To OTC Journal Members: 
 

Geithner and The XLF Trade

The market is buzzing about the stimulus package and what it could mean for the economy going forward. Tomorrow is the big day. The newly anointed Secretary of the Treasury Secretary Tim Geithner got past the back tax issues, got confirmed by Congress, and is ready to announce the big Financial Rescue Plan from the Treasury Department. Wall Street is on pins and needles waiting to dive into the details.

My XLF trade- published on January 23rd, is now working for the second time. My short term target is $11, and we could easily see that this week if the Obama cards fall our way. From the time I suggested jumping in at $9, XLF shot to $10.50 the first time, pulled back to $8.75, and now is back to the $10 range. That's a quick 15% cash- 30% margin. 

There are two possibilities I'm looking for, and either one or both could send XLF past my short term target and possibly considerably higher.

It's all about a new buzz phrase I just heard for the first time earlier today- are you ready?- Here it is: REGULATORY CAPITAL.

Loosely defined, Regulatory Capital is the money that is locked up on the balance sheets of financial institutions thanks to the rather archaic way these monster financial institutions are forced to account for their assets.

As an example look at AAA Mortgage portfolios- the ones that are performing. The most current chart I saw suggests those sorts of portfolios are currently bid approximately $.41 on the dollar.

Consider the ramifications of AAA mortgages trading at a 60% discount. Let's say Wells Fargo has $2 billion in AAA mortgages on its books. I'm making this up as an example- I don't know if it's a real number.

Thanks to the archaic notion of "Mark to the Market" accounting, those mortgages are only being currently valued at $800 million, forcing Wells Fargo to take a $1.2 billion charge and weakening the balance sheet considerably.

Wells Fargo must now raise capital to make it's regulatory minimums against defaults, or sell off the portfolio and convert the assets to cash at a deep discount and an absurd loss when the interest payments are coming in regularly. 

The capital locked up on the balance sheets of all the major financial institutions in this manner is now being referred to as "Regulatory Capital".

So- what's the resolution that favors another surge in XLF? There are two possibilities that could resolve this log jam. Either these AAA portfolios need to go up in value, or a different metric aside from Marking to the Market has to adopted in these special circumstances. It could be a combination of the two.

So, what can Geithner do to help our cause? For starters, I believe the XLF might trade up right past my $11 target if our new Treasury Secretary suggest some sort of suspension or modification of "Marking to the Market".

Secondly, the mortgage portfolios could appreciate back to a more traditional level. This would have the same effect.

I'm hoping the Treasury Secretary will announce some plans to reform the Mark to the Market standards, which could send the financials soaring above the current oversold level. In addition, many are talking about a "Bad Bank" scenario. This would be a government institution set up to absorb the bad assets. Getting the bad ones off the books and just keeping the good ones could bring a strong bid for the good loans. This could put a real charge into the financials.

Here's today's message. If the package includes proposed new rules about marking to the market, and/or creates a "Bad Bank", the XLF could run up higher. That's the time to take your profits.

Under Greenspan we always had the "FED Put". Now, we might have the "Geithner Put".  I'll be waiting for tomorrow's outcome. 

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