I Can't Get No Private Capital

When Hank Paulson shocked and surprised me by wiping out GSE preferred dividends. Although I was wrong about "Hammering Hank" wiping out the GSE preferreds, my prediction that it would wipe out the new issue preferred market was right on, unfortunately. The inability for banks to raise Tier-1 capital may be at the root of the selloff of financial stocks. I am not alone in this opinion.

Paul Miller of Friedman, Billings and Ramsey believes that the U.S. government may need to infuse $1.2 trillion into U.S. banks because private investors will not take risk. Adding fuel to the selloff if the lack of transparency regarding banks exposures to bad assets. Mr. Miller writes: "The sheer size of the capital deficiency, coupled with the opaque nature of credit risk, will keep private capital sidelined."

Few financial institutions have been exempt from the recent selloff. Some firms have seen share prices fall to levels which may necessitate a merger or a sale of some divisions. What could possibly be driving this selloff?

Financial institutions have been reluctant to disclose their exposure to toxic assets. No one is quiet sure what assets are held by each bank and what they are worth. Adding to the jitters has been the practice of some banks of labeling toxic assets a "Level III" Level III assets are not marked to market. When banks move assets to the Level III bucket (for a variety of reasons, none of which anyone believes), the assets do not have to be marked to market (or at all). One bank recently move $10s of billions to Level III. That firm's stock price has gotten crushed. My prediction is that by Monday 11/24/08, Wall Street will look very different.

Not surprisingly, GMAC has applied to become a bank holding company. If approved, GMAC would be able to tap TARP. That could give bond holders a stay of execution. Short-term (months) bonds would likely be money good of approval was granted, but unless GM is able to build and sell cars, GMAC's long-term prospects are bleak. There is something else to consider. The FDIC may be reluctant to grant bank holding company status to GMAC before a GM rescue is finalized. This is because if a bank holding, a GMAC failure would be the FDIC's problem. Stay tuned.

Lastly, when commodities prices were roaring and inflation was on the rise, TIPs were a popular investment, even though we would need Carter-esque inflation for TIPs to outperform treasury notes. Now that inflation has dissipated and deflation may be on the horizon, no one wants TIPs. However, now is the time to buy TIPs. I would buy five year TIPs. Break-evens are sufficiently attractive versus the five-year treasury note to make five-year TIPs attractive investments even if we experience muted or even, negative inflation in the near-term.