TARP Repayment — Some Questions for the “Perfect 10”

Good Evening: There has been no shortage of news items since I last wrote on June 2, but the S&P 500 today closed almost at the same price as it did one week ago. While equities have essentially moved sideways during this time frame, Treasury yields, the dollar, and commodity prices have all risen to varying degrees. Whether these moves are more noise than signal is debatable (I lean toward the noisier interpretation), but perhaps the confusing aspects of two of the bigger stories during the past week can be instructive. Friday’s unemployment report and today’s announcement that 10 financial institutions have been granted permission to repay their TARP funding have, unfortunately, raised as many questions as they’ve answered. That the markets gyrated in the wake of the payrolls data and merely shrugged at the TARP story is clear. Clarity about what now lies ahead for the capital markets is what’s lacking. Bank stocks should be soaring with all the “positive” news they recently enjoyed, but they are treading water as the rest of the market rallies. Is it possible that it has been the Fed’s quantitatively easy policies deserve more credit for the various moves in asset classes than any purported improvement in either U.S. banks or the U.S. economy? Is it also possible that investors are wondering whether or not it makes sense to set the bankers loose again before some important questions receive credible answers? The answers may not be knowable in advance, but bank stock investors, taxpayers, and equity owners of all stripes should at least be asking these questions.

Before posing these inquiries, let’s first examine last Friday’s nonfarm numbers and the uncertainty surrounding their implications. The number of those losing their jobs in May came in well below expectations (-345,000 vs. the -530,000 estimate), but the birth/death model accounted for the difference by adding 220,000 fictional job-finders at a time when the model was designed to be subtracting them. In addition, the unemployment rate ticked up to a worrisome 9.4%, while the wages and hours worked statistics both portrayed a work force that is struggling either to find work or generate enough income from the jobs they are managing to still hold. In response to the contradictions apparent in the nonfarm figures, the green shoots crowd lifted offers for equities and hit bids for Treasurys in the early going on Friday morning, but these moves faded as the data were more closely examined. The confusion over just what the May employment data mean for the economy and securities markets lasted for the rest of the trading session as last week drew to an unsatisfactory close. Taken in context with the recent announcement that credit card delinquency rates are starting to shoot higher, my own view is that Friday’s data don’t bode well for the 70% of GDP that consumer spending comprises.

There has been little in the way of economic data this week, so let’s turn to the announcement that 10 financial institutions seem to have been given permission to redeem their TARP preferred equity securities (see below). Fresh from road shows that have swelled their capital coffers by the tens of billions, these institutions are eager to show the world they are safe, solvent, and ready to once again stand on their own. The Federal Reserve, the Treasury Department, and the FDIC would like the emphasis to be on the safe and solvent part of the previous sentence, while the managements of these firms no doubt think more of leaving behind the scrutiny and red tape that came along with Uncle Sam’s kindness. All parties concerned hope this move to repay the TARP removes any lingering stigma and engenders confidence that all is now well with the banking system.

It was these hopes, as well as higher Q2 guidance from Texas Instruments, that enabled stocks to rally as trading commenced this morning. A 0.5% pop to the upside helped extend yesterday’s late afternoon rally, but the averages soon settled back toward the unchanged mark. A weak dollar and higher commodities prices provided a tailwind for the energy, mining and materials names, and the indexes were able to set mild new highs in the early afternoon. Stocks then drifted into the closing bell, finishing with modest gains on light volume. The Dow Transports (+1.5%) led the way, while the Dow Industrials lagged by finishing virtually unchanged. The action in Treasurys centered on both a successful 3 year note auction and a steepening yield curve. A high bid-to-cover ratio and a large slug of indirect bidders (likely central banks) pushed yields on the short end of the curve down by as much as 10 bps. The middle of the curve didn’t fare as well, and the yield on the 30 year bond actually rose 4 basis points as investors on that end of the yield curve braced themselves for more supply on Thursday. The dollar index retreated more than 1%, a move that gave a boost to the commodity complex. With oil and copper surging ahead, the CRB index was able to rally almost 2.5%.

Mr. Market seems to be withholding judgment as to whether the TARP repayment announcement actually represents the glad tidings smiling regulators and bank CEOs had hoped it would bring. It should be noted that despite all the sightings of green shoots and successful bank secondary offerings, the KBW bank stock index has made exactly zero progress since mid April. Then again, hopes for an economic recovery have led to a 40% rise in the S&P since March; credit spreads have markedly narrowed; rising Treasury yields in part reflect a flight away from perceived safety; and some prices at the short end of the yield curve seem to be pricing in a chance the Fed will actually lift the fed funds target by November (see below). Even commodities have climbed off the canvas to once again show some spunk, so why aren’t these supposedly cheap bank stocks flying right now?

The reasons may have as much to do with the monetary and regulatory climates as they do with any warming in the economic climate. With Washington trying to stimulate with both hands, and with the Fed’s fat fingers on the printing presses, it is of little wonder that some of all the money zipping around has found its way into the asset markets. At the very least, the policy moves described above have led to an increase in confidence of the type which now sees bulls easily outnumber bears in sentiment surveys. The policy responses have caused many to want to believe the banks are now safe and that the economy is on the mend. By fostering the belief that tomorrow will be better than today, our policy makers have succeeded in delivering enough of a recovery in asset prices to help recapitalize the banking system. Will it be enough? And should we now set these “perfect 10” banks free?

After seeing the rules surrounding the TARP change as often as the weather in Chicago, perhaps market participants still have a few questions before they answer either of the above in the affirmative. And before they allow the bankers to throw off the TARP and go about the business of collecting the bonuses that accrue to those who borrow and lend, many taxpayers want to know just what are the terms and conditions under which a bank can gain its freedom from the TARP. I’ve seen quite a few lists, and the following is a less than exhaustive attempt at reprising them:

1. With all the chatter about responsible regulatory reform, shouldn’t the rules governing bank conduct (e.g. leverage ratios, off balance sheet vehicles, etc.) be put in place before TARP repayments flow in?
2. Before TARP preferreds can be redeemed, shouldn’t the banks swear off all the other forms of federal assistance (the alphabet soup lending programs, FDIC-guaranteed debt, etc.)?
3. What exactly does “fair market value” mean when a bank desires to repurchase the equity warrants issued to Treasury in return for the emergency funding given the banks through TARP? No offense to the astro-physicists the banks have on staff, but could we ask for some third party verification of the models used to calculate the fair value of these warrants?
4. What happens if — Nassim Taleb forbid — a Black Swan appears (or even some continued erosion in our economy) that causes a bank or two to want to go back and ask the TARP to reissue them some preferred equity? Should we let them back in under anything other than truly onerous terms, if at all?

I bring these questions up lest we allow the hastily arranged TARP funding for banks to be repaid with equal haste and without the luxury of forethought we taxpayers should now enjoy on the far side of what was a severe financial crisis. To require anything less than some answers to these fairly straightforward questions would lead to an even greater degree of moral hazard than has already been risked on these large financial institutions. Before we let even one bank redeem their TARP preferred stock, let’s make sure we don’t continue to encourage privatized profits and socialized risks.

— Jack McHugh

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