Politicians + Banking Reform = Financial Disaster

Anyone who doesn't harbor some degree of animosity for the bankers who, through a combination of stupidity, short-sightedness and avarice, caused the global financial crisis is a better person than I am.  That said, financial reform should not be tantamount to financial dismemberment.  And there's a little known accounting rule winding its way through financial reform that may be just that.
My writer husband and I often discuss our finances.  He is a brilliant man, one whose brilliance is primarily that of adept observations and the facility with which he uses language to share them.  His writer friends, many of whom are dear to me, share a trait with him:  they hate math.
Consequently, when the business channel drones on about FASB's consideration of mark-to-market accounting for mortgages held by banks, his eyes glaze over like a weary parent listening to his two-year-old blathering unending baby talk.  I imagine many others do as well.
This bill, however, is important.  And I believe that a combination of me speaking English and you being smart will result in your understanding that this is a big deal, and something you should tell your Congressional representatives to stop.
Here goes.
Let's pretend you lend money in the form of buying a bond from the ABC company.  They pay you interest and agree to repay you on a certain date.  Let's say your bond is worth $10,000 (the amount you lend them), your interest rate is 3% and the bond is due (repayable to you in full) on June 1, 2013.  Unless ABC company files for bankruptcy protection before your loan is due, you can expect to be paid $150 twice each year (3% on $10,000), and the full amount you lent them, $10,000, in three years.
Now let's say interest rates go up this Summer.  Now companies like ABC have to pay 4% for borrowed money, 1% more than the amount they're paying you.  If you sell your bond to someone else after rates go up, it will now be worth less than the $10,000 you paid for it, because anyone can now get 4% for their money, and your bond only pays 3%.  If you mark your bond's value to the current market price (mark-to-market), your bond will be worth less after rates go up than it was what you bought it.
But, what if you don't sell it?  What if you hold your bond until June 1, 2013, collect your 3% per year, and get all your money back?
While you hold your bond from now until 2013, what is it worth?

• Is it worth what you could sell it for after rates go up?
• Is it worth what you know you'll receive what the bond is due?

With that in mind, let's pretend you're a bank.  You are now lending money to people to buy houses.  You don't sell your mortgages to investors.  You keep the loans, collect the payments and keep the interest your customers pay.  When rates go up, are these mortgages worth less?  When rates go down, are they worth more?
Yes, according to this new rule.  Why should you care?
If banks have no intention of selling their mortgages, then they probably will be very careful how they lend money.  Why?  If they keep the mortgages, they keep the risk that if borrowers don't pay them back, they'll take the loss.  They won't make crazy loans to people and sell them to investors.  That's good.
But, when rates go up (as they are sure to do), these loans will be worth less.  Then, the banks have to put more money aside for them, and will have less to loan to you.
Seems crazy, doesn't it?  Banks will be penalized for NOT selling their loans to investors, and you'll have a harder time getting a loan.
So, here's the English translation of what's going on.  FASB  (pronounced FAS-bee), is the Financial Accounting Standards Board.  They're considering marking-to-market (immediate sale to investors value, not repayment value) all mortgages that banks intend to keep.
FDIC Chair Ms. Bair is against it, as is former Chair Mr. Isaac.  So am I.  So should you, if you intend to borrow money from a bank who makes mortgages and doesn't sell them to investors.
Contact your Congressional Representatives if you agree, and tell them that you are against FASB Topic 220, 825 and 815.

Is the Stock Market Cheap?

If the answer were "yes" or "no", this would be a short column.
I don't write short columns.
First of all, we have to decide what we mean by "cheap".
I. Ancient History
Going back to the last quarter of 1936, you would have paid an average of $15.82 for every dollar of earnings for the Standard and Poor's 500 Index (more diverse than the better known Dow Jones Industrial Average, which consists of 30, as compared with 500 companies). That average price is the numerator (top number in the fraction) of the Price/Earnings, or P/E ratio. The denominator (bottom number in the fraction) is the amount the S&P 500 earns. So, the average P/E (or amount you pay for every dollar of earnings you're buying) has been 15.82
Last Friday, the S&P 500 average was $1028.93. That's the price. S&P projects the next twelve months' earnings to be $48.67.
1028.93/48.67 = 21.14 Right now, you're paying $21.14 for every dollar the S&P 500 is projected to earn for the next year. That's 25% more than the average price has been since 1936. So, using that measurement, no, the market is not cheap.
II. Last Year
A year ago last Friday, the S&P 500 average was 1282.83. Earnings over the last year were $33.60.
1282.83/33.60 = 38.18. $33.18 is 80% more than $21.14, so the market is a lot cheaper than it was last year. You may have heard something about this. The market is down a lot.
III. Forward vs. Trailing Earnings
Many of you are racing to your Wall St. Journals and saying, "Hey, Kitty, what gives? Their P/E ratio is different from yours!"
You're right.
Some financial publications do the math this way:
Right Now Price divided by Last Year's Earnings
I do my math like this:
Right Now Price divided by NEXT YEAR'S EARNINGS
Why do I do that? Last year's earning were earned by people who bought the market last year. When I talk about earnings, I am talking about now - not last year. I get my earnings projections from Standard & Poor's - not some Wall St. schlub who's trying to talk me into buying or selling. Standard & Poor's doesn't care if I buy or not, so I trust their projections more than I trust those who have a stake in how the answer looks.
My preference.
IV. Comparable Yields
The Federal Reserve, and a lot of other really smart people determine the value of the market by comparing it with what you'd get if you invested someplace else.
Since you're much too smart an investor to jump in and out of the market, paying short term capital gains taxes on all your sales, you are a long term investor. Short term investors don't belong in the stock market. Stock markets can correct, as you've seen recently, and short term investors can get their heads handed to them in corrections.
So, the long term investor compares the price they pay for the market to another long term investment - the 10 year Treasury Note. That's a loan to the US Treasury for that collection of deficits we've been running up lately.
The ten year Treasury Note is paying 3.48%. So, what is the market paying?
It's the reverse of the P/E, it's E/P. Again, the projected earnings are $48.67 and the market is trading at 1028.93.
48.67/1028.93 = 4.73%
4.73% is 26% more than the 3.48% Treasury Note yield, so your return on the stock market looks a lot better than your return on a 10 year bond. And it should.
Those stock market earnings aren't guaranteed. Something bad could happen. There's risk in the market. That's why you should get paid more.
But 26% more is pretty good under anybody's measurement.
V. So, is the market cheap?
Historically cheap? No
Cheap compared to last year? Yes
Cheap compared to comparable yields? Yes
More yes than no.
If this stuff were easy, everybody would be rich.