal Accounting Standards Board) relaxed the mark-to-market accounting standard so banks could delineate between true credit impairments in their investments and liquidity risks.

While not every firm may have entered into hedging strategies, it is naive to think many did not given the perilous price action in the markets over the last 9 months. Fast forward to the current period and we see the SEC is seriously concerned with these issues, as well they should be. CFO Magazine reports, The SEC’s Most Wanted:

Last fall the Securities and Exchange Commission promised to scrutinize the regulatory filings of the largest financial institutions. So it’s little wonder that many of the recent comment letters sent by the SEC to corporations focused on the more controversial accounting issues that cropped up during the current financial crisis, including valuations of financial instruments and other-than-temporary impairments of securities.

The regulator has also niggled nonfinancial firms, by asking finance executives to better explain how they worked through goodwill impairment testing. Brad Davidson, a partner at accounting firm Crowe Horwath who recently compiled a list of frequent topics cited by SEC staffers in comment letters, says finance executives should keep the points raised by SEC staffers in mind as they put the finishing touches on their next round of financial reporting.

While firms may be able to disguise the hidden losses and embedded risks for a period of time (which can be extended, depending on the size and scope of the operation), basis risks have brought more so-called outstanding traders, portfolio managers, CIOs, and CFOs to their knees than they would ever care to admit.

Any readers who have direct or indirect experience with basis risks please share.

LD

The Relaxation of Mark-to-Market May be Stiffening

Posted by Larry Doyle on July 23rd, 2009 2:07 PM |

I have always thought the relaxation of the mark-to-market accounting standard by the Federal Accounting Standards Board (FASB) was nothing more than a vehicle for banks to ‘cook their books.’

Is the grill getting ready to be turned down, if not totally turned off? Kudos again to Bloomberg’s Jonathan Weil for his cutting edge review and analysis of major accounting issues and their impact on our financial industry. Weil reports, Accountants Gain Courage to Stand Up to Bankers:

The Financial Accounting Standards Board is girding for another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out swinging.

It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance companies could keep long-term losses from crummy debt securities off their income statements.

Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July 15. The board might decide whether to issue a formal proposal on the matter as soon as next month.

I am truly heartened (yet simultaneously shocked) that the FASB would choose to pick this fight with the financial industry and their Congressional counterparts at this time. Washington has unequivocally laid out a plan to ‘buy time’ for financial institutions, and in turn the economy, to recover. This proposal, Financial Instruments: Improvements to Recognition and Measurement, would certainly promote transparency while likely exposing real problems within financial institutions.

Weil provides further piercing insights:

“They know they screwed up, and they took action to correct for it,” says Adam Hurwich, a partner at New York investment manager Jupiter Advisors LLC and a member of the FASB’s Investors Technical Advisory Committee. “The more pushback there’s going to be, the more their credibility is going to be established.”

The scope of the FASB’s initiative, which has received almost no attention in the press, is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s tentative plan.

This would mean an end to asset classifications such as held for investment, held to maturity and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.

What would this rule change have meant for CIT?

The commercial lender, which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity. That tells you the company probably was insolvent months ago, only its book value didn’t show it.

What does the banking lobby think of this proposed rule change?

“I guess the nicest thing I can say is it’s difficult to find the good in this,” Donna Fisher, the American Bankers Association’s tax and accounting director in Washington, told me.

Weil concludes:

If the bankers don’t like it, that’s probably a good sign the FASB is doing something right.

Sense on Cents concurs and will be monitoring developments very closely. Thank you Mr. Weil.

LD

How Will Banks ‘Manage’ Earnings?

Posted by Larry Doyle on July 14th, 2009 8:09 AM |

A number of major financial institutions are reporting 2nd quarter earnings this week. Actually, to say these institutions are truly reporting earnings would be a misnomer. To a large extent, these institutions are releasing managed earnings reports. What does that mean? Let’s navigate this ever important sector of our economic landscape.

In simplistic fashion, earnings are revenues less expenses. While financial analysts may want us to take reported earnings on face value, there is a lot more to it than that. What are the quality of the earnings? Are revenues increasing or decreasing? Are expenses increasing or decreasing? Are net margins of profitability increasing or decreasing? Are earnings a function of a growth in revenues or more a reduction in expenses?

In regard to a financial institution’s earnings, the greatest expense is typically compensation and benefits. On Wall Street, the expense associated with personnel usually runs between 50-55% of overall expenses.

On the revenue side of the ledger, earnings are broken down by division. How much revenue is produced from fee-generating business units and is repeatable versus how much is generated from volatile trading businesses and is thus more risky. Fee generating revenue is considered to be of higher quality. As such, the market attaches a higher multiple to the earnings from those business units.

In my opinion, the most opaque component of earnings and income statements revolves around valuations of assets held on the financial institution’s books. This component of an earnings statement is truly where the financial wizards on Wall Street get most creative.  The assets to which I refer are:

1. Securities positions, that is, the variety of different bonds, stocks, and derivatives held by the institutions. While plenty of these assets are very liquid, easily evaluated, and thus easily marked, others are much less so. For a wealth of toxic assets (different types of mortgage assets, CDOs, and the like), these institutions were blessed by the FASB (Federal Accounting Standards Board) to mark them at levels which they deem appropriate versus where the assets may actually be trading in the marketplace. In the process, these institutions are sitting on hundreds of billions of embedded, yet unrealized, losses. How and when may those losses be recognized? When the underlying loans backing these securities default. Let’s move to that aspect of ‘managed earnings.’ (more…)

PPIP: A Virtual “Odd Lot”

Posted by Larry Doyle on July 7th, 2009 8:31 AM |

In Wall Street parlance, a trade of respectable volume is defined as a “round lot.” A large trade is often designated simply as “size.” A trade of relatively small size bordering on insignificant is defined as an “odd lot.” Obviously all of these definitions are relative measures predicated on the magnitude of the market and the prevailing situation. On that note, the initial launch of the Public-Private Investment Program, PPIP, appears as if it will be an “odd lot.”

As Bloomberg reports, Treasury’s Distressed Debt Plan Said to Begin With $20 Billion,

The U.S. Treasury Department may begin its program to spur purchases of mortgage-backed securities from banks with about $20 billion in public and private money, down from as much as $100 billion when it was announced in March, two people familiar with the matter said.

Recall that the PPIP has two programs. The program targeted at raw whole loans has been postponed indefinitely. This program highlighted above is targeted at asset-backed securities (ABS, collateralized by credit card receivables, student loans, and other receivables).

Why is the PPIP getting off with a whimper? Market pundits and government officials would promote the principal that the PPIP is less necessary for the financial industry currently. Why? The banks were able to raise billions in equity capital after the results of the Bank Stress Tests were released. If those investors were comfortable putting money into the system, then why should banks feel an urgency to raise more capital via asset sales utilizing the PPIP? Bloomberg reports as much,

Treasury Secretary Timothy Geithner said then that interest in such U.S. programs may be waning as market confidence improves.

I beg to differ. In my opinion, the PPIP is getting off to such a slow start for a variety of other reasons, including:

1. price:investors continue to believe the underlying assets will experience a greater level of delinquencies, defaults, and foreclosures and thus they are not willing to pay the price banks desire.

2. FASB’s relaxation of the mark-to-market: allows the banks to value these securities at levels above market and avoid taking the loss if they were to sell through the PPIP.  Banks can not avoid the loss, though, as the underlying loans continue to suffer higher levels of defaults.

The New York Times highlighted this exact point this past Sunday in an article, So Many Foreclosures, So Little Logic,

But the most fascinating, and frightening, figures in the data detail how much money is lost when foreclosed homes are sold. In June, the data show almost 32,000 liquidation sales; the average loss on those was 64.7 percent of the original loan balance.

Here are the numbers: the average loan balance began at almost $223,000. But in the liquidation sale, the property sold for $144,000 less, on average. Perhaps no other single figure shows how wildly the mortgage mania pumped up home prices. It also bodes poorly for the quality of the mortgage-related assets lurking in banks’ books.

Loss severities, like foreclosures, are rising. In November, losses averaged 56.1 percent of the original loan balance; in February, 63.3 percent.

3. Uncle Sam: investors have seen how Uncle Sam has changed the rules of the game as he goes along. Examples of Uncle Sam’s abusive tendencies include Congress’ lambasting AIG employees over contractual bonus obligations and the Obama administration ‘running over’ senior creditors of GM and Chrysler. Investors are shying away from doing business with Uncle Sam regardless of the attractive terms within the PPIP.

The PPIP looked good on paper but putting it into practice is a totally different ballgame. Given the strength of these three counteractive factors, I am not optimistic the PPIP will ever move off the “odd lot” desk.

LD

Financial Cooking

Posted by Larry Doyle on July 5th, 2009 8:46 AM |

When business operations make money, it is due to the brains and intellect of management, correct? When business operations lose money, it is some sort of nefarious measure at work in the marketplace which can be ‘corrected’ by changing the rules, correct? The implementation of the relaxation of the FASB’s (Federal Accounting Standard Board’s) mark-to-market utilizes that thought process. Make no mistake, it is flawed and simply allows financial institutions to ‘manage earnings,’ otherwise known as “cook the books.”

We receive a whiff of this recipe in a report by the Wall Street Journal, Home Loan Banks See Net Income Decline 51%. I have maintained that the basic business model of the FHLBs is flawed and we see evidence of this in the fact that outstanding advances (loans) by the FHLBs to their member banks actually decreased in the 1st quarter of this year:

Total advances outstanding from the banks declined to $817.41 billion as of March 31 from $928.64 billion three months earlier. After surging in 2007 and early 2008, demand for those advances has slackened, partly because of the recession and partly because the federal government has offered alternative funding programs for commercial banks.

Without even maintaining the level of advances, the FHLB system is coming under increasing pressure to generate earnings in the face of increasing delinquencies, defaults, and foreclosures on all of their holdings–advances, mortgage originations, and mortgage-backed securities purchased from Wall Street. (more…)

Sheila Bair and the PPIPs Tour: Cancelled

Posted by Larry Doyle on June 4th, 2009 7:56 AM |

What is going on with the PPIPs?

The Public Private Investment Program was “scheduled” to play a grand national tour in helping the banking industry cleanse itself of toxic assets. Did the “lead singer,” Sheila Bair, lose her voice? Did the “backup” in the form of the banks and investors lose their rhythm? Let’s “boogie” on over and check it out.

The FT reports, FDIC Stalls Sale of Toxic Loans:  

Details of the Treasury’s toxic asset plan are in doubt after the Federal Deposit Insurance Corporation on Wednesday said it was suspending a test run of the legacy loans programme.

Sheila Bair, chairman of the FDIC, said development of the programme – designed to encourage investors to buy toxic, or legacy, loans from banks in order to restart the flow of credit – would continue but a pilot sale of assets was on hold.

“Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system,” Ms Bair said in a statement.

Is this all that it appears to be or is there more of a smokescreen on the stage inhibiting all parties – Uncle Sam, the banks, and investors – from “giving it their all”? Let’s dive into the mosh pit.

Sense on Cents views the situation as follows:

1. Impetus for banks to liquidate toxic assets (now called legacy assets by the Obama administration) is dramatically lessened. Why? Are they now less toxic? No, anything but that. With the relaxation of the mark-to-market accounting standard, banks can now “mark to model.” As such, banks are not forced to write the asset value down. In so doing, banks are now not compelled to sell it at a price which would incentivize an investor to purchase.      

2. What about all of the equity capital raised by banks over the last few weeks after results of the Bank Stress Tests? Has that had an influence on banks need to raise capital via the PPIP?

Yes, but remember that the Bank Stress Tests only covered the largest 19 banks in our nation. These banks have been largely successful in raising new capital. That said, the toxic legacy assets remain on their books. Do not forget, though, that many small to medium sized banks and thrifts have a sizable amount of underperforming loans (residential mortgages, commercial real estate, corporate loans) on their books. These banking institutions were neither put through a “stress test” nor are they in a position to raise capital as easily as the large banks.

A successful PPIP program would have helped these institutions.

3. Hints of potential self-dealing by banks involved in the PPIP, both as seller of assets and buyer of assets, would have created a firestorm. I addressed this problem in writing, Putting “The Fix” in the PPIP.      

4. With all due respect to the lead singer, Sheila Bair, all indications are that her handler – an individual named “Uncle Sam” – can not be trusted. Potential investors have been very reluctant to get overly involved with Sam. Why? In other performances, Sam has “strip searched” individuals upon entry and also played various iterations of “bait and switch.”

As the FT reports:

Banks and investors, meanwhile, had misgivings over taking part in the PPIP amid fears the politically charged climate could prompt Congress to change rules on issues such as executive compensation for those firms that participated in the programme.

While this tour is being cancelled, don’t get overly despondent. I am sure our Summer concert series will be able to provide plenty of entertainment going forward!!

LD  

Scott Black on the Markets and Economy

Posted by Larry Doyle on June 3rd, 2009 10:30 AM |

Scott Black of Delphi Asset Management is one of the most highly regarded value investors in the market today. He was just interviewed on Bloomberg News and made the following assessments:

1. the economy can not substantially recover with a high and increasing unemployment rate.

2. there is a current disconnect between equity market performance and economic data.

3. stocks are NOT “once in a lifetime” bargains at current levels.

4. investors are “grasping at straws” chasing the market higher.

5. future earnings for the S&P 500 are $43 on a top down basis and $54 from a bottom up standpoint.  At yesterday’s closing level of 945 on the S&P, those earnings equate to price multiples of 22 and 17.5 respectively. Is that rich, cheap, or fair? Rich.

6. Over and above the fact that the market looks rich at current valuations, the S&P 500 has an 11-12% weighting in financials. Black maintains that we can not properly evaluate the earnings of financial firms under the relaxed mark-to-market accounting. (Please see my earlier post, Wall Street-Washington: “Pay to Play”)

LD

Wall Street – Washington: “Pay to Play”

Posted by Larry Doyle on June 3rd, 2009 7:46 AM |

In my opinion, the relaxation of the FASB’s (Federal Accouting Standards Board) mark-to-market rule was nothing more than a vehicle to allow banks to “cook their books.”  The “cooking” of the books put the burner on a low simmer in order to allow the banks sufficient time to generate earnings. Those new earnings can and will be used to offset the currently embedded losses on the toxic assets still residing in the banking industry.  

The FASB did not relax their accounting rule without enormous pressure applied by both the Wall Street and Washington chefs.  The Wall Street Journal reports, Congress Helped Banks Defang Key Rule:

Not long after the bottom fell out of the market for mortgage securities last fall, a group of financial firms took aim at an accounting rule that forced them to report billions of dollars of losses on those assets.

Marshalling a multimillion-dollar lobbying campaign, these firms persuaded key members of Congress to pressure the accounting industry to change the rule in April. The payoff is likely to be fatter bottom lines in the second quarter.   

I have numerous questions and comments on this topic, including:

1. If this accounting rule was so insidious, why was “mark-to- market” accounting ever enacted in the first place?  

Sense on Cents: As with any accounting rule, the “mark-to-market” was implemented to create transparency.

2. Are the toxic assets still on the bank books?

Sense on Cents: Most definitely. They are merely being masked via this relaxation.

3. Banks maintain the toxic assets don’t actively trade and, when they do, they trade at levels not reflective of their true values.

Sense on Cents:  These assets have traded everyday and at levels assuming a heightened level of future defaults on the underlying mortgages. If the banks believe the market levels are not reflective of true value, then why haven’t they and global investors raised the funds to purchase these massively undervalued securities? Investors trust the market assumption of future defaults.  

The WSJ reports:

Earlier this year, financial-services organizations put their lobbyists on the case. Thirty-one financial firms and trade groups formed a coalition and spent $27.6 million in the first quarter lobbying Washington about the rule and other issues, according to a Wall Street Journal analysis of public filings. They also directed campaign contributions totaling $286,000 to legislators on a key committee, many of whom pushed for the rule change, the filings indicate. 

4. Wall Street paid approximately $28 million in contributions and lobbying to effect this accounting change. The banks made these payments while in receipt of billions of dollars of TARP funds (taxpayer/ government assistance). Did Wall Street effectively utilize taxpayer funds in order to “pay” Washington so the banks could continue “to play” their game?

Sense on Cents: In my opinion, most definitely!!

5. How long had the “mark-to-market” been in effect prior to its relaxation?

Sense on Cents: Decades. It worked just fine.

6. Why didn’t banks lobby in the 2000-2006 era that assets were being overvalued via this accounting standard?

Sense on Cents: Bank executives were being “paid” from those inflated valuations. 

7. Given that the banks now utilize internal pricing models to value the toxic securities, are those models and their embedded assumptions made public so investors can have some degree of transparency?

Sense on Cents: NO!! Why would the banks want the “cooking” exposed?

In summary, this version of “pay to play” will be seen as a watershed event in the Brave New World of the Uncle Sam economy. Why will future economic growth underperform? The banking industry will be forced to continue to set aside reserves against the embedded toxic assets. In so doing, the banks will have less credit to extend to consumers and business.

LD

For more on this topic, I submit:

Putting Perfume on a Pig
April 2nd; post written the day FASB relaxed the mark-to-market standard

Freddie Mac, Fannie Mae Deja Vu?
May 28th; post highlighting the massive embedded losses in the Federal Home Loan Bank system. These losses are masked by the relaxation of the mark-to-market.

Legalized Bribery
February 16th; post highlighting Chuck Hagel and Leon Panetta implicating Washington politicians’ endless pursuit of money. 

How Wall Street Bought Washington
March 9: post highlighting the massive money spent by Wall Street to curry influence in Washington.

Sense on Cents On Economy and Markets: Lets Look Back to Look Forward

Posted by Larry Doyle on May 23rd, 2009 8:50 AM |

The developments in our global economy are so large in scale that it is of paramount importance to develop a macro view. David Swensen, Yale’s head of investments and widely regarded as the top portfolio manager within college and university endowments worldwide, says as much in an interview reported by Bloomberg:

“The crisis forces you to think top-down in ways that would, I think, be unproductive in normal circumstances, or absolutely necessary in the midst of a crisis,” Swensen said. “You have to think about the functioning of the credit system. You have to think about the potential impact of monetary policy on markets over the next five or 10 or 15 years.”

I concur. In that spirit, let’s look back at my outlook from last October so that we can more clearly look forward as we navigate the economic landscape.

Excerpts, with current commentary, from The Economy – What Lies Ahead (originally published October 14, 2008):

1. Global Increase in Long Term Interest Rates – the massive amount of debt that will need to be issued will cause rates worldwide to rise even in the face of a likely significant economic slowdown. 

I still maintain this premise. The move down in the economy last Fall led to an initial move lower in rates on government bonds. Our central bank and other central banks have subsequently supported the economy via quantitative easing (central bank purchasing of government and mortgage-related assets). That said, we are now entering the stage where the global demand for credit is swamping investors’ and central banks’ ability to provide it and rates are moving higher. I believe this move to higher rates, especially in the government and mortgage sectors, will continue. Rates for municipal and corporate bonds should also be forced higher although not as much.

2. Financial asset deflation while hard goods and asset inflation. Why??
I can already hear the printing presses at work churning out currencies worldwide. The rise in interest rates will depress bond values. With slower worldwide economic growth and increasing unemployment, GDP prospects are not pretty for the foreseeable future. I think there is a very strong chance that we will see “stagflation.”
While financial assets have limited upside growth potential and significant downside even from here, hard commodities and assets will likely increase in value, or perhaps I should write will hold their value as financial currencies and financial assets lose value.

I continue to believe we will experience stagflation. Comments by Bill Gross of Pimco highlighting the potential likelihood of the United States losing its implied AAA credit rating adds fuel to this fire.

Individuals, corporations, and governments still need to delever (pay down debts) and will be forced to sell assets in the process. As such, while I think selected sectors of the equity market may hold up, I remain concerned about the overall market. I think the U.S. dollar and other currencies of overlevered (big fiscal deficits) nations will suffer. These developments are inflationary. To defend one’s portfolio from inflation, gaining exposure to TIPS (Treasury Inflation Protected Securities) is prudent. Mr Swensen addresses this point in the aforementioned interview.

3. Where do you put your money??

Take what the market is giving you, and right now they are giving you security and guarantees in deposits in large money center banks . . . this also provides flexibility to provide liquidity for those in desperate need and you will see more and more of that occur both at a personal level and a corporate level . . . BE PATIENT . . . buy QUALITY . . . this market is very quickly separating the wheat from the chaff . . . well managed institutions will gain market share and it will be reflected in the value of their stocks and bonds . . . one has to fully understand an entity’s ability to generate cash flow to meet their debt service and to grow their enterprise.

While rates on CDs and other short term deposits have come down, I still believe it is prudent to remain defensively positioned at this juncture. As the liquidity needs increase – and they are – opportunities will develop in a wide array of markets. While it may be prudent to buy short term bonds of highly rated companies, I still think people should keep plenty of dry powder. Within equities, companies with pricing power (ability to increase prices in an inflationary environment) will outperform.

4. Other Highlights . . .

If the government accedes to the pressure being applied to suspend the mark to market accounting principle, I would expect that move would only prolong the underperformance of the economy . . . I view a suspension of the mark to market as the equivalent of an agreement to officially allow one to “cook their books.”

I very much believe this and maintain this viewpoint.

SELL RALLIES . . . while financial institutions have been feeling the pain of overleverage for the last 12 to 18 months, that pain is just now coming to bear on the consumer . . . given that the consumer represents app 70% of our GDP, the expected precipitous drop in consumption across a wide array of products and industries will be very painful . . . you will see a litany of corporations announcing layoffs on a regular basis . . . Pepsi did just that this morning.

I also maintain this premise. I believe we will experience double digit unemployment this year given the problems in the automotive (production, parts, and dealers), and municipal sectors (forced cuts as tax revenues plummet. California is the poster child!!). Retail sales will remain low keeping domestic production and imports also depressed.

Please share your thoughts and opinions. Each and everyday is a microcosm, but we need to maintain the macro view as we navigate the economic landscape!!

LD






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