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Going “All In”

Posted by Larry Doyle on February 26, 2009 10:59 AM |

The government yesterday released the specifics of the Bank Stress Test to be undertaken by the 19 major banking institutions in our country. Those details in conjunction with the testimony provided this week by Treasury Secretary Geithner and Fed chair Bernanke provide a very clear signal as to the government’s approach to our economic problems. In my estimation they are clearly indicating they are going “all in!”

Before we get to the market reactions, allow me to share insights from a highly regarded bank analyst and then comment myself. 

Most analysts and economists view the government’s worst case scenarios under the bank test as not much more severe than what many already expect. I’m an optimist by nature but live by the mantra of hope for the best, prepare for the worst. The market will discount the government’s worst case.

In today’s New York Times, Chris Whalen, highly regarded bank analyst at Institutional Risk Analytics, offers that Citigroup and other major banks will almost certainly become insolvent in the midst of absorbing expected losses from this recession.

He adds, “the stress test is about politics. The O.C.C (Office of the Comptroller of the Currency) and the Fed already know the answer. The answer is that we’re going to have to come to a decision: are we going to put in more equity or are we going to resolve the banks through bankruptcy?”

While Geithner and Bernanke have not categorically stated exactly what they will do, they have stated what they will not do and that is the immediate takeover of a bank, the transferral of toxic assets, and the unwind or sale of remaining assets/divisions.  The stress test outlines that if a bank is not deemed to have sufficient capital, then that institution must raise sufficient private capital within 6 months prior to further government intervention. What does this mean? The government just bought 8 months (2 months to undergo the test, 6 months to raise private capital) prior to doing anything. The market now expects that common shareholders in the major banks will not soon be diluted or wiped out and thus these banks’ stocks have bounced 10-15% in the last two trading days. (A 15% bounce on a $2 stock is hard to swallow after that stock has traded down 95%!!).

Fast forward 8 months and I would expect certain of these banks will be back at the government trough. In fact, it is expected to be announced today that the government will convert its preferred stock position in Citigroup to common stock and will thus have approximately a 40% ownership stake in the company. The banks will have the option of indicating their intention of taking government capital even after the test is completed and pricing that capital at a 10% discount to the closing equity price on February 9th.  What does that mean? The taxpayer is committed to buying equity at prices higher than current market!!   

My gut tells me this scenario plays out with a number of other institutions as well. In fact, it already has with AIG (80% stake and likely growing), Freddie, and Fannie.  I expect a similar scenario with the auto companies. 

What are the government’s commitments to date? Approaching $12 trillion, although to be fair we do not have that amount of total equity risk at stake as certain programs are short term in nature and provide backstops. Even though we may not have $12 trillion at risk, we still need to raise those funds. Where do we get that kind of money?

1. Taxes: We are seeing this right now and if anybody thinks for a second that the top 2% of taxpayers are going to finance the entire tab, think again. I would expect tax rates to move higher for more and more of our populace as we go forward.

2. Reduced Spending: We’ll see, but despite the rhetoric my confidence level, along with the markets’, is low that a Democratic led Congress will display the necessary discipline here.

3. Issue More Debt: It’s already coming. Who will purchase this debt? Great question. Regardless of who purchases it, rates are headed higher. We’re seeing it happen right now.  

Given all of this information, I project that the equity market may move sideways for a while simply because the government has the checkbook open, but I am now even more concerned that interest rates for government debt will move higher. Given the tremendous amount of  government financing, this will only increase the “crowding out” effect (government borrowing soaks up capital that may otherwise have gone to the private sector) and make private borrowing more expensive. We have seen this in the last ten days. In fact, this week government rates are up 20 basis points (1 basis point is .01%) with the equity markets unchanged albeit in a volatile fashion.

I wish I were more sanguine, but this is how I see it.

Also, virtually every economic historian views increased taxes and increased protectionism as the factors that deepened our economic malaise in the 1930s.  


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