Looking across the world, things are out of kilter but not necessarily in the ways that are obvious. Clearly, US equities have been driven down to their lows of the fall with financials continuing to be the lash on the equity horse. It seemed every time I looked at the sector breakdown of the S&P when the market was down this week, financials were down 7% when the rest of the market was only down 3.5%. As I and many others have been saying, there has to be action from the FDIC to close down/merge zombie banks to clear the stench from the air.
Believe it or not, the structure for doing this was laid out in Geithner's news conference. The FDIC is expected to get expanded authority beyond depository institutions to cover all financial entities in it's quest to review all relevant companies. The FDIC's "stress test" for banks to discern their ability to lend in "a more severe decline in the economy than projected" will be the metric for staying alive. These survivors will be allowed access to a capital buffer in exchange for convertible preferred shares which can be converted into common shares. The ones that don't pass will experience a form of nationalization that includes wiping out shareholders, replacing management, and liquidating the assets.
While takeovers/nationalization is seen as the end of the world, what is happening is analogous to what happened last October in the commercial paper market. Back then, the CP market was declining rapidly due to the breaking of the buck by the Primary Reserve Fund. This led the Federal Reserve to come to the rescue by creating a backstop program for investors in CP. The problem was they announced the program at the beginning of the October, but didn't start it until the end of October. Thus, the CP issuance collapsed by about 20%. Why would an investor buy unsecured CP when they could wait 3 weeks to buy secured?
This is precisely where financials are right now. The US Treasury has told us that the FDIC will be stress testing the financial institutions to decided who's fit. The assumption is that the FDIC will aid banks passing the test and then close down banks that can't. It's like the anonymous steroid testing that caught Alex Rodriguez: everyone will be under suspicion until the list is released. The markets will sell financials until the FDIC makes it's list known.
Without question, the other major piece of the puzzle is housing and how to stabilize the market. President Obama laid out his vision for how to do this yesterday by announcing a $275 billion program. Unlike Paulson's failed Hope program, Obama's provides monetary incentives for lenders to participated and provides a 3 year lock in component to ensure continued participation. The use of Fannie and Freddie to lead in the refinancing is what I've been expecting since the government took them over. The plan has $200 billion set aside for them to refinance loans to as many as five million homeowners that have little equity in their homes or those homeowners that owe more than their homes are worth. We're still awaiting word on how they will adjust loans that have been securitized.
While the plan has merit, the bigger positive for housing continues to be the dramatic under building that is occurring and the rise in applications for mortgages. Yesterday's housing starts and building permits show continued drops which means less supply on the market. Even with softer demand, the under building creates a void that is getting filled by sales of existing homes that include foreclosures. December's surprise 6.5% increase in EHS was a tonic to reducing the inventory of unsold homes from 11.4 months (a high) to 9.6 months. The mortgage applications increase leads me to believe we can see something similar happen in January. This process will eventually cause housing prices to slow their descent.
If Obama's plan for housing works at all coupled with what I've described above, we should see a rapid drop in inventories and home prices stabilize by the summer. This would have a cascading effect to the bank's toxic assets to stabilize them as well. Yes, this is wildly optimistic compared to Nouriel Roubini and John Williams who have been correct in calling for the recession/depression. From companies accessing the capital markets to CDS spreads stable with stocks declining to no new lows for the US dollar against the Yen, the markets have shifted and are not resembling November except for the Dow.
Let's see how fast the FDIC can stress test to get the market to stop stressing about the financial sector.