The Mark-to-Market Bank Trade This Week

| About: ProShares Ultra (UYG)

Currently, there are approximately 45.4 million mortgages on houses, condos and co-ops in the United States. Of this number 11.18% or about 5 million of these mortgages are either in foreclosure or delinquent (at least 1 month behind) on their payments.

The homes in foreclosure are 3.3% or about 1.5 million mortgages. Using these numbers and considering that collateralized mortgage obligations [CMOs] comprise the bulk of the now infamous ‘toxic’ loans that are cramming up the banks loan portfolios and balance sheets these days, you might think that these bonds should now be valued at between 96.7 cents (3.3% foreclosure) and 88.8 cents (11.18% delinquent) on the dollar. The reality of where these mortgages are being ‘valued’ at is far different.

Some portfolios of these mortgages have been sold at as little as 20 cents on the dollar in distress sales by banks desperate for funds with the only buyers around being bottom feeders. No one knows how bad the problem was or would get, so all the regular buyers evaporated as nobody wants to be the last guy holding these things when any further problems are discovered.

In a regularly trading and active market, the price at which a mortgage, stock or bond is valued at is where the last trade was. The problem now is that these mortgages are not trading AT ALL. The auditors for these large bank mortgage portfolios are now faced with how to value these mortgages when there is no market trading to use to value them. In the past, Arthur Andersen was put out of business for not properly auditing Enron’s assets and this caused the mark-to-market regulations to be passed. Outside or independent auditors these days are not taking any chances of running afoul of the U.S Government and being put out of business as Andersen was.

What these auditors have been marking the banks portfolios to is a few mortgage indexes that trade just like stocks do, are actively traded, and thus the auditors give an accurate market price for the bonds. This practice gives the auditors something that they can mark the mortgages value to and also defend themselves in court with should someone try to prosecute them for not doing their job properly.

In the corporate, treasury and mortgage bond markets a ’round lot’ is a $5 million block of bonds. The dollar size of the traded bond markets far exceed that of the stock market which contains most of the indexes.

Here is the rub… if you want to short a bank that is trading 30 million shares a day you can get your short position put on, but you are not going to have a lot of influence over how that stock trades.

On the other hand, if you have a large fund and maybe a few friends that are also running a lot of money, you and your buddies can put short positions on the bank's stock and then start hammering the index down lower and lower with shorts. If other market players start seeing the index drop under this pressure they might either sell their long positions in that index or start selling short as well as they might think someone knows something they do not. This selling begets selling and the pressure drives the index lower.

Now, when the auditors come in to value the bank's mortgage portfolio they mark the values down in accordance with the beat down mortgage index and then the bank declares a huge multi-billion dollar loss - the stock drops like a stone and the shorts make a lot of money. With no trading of the actual mortgage bonds the index has no other market to take cues from so they are easier to push around. Bad news about mortgage losses at large banks negatively affects the perception of all banks' value and also of these indexes and makes them even weaker and the cycle starts all over again. The lack of the large number of dollars trading in the bond market leaves the index naked and vulnerable to being pushed around by a lot less money.

Here is one possible way two funds could game this index easily in the absence of a deep bond market that is trading actively and properly;

Let’s say Hedge Funds A and B put short positions on the index and on a particular bank. Then, Hedge Fund A sells Hedge Fund B $5 million of mortgage bonds, through a clearing broker dealer, at 30 cents on the dollar - even though the bonds are worth a lot more. The people trading the index see this price go off, as does the large clearing broker dealer, and the index drops like a stone whereby the two hedge funds cover their shorts and make a lot of money.

Both funds do nothing for a month and the index trades back up a bit. Then, the same funds once again put short positions on in the index and Hedge Fund B sells the same $5 million block of bonds back to Hedge Fund A, through the same broker dealer at the same price, and the index plunges again and both funds make money AGAIN. Net-net the two funds are flat on the actual bonds and they both made a lot of money on the shorts placed on the index and even make money on the shorts placed on the bank stock.

There are other ways to make money when you get involved with trading the credit default swaps [CDS] issued on the banks debt. The hedge funds could also buy the credit default swaps of a bank and make money there if the index and the bank stocks drop. A credit default swap is basically buying insurance on the fact that a bank will pay the interest and principal of their bonds. If the price of the stock drops after a bank declares a large loss as a result of the bank's mortgage portfolio being marked down when the auditors mark their portfolios to the index - which you are about to drive down - the value of the CDS (insurance) rises as the bank looks weaker and thus their chances of paying their debt goes down.

Furthermore, merely buying the CDS on Bank A and driving its price up makes the market think the bank is weaker for some reason and they might stop buying the bank's stock or start shorting it, creating another negative force on the stock.

All in all - the 3 markets - the stock, the CDS and the Index are usually tied to the trading of the much deeper mortgage bond market. You take away the ballast of this system and gaming the other three becomes a lot easier.

These markets are now not functioning properly.

Obviously I am not the only person that knows this is going on. Jim Cramer of Mad Money has been screaming his head off about this and finally the politicians and the slow footed SEC are noticing. On March 12th (Thursday) there will be hearings held about whether or not suspending the mark-to-market regulations might help the market. The less astute politicians are against it and unwilling to see how changing conditions may have made a well intended regulation now become a tool for distorting markets. Unfortunately, the level of financial intelligence in Washington DC is now running at all time lows.

Should these regulations be relaxed there could be a MASSIVE rally in the bank stocks. All the shorts in these stocks would want to get out and short rallies are usually very fast and powerful. Also, all those that have bought the CDSs on these banks will sell them as the stocks are rising which lowers the debt to equity ratio and increases the chances these banks will make good on their debts. Therefore, the cost of insurance on the banks goes down and this is the price of the CDSs. This selling will say that the risks of owning these banks debts is dropping thereby confirming the rally in the bank stocks and the indexes are based on the bank stocks and would rise as well. All fall down or all rise up - it is a circular construct.

Basically, all the money sitting short will run for the exits. The stocks will pop, the CDSs will drop and the index with will fire higher both on the strength of the bank stocks and because the shorts in the index will get squeezed and run to cover.

How can you play this possible move?

Buy the Ultra Financial ProShares (NYSE: UYG). This ETF is trading at $1.50 right now so all you are theoretically risking, in a worst case scenario, is that $1.50 per share. It is very unlikely that all the banks included in this ETF will go to zero - but this is your worst case exposure.

The UYG consists of derivatives (options, futures, etc…) that have been constructed to DOUBLE the move made by the index of the financial sector.

This ETF could pop to $4 or a lot higher in no time at all. So, you have a 200% plus upside and a 100% downside (which is very, very, very unlikely). Most likely if the 12th comes and goes and the regulations are not altered at all you lose up to 50 cents - tops - on the index.

I like those odds (5+ to 1) and if decoupling the index from the banks portfolios for a while allows some recovery in the banks and stabilizes the market as a whole - a bottom could be put in and turn the fortunes of this entire market around. Think about it - if the index rises the next time the banks report earnings they would be taking MARK-UPS on these bonds as they have not sold them. That multi-billion loss might turn into a multi-billion gain and who is going to stay short a bank stock knowing that is coming?

These are a lot of ‘ifs’ but isn’t that the game you play every time you invest? There are always ‘ifs’ but if you can find a situation where it makes sense to make an ‘if’ into a profit you should pay attention.

I realize me calling a possible market bottom all based on the possible suspension of a regulation is a bit of a stretch. This bear market was started by the banks and I believe the first step towards stopping this runaway bear, which is not cascading into other sectors, will be when a bottom has been put in the financials. Also, suspending the mark-to-market regulations for a little while in the financial sector wont cost us another $787 billion now will it?

Disclosure: No position