Archive for April, 2009

First Quarter 2009 Investment Review

Friday, April 10th, 2009

Mark-to-Market: March Madness?

By now the first quarter stock market gyrations and the NCAA basketball tournament (referred to as “March madness”) are history.  At least the latter has a regular and finite schedule.  The stock market does not.  US stocks remained weak and volatile in the first quarter ended March 31, 2009.  Stocks, as measured by the S&P 500, dropped 11.7% in 1Q09 but dropped 18% from year end 2008 to March 11th while the DJIA index dropped 25% year to date through March 9th. .  By March 23rd they had both staged their biggest 10 day rally since 1938 with the S&P up 18% and the Dow up 14% (both indices rose about 7% on March 23rd alone).  Yet the S&P dropped 5% from March 26-30th before recovering modestly on March 31st.  March madness?

If you read, watch, or listen to financial or investment media you have heard the term “mark to market (MTM)”.  MTM is a process where one assesses the value of an asset, investment, or loan and re-prices it to reflect where it could be sold as of that date (in the “market”).   This accounting concept was designed to allow investors to better judge a company’s balance sheet, thus enhancing transparency.   The weakness in stock valuations earlier this year, particularly for financial companies, reflected investors’ fears financial firms owned assets that had not yet been written down “to market”.    Before stock prices turned, numerous experts were predicting mass nationalizations of banks.  March madness?  The drumbeat was so loud that Ken Lewis, CEO of Bank of America, wrote a Wall Street Journal opinion on March 9th addressing “myths” about banks not lending, being insolvent, the TARP program not working, the assumption that taxpayers would lose all their money from TARP, that banks must be kept accountable, and that nationalization (of the industry) was inevitable.


Are investors correct in their assessments that bank balance sheets are so fragile that nationalization is necessary?  Or does mark- to- market overstate the risk?  Why should we care?

Some argue that we need more mark to market, not less.  We beg to differ.  The uncertainty around banks has always been, and will always be, how large their loan losses are over an economic cycle.  Marking intermediate and long term loans to “market” – at prices vultures might pay in uncertain times to make a large profit on them – borders, in our opinion, on the ridiculous.  Banks know that a percentage of loans will go delinquent and incur losses – it is an inherent part of their businesses.  That is why they keep some cushion (capital and reserves) during the good years – to prepare for the lean times.  What if we marked to market our homes monthly and mailed those statements to ourselves?  We would feel pretty confident about our financial situation in good markets and maybe quite nervous in the bad ones but it likely wouldn’t change our plans to live there.   What if we marked-to-market our cars, furniture, clothes, and computers?  Kind of silly, you say?  We agree.  We use these things and receive value from them every day.  The exact value of an item matters only if we have to sell it and even then the value would depend on how many other comparable items were for sale and how many willing buyers there were.  Marking our lives to market would be (March) madness.

The global financial system has been heavily supported since September, 2008 following the bursting of the US housing and securitization bubbles in late 2007 and the failure of Lehman Brothers.  In response, the government lowered interest rates, raised deposit insurance limits, and infused billions of dollars into banks to strengthen their capital.    Many are upset that the government may be doing too much to bail out the banks.  Warren Buffett succinctly summarized the financial landscape recently:

‘Whatever the downsides may be, strong and immediate action by government was essential last year if the financial system was to avoid a total breakdown. Had that occurred, the consequences for every area of our economy would have been cataclysmic. Like it or not, the inhabitants of Wall Street, Main Street and the various Side Streets of America were all in the same boat.’ — Warren Buffett.

Bold government and regulatory initiatives have already pumped over $5 trillion into liquidity facilities, $1 trillion into financial firms as capital, and another $1 trillion into loan guarantees.  In mid February, the government approved a massive stimulus package to boost economic activity.  In late March, a new Treasury program (with favorable terms from the FDIC and the US Treasury) was unveiled to facilitate the purchase by private investors of “legacy” (they had been called toxic) troubled assets.  As we entered 2009, we viewed the economic and investment landscape cautiously.  Consequently, we counseled many of our clients to take a less aggressive near term investment posture.  However, we also favored maintaining diversified portfolios with some equity exposures where clients could live with the volatility.    As shown below in Figure 1, stocks were down in 1Q09 but well off their early March lows.  Financial stocks, while still lagging, are also well off their lows.

Figure 1: Total return YTD of the S&P 500 Index and the S&P 500 Diversified Financial Services Index:

sp-ttlreturn

Markets now seem to be expecting some of the government programs to work, or at least allowing for the possibility of success.  As the facts emerge over time markets will rise and fall.  On the heels of a sharp decline in stocks in 2008, and early 2009 it is understandable that investor confidence was shaken.  Losing hard earned money is not pleasant. None of us knows what the future holds so we keep some cushion in savings.  Excess financial resources beyond this should be invested (in harmony with our risk profiles) to meet our varying financial goals.