A Dash of Insight

Bad News on Housing

We continue to believe that the Dodd/Shelby housing bill is important for financial stocks and the market as a whole.  Yesterday's 83-9 vote on cloture, the Senate process for limiting debate, seemed to signal passage.

After the market close today it became apparent that there are additional hurdles, suggesting that  the bill will not pass before the July 4th Congressional recess.  One Senator, John Ensign (R-Nev) is using the full range of arcane Senate rules to block the bill.  Sen. Ensign wants to add an amendment concerning tax credit incentives for renewable energy.  The problem is that the House has already rejected this non-germane amendment.  Allowing it would also open the door for many other non-germane amendments.

The sponsors insist that the measure will eventually pass, even if brought back after the July 4th recess.  The markets are not very patient on issues like this, and the potential for a Bush veto remains.

Our own feeling is that if the bill passes,  the President will face extreme pressure to sign it.  The measure has overwhelming support in both parties.  Legislators campaigning this year will want to show that they were helping distressed homeowners.  Some of the key Republican states are those most affected by foreclosures.

Please note that we are doing market analysis here -- not an assessment of the merits of the legislation.  Many market pundits seem willing --even eager -- to see a complete cratering in housing prices with the fancy name of "price discovery."

We shall return to the merits of the legislation at a future date.  For now, we suggest that investors considering banks or other financial stocks should keep this development in mind.

And meanwhile -- note how a single Senator had the power to block legislation that had the overwhelming support of both parties.  It is a lesson in how difficult it is to pass a bill -- a subject from one of our classes in the old days.

Housing Bill Veto Threat

There is a threat to the housing bill that has been moving through Congress.  It is important, and attracted little market attention today.

Background

The House passed an aggressive version of housing relief, led by House Financial Services Committee Chair, Barney Frank (D MA).  The Senate went through a negotiating process, with Sen. Richard Shelby (R AL) acting as the spear carrier for the Bush Administration.  Shelby succeeded in negotiating a compromise with Sen. Banking Committee Chair, Christopher Dodd.  The compromise bill cleared the committee on a vote of 19-2.

In the normal course of events, the bill would be passed by the Senate, since it has strong bipartisan support.  Many key Republicans represent states hard hit by potential foreclosures.  The next step would be a conference committee to reconcile the differences with the House version.  The plan was to complete legislation for President Bush's signature by July 4th.

Today's Developments

Today's story, breaking from various sources, got little attention during trading.  To the surprise of most (since Shelby had already used the Bush veto to exact various compromises) the Administration announced opposition to the Senate measure.  This bill was more conservative than the Frank version from the House.

Influencing the decision was information suggesting that some key officials, including Senators, received favorable loans from Countrywide.  Some analyses of the legislation suggest that Countrywide will be unduly assisted by the legislation.  There are many articles on this subject, but we recommend the very objective reporting from CQ Politics.

Our Take

At "A Dash" we have emphasized that solutions to the housing problems will not be a single comprehensive solution.  Instead, government works in incremental fashion, addressing one aspect of the problem at a time.  Some of the increments are in place, but this bill is an important addition.

As usual, we urge readers to put aside personal opinions about the  merits of the legislation and consider the market impact.  That is our mission.

This bill would help to stabilize housing demand.  There has been a lot of attention paid to housing supply, but there is also latent demand.  Most observers believe that some buyers are waiting to see stability.  Others need some help in qualifying for loans.  For these reasons, the measure is expected by most to help the housing market in an incremental, but important fashion.

A Presidential veto would be a negative for housing, credit markets, and the stock market in general.  It is possible that a scandal involving leading Senators could either delay the Senate passage, the conference committee action, or passage of the resulting bill.  It might also provide justification for a Presidential veto, especially since the lame duck Bush Administration may not be fully aligned with the GOP election needs.

If the political turmoil derails the legislation, we view this as a serious negative for US stocks.  If the issue is not resolved soon, no action will be taken before the election.

It is a strange fact of our political system that the implications for specific individuals and companies may outweigh a general concern.  One is easy to describe and makes good election fodder.  The other involves a deeper understanding of economic effects, one that eludes the grasp of the average voter.

Important News on the Housing Bill

When something important happens, with potential market effects, we interrupt our normally scheduled programming for an update.

We intend to publish the answers to the economics quiz and to announce the winners.  Meanwhile, potential entrants have another day to win this prestigious contest!

The Housing Compromise

At "A Dash" we have written a series of articles on  housing problems and possible solutions.  Since the government steps have been incremental in nature, the market has not really responded.  At some point, there will be a realization that something important has happened.

Last week we pointed out that investors should be watching Sen. Richard Shelby as the indicator of a real compromise.  A Senate Banking Committee compromise was reached today.  While there are more steps in the legislative process, we see this as the real hurdle.

The Significance

We note with interest the opinion of Nouriel Roubini, an outspoken bear on the housing situation.  In two articles, Roubini discusses the merits of the proposal and responds to critics of his viewpoint.  Here is a key portion of his argument, but readers should consult both articles.

Very few reflected on the substance of this proposal and its strong economic logic that would benefit borrowers, lenders and even the government as the fiscal cost of no action (a systemic banking crisis that would trigger a costly fiscal bailout of banks given deposit insurance) is much higher than the potential modest fiscal cost of this proposal.

Conclusion

This is good news for the housing market, the economy, and the stock market.  We shall delve more deeply into the proposal and the effects in future articles.  We shall also examine the reactions of economists and prominent bloggers.

UPDATE, 5/20/08, 1 PM CDT

The editors at TheStreet.com have kindly moved my article on the Frank/Dodd legislation to the non-subscription portion of the site.  Readers of "A Dash" can check out this article for insights from Doug Kass and Jim Cramer, the description of the remaining steps before it becomes law, and the reasons I believe President Bush will sign the legislation.  The process is going to take another six weeks or so, but it will get more attention before then.

Sell in May?

There are many Wall Street adages.  Some seem to have predictive power, including the idea that one should "sell in May and go away."

Such slogans have extra influence because of the catchy, alliterative qualities.

When Indicators Conflict

There are a number of conflicting adages at the moment.

There is the Presidential Election Cycle. We have not been big fans of this because the causal model is elusive.  This year, however, we have both the Fed eases and the stimulus package.  If ever the theory were to work, this might be the time.  We also note that the popular bearish commentators embraced the theory when it suggested market weakness, but have fallen silent during the period when it suggested strength.  This should be interesting to contrarian investors.

There are technical considerations.  Can the market break through apparent resistance?  That is the current battleground for traders.

There is the question of earnings forecasts and targets.  First quarter earnings and outlooks were not as gloomy as expected.  Financial writedowns?  Yes.  Other companies?  Not so bad.  It was an unexpected double-digit gain for non-financials.

Summing up the Prospects

Two of our favorite sources provide some insight.

Bespoke Investment Group notes as follows:

Bespoke readers might remember that Goldman got rid of bullish strategist Abby Cohen when the market was cratering in March.  Cohen had a 2008 price target of 1,675 for the S&P 500, and after replacing Cohen at the market's bottom, Goldman's new strategist (David Kostin) lowered the firm's year-end S&P 500 price target from 1,675 to 1,380.

Readers should check out the entire article.  The Goldman economics team is very bearish and that has now expanded to their strategist team.  These are often quite different within a single firm.  This is a classic case of "global strategists" versus bottoms up analysts.  It bears watching, but regular readers of "A Dash" know that we think the bottoms up guys are under-rated.  Everyone is still fighting the old war of the 2000 tech bubble when companies and analysts hyped.  When will we learn that the world is different now?

Muckdog wisely highlights some research from Sy Harding via Mark Hulbert.  The gist of the story, which you should read for the full account, is that the "sale date" might be delayed this year.

That is consistent with our current model output, and our sense of the fundamentals.  To check this out, readers might wish to revisit this article, from April 3rd.

And by the way ---

What happened to "Don't Fight the Fed"?  We highlighted this as a "top secret" investment opportunity -- early, but not wrong.

Candidates and Fuel Prices

Sophisticated market observers and economists joined today in objecting to Presidential candidate positions on energy issues.

The Statements

Sen. McCain was first with a proposal for a "gas tax holiday" this summer.  Sen. Clinton joined in, leaving Sen. Obama as the only holdout for maintaining federal gasoline taxes.

Sen. Clinton has been even more aggressive about high profits for oil companies.  This afternoon, as spotted by Colin Barr, her campaign complained about the decline in ExxonMobil stock, in spite of excellent earnings. 

There is something seriously wrong with our economy when Exxon’s record $11 billion in quarterly profits are seen as a disappointment by Wall Street,” Clinton said. She went on to use the company’s latest gains to reiterate her call for a gas tax holiday — a proposal has been criticized by economists who say it won’t result in lower prices for consumers. “I believe we should impose a windfall profits tax on big oil companies and use that money to suspend the gas tax and give families relief at the pump.

The Reaction

Not surprisingly, these proposals generated near-universal dissent from the economic community.  The complaints about profits and the ExxonMobil stock decline of 3.6% created similar objections among sophisticated market observers, like the panel on Kudlow and Company.

Barry Ritholtz is ready to give a good lesson to the candidates.  Check out his article about how the candidates fail Econ 101 (a course frequently cited at The Big Picture!).

We are delighted to find ourselves in agreement with Barry, the economists, and the savvy market observers on Kudlow's excellent program.

But here is the question:  Do the candidates really not understand how economics and markets work, even at the level of Econ 101?  Or is their motive a different one?

Is This Credible?

Well -- McCain admitted that he was soft on economics and was reading Greenspan's book to bone up!!  In spite of this, we think his team has enough economic horsepower to "speak truth to power" as we say in the public policy business.

Senator Clinton's case is even more clearcut.  She turned $1000 into $100,000 in only ten months of cattle futures trading, a record that none of us can claim.  She did it by "following the market closely" and "making her own decisions".

So she understands markets.  Her campaign also knows the proper role of experts, according to the Wall Street Journal.

Clinton’s position on the gas tax runs counter to that of economists across the political spectrum who argue that a temporary tax reprieve would do little to lower gas prices this summer.

“There are times a president will take a position that a group of quote-unquote experts will agree with and there are times when a president will take a position that a group of quote-unquote experts won’t agree with it,” campaign spokesman Howard Wolfson told reporters today, “Sen. Clinton believes this is the right policy.”

An Alternative Explanation

Instead of assuming that people intelligent and successful enough to be Presidential candidates are stupid, let us instead assume that they are smart.  As time winds down in a life-or-death struggle, the candidate looks for anything that might work.

It is natural to look at the issues of the day and gauge the public reaction.  Everyone is worried about high fuel prices.  Whom do they blame?

Here are data from a 2007 poll.  We follow such polling questions constantly and the numbers do not change that much.  The data show that the average person blames big oil or government for high fuel prices.  They do not understand much about market forces.  They go for conspiracies and simple-minded answers.  It is a winning tactic, at least in the short run.

If you were a candidate, would you try to educate the 2/3 of the people who are wrong-headed, or would you "go with the flow?"

Here is the poll question:

Who do you blame the most for the recent increase in gasoline prices - oil producing countries, oil companies, President Bush, Americans who drive vehicles that use a lot of gasoline or normal supply and demand pressures.

Oil companies	43%
President Bush	20%
Supply and demand	13%
Oil countries	11%
American drivers	4%
Not sure	9%

Pandering?

Barry calls the candidate efforts "pandering" and the term seems to fit.  Let us take careful note of the circumstances:

• An issue where nearly all of the top experts -- people who have relevant credentials and have reflected carefully -- draw a conclusion different from many average  people.
• Many consumers of the information believe in conspiracies and simple, common-man explanations.
• The candidate, someone in a position of leadership, chooses to exploit the public mis-perception rather than to educate and to lead.
• The resulting pandering helps the candidate, but might well hurt the average voter -- the person consuming the candidate's message.

This all has an eerily familiar pattern.  It is something to think about.

And by the way, we do not think any of the energy proposals have a ghost of a chance of passage.

Weekly Sector Update

The apparent shift in Fed policy was partly anticipated by the markets.  As a result, the expectations concerning the dollar changed.  The TCA-ETF portfolio from last week had a number of "weak dollar" plays, foreign markets, energy, and basic materials.  The data for this week (as of Wednesday's close) show a shift in the rankings, with more emphasis on technology.  (This is evolving rapidly).

The table below shows this week's rankings.  Vince has adjusted the strength scale to aid in the interpretation.  The underlying method has not changed.  A reading of zero indicates the average expected performance of a sector over a one-month time frame, the general time horizon for the model.  A reading of 50 indicates an expected return that is one standard deviation above the average, roughly the top third of returns.  A reading of 100 indicates an expected return of two standard deviations above the average.

While we update the model daily, we have introduced a program for average investors that does weekly trades unless emergency adjustments are required.  A report on this program is available upon request.

(Click to see the chart)

Housing Problem: What Inning is It?

Are we the only ones getting tired of the "What inning?" question?  When we think baseball, it is better to enjoy the early success of Chicago's two teams, especially the suddenly slick-fielding White Sox.

For several months financial television asked everyone about recession chances.  Prior training or experience not required -- all opinions welcome.

The question du jour is now, "Which inning of the mortgage crisis are we in?"

John Hussman's Answer

The widely-read and respected John Hussman complains as follows:

One of the fascinating aspects of Wall Street is the ability of analysts to provide opinions without the faintest backing from evidence. Among the latest topics of opinion is how far the mortgage crisis has to go. Evidently, the idea is that the recession that these analysts didn't forecast is already over, so it is time to “look across the valley” on the belief that most of the writedowns are behind us.

Hussman's own approach is to take a schedule of resets and integrate the curve to show a cumulative effect.  From this, he concludes that we are still in the early innings, with each inning lasting three months.  The worst is yet to come, etc.  Check out the entire article.

Two Errors

The Hussman analysis makes two serious errors.  First, he uses data from nearly a year ago.  This is assuming that ARM resets are a stationary target.  In fact, many mortgage holders have already refinanced.

This was reflected in a recent AP-AOL survey, the subject of an article we wrote for Real Money (subscription required).  Two survey results were especially relevant to this question:

1. Only 11% of those with mortgages have adjustable rates; 18 months ago, the figure was 22%. This suggests that there has already been a lot of refinancing.
2. Among homeowners with adjustable-rate mortgages, those who are worried about making their payments after an increase is 36%, exactly what it was in the prior survey.

We are hesitant to mix two different methods of measurement and two different time periods, but surely there has been some change since the stale chart cited in the Hussman article.  If he is going to use some fancy analysis to impress and frighten the average reader, at least he could update the data.

The second Hussman error is quite common.  He is focused on the problem while completely ignoring any solutions.  The loosening of restrictions on Fannie and Freddie (including the conforming loan cap and the overall portfolio cap) will help to encourage refinancing that was difficult a few months ago.

Jordan Kahn at In the Money, one of our featured sites, writes as follows:

I think the news from Freddie Mac (FRE) today was pretty significant, although it received little attention.

In the press release, Freddie said it will buy jumbo mortgages in high-cost regions from Wells Fargo (WFC), JPMorgan Chase (JPM), Citigroup (C) and Washington Mutual (WM). The government-sponsored enterprise expects to finance between $10 billion and $15 billion in new jumbo mortgages in 2008.

He points out that the old caps were ridiculous in some areas, a theme we have also argued.  Jordan calls it "big news" which will help us get closer to a bottom in housing.

[Jordan sat in the hot seat today, covering for Doug Kass on his daily investing blog, The Edge.  Doug is doing a lecture at the Harvard Business School!  We hope that the Wharton man gets the appropriate respect from the Harvard crew.  Meanwhile, Jordan did his usual great job as a substitute.]

Conclusion

Ironically, John Hussman did exactly what he accused others of doing.  The evidence he adduces for his answer to the "innings question" is no more plausible than anyone else's.

Our own answer?  We do not know.  Neither does anyone else.  It is going to depend upon the ability of people to refinance, where fixed rates go, how quickly Fannie and Freddie and the FHA provide help, and whether a foreclosure assistance bill passes Congress and gets signed by the President.

We do not know the answers to those questions, but at least we know what to look for.

TCA-ETF Update

As we regularly do on Thursday, we are showing an update on our TCA-ETF sector model rankings.  The overall result for the third cycle, begun on January 25th, is about even, roughly the same as the S&P 500 and a bit ahead of the NASDAQ.  There are two interesting things to observe.

First, the strongest sectors remain the "weak dollar" plays.  Second, the overwhelming majority of sectors are in the "buy" range.

Interested readers can get a report via email on participating in our weekly trading program for individual investors.

Credit Default Indexes: Frankenstein's Monster?

Bloomberg writers Neil Unmack and Sarah Mulholland do a nice survey of viewpoints (Swaps Tied to Losses Became `Frankenstein's Monster') on the problems in relating credit default swaps, indexes and cash markets.

A telling quotation comes from Kevin Gould, the head of data products and analytics at Markit, the source of various indexes.  As expected he provides a defense for the product:

The ABX index has brought greater transparency to the market.  Without it there would have been a number of market participants that would not have been aware of the levels of distress some of their assets were under.

Fair enough.  But Gould also states, (Markit's) "indexes should be used as a tool to gauge the direction of credit markets, not necessarily to value the underlying assets."

Now they tell us!

Many believe that the (very real) credit problems have been exacerbated by faulty government regulation that does exactly what Gould says we should not do.

The Bloomberg Take

Anyone who wants to read all perspectives should check out the entire article.  Mainstream media has given scant attention to this theme.  Meanwhile, this segment captures the spirit of the article:

`Totally Uncorrelated'    

The latest version for AAA rated subprime mortgage bonds slumped by 43 percent since it began trading in August, according to Markit, as rising U.S. home loan delinquencies triggered a surge in the cost of credit-default swaps. That implies a 53 percent loss on the underlying mortgages, according to Schultz [head of asset backed bond research at Wachovia], almost four times the 13.75 percent rate predicted by Wachovia.    

The cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, more than four times the 2.8 percent forecast in the event of a recession by JPMorgan Chase & Co. analyst Alan Todd in New York.    

``ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,'' Swiss Re's Aigrain said at the Dubai conference.

Market Breakdown

The difficulty in using these indexes comes from the inability to arbitrage the widely perceived discrepancies.  Brad De Long raises the question of how to make money from this.  We examined the problem a few months ago in this post.

Anyone with a good answer to De Long's question can both make a profit and improve market efficiency.

Thanks to Gary D. Smith for pointing out this story, which seemed to get little attention today.

 

                    

Your Biases Cost You -- A Lot!

One of the reasons we moved from the academic world to the investment world was the potential for profiting from widely-held misperceptions.  Such situations abound in the current political and market environment.  Investors who understand this can have a field day.

Background

In the study of economics, political science, and public policy formation there is a body of work supported by evidence.  There are also areas of disagreement.  A student entering the first course in these subjects comes without knowledge, but with plenty of biases about "how the system works."

It is easily demonstrable (and the subject for more articles) that those who study these subjects find agreement on a wide range of topics.  The experts may seem to disagree, and they do on many theoretical offshoots and specific implications.  It is more interesting for them to debate the disagreements.

Meanwhile, the average reader (or investor) did not take these classes, or long ago forgot what they learned.  This provides an interesting opportunity for the Internet age, where bloggers and mainstream media alike are hungry for content.

One simply takes some plausible "everyman" idea, then takes some development in the news, and spins it to the lowest common denominator of understanding.  Since most people share the underlying value bias, they uncritically accept the conclusion.  Your blog or column is popular.  You get acclaim and high ratings.  Life is good!

The Case in Point

Yesterday we wrote about the SEC opinion letter, which attempted to improve both accuracy in valuation of assets and visibility to the investor.  If anyone takes the time to read the entirety of the letter, it is obvious that whatever method chosen by a company and its accountants must be revealed and described in full.  There is complete visibility of method and conclusion.  Those with a value bias do not quote the key parts of the letter, as follows:

If you conclude that your use of unobservable inputs is material, please disclose in your MD&A, in a manner most useful to your particular facts and circumstances, how you determined them and how the resulting fair value of your assets and liabilities and possible changes to those values, impacted or could impact your results of operations, liquidity, and capital resources. Depending on your circumstances, the following disclosure and discussion points may be relevant as you prepare your MD&A:

• The amount of assets and liabilities you measured using significant unobservable inputs (Level 3 assets and liabilities) as a percentage of the total assets and liabilities you measured at fair value.
• The amount and reason for any material increase or decrease in Level 3 assets and liabilities resulting from your transfer of assets and liabilities from, or into, Level 1 or Level 2.
• If you transferred a material amount of assets or liabilities into Level 3 during the period, a discussion of:    
  • the significant inputs that you no longer consider to be observable; and
  • any material gain or loss you recognized on those assets or liabilities during the period, and, to the extent you exclude that amount from the realized/unrealized gains (losses) line item in the Level 3 reconciliation, the amount you excluded.
   
• With regard to Level 3 assets or liabilities, a discussion of, to the extent material:    
  • whether realized and unrealized gains (losses) affected your results of operations, liquidity or capital resources during the period, and if so, how;
  • the reason for any material decline or increase in the fair values; and
  • whether you believe the fair values diverge materially from the amounts you currently anticipate realizing on settlement or maturity. If so, disclose why and provide the basis for your views.
   
• The nature and type of assets underlying any asset-backed securities, for example, the types of loans (sub-prime, Alt-A, or home equity lines of credit) and the years of issuance as well as information about the credit ratings of the securities, including changes or potential changes to those ratings.

An objective reader of this letter might well question a pundit who suggests that something in this process reduces visibility to shareholders.  The idea that it encourages fraud is just silly.

The Value Biases in Place

There are several easily identifiable biases:

• Markets always yield the correct valuation, regardless of liquidity.  Anyone with actual trading experience knows this to be false.  There can be many reasons for buyers to step back, often based upon a lack of information or guessing that others will not buy either.  The Fed, through a number of measures, and the SEC, have both recognized this, attempting to stabilize markets until there is more visibility and more trading.
• The SEC and the Fed are trying to fool people.  One should recognize this as an assumption, not a conclusion based upon evidence.  Try doing a critical reading of those  taking this viewpoint.  What evidence is there  that this is what these agencies actually do?  We might add that our own  study of government (based upon forty years of experience) yields a quite different conclusion.  Most of the participants are non-partisan, senior officials who are attempting to get it right.  Unlike the pundits playing to an audience, they are genuine experts in their field.
• Companies lie.  Accountants back them up.  This value bias stems from the 1999-2000 bubble experience.  Wall Street pundits can invoke these examples and everyone can remember them.  Did any of these pundits note the passage of Sarbannes-Oxley?  Did they notice the death sentence delivered to Arthur Andersen?  Do they believe that these changes have had no effect upon corporate and accounting behavior?  Our own experience as a member of the board of a public company and as a reader of many corporate reports suggests a very different conclusion.

Evidence

This article from Accrued Interest provides some great information about the liquidity in many bonds and the issues in marking to market (although the author may not share our conclusions).  The CDO liquidity is even worse.

Tonight's discussion on Kudlow has an interesting exchange (starting at 4:15) between Barry Ritholtz, who believes that the SEC opinion promotes fraud, and Vince Farrell who makes an insistent rebuttal.  (Both are colleagues on RealMoney, and frequently offer valuable insights).  Vince invokes the example of AIG and their accountants as refutation, an example we have cited at "A Dash." 

One might also compare the conclusion with Barry's take on home prices.  He seems to feel that this market, despite millions of trades, does not accurately reflect pricing because some homeowners are unrealistic in their offers.  The implication is that distressed trading in CDO's, based upon few trades, is valid, while home prices, based upon many trades, are not.

Conclusion

There are many investors who are currently acting out their biases.  In a world where one is free to reject any piece of data as somehow flawed, the initial value biases govern behavior.

At "A Dash" we have attempted to show a powerful and ongoing effort by various parts of government to deal with the relevant issues.  We expect each of these initiatives to have an effect, with a strong cumulative effect. 

Meanwhile, investors and managers rejecting stocks and going to cash are not just fighting a Fed that is cutting rates, something we warned about.  They are fighting a creative Fed that is willing to employ new tools never before considered.  They are fighting the stimulus package, the SEC, expansion of Fannie, Freddie, and the FHA.  The Frank/Dodd legislation will be the next battleground.  If the Bush Administration agrees to a compromise, it will be another significant effect on housing supply and demand.

It is so easy to point out problems, and so difficult to see the solutions.

SEC on Marking to Market: Another Problem Solved

A major market problem relates to how financial institutions must recognize the  value of securities  that are not trading in a liquid market.  The financial assets include complicated securities including various tranches of mortgage debt.  Everyone agrees that these are difficult to value.

Given this problem, buyers have stepped away.  There is no legitimate market, one of the  major problems for achieving some stability in equity markets.  The Fed has addressed this by accepting, at a discount, such securities in TAF auctions, and more aggressively in opening the discount window and taking action in the Bear Stearns buyout.

Anyone in the money management business respects market pricing -- when it is valid.  At "A Dash" we certainly agree.  Freely trading securities should be market to market.

The Problem

Difficulties ensue when specific securities are sold in a distressed market.  Since there is no real market for many CDO's, the various methods of evaluating them may be generating questionable pricing.  Under the recently adopted FAS 157 rules, companies are compelled to recognize such pricing, even if the expected payouts do not conform to the actual sale prices.

FAS 157 was intended to force financial institutions to recognize actual pricing on balance sheets, with the consequences flowing through to income and earnings.  So far, so good.  The problem came when there was no legitimate market for the securities.

This led to a death spiral, where a distressed firm would be forced to blow out assets.  Those who chose to hold the assets -- anyone not under compulsion -- expected to achieve much better results.

But what about the "temporary" marks?

The SEC Action

The SEC released a letter to firms offering advice on how to handle this situation.  It did not give a free pass for bad assets.  It did allow companies, with advice and consent of their accountants, to make a FAS 157 exception when certain assets, sold by other companies, had been, in the indelicate terms of traders, "puked out" , at prices that did not represent reality.

The Impact

This is an important step.  Some have argued that "mark to market' should be suspended.  The SEC is not doing that.  The proposed interpretation is more measured and more thoughtful.  It is very bullish for financial stocks, since it allows them to make more realistic valuations of assets.

The Spin

The story has been picked up by all of the big-time bearish blogs, including Ritholtz and Mish.  It was featured by the New York Times.  At "A Dash" we have some questions for these sources:

1. Do they distinguish pricing when it comes from liquid markets as opposed to distressed markets?
2. Why are they so confident about the true value of Level III assets?

Conclusion

The critics of this move are all guilty of a logical fallacy -- affirming the consequent.  They believe that they are the only ones who really know the value of complex CDO's and that companies should be compelled to use any trade as a mark.  Is this approach one that will actually help investors?

What has really happened is an intelligent step by the SEC to allow companies some latitude when  market trading is not a good indication.

Meanwhile, the average investor who checks out the top blogs and the New York Times sees something that is downright scary.  It is another example of where an intelligent investor, seeking information, confuses sensationalism with sound advice.

We wish we had a specific catalyst to cite, but we do not.  The SEC action is another important step to solving the related housing and mortgage problems.  Who knows when more traders and investors will grasp this point -- something that seems quite obvious to us.

If you cannot pass this investment test, turn over the car keys

Here is a key question for investors and traders alike:  Do you want to be entertained by the colorful opinions of bloggers about what government should do or would you rather profit by understanding what they will do.

Background

We have highlighted the distinction between normative and empirical analysis -- opinions about what ought to be done versus the dispassionate study of behavior.  We suggested in December that the Fed was on a mission, using creative tactics.  We highlighted an excellent article from Abnormal Returns describing the difference between "Positive and Normative Blogospheres."  We have suggested that those offering opinions should first get some information -- at least reading some Fed briefings and old transcripts of meetings.

A Good Explanation

While doing research for our sister site, Election Stocks, where we analyze candidate issues and link them to specific investments, we came across a five-year analysis of the Iraq war.  We recommend checking out our comment on this subject, and the complete study.

Meanwhile, the explanation of the work provides an excellent insight into the distinction between those doing "politics" and those doing public policy analysis.  The report comes from a private sector group.  They make money by providing analysis, not opinion.  The following is the explanation of their mission, taken from the report:

The debate is over whether the invasion was a mistake in the first place, while the divisions over ongoing policy are much less real than apparent.

Stratfor tries not to get involved in this sort of debate. Our role is to try to predict what nations and leaders will do, and to explain their reasoning and the forces that impel them to behave as they do. Many times, this analysis gets confused with advocacy. But our goal actually is to try to understand what is happening, why it is happening and what will happen next. We note the consensus. We neither approve nor disapprove of it as a company. As individuals, we all have opinions. Opinions are cheap and everyone gets to have one for free. But we ask that our staff check them — along with their personal ideologies — at the door. Our opinions focus not on what ought to happen, but rather on what we think will happen — and here we are passionate.

Conclusion

The Stratfor description is exactly what makes public policy analysis valuable.  It is just what we are trying to do at "A Dash."  While we have opinions about what government should do, our mission is in helping investors understand past actions and predict future moves.

Those who do not understand this distinction are failing an investment Breathalyzer test.  They have become intoxicated with the  punditry and the debate over policy while losing focus on the cumulative effect of the many incremental policy changes.  These changes are starting to add up, (yet another future topic.)

Meanwhile, if you do not see the difference in these types of analysis, you should do the following:

Turn over your investment car keys to an index fund manager!