Friday market update

For a third consecutive day, the broader market enjoyed a nice advance. In fact, nearly 50% of the losses seen over 20 plus days of trading prior to Tuesday’s rally were recouped by the end of today.

But it was likely a lot of short covering, when those who have the least confidence in the long term prospects are forced to bank their gains being short and buy some stocks to cover their short positions.

Sure, a retail report came in better than expected and there are a lot of bulls who feel that since Novembers lows have now been tested and since prices of many indexes have moved back above this important low that a spin could be made that the fearful statements of dropping back to 1996 lows is way overplayed and the broader market has actually succeeded in holding the test of support at the November lows.

Technically, this is only true for the Nasdaq indexes. The broad market indexes, such as the Wilshire 5000 and the S&P 500 convincingly broke below the November lows. And while a rebound could recover much of the recent losses, the die seems set.

So what sparked today’s rally on the heels of Tuesday’s oversold short-covering?

It’s the subject of “mark-to-market” for the banks. It is finally getting some real attention. You see, a hearing was convened today in Washington to consider alternative methods of valuation rather than the current mark-to-market rule.

This rule is not very old, only brought into play since November, 2007. Do you see a striking coincidence to when this rule was made and the beginning of trouble in the financial sector?

Here’s why. In a strong economy, when assets are appreciating, i.e., the housing bubble, the investment banks and other financial institutions wanted to be able to state the market value of their collateral, thus giving them higher capital to loan ratios – hence the desire on their part for a mark-to-market rule.

But in a weak economy, when assets are depreciating, i.e., the current bursting of the housing bubble, this new rule bites the financial guys firmly in that large rear muscle.

When assets collapse in value and are then sold at a fire sale, such as what occurs in many foreclosures, the “market” value of comparable collateral is now forced to be valued similarly, forcing banks to write off billions of paper losses, even though the majority of their current loans are being serviced according to the original mortgage terms.

When the government later bails out the banks by purchasing shares and capitalizing the banks the cash inflow does nothing but sit there on paper helping the bank with their capital to loan ratios. All those billions of dollars in essence did nothing by going into the banks as capital even though it did keep them from going under. It really could have been done a different way.

If the toxic assets had been purchased from the banks then the banks would have had cash, remained private, and the asset to loan ratios would have kept them in business and possibly able to re-loan out the new money.

The average person is likely offended at the proposal to suspend or ameliorate the mark-to-market ruling for the banks. They know that if the price of their homes goes down they can’t pretend that it is still worth more and get a loan based on its old 2006 value. Individuals are simply stuck with the losses in home equity.

But stock investors see the picture a little differently. The feeling is that a fire sale of an asset at even lower than market prices forces 90% of their loans that are being serviced just fine to have too low a collateral value. The reasoning being that if these long-term loans instruments are serviced and held to maturity then the real value is at least the face value of the mortgage, not some fire sale price by comparable foreclosures, etc.

And so when a hearing is convened to discuss this subject, shortly after Ben Bernanke even says something different should be done, traders holding short positions became nervous. They bought stock this week to cover their short positions and a spike rally is the result.

This kind of buying is usually over in a few days and the real market bias begins to return, in this case, a decline in prices, coincident with a weak economy.
But this instance may be different.

It is suggested that over the next few weeks a proposal to modify the current mark-to-market rule will be presented. I suspect it could allow banks to state the value of their performing assets much closer to face value rather than the lower fire sale values.

This re-evaluation alone would change the reserve ratios at the banks and in essence free up a lot of capital that is currently locked down. The lending that could result may actually provide more real stimulus than the better known Stimulus Plan just passed by congress.

However, there is motivation to keep the mark-to-market as is. If banks are forced to liquidate these performing assets at fire sale prices and private capital enters the fray to pick them up at these discounts, then who benefits when the loan is serviced to maturity? Right – the private money that came to the rescue of the banks and took the toxic assets off their balance sheet at a bargain price. The banks don’t want to do this.

You will hear strong arguments on both sides of this rule, but my bet is that it will be modified. The market will react positively if this happens. Whether it will be enough to make a difference over the long run is a subject for another day – but I have my doubts.

But for now, the stock market likes the talk that is going on and is hoping for a change in the rule. A change they can have confidence in – for a change.