Market shot up more than 6% on Citi news

Today, the market rose more than 6% (Nasdaq was up actually 7%), on the report that Citi was profitable for the first two months of the year.

Investors seemed to be surprised by this news. That just shows that majority of the investors do not understand the nature of the current financial crisis.

I am not surprised at all. Citi, and other banks, should be making tons of money right now. The yield curve is so deep, and the FED is giving them almost free money to borrow. If they can't make money now, when can they?

In fact, according to an internal memo sent to Citi employees by Citi CEO Vikram Pandit, the company may generate more than 8B operating profit in the first quarter of the year.

From the very beginning, the root problem of many US financial institutions was not operating problem, but asset problem. Because the value of mortgage back securities many of these company hold on their balance sheet has declined dramatically, these companies are facing a capital shortfall.

I would argue that some of the decline in value of the mortgage-backed securities was artificial, a result of mark-to-market accounting based on questionable market valuation (for example, CDS-implied value), and does not reflect true economic value of these securities.

Let me explain: the total US MBS outstanding is valued at 10 trillion. Most of these MBS should have loan-to-value ratio of 80%. Let's assume that house prices have all declined 40%, which is a much worse assumption than what actually occurred, then the maximal write-off of the MBS value should be 20% of the 10 trillion, or 2 trillion. Between the FED and Treasury, more than $5 trillion has been pumped into the US financial institutions. Are we still saying these companies are insolvent? Give me a break!

I believe that most of the US banks are now making a killing. Their borrowing cost is almost none (interest rate is close to zero), but the interest rates they charge to borrowers are very high. And the Fed is willing to lend to the banks as much as the banks demand, through the Fed funds discount window. There is absolutely no reason why banks won't make huge profits right now.

But banks will have to continue to face asset write-off problems, as long as the current flawed mark-to-market accounting is in place. There is an analogy here: the banks are like a person who have a very well paid job. The person is earning a very high income, but because of the bear market, the person's 401K and other equity investment accounts have lost a lot of money, and his house is probably worth a lot less. But the person does not intend to cash out his investments, or sell his house. His job pays him well. Is he worried? No. He shouldn't. Because the stock market will eventually recover, and the house price won't remain depressed.

I think same is true with the banks now. The value of their assets is now depressed, because risk premium is high (the discount rate is high). But the banks continue to earn good profit from loans they give out. Overtime, when risk premium starts to subside, the value of the banks' assets will recover.

All of those doomsday-sayers don't know what they are talking about.