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Isn’t it curious how every single recession is labeled as the “big one”? Inevitably people start wondering if the current recession will lead to another depression. They’ve done so in pretty much every recession I can remember since I was born in the late 70s.

In the midst of every recession, laws and regulations are being passed to prevent the same problems from occurring again. But like squeezing a balloon on one end, only to see the air move to another end, whatever we do, inevitably different factors will cause the next recession. So yes, every recession is different. And every recession needs to be fought with different tools.

Every recession feels like the end of the world. Can anybody tell me the last time that people, while in the midst of an ecomonic downturn, did not panic? When was the last time a majority of people just huffed and puffed, checked their watches and said “Oh well, there is another darned recession, but well, it’s going to be over in a few months”? Or the last time magazines had cover pages which said “Don’t worry about this recession”? Neither can I.

You cannot take the fact that many smart people are concerned as your guideline to pull all your money out of the market. They were just as concerned after the tech crash. Can nobody remember this? I cannot for the life of me recall anybody saying “Don’t worry about stocks being cut in half and people being fired by the buckets. Just look at the real estate market, people are actually getting richer and richer”.  Only after the recession was over, economists started pointing out these factors and saying that actually it wasn’t that bad. But in the thick of it, pretty much nobody said anything positive. Just like today.

Looks like today we gave back all of yesterday’s gains and then some. We do that a lot. One could also say we are going sideways and probably will keep going in that direction until there is a little more clarity regarding when this mess is FINALLY GOING TO BE OVER. (I’m reminded of Kenan Thompson as Oscar Rogers on SNL in his “Fix it” skit).

We’re essentially bumbling around at the bottom, rallying violently on every scrap of news that give us hope, but then inevitably sell off again in the constant onslaught of bad news. Every day we are facing more job losses, dismal earnings, Meredith Whitney’s latest bank bash, and much, much more.

Sometimes we rally in spite of bad news. Sometimes we don’t. Sometimes we completely overreact to information that has been out there for at least three months already, and should have been more than discussed to death. Though it never seems to fail to surprise in a bad way.

Tomorrow we’ll get the latest GDP number for Q4 2008. Looking at the 50 % haircut the markets have already “experienced”, a pretty bad number should be more than priced in. But yet, I’m sure once we see the -5 % (or worse ) reading on our screens tomorrow the markets will freak, as if they could not possibly have seen that one coming.

But even that selloff won’t matter. Losing 10 % in three days is irrelevant because you can all get it back three days later. All the current bad news is priced in and won’t move the markets in any direction. To go significantly lower we need events that are significantly worse than what the market already expects. I don’t even want to speculate what that may be. And to go significantly higher we either need a) unexpected good news (as in “housing is bottoming”) or b) an absence of bad news. I think we will see b) before a). But even b) is not really near. So I guess we’ll just keep on grinding sideways.

In other news: I do enjoy Twitter. I was lucky that pretty much all my market calls so far worked out, but then again, I was quite general with some of them. I shall twitter more in the future.

Financial stocks are rallying after hours on news that the government might soon install a bad bank.

Mike Mayo, a banking analyst from Deutsche Bank, agrees with me that it would be a terrible idea to start nationalizing left and right. Interestingly, the solution he mentions is very similar to what I proposed here on SereneInvesting.com last week. One of my ideas dealt with the government offering insurance for the banks. The government would take any losses first, but it would be fully reimbursed over a longer timeframe and Mike essentially suggests the very same thing.

Just remember: you read it here first.

Another example of why it usually pays off to wait with your judgment until you hear both sides of the story was delivered today when John Thain explained last week’s allegations in a memo.

The $ 1 million remodeling job apparently wasn’t done recently, but more like a year ago when dinosaurs roamed the earth and banks were still generally trading above book value. Oh, and it wasn’t for his office alone, but also covered two conference rooms and a reception area.

This makes it only slightly more understandable though. Regardless of the prevailing economic environment, executives should be a good steward of their shareholders money. Spending $ 300,000 per room, more than the average American house costs, is tantamount to throwing money out the window. He can do that with his own money anytime, but not with shareholder funds. Thain promised to reimburse Bank of America for the expenses, but it still leaves a very shallow aftertaste. You can bet that without the controversy he would not have done that.

On the other hand, his explanation regarding the bonus payments makes sense. The term “bonus” implies for the average American monies they receive for extraordinary performance. Understandably most people were outraged when they heard about billions of dollars of bonus payments paid to Merrill employees at the end of the year, even though the bank almost collapsed.

But two things need to be kept in mind: not every single department of Merrill sucked and if you punish your best performers even though they had nothing to do with the legacy problems of the bank you’re basically asking them to leave, hurting your franchise. Secondly, regardless of the term “bonus”, these payments do not require extraordinary performance and are simply part of your overall compensation package. This is similar to cutting your salary in two parts, calling the first 50 % your salary, and the second 50 % “bonus”, regardless of your actual realized performance on the job.

When you work for Wall Street your basic salary is usually much lower than your bonus, at least for most front office jobs. Stopping all bonus payments to everybody would equal a salary reduction of 50-70 % for many top bankers. While this may certainly be fair for bad performers (and boy, did we have enough of those last year), there are still enough people out there who did a good job and who had nothing to do with the downfall.

Finally another weekend is upon us. And boy, it didn’t come soon enough. What a terrible week it has been. Almost every day there was more carnage in the markets, particular the financial sector. Will it ever end?

As a serene investor we have to acknowledge the fact that we don’t know. But neither does anyone else. Historically these bad times did end eventually, and I happen to think that it will be the same with this crisis. Nothing about our current problems strikes me as particular unsolvable. We just have to keep our fingers crossed and hope for the best.

A good way to wind down in such stressful times is to listen to chill-out music. Close your eyes, let your mind wander and visualize a better tomorrow. No harm in that, is there, ay? And to help you relax I’ve included a very nice song from my favorite German act “Schiller” . Enjoy:

Watch out, S&P and Moody’s love to downgrade stocks on Friday after close. They might not like how GE insists on paying out the dividend. To me the current depressed stock price already more than reflects a downgrade, but in this horrible market nothing ever seems to be priced in.

Update: so obviously there was no downgrade. I have no opinion whether a ratings cut would be justified or not; I’ll let others speculate what constitutes a proper AAA rating and what doesn’t. But as we’re talking about ratings, to me Moody’s and S&P should be shut down and replaced by government run, non-profit rating agencies. The amount of damages these two institutions have caused is completely beyond comprehension. Had they done a proper job, the global fallout of the housing bubble would have been so much smaller it’s not even funny.

If you want a better, more acurate rating than what these clowns can provide, just program a short macro that rates a security based on it’s current price / marketcap / OAS. Much more timely.

This morning Bloomberg runs a story about Oppenheimer’s Meredith Whitney, financial guru du jour, who suggests banks to hold a yard sale. She compares them to cash strapped consumers who need to sell their family jewelry at Cashville or their clothes from the 60s in a garbage sale. Why, so she wonders, do banks live to different rules than everybody else?

Miss Whitney, one reason may be that banks actually hold assets. They may be labeled toxic, but most of them are still paying very un-toxic dividends and coupons. Last time I looked, my high school gear was just taking up space, not paying me anything.

Secondly, banks are not cash strapped. The only problem they have are analysts like good old Meredith who think they’re undercapitalized for the Great Depression(TM) ahead. Well, so are probably a large number of Americans out there, and yet nobody forces them to start selling of assets or declare bankruptcy simply because their current net worth is negative. And strangely, nobody asked to have these Americans nationalized either.

I know that Meredith currently can’t do no wrong because she has been right a few times in a row. But I’ve seen enough of these sages go down once the markets turned around. Let me borrow a quote from Princess Leia for Meredith: “Some day you’re gonna be wrong, I just hope I’m there to see it.”

If there is one insight from 2008 that 99 % of all investment professionals seem to agree on, then it is that you should never have banks or institutions that are so important that their failure can trigger a systemic crash. Thus some are actually suggesting growth or size curbs. The idea: Isn’t it much better to have hundreds of smaller banks instead of a handful of big ones? If any of them failed nobody would care. Right?

No.

The problem starts with the fact that most banks run very similar portfolios. If there is some financial product out there that is extremely profitable but not yet offered by some bank, let’s call it Bank Gotham, Gotham’s managers sooner or later by necessity have to offer a similar product, regardless of what they may think of it in terms of risk. If they do not follow suit, shareholders will increasingly grow impatient and question why everybody else is growing so much faster than Gotham. You as Gotham’s CEO can only afford to do this for so long before you’ll be forced to fire your prudent risk managers and replace them with expensive hotshots who successfully ran such products at other banks. And if you don’t do that, your own job as CEO will be on the line.

Okay, so now you have 50 different smaller banks out there, all with very similar portfolios. What happens in such a world when huge financial shocks run through the system, for example a nationwide house prices decline of 30 % within two years? Gotham’s Option ARMs and subprime loans will blow up in their face and before you know it the FDIC comes in and seizes the bank.

Alas, 13 or so other banks have the exact same problem and will all fail simultaneously. So, instead of having one big Lehman Brother going down in flames you’ll have 13 smaller players going down all the same. The overall shock to the system would be similar.

I have to admit: sometimes it is very hard to stay serene. And now is one of those times. When all around you seemingly intelligent people really do believe that nationalizing banks before they have issues is a good idea, then yes, I do lose my patience.

Felix Salmon is almost foaming at the mouth and touts this idea exclusively in most of his posts of late. He quickly dismisses two reasonable alternatives, namely the aggregator bank or the government reinsurance.

Let’s respond to what he said: According to him the aggregator bank doesn’t work, because if it bought assets at the price they’re really worth then the “insolvent” seller banks would still be bankrupt. This is true if and only if a) the aggregator bank pays the current depressed market price or lower, and b) the seller bank sold a substantial amount of their assets today at depressed prices. But what if they only sold off some assets to reduce exposure and take the risks on others, paying out actual realized losses over time as they materialize? Hmm… And what if the aggregator bank believed that AAA rated CMBS tranches with 30 % credit support should be valued higher than 60 cents on the dollar?

He then talks about the difficulties of establishing a fair price. Well, isn’t this the crux of the matter? Why is Felix assuming that current prices are fair prices? They can either be lower or higher. If they’re higher, then where is the problem? And even if they were lower, most of these assets do not mature TODAY, so any losses would be spread out over the life of the loan. So why would you force banks to realize these losses today? On what grounds?

Many of these problems also apply when you look at his dismissal of the reinsurance idea. Once again he assumes that current depressed prices are fair. And once again he assumes that banks would shed all their assets at current distressed marks. Why would they do that again? He doesn’t answer.

No, to Felix the best idea really seems to be to wipe out common stockholders simply because based on dire default rates that all materialize TODAY tangible common equity is gone, regardless whether loans are still performing. This kind of thinking only makes sense when you’re short.

The solution indeed is much simpler: instead of deliberating if one or another approach is the best, do them all. When banks become illiquid or insolvent, nationalize them. If they want to sell assets, set up the aggregator bank and try to do a good job valuing those assets based on conservative assumptions. And if they want to reinsure parts of their portfolio (and thus preserve some of the upside), let them do that at reasonable rates. To avoid the taxpayer footing the bill you could even say that if actual losses exceed assumed losses the bank is still on the hook, but with a somewhat generous payback period (including interest of course).

But what if the government is worried about banks cutting back lending and therefore want to extend unreasonable loans to businesses or consumers? Well, they do not have to force banks or take them over to fix this issue. All they need to do is set up their own bank and offer loans similar to agency mortgages through other banks. Then banks who don’t want to lend to uncreditworthy people and instead delever can do just that.

Common sense. What a concept. Look it up in the dictionary, Mr. Salmon.

P.S.: Here is a good post from the WSJ regarding the current opportunities in banks.

The latest leg down in the markets has me puzzled. Other than the news that Citigroup is selling a stake of their Smith Barney subsidiary to Morgan Stanley and that Bank of America is seeking government support for their acquisition of Merrill Lynch there really wasn’t any major news out there.

The disappointing retail sales data should have been a non-issue. It was widely advertised that Christmas retail sales would drag since … eh …. September. Okay, so sales are down a little over 2 %. Well, stocks are off 40 %. Could any of that be priced in? Hmm.

Why are the Citi and Bank of America news inducing another round of “nationalization” talks? People have complained for years that Citi was too large for its own good. And Bank of America is just asking for the same favor that was granted to J.P. Morgan when they acquired Bear Stearns and Washington Mutual.

I think equity investors are foaming at the mouth with blind panic, oblivious to the dramatic improvement in credit risk metrics all across the board over the last four weeks. In October and November I could understand a 10 % selloff within a few days, but now?!