Issue 13 • FEBRUARY 25, 2009

Bank Bailout Plan: The Devil is in
the Details

So far, our new President has signed a $787 billion fiscal stimulus plan into law. He also announced the outline of a Financial Stability Plan and a housing recovery plan. Yet, the stock market continues to slide lower, with the Dow Jones Industrials setting new bear-market lows last week, and the S&P 500 Index following suit this week.¹

It’s clear that recent market actions signal a vote of NO-confidence for these various “rescue” plans from Washington. The biggest concerns seem to be the glaring lack of specifics about how these banking and housing rescue plans will work. All we have seen so far is a bare-bones outline of each plan, without much in the way of details — and the devil is always in the details.

The keys to any effort to restore lost confidence in financial markets — and in banks especially — are clarity and transparency... in other words: DETAILS. A clearly articulated plan of action that lays out the specifics and includes measurable results is what’s needed to calm jittery investors.

Less Uncertainty and More Clarity, Please

Last year, the government’s response to this crisis seemed chock-full of uncertainties, with the game plan changing all the time. So far this year, we have seen only “summaries” of the new administration’s plans, but still no specifics. When investors are unsure of the rules, they refuse to play the game, waiting instead for details to emerge. Only a specific plan will reduce market volatility.

In a previous issue of Weiss Advice I said, “To truly restore lost confidence and credibility in the financial sector, what’s needed is for these institutions to come clean about the true extent of their losses and weakened capital state.”

Well, the outline of the Financial Stability Plan (FSP) — or “Geithner Plan” (named after the embattled new Treasury Secretary) contains a common-sense provision that may finally put us on the right track.

The nation’s largest banks (those with $100 billion or more in assets) must prove themselves solvent by submitting to a “stress test” according to the FSP. As if the extreme stress level inflicted by dysfunctional credit markets over the past 12 months wasn’t enough. Of course, the details are still fuzzy, but are promised to be coming soon (along with details for the housing stability plan).²

Cramming for the Stress Test

In my view, such “stress tests” must be realistic and penetrating enough to separate the good banks from the bad. It’s not hard to guess which banks may fail this stress test — their share prices are already trading in the low single-digits, more like a call option on survival, than a reflection of true business worth.

To provide investors with real information, any stress test performed on the banks must include a realistic forecast of an economy likely to deteriorate further in the months ahead, including a further drop in home prices and commercial real estate, plus rising credit card and commercial loan defaults.

The real key to the future success of the Financial Stability Plan is how well it deals with the results of these stress tests.

Presumably, banks that PASS the government’s stress test will have enough capital to survive on their own, without more government money. Another provision in the plan calls for the creation of a Public-Private Investment Fund (PPIF) to purchase “toxic” assets from banks — the “good” banks — to help them reduce balance sheet risks, which is another key to restoring confidence in the sector.³

The presence of private capital investors in PPIF should add a layer of discipline to the process, helping to ensure that the government doesn’t overpay for the toxic assets it purchases from banks.

Pass, Fail or Incomplete?

But what about the “bad” banks, those that FAIL the stress test? This is where the plan gets murky, which is exactly why investors are demanding more details.

According to the FSP outline, a Capital Assistance Program (CAP) will be “generally available to eligible banking institutions as a bridge to private capital.” Additionally, “capital provided under the CAP will be in the form of a preferred security that is convertible into common equity.”⁴

This part sounds suspiciously like another government handout to Wall Street. If so, this is the equivalent of giving an “incomplete” grade to a student who is obviously failing. It’s a free pass, another incremental form of government nationalization of the banks, and it could be a recipe for disaster. This was the course taken by Japan in the 1990s to prop-up their “zombie” banks — by continuously feeding them fresh chunks of “flesh” in the form of government handouts — rather than forcing them to come clean about their losses.

Warning: Zombie Banks Ahead

In Japan, this process went on for years, resulting in the country’s “lost decade” of economic depression — an event that has now stretched nearly two decades and counting. Japan’s actions only postponed the ultimate day of reckoning, resulting in prolonged pain and greater losses for Japan’s banks and its economy.

It took ten years for Japan’s banks to own up to their losses, finally writing off 96 TRILLION yen, equal to 19% of Japan’s entire annual economic output! By then, Japan’s Nikkei stock index had plunged nearly 75% in value, and real estate prices in Japan declined for 15 straight years!⁵

Japan’s mistake was postponing the painful, but inevitable details. Not forcing major banks to submit to merciless audits and declare bad debts sooner. We MUST not make the same mistake here and now. The U.S. banking system has already failed us. Massive government investment and loan guarantees have already started us down the road to bank nationalization.

The Devil You Know...

At this point, we just need to know the details (devil and all) of what form the government plans will take. If we proceed swiftly to recognize “toxic” assets for what they are: bad debts that need to be taken as losses and written-off, then some major banks could be forced into government receivership and liquidation. But, this has been handled in a relatively smooth manner already with several big financial firms including: AIG, Washington Mutual and Fannie Mae.

This outcome may be distasteful to some (especially common stock holders of the “bad” banks who will likely get wiped-out), but it’s far better than turning banks into “zombies” with a prolonged addiction to government handouts.

Such decisive action would be bad for the share prices of some big banks, those that are clearly in trouble, but it might be positive for the overall stock market. That’s because there will be a clear plan of action to deal with this crisis at last, and a clear set of rules to resolve troubled banks.

We will be eagerly anticipating the details of the Financial Stability Plan.

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ Bloomberg: “Obama to Work on Executive-Pay Limits Amid Complaints”, 2/15/09
² U.S. Department of the Treasury, 2/10/09
³ Ibid
⁴ Ibid
⁵ New York Times: “In Japan’s Stagnant Decade, Cautionary Tales for America”, 2/12/09