Power and Responsibility

In the Spiderman story, young Peter Parker is told this by his Uncle Ben. Uncle Ben explained that just because one can do something doesn’t mean they should. This is a lesson the banking industry (and the world) is currently learning.

Beginning with President Reagan’s push for deregulation and free markets and continuing through President Clinton’s signing off on the abolishment of the Glass-Steagall act in 1999, the U.S. economy enjoyed a degree of freedom not seen since before the great depression. Financial institutions took advantage of their newly-found power. However, we now know they fell short in the responsibility department. Thanks to the banks, we have moved from an era of free-market capitalism, to an era of government control and intervention. Goodbye Adam Smith. Hello John Maynard Keynes.

What does this mean for banks, the economy and the markets? First, the days of 20 or 30 times leverage is dead. Since common sense did not prevent this kind of levering, the government will. The government will likely try to head off crises such as we have now by constantly overseeing bank operations. This means earnings will be lower than in the recent past and equity dividends will remain somewhat low for the foreseeable future.

Secondly, the days of easy lending are over as well. Although it is true that banks are now better-capitalized, their abilities to lend hinge on investor appetite for asset-backed, mortgage-related securities. No longer will investors merely trust the credit rating services. They will want to know the specific details of the underlying collateral. Vehicles backed by lower-quality assets will be shunned by many investors, regardless of the level of seniority of the tranche in question.

Lastly, reduced leverage and the resulting reduced lending (albeit better than today’s lending environment) will keep economic growth below levels seen during the housing bubble. It will also prevent the purchasing of big ticket items, such as homes and automobiles, from reaching bubble levels. Big ticket items will now be purchased by those who can truly afford them (for the most part).

This will mean that home prices will rise, but at a pace dictated by the gradual movement of the supply glut of homes. Until home inventories fall (and they are sizeable) home prices will fall and then stagnate. Automakers which are already in precarious situations could find themselves in bankruptcy, unless they are the beneficiaries of government assistance.

Is this the end of the pain for the banks? No, they still have toxic assets on their balance sheets. They will have to take losses, unless the government buys the toxic assets at prices above what they are truly worth. Make no mistake, many (if not most) of the toxic assets on bank balance sheets have essentially failed. While the assets are not worth zero, they are not worth par and never will be. Want a hint of how bad things could be? Wachovia had to come clean as a result of it being purchased by Wells Fargo. According to Bloomberg News, Wachovia has now written down $96.7 billion. This is almost twice what Citi has written down ($54.7B). Citi is believed to have the largest collection of toxic assets. Only government over-payment via TARP or creative accounting can prevent further large writedowns at the major banks.

Preferred holders can breathe a sigh of relief now that it is clear that the government will not require banks to suspend preferred or even common dividends, so long as the banks pay dividends on government owned preferreds. There is one fact of which investors and financial advisers should be aware. Trust preferreds are SENIOR to government preferreds. In theory, banks could not pay the government and still pay the dividends on trust preferreds. Also, since trust preferreds are cumulative, investors are entitled to missed dividends as long as the issuer does not fail. Bank failures have just become much less likely thanks to the Peoples Republic of America

What does this mean for interest rates and corporate bond yields? Long-term interest rates should rise due to the new supply of government debt and the dilution of the value of the dollar. However, that may be moderated some by a continued flight to the dollar as the U.S. is still the safest place to park one’s money.

Corporate bond spreads on non-financials should not change much, narrowing somewhat, as they have not widened out in the same fashion as financials. Financial sector senior notes could experience significant spread narrowing now that the government is temporarily guaranteeing senior bonds. Although rising long-term rates could erode any capital gains benefits from spread narrowing, I believe that the spread narrowing may be enough to keep corporate bond prices stable.

For the next year or two we will be playing defense. Investors should stay with the higher quality names as the near-term economic weakness could be a death-knell for troubled companies.