Good Evening: A rally on Wednesday morning gave way to a sell-off in the afternoon that left the major averages with modest losses. Hewlett-Packard, Bank of America, TARP repayments, and the Fed minutes all vied for investor attention during a session which saw reflation-oriented investments benefit the most. I will cover the topic of TARP repayments by letting Barry Ritholtz weigh in on the subject, and then I will offer my own thoughts about a common sense regulatory framework that should precede these proposed repayments.
Bank of America made headlines last night and this morning by selling a massive chunk of new stock to investors. BAC sold 1.25 billion shares and raised some $14 billion in the process. Market participants were impressed that investors were willing to overlook the dilution and fork over such a large sum. BAC purports to use the proceeds as part of an effort to repay the TARP, and this news helped equities overcome a rather dour earnings release from Hewlett-Packard. The major averages opened more than 1% higher and then doubled those gains within the first sixty minutes of trading. Those highs were it for the day, however, as the indexes gave back the majority of those gains prior to the release of the April FOMC minutes.
The minutes revealed at least two minor surprises. The first came in the form of a noticeably less sanguine economic outlook for the rest of ’09 and into 2010. The second came in response to this forecast when more than a few FOMC voters wondered aloud whether the Fed should expand its Quantitative Easing program. That the FOMC ultimately decided to wait is not the story; that $1.75 trillion in bond purchases “might not be enough” is, especially in light of a similar debate at the ECB (see above). It is therefore of little wonder why TIPS, commodities, and reflation sensitive equities did so well today. More money printing and the sea of paper it generates will only force investors to construct life rafts out of real stuff. And in this funny-money flood, precious metals should levitate rather than sink.
Stocks didn’t react much in the wake of these disclosures from the Fed, but they definitely turned tail and headed lower as the closing bell approached. The final losses ranged from only a fraction for the Dow Transports to 0.8% for the Russell 2000. Treasurys bucked the “reflation trade” theme and rose, probably in the hope that they will benefit if the Fed does decide to expand its bond purchase program. The 10 year note yield fell 6 bps. The quantitative loser in today’s debate over money printing was the U.S. dollar. The greenback took a 1.2% rap on the knuckles, a result that was very well received in the commodity pits. Lower crude oil inventories also helped as the CRB index posted a gain of 1.4%.
As banks major and minor jostle with each other for a chance to issue secondary offerings and repay their TARP loans, Treasury Secretary Geithner is making ready with the preparations. He proposed today to dump as fast as possible whatever warrants you the taxpayer have received in return for bailing out the global financial system. The warrant issue aside, Fusion IQ’s Barry Ritholtz says, “Not so fast” when it comes to allowing companies to repay their TARP preferreds. Barry points out that the regulatory climate has to change before we allow firms to discharge their obligations. I stand with Barry on this issue. Before major financial institutions are allowed to repay their TARP funds in a bid for freedom, I think we need to consider setting up a common sense regulatory framework before we send them on their way. Peruse Barry’s to do list in the Big Picture article above, and I must also give a nod to Chris Whalen’s notion that TARP recipients must go cold turkey on FDIC-backed debt issuance before they are permitted to throw off the TARP.
Some blame the climate of deregulation in recent years for the financial mess we now find ourselves in, but those lax regulatory standards took decades to erode. The deregulation movement started in the ’70’s with the airlines under President Carter; sped up under Reagan; slowed down under Bush I; sped up again under Clinton; and went into overdrive when the Bush II administration put a child-like faith in the markets to look after themselves. President Obama has indeed brought change, but the fear is that he wishes totally re-regulate, thus involving government too heavily in too many industries. Perhaps the best financial regulation is not the “all or none” debate into which the major political parties so often descend. Smarter regulation would involve a hybrid of both philosophies. In addition to Barry’s list, let’s also think about incorporating some of the following concepts:
1) Require all financial institutions to keep all assets and liabilities ON the balance sheet
2) Require better and more detailed reporting of all financial exposures (i.e. disclose the cost of each asset, its current market price, as well as a fair value estimate of each asset — put everything on the table for the regulators). We should require mark-to-market accounting when calculating the leverage ratios described next.
3) Require a hard cap on leverage of no more than 10 to 12 times tangible common equity. This cap must apply to all financial institutions wishing to do business in the U.S. and needs to be coordinated with EU and Asian financial overseers. It also must be imposed over time in order to give institutions a reasonable chance to comply (some, like MS, may even be near this level now).
4) Require all firms originating a securitization deal to retain a small portion of each transaction on its books. Eating what they cook will force financial institutions to employ better underwriting standards. If these firms whine about how they’ll pay for it, let them use the funds accruing in their employee bonus pools.
5) Once these rules are in place and once the leverage has been worked down to the cap levels, then let the banks decide for themselves which businesses they lend to and which markets they participate in. Government should have no role in making these decisions and should stand aside as long as those institutions stay within these “boundary fence” rules.
6). In order to give the above framework some teeth and convince management that they have to manage with NO future expectation of a federal bailout, the final step is to abolish the “too big to fail” doctrine. Let managements and shareholders know up front that there will be no more AIG life-lines. Troubled institutions in the years ahead will be either wound down or merged, just as Indy Mac, WaMu and Wachovia were during this cycle. As Barry suggest, we may have to go back to the days of Glass-Steagall to accomplish this goal.
In short, I’m proposing large and well enforced boundary fence type of regulatory framework inside which banks and other financial institutions can more or less freely operate. Government intervention (as with Chrysler) and rule making on a micro scale is just as wrong-headed as letting the banks do whatever they want. Placing visible and enforceable borders around financial institutions will work precisely because it acknowledges both human dimensions so common to capitalism — the freedom of choice that allows Adam Smith’s Invisible Hand to operate, and the Visible Fist of government that tries to prevent the greedy from gaming the system in ways dangerous to us all. Though the Rio Grande river gets more attention, this is the type of “border security” legislators should focus upon. I know it’s a lot to ask of our elected leaders to want them to enact smarter regulation, but it sure would be nice if they at least tried.
— Jack McHugh