Still the decline in the broad market was tepid, for this environment at least. The S&P 500 had been down as much as 1.8% early in the session, bounced to a 0.6% gain in the afternoon but eventually succumbed to the aforementioned concerns falling 1.5% in the final 90 minutes.
Market Activity for December 17, 2008
Utility, technology and energy shares took the brunt of the damage falling 2.92%, 1.73% and 1.59%, respectively. Consumer discretionary and basic material stocks were the only gainers of the 10 major industry groups. (Strange how consumer discretionary shares gained ground on a day global economic worries were the primary concern, but the group was helped by a jump in Macy’s shares after the retailer negotiated a more flexible bank-credit agreement.)
The Dollar
The dollar got clocked yesterday, extending a six-session decline as all of this talk and action of massive fiscal stimulus and the Fed’s latest comments have caused investors to think about fundamentals again. The Fed has flooded the system with dollars, and they signaled they are willing to do much more if they feel necessary. This was setting up for a dollar rout, as much as it pains me to say it, as we’ve touched on for a few weeks now.
The greenback had benefited from the flight-to-safety trade, but it appears some of this trade has moved to gold – up 16% over the past eight sessions. Of course, gold doesn’t pay interest or a dividend, but some don’t seem to care about that right now as the four-week T-bill has traded at a negative yield and 90-day bills trade at 0% -- it’s a crazy world.
Mortgage Applications
The Mortgage Bankers Associations reported their refinancing index rose 6.5% last week. The index has risen four of the past six weeks as the 30-year fixed-rate mortgage has dropped from 6.4% at the beginning of November to 5.18% last week.
The group’s purchases index fell for the second week, declining 4.5% in the week ended December 12, which followed a 17% decline in the prior period.
Crude-Oil
OPEC members agreed to cut production by 4.2 million barrels per day at the cartel’s meeting yesterday. The reduction brings OPEC’s daily production to 24.845 million barrels from 29.045 million which was the official quota back in September. This is a huge reduction and will have on effect on price even with lower levels of demand.
The issue that OPEC generally has to deal with is cheating – individual countries producing more than the quota calls for. When oil prices are rising, especially dramatically like last spring/summer, they have an incentive to keep oil in the ground – it’s free storage and producers are confident a higher price will be captured a month down the road. However, when prices are falling the OPEC members generally produce more than their quota for fear next week will bring less revenue.
(The futures market is currently in contango – future deliveries trade at a higher price than the spot price. This would normally cause producers to allow supplies to build, which is true here in the U.S. but OPEC countries are do dependent and hard-up for oil revenues, they will be cheating.)
Since crude prices have tanked $100 per barrel over the past five months, the members are hurting for revenue – especially countries like Venezuela, Libya and Algeria. The cheating that results will make the reduction less effective. Still, the size of the cut is so large it should push prices higher nevertheless. Not yesterday though.
The market ignored the production cut to focus on the weekly supply report, which was quite bearish and sent crude below $40 per barrel for the first time in four years. It recovered a bit to close above the 40-handle at $40.06.
The Energy Department reported crude supplies rose 525,000 barrels to 321.3 million barrels last week – roughly 5% above the five-year average (effectively more than that considering the drop in demand). Stockpiles have climbed 11% since September 19.
Loans and Mark-to-Market
The Fed continues to pump massive amounts of liquidity into the system, yet banks continue to hoard the cash, unwilling to increase lending. And who can blame them? With mark-to-market accounting rules that determine capital-adequacy ratios, why would they take on assets like car and home loans? Why extend credit lines? Lenders would be holding back in a tough environment already, but even more so due to this rule.
With default rates growing and the housing market showing no sign of reversal just yet, lenders know they’ll just be writing down more assets, which will force them to raise more capital and put up more collateral. This is the insanity of pro-cyclical accounting rules. When asset prices are falling banks have to write-down assets (even those they have no desire to sell), causing them to raise more capital, which forces them to sell more assets, pushing prices down more and thus more write-downs. It’s a death spiral.
Using mark-to-market accounting with which to based capital adequacy ratios was put in place in November 2007; the timing could hardly have been worse. This accounting standard is tantamount to your neighbor having to sell his house today because of special circumstances (and because of the urgency must take a 30% haircut), and you then would be forced you to lower your home’s value by 30%, say from $300,000 to $210,000 – even if you have no desire to sell. Oh, and by the way, you’ll have to come up with $72,000 to keep your LTV at 80%. Wouldn’t that be nice.
If we would have had this standard in place during the S&L crisis we’d still be dealing with the effects. We must return to the former standard, which based capital adequacy on the original cost of an asset; it served us well. Remember, mark-to-market is no better in a rising asset price environment as firms will be required to hold less capital than would otherwise be the case, which obviously carries its own risks.
Sure, if a financial institution is going to sell an asset, then they will have to take the market price and accept the hit to earnings. However, for assets with 10-20 year lives, and most of which continue to kick off cashflows, it makes no sense to continually mark these asset to distressed-market prices. This has greatly exacerbated the current situation.
Have a great day!
Brent Vondera, Senior Analyst
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