Good Evening: A raft of economic news and hints about next week’s financial rescue plan prevented our capital markets from taking a well-deserved rest prior to tomorrow’s unemployment data. Analysts’ forecast for tomorrow’s numbers are all over the map, but investors seemed to want to believe next week’s announcement out of the Treasury Department will trump whatever Friday’s statistics bring.
Earnings reports were a bit of a mixed bag, with companies like Cisco reporting both an earnings beat in the current quarter and a disappointing outlook for the next. Kraft missed estimates, though Visa and MasterCard exceeded theirs. Thursday’s economic reports were a touch clearer. The employment news was downbeat as the Monster employment index fell and jobless claims rose to new cycle highs (see BAC/MER’s take below). The claims news caused BAC-MER to lower its forecast for nonfarm payrolls to a below consensus -600K, while the same news caused Goldman Sachs to raise their forecast to an above consensus -475K. All the job-shedding we’ve witnessed recently has helped productivity, according to today’s Q4 report. Output did a swan dive, but hours worked fell even faster, helping to push productivity higher by 3.2%. Finally, unit labor costs were better behaved than had been expected.
U.S. stocks opened to the downside, perhaps in reaction to some of the above statistics. The S&P 500 was down 1% soon after the open, and the rest of the averages were sporting similar losses after an hour’s worth of trading. It was then that some rumors started floating around various trading desks (thank you, George). The chatter centered on a potential suspension of mark-to-market accounting rules for bank assets. Whether this potential suspension would apply narrowly or broadly, be temporary or long term, was a matter of considerable debate and speculation. It’s quite possible that Fannie Mae’s decision to loosen its own rules added credence to all the rumors (see below). The banks have been clamoring for this suspension for a while now, and despite the fact that we all know its a joke (rule changes don’t change cash flows or asset values), investors decided to hit the buy key first and worry about value later.
Equities levitated on this fresh supply of hot air, going from red to green in less than half an hour. The major averages rose until they were 1% to 2% higher just before lunch, with a turnaround in many bank names representing the main theme. Stocks then traded sideways for the rest of the day, leaving the averages with gains of between 1.35% (Dow) and 2.2% (Dow Transports). Treasurys idled for most of the session, and yields fell between 1 and 4 basis points. The dollar posted a modest 0.4% gain, while commodities finally found the strength to rally. Energy, grains, and precious metals led the way as the CRB index rose almost 2%.
Once tomorrow’s unemployment stats have been announced and digested, I get the sense that market participants will spend much of Friday’s session positioning themselves for next week’s “major announcement” from Treasury Secretary, Tim Geithner. I’m hoping some form of cap on bank leverage similar to the one I proposed last night is part of this “sweeping overhaul”. I received quite a few questions about my idea via email, and most of them centered on Wall Street’s ability to use financial engineering to game the system and thus evade capital requirements.
One reader worried that Credit Default Swaps would be used in lieu of cash instruments, and another thought employee pay at the banks should be cut so drastically that bankers will be forced to go back to being their dull, pre-boom selves. I prefer not to micromanage either the banks or the bankers, and slashing compensation (or giving them lobotomies) wouldn’t be constructive. The basic idea is to put tight and enforceable borders around the banks — and then let them choose how to do business within those limits.
As for CDS and other exotic derivatives, I have two responses. First, require them all to be listed exchange-traded products with daily cash margining. Second, any derivative not directly hedging a cash market exposure will be subject to the same capital requirement as the cash instrument they reference. For example, a CDS position referencing an investment grade corporate would result in the same capital set-aside requirement as the corporate bond itself (same for high yield bonds or sovereigns). All products, no matter how well “engineered” are either a cash market instrument or a derivative of one. CDS and other derivative instruments were originally created to be used as cheap hedging vehicles, so let these instruments return to their roots.
How we get to the promised land of less leverage will matter, too. Set the leverage cap too low and enforce it too quickly and the system will melt down again due to forced selling. Perhaps we could do it like mileage requirements for the auto makers — start with a realistic goal in year 1, and tighten the standards a bit more each year until the leverage levels reach our ultimate goal (10x to 15x). Then again, given the track record our government has had with the automakers, my plan might work better on paper than in practice. No system will be perfect and Wall Street will try hard to game whatever new system is put in place. But if we can set up reasonable and enforceable leverage limits for the banks, then the impact of their inevitable future mistakes will be less likely to endanger the whole system. We might some day even begin to let banks fail again. Jack McHugh
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