Futures Market Blog

How Toxic Are the Assets?

Modified Mark-to-Market (MMM) Balance Sheet Asset Valuation Method

By Dr. Ned Gandevani © 2009 (http://www.WinningEdgeSystem.net)

As the market takes another tumble to make lower lows in February, 2009, the toxic assets of financial institutions continue to be the focal point for our policy makers and financial analysts. The bad bank-good bank dispersal seems to be on the move through harness of stress test by the Fed officials and new secretary of the treasury, Tim Guietner. There are about 18 banks which will be exposed to this process in the first stage towards cleansing toxic assets held by the banks. Although not much details have been reported about the process, but one could assume that a type of “if what scenarios” to measure the worst case-scenario impact on their financial standing may be applied. However, as the stress test may take 6 to 8 weeks to finalize, the market has to deal with uncertainty. Since uncertainty and lack of conviction would lead to more instability, we could see further deterioration in the economy and stock markets.

Financial companies comprise only about 10% of the S&P 500 index, a boarder market performance measure. However, it holds a critical role in igniting the capital markets healthy performance. To sustain a dynamic growth, developed countries need to provide an efficient flow of credit from savers to borrowers. Accordingly, the credit as the life blood of the economy has to be available to corporations and economic agents. However, if banks and other financial institutions do not prosper, they cannot facilitate credit and leverage.  Earnings and profits help banks to capitalize on their assets and provide capitals for new projects, expansions, social and private commercial developments which in turn creates more jobs and prosperity for communities and individuals. Consequently, it is a major step toward a long lasting prosperity to nourish financial health of banks and financial sector. Market participants realize the current pathetic and dismal state of major financial institutions and do not care to buy the market. Consequently, institutional investors and traders do not anticipate any major stock market rebound despite its oversold conditions.

There are three major methods to value the balance sheets assets for financial companies; historical cost basis, mark-to-market and market-to-model. Each of these three methods provide some advantages but none is free from limitations and pitfalls. After a brief overlook for each of these three methods in the following sections, I propose a method as an alterative for balance sheet asset valuation. Consequently, if we agree on a practical but comprehensive approach to measure and clean toxic assets held by banks and other financial institutions, market and later on economy should pare off losses and begin their recoveries.

Historical cost basis method considers the acquisition cost for an asset less its depreciation for value of an asset.  As an example, if for an equipment $1000 was paid for acquisition in two years ago. Today, its value could be estimated as the purchase price less depreciation for two years. However, depending on which deprecation method (straight line, declining balance, and Modified Accelerated Cost Recovery System, MACRS) a company may utilize, one would obtain different values. This is a popular and relatively straightforward practice, since it values assets at the production cost or purchase price, less depreciation. Long-term and fixed assets like land and buildings are valued at net historical costs, and current assets at cost or net realizable value, whichever is the lower. The main limitation of this method is its lack of dynamic adjustment with market conditions. Financial institutions utilizing this method are unable to capitalize from their assets value. In other words, the historical cost method could create an enormous cost of opportunities in booming economy.

Second method is mark-to-market which values balance sheet assets based on their fair market value, accordingly. This method has the ability to absorb market conditions and adjust accordingly. Consequently, as asset prices rise, banks are able to capitalize on them and in turn increase their lending activities. However, when asset prices fall, as the case for now, it could literally destroy the holding companies equity values. In discovering market price several methods could be utilized, historical values and comparative method. Both assets and liabilities could be discounted based on current ongoing market price. Conversely, if there is no market for it, literally asset prices could fall to zero. This method has been used in futures markets by traders for a long time with no problems. In futures and commodity market, for every buyer there must be a seller and many cases the clearing house is the other end of any transaction. Despite price limit down or up due to market shocks the clearing house is there to ensure the existence of the market. Consequently, the market-to-market method is a valid and realistic approach as long as there is a market. Internal Revenue Code Section 475 which covers the mark to market accounting method rule for taxation, states that qualified securities dealers and commodities clearing houses when elect mark-to-market treatment should recognize gain or loss based on selling price for the properties at going market rate or fair value at the end of reporting year.

Yet, another method for balance sheet asset valuation is mark-to-model. Companies may develop a financial model with internal assumptions.  This method is less reliable than tow others since it may be unclear how realistic the assumptions and model’s variables are assigned. Moreover, a company could deceive the investors by hiding its model due to “highly proprietary model” justification and hence have less transparency.  Enron is a good example for deceiving the investing community by valuing its balance sheet assets based on mark-to-model.  Regardless of how complex a model might be if there is no real counterpart to purchase the assets, the model is doomed to fail.

Considering the limitations that each of the above-mentioned pricing approaches impose, to solve the toxic assets issue, I propose a Modified Mark-to Market (MMM) approach. Assets would be valued based on market-to-market. However, Federal Reserve should create an exchange type of clearing mechanism for any financial asset. Undertaking this would create a floor for assets prices and bestow a healthy dose of confidence in the market place in times of economic contraction and slow down. Since this method is dynamic which captures high valuations in economic boom, it should contribute more growth opportunities to the economy. Furthermore, the ability and skills of financial institutions should enable them to implement proper risk management strategies against any systematic risk. This allows them to preserve the value of their financial assets despite any market sell off and correction. However since the Fed is always there and provide a buyer of the last resort for sellers, financial markets should experience relatively higher stability in turbulent times.

To diminish any uncertainty about the future of financial institutions like Citibank and Bank of America, there should be a clear decision about adherence to a proper method for balance sheet asset valuation.  Modified mark-to-market (MMM), a dynamic and realistic asset valuation model could be utilized with the backing of Federal Reserve as the buyer and assessor of the last resort in times of selling pressure. When there is a clear direction and method is established for balance sheet asset valuation, we could a meaningful turn around in our stock market and economy.

How Toxic Are the Assets?

Modified Mark-to-Market (MMM) Balance Sheet Asset Valuation Method

By Dr. Ned Gandevani © 2009 (http://www.WinningEdgeSystem.net)

As the market takes another tumble to make lower lows in February, 2009, the toxic assets of financial institutions continue to be the focal point for our policy makers and financial analysts. The bad bank-good bank dispersal seems to be on the move through harness of stress test by the Fed officials and new secretary of the treasury, Tim Guietner. There are about 18 banks which will be exposed to this process in the first stage towards cleansing toxic assets held by the banks. Although not much details have been reported about the process, but one could assume that a type of “if what scenarios” to measure the worst case-scenario impact on their financial standing may be applied. However, as the stress test may take 6 to 8 weeks to finalize, the market has to deal with uncertainty. Since uncertainty and lack of conviction would lead to more instability, we could see further deterioration in the economy and stock markets.

Financial companies comprise only about 10% of the S&P 500 index, a boarder market performance measure. However, it holds a critical role in igniting the capital markets healthy performance. To sustain a dynamic growth, developed countries need to provide an efficient flow of credit from savers to borrowers. Accordingly, the credit as the life blood of the economy has to be available to corporations and economic agents. However, if banks and other financial institutions do not prosper, they cannot facilitate credit and leverage.  Earnings and profits help banks to capitalize on their assets and provide capitals for new projects, expansions, social and private commercial developments which in turn creates more jobs and prosperity for communities and individuals. Consequently, it is a major step toward a long lasting prosperity to nourish financial health of banks and financial sector. Market participants realize the current pathetic and dismal state of major financial institutions and do not care to buy the market. Consequently, institutional investors and traders do not anticipate any major stock market rebound despite its oversold conditions.

There are three major methods to value the balance sheets assets for financial companies; historical cost basis, mark-to-market and market-to-model. Each of these three methods provide some advantages but none is free from limitations and pitfalls. After a brief overlook for each of these three methods in the following sections, I propose a method as an alterative for balance sheet asset valuation. Consequently, if we agree on a practical but comprehensive approach to measure and clean toxic assets held by banks and other financial institutions, market and later on economy should pare off losses and begin their recoveries.

Historical cost basis method considers the acquisition cost for an asset less its depreciation for value of an asset.  As an example, if for an equipment $1000 was paid for acquisition in two years ago. Today, its value could be estimated as the purchase price less depreciation for two years. However, depending on which deprecation method (straight line, declining balance, and Modified Accelerated Cost Recovery System, MACRS) a company may utilize, one would obtain different values. This is a popular and relatively straightforward practice, since it values assets at the production cost or purchase price, less depreciation. Long-term and fixed assets like land and buildings are valued at net historical costs, and current assets at cost or net realizable value, whichever is the lower. The main limitation of this method is its lack of dynamic adjustment with market conditions. Financial institutions utilizing this method are unable to capitalize from their assets value. In other words, the historical cost method could create an enormous cost of opportunities in booming economy.

Second method is mark-to-market which values balance sheet assets based on their fair market value, accordingly. This method has the ability to absorb market conditions and adjust accordingly. Consequently, as asset prices rise, banks are able to capitalize on them and in turn increase their lending activities. However, when asset prices fall, as the case for now, it could literally destroy the holding companies equity values. In discovering market price several methods could be utilized, historical values and comparative method. Both assets and liabilities could be discounted based on current ongoing market price. Conversely, if there is no market for it, literally asset prices could fall to zero. This method has been used in futures markets by traders for a long time with no problems. In futures and commodity market, for every buyer there must be a seller and many cases the clearing house is the other end of any transaction. Despite price limit down or up due to market shocks the clearing house is there to ensure the existence of the market. Consequently, the market-to-market method is a valid and realistic approach as long as there is a market. Internal Revenue Code Section 475 which covers the mark to market accounting method rule for taxation, states that qualified securities dealers and commodities clearing houses when elect mark-to-market treatment should recognize gain or loss based on selling price for the properties at going market rate or fair value at the end of reporting year.

Yet, another method for balance sheet asset valuation is mark-to-model. Companies may develop a financial model with internal assumptions.  This method is less reliable than tow others since it may be unclear how realistic the assumptions and model’s variables are assigned. Moreover, a company could deceive the investors by hiding its model due to “highly proprietary model” justification and hence have less transparency.  Enron is a good example for deceiving the investing community by valuing its balance sheet assets based on mark-to-model.  Regardless of how complex a model might be if there is no real counterpart to purchase the assets, the model is doomed to fail.

Considering the limitations that each of the above-mentioned pricing approaches impose, to solve the toxic assets issue, I propose a Modified Mark-to Market (MMM) approach. Assets would be valued based on market-to-market. However, Federal Reserve should create an exchange type of clearing mechanism for any financial asset. Undertaking this would create a floor for assets prices and bestow a healthy dose of confidence in the market place in times of economic contraction and slow down. Since this method is dynamic which captures high valuations in economic boom, it should contribute more growth opportunities to the economy. Furthermore, the ability and skills of financial institutions should enable them to implement proper risk management strategies against any systematic risk. This allows them to preserve the value of their financial assets despite any market sell off and correction. However since the Fed is always there and provide a buyer of the last resort for sellers, financial markets should experience relatively higher stability in turbulent times.

To diminish any uncertainty about the future of financial institutions like Citibank and Bank of America, there should be a clear decision about adherence to a proper method for balance sheet asset valuation.  Modified mark-to-market (MMM), a dynamic and realistic asset valuation model could be utilized with the backing of Federal Reserve as the buyer and assessor of the last resort in times of selling pressure. When there is a clear direction and method is established for balance sheet asset valuation, we could a meaningful turn around in our stock market and economy.

This little trading tip can and will make a difference in your trading results in 2009.

Stops are enormously important part of a traders arsenal of trading tools. Some traders confirm that stops are the most important part of their trading armor.

So here are three ways to use stops to protect your capital and lock in profits from a trade. These three money management techniques can be used in stock, futures and forex trading.

The important rule is that you do use a real stop in the marketplace. A friend of mine joked with me that that he had never seen a “mental stop” filled electronically or in the pits.

If the market is good your stop will not be hit. If the market is bad or changing direction then you’ll want to be out of it anyway. That is why stops are so crucial to trading success.

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Here are the three most commonly used types of stops. Which one do you use?

(1) Dollar stop.
(2) Percentage stop.
(3) Chart stop.

If you chose (1) you’d be correct, but, you would also be correct if you had chosen 2 or 3. All three are money management stops and are used to either lock in profits or protect capital.

1) A dollar stop, is when you set a predetermined dollar amount to a trade. Let’s say you want to risk $500 on a grain trade or $750 on a stock trade. Once you get your fill back from your broker or electronically online you simply figure from your fill price where to put your stop.

Pros: Easy to implement and use.
Cons: Can place stops too close in a volatile market

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2) Percentage stop, is a very simple way for you to place a stop on a position. Here’s how it works. Let’s say your trading account is 100,000 dollars and let’s say you only want to risk 1% of your total portfolio on any one trade. You simply take a $1,000 risk which represents 1% of your over all portfolio. This can help enormously in avoiding taking BIG LOSSES. A 1% loss is easy to absorb. A 30% or 40% loss in a trade is an account killer, and should be avoided at all costs.

Pros: Easy to implement and use.
Cons: Can place stops too close.

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3) Chart stop, a chart stop is where you place a stop that is either above or below a crucial chart level. The good thing about a chart stop is that this level is often used by other traders. That can both be a good thing and a bad thing, here’s why. Using either one of our first two examples only you know where the stop is. With a chart stop, a great many traders/brokers know that is where the stops are. In an illiquid market this type of stop should not be used, as many times brokers gun for the stops. In a highly liquid and active market this is a good stop to use.

Pros: Very easy to implement and use.
Cons: Can’t be used in thinly traded markets.

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So there you have it. Now you have all three ways to manage your money and protect your profits in 2009.

Use stops…let them work for you.

How to Manage Money and Time

You pay a price for every profit you take with time and effort required to obtain it. Not to mention the years of experience upon which your knowledge and system methodology have been constructed. The slippage, and getting knocked out on a winning trade by one tick have a cumulative mental attrition that can only be offset by constant profits, vacations and other interests not market related. Time is the most valuable commodity in every person’s life because each person knows he only has so much of it. To use time wisely creates more of it. To use money wisely creates more of it. It is ironic that man is the only animal that knows he is going to die, and the only animal that laughs. There is probably some profound message in this irony, related to trading.

One of the most frustrating things in trading is knowing what to do, how to do it and when to do it, and not being able to execute. This is why it is so important to have a decent broker with good executions even if you have to pay a little more to obtain it. A bad fill hurts you a lot more than a higher commission. If you get slipped a tick in and a tick out, you will have paid a lot more than perhaps, a $25 commission. But the most frustrating thing is not being able to get the job done, when you know how to do it. This has been a plague on trading from before I began to trade. It is always a problem to a greater or lesser extent.

Introduction to Futures Spread Trading

Most new traders to the futures arena, as well as many veteran traders, never become involved with trading spreads. Perhaps it is an intimidation factor, as spreads certainly sound more complicated than trading just an outright long or short position. In fact they are more complicated, but even a novice trader can easily grasp the concept of trading spreads with a little reading and a little work. No pain, no gain as they say, and spreads can certainly be a part of a successful trading program.

What exactly is a spread? It is no more than going long one contract and going short a different but related contract. A popular inter-market spread would be a long wheat/short corn position. The contracts are different, but they are related (corn and wheat are both grains that can be substituted for one another in certain case – e.g. Animal feed). An example of an intra-commodity or calendar spread would be long Nov Orange Juice/short July Orange Juice.

What is interesting about a spread trader is that he does not care whether his contracts go up or down in price, only that the difference in price between the 2 contracts changes in his favor. Let us assume that a spread trader put on the long wheat/short corn spread mentioned above. The objective is for wheat to gain in price on corn. This can happen even if both contracts go down, as long as the price of corn falls further. One can also profit if both contracts rise, as long as wheat rises further in price. Of course there is always the holy grail of spread trading, where one’s long position rises and the short position falls.

Why should the novice trader learn about spreads? A very simple reason might be that professionals trade spreads, and they tend be more successful than your average small speculator. Some other very good reasons are that:

1. Spreads can allow a trader to better manage his risk – many spreads have theoretical floors in their value due to the nature of the market traded, especially carry markets such as the wheat, corn, soybean, and energy markets. Also, many spreads, although not all, can be less volatile than outright positions.
2. Many spreads tend to trend more reliably than an outright position, in general.
3. The seasonal aspects of many spreads can be quite strong.
4. When a market locks limit-up or down, an outright trader can be trapped whereas a spread trader may still be able to close out his position.

Of course, spread trading also has a few caveats. In many cases spreads still cannot be traded on electronic platforms, and spread orders must be sent to the pits. As we all know this can lead to missed fills and delays in fill reports compared to electronic trading, especially in fast markets. Also one needs to be aware that not all spreads are highly liquid, so at times market orders can be risky.