Stocks Rally on Plan for Government Equity Infusions, Continued Pursuit of Evil Shorts

Reader eh pointed out in comments today that we could see “a monster snapback rally” should the tone of news improve, and one may be in progress.

Bloomberg reports that Senator Charles Schumer proposed creating a new agency to provide equity to distressed financial firms. The stock market, and financials in particular, applauded.

But in this skeletal form, this seems like a world class bad idea. The only successful example of dealing with a financial crisis is Sweden, which did not try to prop up troubled banks, but instead nationalized them, wiping out equity, brought in new top executives, and recapitalized them. The cost of failure was high to the incumbents and the solution was comprehensive, not piecemeal.

There seems to be a surprising willingness to accept its positioning as a “permanent solution” at face of the fact that this is a more like blood transfusion into a very sick patient: it will keep them alive without in many cases restoring them to health. Without other measures, such as the son of Resolution Trust Corporation proposed by Nicolas Brady, Paul Volcker and Eugene Ludwig in yesterdays Wall Street Journal, this runs the risk of being a page out of the failed Japanese playbook, where losses were not recognized and zombie banks were not permitted to fail. This US variant may keep them in a slightly more vital state, but that’s a long way away from a solution.

However, a potential shortcoming of the RTC version 2.0 idea is that we now live in a world of mark-to-market accounting. One imagines that sales out of this entity would be deemed to be fire sale prices (even though the Brady/Volcker/Ludwig piece used the formula “fair market prices”) and financial firms holding similar assets would not be required to mark them to those levels. But will anyone trust any non-market-price-based valuation approach? As much as the purge needs to (and inevitably will) happen, the RTC was not formed until a lot of thrifts had already fallen over. Implementing a similar vehicle at this juncture could have nasty unintended consequences.

Reader Dwight e-mailed us pointing that Pimco via CNBC said something we have mentioned in passing in earlier posts: with the RTC, the FDIC was disposing of assets that had already fallen in its lap via thrift failures. But this entity instead proposes to buy assets. How will the price be determined for assets where there is no market, or where transaction volumes are very small? Note that small sales do not represent where larger trades should be priced. A tremendous number of players have set up distressed asset funds, yet perilous few have done any buying. Will this son-of-RTC really set market-clearing prices? It could instead, via a combination of lack of savvy or having compromised, conflicting objectives, instead validate above-true-market prices, which is a bad outcome on many fronts (throwing scare fiscal firepower away on a failed mission, preventing rather than facilitating price discovery).

One also wonders if this high concept is, like the Frannie/Freddie conservatorship and the AIG rescue, intended again to keep the US at less than 80% ownership to avoid consolidating the debt (and presumably the assets) onto the Federal balance sheet. Even though the difference between 80% and 100% may not make much difference in practice, it’s troubling to think that accounting considerations might be constraining policy options for such a high-stakes operation. And does anyone think the rating agencies and our foreign creditors aren’t acutely aware of the size and scope of the obligations the US government is taking on?

Perhaps the biggest shortcoming of this idea is it assumes the US has the wherewithal to pull this off without the tacit support of our friendly foreign funding sources. Unlike Japan in the 1990s, which had a high enough savings rate to deal with its crisis internally, we are at the mercy of our overseas creditors.

Brad Setser has pointed out that the reason the US economy is not doing as badly as its financial firms is that we have been the beneficiaries of a “quiet bailout” of about $1000 per person via continued purchases of US Treasuries and Agencies during the market upheaval. But the Freddie/Fannie rescue, the Lehman failure and the AIG rescue have brought the US financial woes to the attention of the man in the street in Asia, and he is not taking it well. It may become increasingly controversial for foreign central banks to keep buying US paper, particularly since the amount on offer is sure to be going up.

From Bloomberg:

U.S. stocks rose on prospects the government is formulating a “permanent” plan to shore up financial markets and regulators and pension funds took steps aimed at curbing bets against banks and brokerages.

Bank of America Corp., American Express Co. and General Motors Corp. climbed more than 10 percent after Senator Charles Schumer proposed a new agency to pump capital into troubled financial companies. Wachovia Corp. rallied 48 percent, while Morgan Stanley and Goldman Sachs Group Inc. erased most of their earlier plunges, as regulators in the U.S. and U.K. stiffened rules against so-called short sales and the nation’s three largest public pensions stopped lending shares of Goldman and Morgan Stanley to short sellers.

On the pursuit-of-shorts front, the Wall Street Journal tells us:

New York Attorney General Andrew Cuomo said he has started a “wide-ranging investigation” into short selling, or bearish bets, in the financial sector. The UK Financial Services Authority imposed a temporary ban on short-selling financial stocks Thursday. And The California Public Employees’ Retirement System, the nation’s largest pension fund, said that starting Thursday it is no longer lending out shares of Goldman Sachs Group and Morgan Stanley, joining a growing list of public funds that are trying to limit short-selling of those two stocks.

Another bit of cheer is that Morgan Stanley is in talks with its investor, China Investment Corp, about another equity purchase, as well as engaged in merger talks with Wachovia.

Perhaps the real reason for the reaction was indirectly revealed in an e-mail message from hedge fund manager Scott, who was mystified at the rally of two days ago and is no doubt even more perplexed today, and saw this anecdote as providing a partial answer:

{An independent analyst} was asked to speak to a slew of {big firm you’ve all heard of] financial advisor types, more or less retail guys. I have no clue about the kinds of assets they control, but they certainly work out of a nice building in the financial district, and I imagine they all have nice suits and well-heeled clients.

And {the analyst] (who speaks on a daily basis with 4 or 5 of the most talented, sophisticated investors in the country, and somehow got thrown into that mix) said he basically just started asking these guys questions about, for example, what Lehman and AIG meant to the world’s financial system, and what their failures might portend. And they were clueless about the ramifications of all of this.

I‘ve been operating on the assumption that it was just laziness or complacency about risk that kept markets elevated. And now I’m wondering if I need to rethink that, and ask if there’s actually a total lack of awareness of what’s going on, which would obviously change the way you’d think about market pricing and how the market reacts to events.

In any event, my thoughts on today revolved around the fact that AIG was really a binary event—rescue or bankruptcy. The odds in favor of rescue far outweighed those of bankruptcy—I didn’t see how the Fed could let it fail. So call that 80-20, or 90-10, somewhere in that range. But against those odds, it seemed to me that the upside-downside weighed heavily on the side of caution. AIG rescued, 3-5% upside. AIG BK, 10% downside, before the real world ramifications started to seep into the picture. So the fact that the market did so well, with that big unknown hanging over its head, said to me that we are very far from a bottom here. But I thought it was merely complacency about risk that had to be overcome, and now I’m beginning to think that recognition of risk has not even really reared its head to date, astonishing as that thought seems.


Originally published at Naked Capitalism and reproduced here with the author’s permission.  

One Response to "Stocks Rally on Plan for Government Equity Infusions, Continued Pursuit of Evil Shorts"

  1. Mohit   September 19, 2008 at 7:19 am

    If stock prices are to be regarded as some barometer of the mid-term future of an economy, I am amazed that the DJIA futures for Sep 19 should point to a world that is better than before Fannie Mae and Freddie Mac were nationalised, Lehman fell, ML was swallowed, and AIG all but nationalised. Clearly the ‘nice suits’ know something you and I don’t.