Bank Stress Tests II - Managing Expectations

So what's the likely upshot going to be on the bank stress tests? The government will end up converting its preferred stock into common shares of several of the major banks; the New York Times' list of common tangible equity levels makes it clear that Citigroup seems a definite candidate for the regulator's "must do more" list; Goldman and JPMorgan are unlikely to be allowed to pay back their Tarp funds immediately. After all, the point of the stress tests is to ensure that major banks end up holding "additional capital to provide a buffer" in case events take a turn for the worse - and while the two banks certainly have more capital than some of the others, that presumably is what regulators mean by "buffer".

That's not the only argument that regulators can wield in the debate surrounding the repayment of Tarp money: there's also the issue of what's good for the economy as a whole. Banks are a key conduit to get credit into the hands of consumers and businesses - even more so because the credit markets remain broken. Regulators are trying to manage the transition from a system in which the unregulated securitization markets took care of a hefty chunk of credit flows to the broader economy to one that relies more on the regulated banks. And they're doing this at a time when risk appetite, while better than late last year, is still pretty shaky. Sky-rocketing corporate defaults could yet send corporate debt markets into a tailspin - markets by the way that still require a fair amount of government support - we still don't know what shape the recovery will take (W or L or U - one hopes for U but can't exclude the other two). Most tellingly, the first quarter profits in the banking sector came mostly from fixed income trading - hardly a sustainable earnings driver.

So where does that leave markets? About where they are - if regulators and the banks themselves manage the results of the stress tests and their consequences properly. Financials will continue to gyrate but we shouldn't see the kind of selloff we saw last year. Bank debt spreads and CDS remain wider than normal, and rightly so, these aren't normal times. But managing the fallout won't be an easy task. The Fed notes in its white paper that "a need for additional capital or a change in composition of capital...is not a measure of the current solvency or viability of the firm." One can only hope investors are listening.

Ringfencing The Financial System

The strains are back with a vengeance in the global financial system - banks everywhere, from Germany to the U.S., are fessing up to more losses, the Irish government stepped in to nationalize one of the country's largest banks, financial stocks have led share markets lower (though today, the market's animal spirits seemed to come back a bit before everyone got distracted by the plane that landed in the Hudson river). Yet the usual stress gauges were pretty well-behaved Thursday, even as Bank of America stocks hit the skids and were down 20% at some point: Libor/OIS - the difference between interbank lending rates and the Fed's expected rates - barely budged, three-month Libor ticked up a smidgen and is very likely to rise by more in the coming sessions - but the crucial difference between January 2009 and September/October 2008 is that the central banks, by cutting rates sharply and pumping cash into the economy with all their might, have built a firewall to stop the financial forest fire from spreading.

With global central banks the main takers of risk in financial markets, the banking system now has time to sort itself out without the rest of the credit markets going into deep freeze. And there's a lot of sorting out to do: the tab for investing in those fancy supposedly safe structured products keeps rising: estimates now put it at just over $2 trillion (of which banks globally have taken about half the losses so far). It's not just Citi that is going to need a "good" bank/"bad" bank solution - in which the toxic assets are separated out and handed over to the government, with some kind of profit-share agreement to make the low price banks will get for these assets tolerable. Already, some are wondering whether it really was just Merrill's dismal 4th quarter performance that made Bank of America go cap in hand to the Treasury. And JPMorgan's 4th quarter profit was largely due to its takeover of Wachovia. Deutsche Bank is looking at a $5 billion-plus loss for the fourth quarter and is trying to stave off the inevitable with some fancy deal with Deutsche Post.

What's clear is that we can't afford to just sit back and wait for the banks to get a grip on this mess of their own accord- just look at how long it took Citigroup to acknowledge what everyone has been saying since August 2007: in its current form, it cannot be managed properly. Supervisors as part of the government need to remember that they are the guardians of the public's tax monies that are being pumped into the financial system. They need to lay down the law - as apparently the FDIC did, insisting that Citi address its problems (that doesn't speak well of the Fed as super-regulator but then, the Paulson plan may be obsolete now) - or else we'll still be dealing with a feeble banking system when current President-elect Obama finishes his second term.

Groundhog Day - Or Why Change Is Not What We Need At the Federal Reserve

It's like Groundhog Day: one major bank's stock price is falling like a stone, another banking behemoth is getting money and/or guarantees for toxic loans from the Treasury, investors are piling into super-safe Treasurys, the euro is getting pummeled against the dollar and the yen. It's Jan. 14, 2009, but it feels like any day in September or early October 2008. Or late-June 2008. Or March 2008. Or August 2007. It's clear we're stuck in the depths of the woods and there's very little light shining through the mountains of bad loans sitting on bank balance sheets to show us the way out. And that is why, amid all the many pressing issues he has to deal with, President-elect Barack Obama should announce now that he plans to re-nominate Ben Bernanke as Federal Reserve chairman when his term expires next year. There are several reasons why he should do this so far in advance:

-There's enough uncertainty in financial markets and the broader economy to keep us all awake at night for the next couple of years - the last things these markets need are jitters, rumours and chatter about who will lead the central bank as it attempts to steer us out of this mess without causing greater problems down the line. And you can bet your bottom dollar that sometime in the summer, the guessing game will start.

-Let the best man (or woman) win: Bernanke is hands down the best choice for this job. He's the foremost scholar of the Great Depression. His communication skills are impeccable and inspire trust (take a look at the speech he gave this week in London - chockablock full of information, expressed so clearly that the text could double as the basis of an introductory course on financial crises at any college).

-It's the Bernanke Fed's programs and actions that have helped pull credit markets back from the brink - just look at the impact of the mortgage bond purchase plan; it was the Fed's announcement of this plan that finally got mortgage rates to budge. They were well above 6% for a 30-year fixed rate mortgage at that point back in November, now they're just above 5%, thanks to the boldness of the program; a committment to buy $500 billion - equivalent to an entire year's worth of net new supply - within six months.

-Given the depth and intractability of the financial system's problems, come next year, the Fed will very likely still be the main counterparty and risk-taker in the credit markets. Confirming Bernanke now means stability at the helm of the markets lifeline provider - a great help in the current chaotic times. No central bank has ever attempted what the Fed is currently aiming for. There is no upside to switching drivers mid-race in this case.

Obama was elected on the wings of change. But for the sake of the U.S. economy - and with it, the global economy - he should seek not change, but continuity, at the Federal Reserve.

Beware The Cheerleaders

The search is on for a silver lining - see today's NYT (Jan 3, 2009), which managed to juxtapose "Stocks Rally, Will January Be An Omen?" and "Manufacturing Suffering In All Corners" in a feat of considerable irony, to name but one. We'd all do well to reread The Great Crash by JK Galbraith as a reminder of how the desire to see an upturn just around the corner blinded so many of the socalled experts and reporters (the book also has a fine Madoffian cast of crooks and criminals, speculating bankers - and accords leverage a prime role in the crash - a blueprint for the events of 2008...)

Let's not forget that without massive infusions of cash from the Fed and the government, there would be no markets at all for anything except U.S. government bonds. Mortgage rates are only so low because the Fed said it would buy this year's entire net new supply of mortgage-backed securities; I've given up trying to count the number of times a recovery in the commercial paper market - where only highly-rated companies can borrow anyway - has been forecast - it's been on life support for the past three months, and is likely to stay on life support from the Fed for the whole year. The Treasury announced a program Friday that implies it will guarantee any bank's bad debts - along the lines of the Citigroup rescue. The government bond market is wondering who on earth is going to buy $2 trillion of supply - there are already more than $5 trillion outstanding.

The world is coming off a massive debt binge - and yes, it is a global issue: the big export nations were just living off the U.S. consumers' reckless spending. Rebalancing the global economy is going to take much longer than six months - and any recovery in the economy, so necessary for a sound basis to any longer-term uptrend in stocks, is going to be a messy, volatile process. The big difference this time around lies in the interconnectedness of all markets across all regions, and the complete breakdown of the financial transmission mechanisms - trade finance has evaporated. How the wealthy Asian exporters and the large oil exporting nations weather the current storm matters a lot more than it did in the 1980s - they're the ones with current account surpluses that need to be reinvested, but some of them also face very fragile domestic outlooks. The euro doomsayers will be proven wrong, but that doesn't mean there won't be strains in the euro zone, the European Union and neighboring countries. Russia is walking a tightrope, yet again.

Rather than hunting around for silver linings on the basis of one day's trade, we might do better to seriously consider just how much it is going to take to resolve this mess - in terms of global political leadership, government spending and sheer luck.