Partial Profits and Toxic Debt

Markets made the most of the details released Monday on how the government plans to deal with toxic debt at banks.  The new information helped continue the rally started March 9th.  The action overall, however, is suspect.  Consider the following:

• The rally was touched off with partial quarter reports by Citigroup, JP Morgan and BofA saying they were profitable in the first two months of the year. Gee, we only have to wait another month to find out what happens to their profit after they factor in write-downs and other costs over a full quarter.
• This was followed by The Fed announcing a huge quantitative easing program which may offer some short term benefits but has very negative long term costs.  The same day the dollar took a dive and prices for several inflation sensitive asset rose.
• Monday morning Treasury Secretary Geithner announced his private-public toxic debt plan.  Let me see if I get this right.  The government wants investors to buy bonds that a judge can modify (Home Affordability Act - an unintended consequence?) using cheap financing and 6 to 1 leverage (characteristics of what got us in this mess).  The market was thrilled to at least have a Plan A and perhaps it will help banks clean up their balance sheets.
• There was little stock leadership in the rally, mostly very depressed stocks (many big financials) coming up from very low prices.  This does not bode well for sustainability.
• The bond market does not seem to be as euphoric.  Interest rate spreads on bonds issued by financial companies tracked by Merrill Lynch have only narrowed slightly from the high they hit on March 11^th.  The bond market seems to be reserving judgment on partial quarter profits and toxic debt recovery plans.

In my opinion, these along with many other characteristics, call this market advance into question. 

In terms of economic news, we have received the first signs that the U.S. economic contraction may be stabilizing.  ECRI reported some improvements in the housing market, among other developments, contributed to a stabilizing of their leading U.S. economic growth indictor.  This is a potentially positive development but will require confirmation in the weeks that follow.

Regarding how we could solve the toxic debt problem in other ways.  One idea that has been suggested is to nationalize insolvent banks and transfer their operations to regional banks that are in better fiscal shape.  This action would severely impact the capital structure of the insolvent banks and may send massive ripples through the global financial system.  It would probably require coordination with monetary authorities in other countries.  It is entirely possible that a Plan B of this sort is in the works.  Congress is already considering non-bank takeover power of financial companies.  What is surprising to me is how long it is taking the government to address the severity of the problem and a willingness to come clean about what it is going to take to fix it.

The risk in Geithner's plan is that asset sellers (banks) and buyers (institutional investors) will not be able to agree on price, even with the incentives offered to buyers and the government arm twisting sellers, so few transactions will actually result.  Banks will continue to hoard their capital and the much needed stimulus to constructive lending will be non-existent.  I am also surprised by the degree to which our government has rewarded the management of institutions that managed risk so poorly.  Since when is failure not an option?  In cases like this we want failure to be orderly, but at some point we have to recognize the losses (unless we can continue to defer it).

With Medicare, Social Security, deficits and national debt, it is difficult not to be disturbed by the path our government has taken.  I don't even want to think about what the future will hold if the plans being unveiled, and there is little room for error, fail and they don't have a Plan B.