To OTC Journal Members: 
 

On Monday I finally got caught up on a couple of BLOGS I've been wanting to post for sometime. There's updates on both China Energy Recovery (OTC BB: CGYV) and PhotoChannel Networks (OTC BB: PNWIF). 

While neither of these stocks is anywhere need making us any real money, both are far outperforming the indexes, which are falling to new lows every day. While the Russell 2000 is making a 12 year low, CGYV is 66% above its November low, and PNWIF is 40% above its November low.

The BLOG is your opportunity to ask questions and offer comments. I will make an effort to answer every legitimate question. If I don't know the answer, I will contact the management and get the answer. Alternatively, if you have questions you don't want publicly displayed, you can always email me directly at editor@otcjournal.com. If you submit a comment or question, it will not appear on the site until I have responded.
 

The Mark To the Market Financial Mess- What's It All About?

These big down drafts in the markets are all about Wall Street's fascination with the financials, and the havoc their poor performance is wreaking on the large indexes- specifically the DOW and the S&P 500.

Here's the chart that's absolutely killing the financials, and it's important to understand what this is all about. When Wall Street pundits scream we have to suspend "mark to the market", this is what they are talking about.

Banks carry assets on their balance sheet. In our current regulatory environment, what a bank carries on its balance sheet with regard to its assets vs its liabilities has a lot to do with how the bank functions and what kinds of loans it is capable of making. Thanks to more lax standards that were implemented during the Clinton Administration, banks can now loan $40 for every dollar of actual cash they have. That's the leverage that has gotten the whole sector in trouble- along with the phony deriviatives- but that's a whole other edition.

So, let's say you are a bank that has a large portfolio of mortgages. These particular mortgages are all AAA, but were originated since the beginning of 2007.

Let's say, hypothetically, you orginated $100 million in AAA mortgage loans. As you can see from this chart, today you have to carry that $100 million in loans at a value of $28 million, despite being AAA mortgages. This is because the market for those mortgages is highly illiquid and very inefficient.

At $.28 on the dollar, the market is making some overly negative assumptions. For example, let's take a home that was purchased for $300,000 since the beginning of 2007. The home owner has AAA credit, and is making all the payments in a timely manner. Let's assume this individual put down 10% on the purchase, leaving $270,000 on the note.

In a best case scenario for the bank and the real estate market, the home owner just stays put and keeps making their payments. The bank collects its interest, but still has to raise more capital to shore up its balance sheet.

Let's say the owner notices the same house is now selling for $175,000- down 42% in the last 18 months- a pessimstic number in most markets. The owner says to himself "why should I continue making the payments on this place when I need 58% appreciation in property value just to break even? Why not just give it back to the bank? "

So, the home owner swings by the bank and says- SEE YA! I'm not paying for this property for the next 5 years just to break even. It's all yours. I'll go rent for a while, rebuild my cash, and then buy something later.

Now the bank reposseses the home, and sells it at auction. Other like homes are selling for about $175,000. Let's say the bank auctions it cheap at $150,000. Now, the bank has $150,000 back on a $275,000 mortgage- or 55%.

This is a pretty realistic scenario. Banks are able to sell foreclosure properties, at least out in my neck of the woods in San Diego. Believe it or not, real estate closings were up 40% in January over January of '08, but they were mostly foreclosure sales.

So, the bank was able to recover 55% in this particular scenario, but is only being given credit for a value of 28%. Also, bear in mind, in a AAA portfolio of mortgages, you're just not going to have a 100% default rate. It will be much lower. The AAA portfolios at $.28 on the dollar are simply priced incorrectly for the true intrinsic value.

Oh, and by the way- the current mark to the market on subprime is about 15%. Therefore, if you assume a 100% default rate, you are only pricing the value of all this repossesed property at $.15 on the dollar. It's like saying last year's $500,000 home is now only worth $75,000. That's an overly pessimistic pricing metric in my view.
 

Financier of Last Resort

So, what can a bank do to deal with this overy oppressive environment? The US Government has turned into the "equity investor of last resort" to help the banks get the money they need to remain solvent.

Since these are extraordinary times, extraordinary measures need to be taken. Wall Street has been calling for a suspension of "Mark to the Market" accounting. The inefficiencies in the mortgage market suggests this could be helpful. However, if you are going to suspend mark to the market, what do you replace it with?

Enter the Treasury Department's new "Stess Test", designed to provide a realistic evaluation of the health of a bank's balance sheet. 

Here's how the "Stress Test" is going to work. The Federal Reserve is going to examine the books of 19 of our largest financial institutions. The FED is going to assume the economy contracts by 3.3 percent this year and remains almost flat in 2010. They will also assume that housing prices fall another 22 percent this year, unemployment will shoot to 8.9 percent this year, and hit 10.3 percent in 2010. 

Once the Stress Test is completed, the FED believes it will understand the worst case scenario for the capital the banking system is going to require to remain solvent. The FED is going to continue injecting the required capital to prevent the behemoth financial institutions from going under. Eventually, those financial institutions will start making loans again.

Going back to the chart- it's amazing how the S&P 500 is trading in lock step with the mark to the market price of mortgages. I don't believe the market has the ability to reverse course until the bids on mortgage portfolios firms up, or the Government uses their "stress test" to replace the value derived from Mark to the Market on the balance sheets of the banks.

Personally, I would endorse using US taxpayer money to purchase performing mortgages from the banks at $.50 on the dollar. It would create a bid for those worthy, and be a good investment on behalf of taxpayers. There will be a market for these homes at a 50% discount, and the American tax payer would be well served with this investment.

It is entirely possible the market could simply continue tanking for another month while the government applies its stress test to banking assets, and then delivers the results. Regardless of how it comes out, I believe a worst case scenario would be an improvement for the financial balance sheets, and perhaps some sort of bottom in the markets.

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