EconInvestor

You have to view the video “The Greatest Boondoggle in History” Banks Buoyed at Taxpayers’ Expense - Stress Test is Phony - Yahoo!Finance-May 8, 2009. 

The bank “stress tests” are phony. They didn’t work in the past. They underestimate the amount of capital needed by the banks. 

The biggest shock coming to the system are the Adustable Rate Mortgages (ARMs) coming due next year. The worst is not over!

In reading the article “ Top Banks Got ‘Offer’ They Couldn’t Refuse “, it was disappointing to see in a country that promotes free enterprise that the top nine US banks were forced to have the government buy shares in their bank.

The idea was that if banks individually asked the government to buy shares in their banks, they would be seen as weak - causing flight by consumers and investors.  So, if the government bought into all the top banks, no one bank would stand out.

There are several problems with this policy.  First, if a bank pursued a better financial strategy than one that is in trouble, why should their shareholders have to have their shares diluted?  Second, the market discipline of failure is not being promoted.  Third, the Fannie Mae and Freddie Mac problems were well known prior to their failure. Political pressure was put on them to promote even riskier loans.  Once the government owns a share in the company - even if it is preferred, non-voting shares - what will stop the government from pressuring the banks to pursue certain political policies?

While the goals of the government are laudable, the policy to achieve those goals remains questionable.

By Monday, the Securities and Exchange Commission (SEC) will probably modify its ban on short-selling stocks ( SEC bans short selling in hundreds of financial stocks ) to allow options market makers to engage in short selling. ( SEC Considers Revising Shorting Ban in Options Market ) However, the fact that it didn’t consider the effects on the options market ( Options Clearing Corporation Statement Regarding SEC Short Sale Ban) shows how little thought went into the ban.

The ban is a bad idea from two perspectives: short-term and long-term.  For now I’ll assume that the SEC will revise the ban in the options market and won’t go into that issue. 

From a short-term perspective, what happens to those already holding short positions?  It appears that the government just forced them to buy in order to close out their position.  How much of Friday’s run-up was due to shorts closing out?  Why should they be forced to take a loss?  Shorts were engaged in legitimate trading.  The government just changed the rules in midstream.

Rven if the shorts are allowed to hold their positions, the ban on new shorts will put enough short-term pressure to force a close-out at a loss.

Another related short-term issue is the effects on hedge funds. Some of these funds may have to close out their positions at a loss. This could drive down their prices. This could cause a run on the fund or cause problems with their collateral or capitialization.

One long-term issue is that it now increases uncertainty and volatility into the market.  Now traders have to worry about what unexpected action the government might make.

Another long-term issue is that it encourages the idea that the government can step in at the spur of the moment and change the rules of the game.  Another way to make money is to have the government issue a new trading rule in your favor. Already some companies are trying to get on the list of banned from being short sold ( Companies try to scramble aboard SEC short selling lifeboat).

Along these lines, why is  AHD - ATLAS PIPELNE HLDINGS and  NSH - NuStar GP Holdings on the list?  Two oil pipeline companies on a list to help financial companies in distress?  This seems like some insider connection at work.

My next post will go more into this ban.

The Wall Street Journal has an excellent article that follows the events that led to the Fed bailout of AIG. (  Bad Bets and Cash Crunch Pushed Ailing AIG to Brink ) What is surprising is how AIG kept underestimating the amount needed to keep solvent. First it was $20 billion, then $40 billion, then $60 billion, then $70 billion, then $80 billion.  How can management put together a deal when it doesn’t know its financial position?  The answer is: it can’t.

It is clear now why Hank Greenberg’s attempt at a bridge loan failed.  The numbers were probably much bigger than what he was initially told.

I’m still trying to digest the Fed’s move on AIG. One interesting article is  AIG’s businesses for sale as bailout buys insurer time . In the comment section, someone pulled from Bloomberg, the following:

“Greenberg, who remains one of the company’s biggest stakeholders, said the company needed a bridge loan instead of a plan that put the company under government control. An investor group led by Greenberg said in a federal filing hours before the rescue was announced it might want to buy the company or some units or make loans to AIG.”

“`Why would you want to wipe out shareholders when you just need a bridge loan?” Greenberg, 83, said in an interview before the announcement. `It doesn’t make any sense.’ Greenberg declined to comment after the Fed announcement, spokesman Glen Rochkind said. ”

It is easy to second-guess, but it does make one wonder if a non-government bridge loan could have been made instead of the government loan.