Those Happy Bankers

We were pulled into this recession by problems that bankers had with defaulting sub-prime mortgages, and other difficulties in the banking industry.

Some think we'll start to recover with leadership in the financial/banking sector of our economy. We did witness some positive signs this past week, and the stock market responded quite favorably.

Be careful with your interpretation of the stock market, however, as this may simply be a short lived rally within an existing bear market--lasting only a week or a couple of months before the next stock market decline.

The spark that ignited this latest stock market rally was comments from Vikram Pandit, CEO of Citi, telling employees they will turn a handsome profit in the first quarter, their best money gain since 2007. This was followed up by similar comments from Ken Lewis of BofA and Jamie Dimon of JPMorgan.


Why are they so rosy all of a sudden? Has the sky cleared--and all the woes been erased by the $700 billion TARP bailout of last fall?

No, those mortgage defaults are still on their mind. While TARP and other government measures are helping--and we may see revision to the mark-to-market accounting rule that I wrote about a few days ago--there are still significant hurdles for the banking industry.

BUT, there is some very good news that banks are now starting to report. Banks make money on spread. They borrow at low interest rates--and then lend at 1, 2, 3 or more percent higher rates. This is a significant source of operating profit, and since last year, they have gone about their normal business of leveraging for profit.

Here is a chart showing how much banks pay depositors, in general, for short-term certificates of deposit (CDs)--and how much they charge home owners these days--who are happy to either obtain new credit or refinance their homes at relatively low interest rates.


Looking at this chart another way, in terms of spread, here is why banking CEOs are so pleased with their bottom line these days. This spread of over 4 percent means big bucks for banks--and it reveals a possible turning point--which we will all applaud as we look for a recovery from the current recession.

Mark-to-Market

Have you ever heard of this arcane accounting term? Mark-to-market accounting rules, enforced by the SEC and the Financial Accounting Standards Board (FASB), require a company to value -- or "mark" -- assets on its books based on the price they would bring if they were sold today.

Mark-to-market accounting existed in the Great Depression and according to Milton Friedman, it was responsible for the failure of many banks. Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157 went into effect in 2007, reintroducing mark-to-market accounting, look what happened.

According to my favorite economist, Brian Wesbury, two things are absolutely essential when fixing financial market problems – Time and Growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.

Because these accounting rules force banks to write-off losses before they even happen, we lose time. This happens because markets are forward looking. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.

This affects growth. By wiping out capital, fair value accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed and the government proposed bailouts. This drove prices down even further, which hurt the economy. It’s a vicious cycle.

Former FDIC Chair William Isaac places much of the blame for the sub-prime mortgage crisis on the Securities and Exchange Commission and its fair-value accounting rules, especially the requirement for banks to "mark-to-market" their assets, particularly the mortgage backed securities.


You may recall John McCain's criticism of the SEC during the Presidential race last fall. He even called for the resignation of the SEC chairman Christopher Cox.

Under the mark-to-market rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities.

When a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.

Panic sets in and no one wants to buy mortgage-related securities, which drives their value under mark-to-market regulations down toward zero. Balance sheets under mark-to-market suddenly start to show insolvency.

This downward spiral shuts down lending to these companies, so they lose all liquidity (cash on hand) needed to keep company operations going.

Stockholders--realizing that they will be wiped out if the companies go into bankruptcy or get taken over by the government--start panic selling, even when they know the underlying business of the company is fine.

In theory, if banks no longer had to account for these valueless assets on their books, their balance sheets would suddenly improve and -- this is the important part -- private capital would start to flow back into the banks. Right now, an estimated $9 trillion to $10 trillion of private capital is sitting on the sidelines because it doesn't want to invest in sick companies.

Again, in theory, if mark-to-market were temporarily lifted, the big banks could get well almost overnight.

Tomorrow Rep. Paul Kanjorski (D-Penn.), will convene a hearing of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises to talk about mark-to-market.


The downside? If mark-to-market is lifted for good, or is made too lax, companies could create balance sheets that are pure fiction, giving potential investors zero insight into the health of companies.

FASB 157 may ultimately be the right standard, but it was reimposed at exactly the wrong time. This isn't an ordinary period and FASB 157 is creating more stress than it needs to for the financial sector and the broader economy.

Short-term assets should not be given arbitrary values unless there are actual losses. The mark-to-market mania of regulators and accountants is utterly destructive. It is like fighting a fire with gasoline, says Steve Forbes.


He goes on to say, If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans.

Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.

Finally, it would be worth your while to listen to Brian Wesbury discuss the issues pertaining to this vital topic. Notice in his comments how the stock market reacted to rumor of a suspension--in early February. Investors are telling us how pervasive this rule is in hindering constructive recovery of banks.

Unfortunately, Treasury Secretary Tim Geithner provided no details in his news conference--and our stock market took yet another hit, affecting millions of Americans' retirement savings.

Feds & Recession

What does the New York Feds know that you don't about US recessions?

Their research since the late 1980s reveals that the slope of the yield curve is a reliable predictor of future real economic activity. Specifically, the Fed model uses the difference between 10-year and 3-month Treasury rates to calculate the probability of a recession in the United States twelve months ahead.

You will notice in the chart how closely the Fed model correlates with recessions of the past 4 decades.


The Fed's data show that the recession probability peaked during the October 2007 to April 2008 period at around 35-40%.

The Fed model shows a recession probability of only about 1% on average through the next 12 months. The New York Fed's Treasury spread model predicts the end of the recession in 2009.

I find it interesting that the Fed model has accurately predicted the last 7 recessions dating back to 1960.

According to my favorite economist, Brian Wesbury, "Some early warning signals suggest an economic recovery should start taking hold by mid-year."

Recently I published a L U V article about the pattern of this recession. Based on this information, the V outcome predicated by Brian Wesbury is possible.

We're So Gloomy

I haven't really been able to sort out exactly why there has been this degree of pessimism. George Bush

Consider the excerpts from this Time Magazine article.

Why are Americans so gloomy, fearful and even panicked about the current economic slump? Ten years ago we would have thought this was paradise, and now we're whining about it," says David Wyss, chief economist for the consulting firm DRI/McGraw Hill.

Many, many business leaders share this lack of confidence and recognize that we are in real economic trouble," Says University of Michigan economist Paul McCracken. "This is more than just a recession in the conventional sense. What has happened has put the fear of God into people."

Americans are so uneasy because they feel economic turmoil on two levels, one relatively superficial and the other much deeper. The deeper tremors emanate from the kind of change that occurs only once every few decades.

Many economists agree that the U.S. will face at least several years of very modest growth, probably in the 2% to 3% range, as consumers and companies work off the vast debt they assumed.

The reckless borrowing made a reckoning inevitable. "You can't spend eight years priming the pump and getting all your growth through debt in the private, corporate and public sectors and expect to come out of it overnight," says John Bryan, chairman of Sara Lee.

"We're not going to get any momentous return to growth anytime soon," concurs an Administration economist. "People are smarter than we give them credit for. They've known we couldn't keep borrowing our way to prosperity forever."

While some economists have described the current slump as a near depression, that phrase overstates the case if it is taken as a comparison with the period 1929-33, when the U.S. economy contracted by nearly a third.

In some respects, the current recession is more painful than the numbers show because this slump is so different from most. The current unemployment rate appears to be well below the level reached in the 1981-82 recession, when joblessness peaked at 10.8%. But experts say the comparison is misleading because the labor force is growing far more slowly today than a decade ago, which means that fewer people are seeking jobs.

Another factor that has aggravated unease in this recession is that there has been no sense of leadership, let alone prescience, from Washington. Consumers were blindsided by the failure of the White House and most economists to foresee the length of the downturn. "Everyone was told it was going to be mild," says Stephen Levy, director of the Center for the Continuing Study of the California Economy.

Consumers will have to open their wallets before any recovery can get rolling, and that is by no means ensured.

So far, though, no reprieve from layoffs is anywhere in sight.

At the very least, the current malaise has raised the public's consciousness about the need for real leadership and accountability in both Washington and corporate America. People are smart enough to know when they are being squeezed.

OK, I did leave hints in this excerpt of a Time Magazine article. Did you pick them up? Here was a major hint:

The current unemployment rate appears to be well below the level reached in the 1981-82 recession, when joblessness peaked at 10.8%. But experts say the comparison is misleading because the labor force is growing far more slowly today than a decade ago...

First of all, the quote was from President George Bush.


The Time article was published January 13, 1992 (ie, "today" in this article) by John Greenwald.



Here are trends in unemployment rates--including that 1990-91 recessionary period, and today (2008).



Time will tell if/when we reach the unemployment rate of the 1990-91 recession, or of 1973-74, or of 1981-82...let alone the peak of the Great Depression which reached 25.6%.

Regardless, financial setbacks are not fun, and we tend to be a gloomy sort when things aren't going our way.

Around the globe, 18 of 24 countries surveyed by Pew describe current economic conditions as bad. The negative economic outlook is worse as the median percentage rating their national economy as "bad" rose from 50% in 2007 to 61% in the latest survey.

Two notable exceptions, China and India, remain upbeat about national economic conditions, although Indians are less positive than they were a year ago. Some of the most negative evaluations of economic conditions come from citizens of advanced Western countries.