Stocks traded fitfully higher this week as skeptical investors swelled with cautious optimism about new proposals to save the investment-grade ratings of the nation's two largest bond insurers.
revealed it had snagged $3 billion in a rights offering from a motley gang of banks and hedge funds, and the new chief executive of announced a five-year plan to Botox-up his firm's wrinkled capital base with a fistful of cash and a dividend halt.
If these solutions sound a little flimsy, considering that the ratings agencies that gave them their blessings are the same ones that horrifically misjudged the bond insurers' capabilities in the first place, you're on the right track. The two companies, after all, are still on the hook for as much as $400 billion each in debt guarantees.
If big investors ultimately turn against their wishful stories, as evidence suggests they will, the market's recent surge will turn out to be a trap that will end with a major reversal by the second week of March.
Although the Dow Jones Industrial Average ($INDU) has fattened up by 400 points since mid-February, it is still down 600 from the start of the year, with lots of resistance overhead from investors who are looking to unload shares bought much higher. And the major financial companies, which should theoretically be the most electrified by the insurers' lifeline, have met the news with indifference. Ambac has been mostly flat since the news broke, while , and have yawned sideways.
The crash you don't seeGovernment-sponsored mortgage lenders and have caught a break, to be sure, with caps on their lending levels lifted this week, but business is still so poor, largely because of the corrosive effects of their credit derivatives books, as I explained in December, that they will still have a hard road to climb after the rally fades.
And most vividly, far from the gaze of dewy-eyed equity investors, the credit markets continue to crash. Auction-rate securities -- municipal bonds bought as cash equivalents through mainstream brokers because of bonds' modest yield advantages over certificates of deposit -- have been failing all month. How can everything be OK if investments sold to widows and orphans have completely lost their liquidity, with no end in sight? One Seattle stockbroker who put retirees' life savings into auction-rate notes told me he has suffered the first sleepless nights of his career, worrying over when his clients will be made whole.
The deal to patch up the bond insurers with duct tape and rubber cement was, in short, supposed to make everything better for banks and brokers, but it is a temporary fix at best. It may slow the bleeding in the financial sector, but it is not a tourniquet or panacea. And there remains a ton of skepticism from major investors about the ability of banks to survive the current mess with all their limbs, toes and fingers attached.
Murder by deathOne reason for the disconnect is a growing sense that life in the world to come is just not going to be very attractive for most financial companies no matter how much freshly printed money central banks pour into the system. For many years -- or roughly as long as angry memories last -- they will have to give up the obtuse ways that they generated mountains of fees by selling specialized investment instruments to suckers who didn't ask enough questions.
A review of recent filings at the Securities and Exchange Commission, and company statements, shows the mortgage-securitization market is dead, the structured-investment-vehicle market is dead, the collateralized-debt-obligation and leveraged-loan markets are dead, the auction-rate securities market is dead, and the credit-default-swap market is dying. Until banks can identify a new set of chumps to buy complicated, expensive, illiquid investments at outrageous prices, there will be a big smokin' hole in their profit-and-loss statements.
In the meantime, it looks like banks will have to go back to, well, banking. That's not such a terrible business, but a plain-vanilla retail and commercial lending product mix won't grow very much, at least domestically. So for the rest of the year, financial-industry investors are going to have to realign their expectations with the new reality of dramatically lower returns on equity, and they will see shares basically trade sideways, if not decline, even if the rest of the economy perks up.
The deeper problem is that losses from credit derivatives and subprime-mortgage defaults are only one problem for banks, essentially the first of two bear markets. The other is lower earnings, which most investors have yet to come to grips with. The real danger is that attempts by government and industry rescue squads to interfere with market forces with well-intentioned triage missions will serve only to stretch out banks' pain -- much as was seen in Japan during its two-decade recession.
Sugar pillsCompanies in Japan saved face but were essentially walking zombies that lacked the reserves or credibility to lend their way back to the profitability they'd enjoyed during the years of the country's real-estate bubble. Policymakers in the U.S. know that but so far seem powerless in an election year to resist the temptation to appear to be doing something.
Perhaps they should learn a cross-industry lesson from a British study released this week showing that expensive antidepressants are not much more effective than placebos. The report suggested that manic-depressive patients were just as likely to benefit from a brisk walk in the woods as from popping $100 pills.
Surely the same advice could be given to the stimulant pushers in Washington, for no matter how many expensive injections of tax rebates or monetary back rubs they wish to apply to solve banks' anxiety disorders, the best remedy may be just a rather lengthy stroll through time to let kinks in the system straighten out and allow credibility and healthy levels of greed to flow back naturally.
Too pessimistic? Maybe, but don't think I'm blind to the positives in the environment. The M2 measure of money flow has surged by $140 billion due to the Fed easing already; tax refunds have totaled $80 billion so far and will be augmented by $170 billion in rebates soon; technology companies' earnings are surpassing expectations; construction contracts for power infrastructure are rising;, and are all on a roll; retail sales in January and February were largely better than expected; unemployment claims are not out of control; a less antagonistic new administration in Cuba could add a touch of growth to tourism; drug regulators are lightening up on biotech companies; Kansas is close to clearing the way for two massive new coal plants; Democratic and GOP campaigners have already spent $260 million in ads to boost broadcasters; inventories are relatively lean; wage growth is steady; a pool of investable funds overseas is just itching to buy big stuff in the United States and Europe; and the federal funds rate will fall to 2.5% in the next month.
Yet a credit contraction is likely to trump all of the positives. So enjoy the rally for a few more weeks, but be prepared for a new leg down by the time second-quarter redemption requests hit hedge funds and banks announce their next round of write-downs.
Fine printTo learn more about Japan's post-credit-bubble recession, read this paper at the Ludwig von Mises Institute's Web site. . . . To learn more about that British antidepressant study, visit this MSNBC story or this one at a Canadian health news site. . . .
At the start of the year, I recommended agriculture as potentially the best sector for this year in this column. Skyrocketing wheat and corn prices have certainly lifted the sector and key stocks and exchange-traded funds. I will explore that further next week.
At the time of publication, Jon Markman did not own or control shares of any companies mentioned in this column.