Friday, May 2, 2008

Bank Capital Drive Looks Good?/Economy Crossroads

The market is mixed today as Wall St. tries to figure out which direction the economy is heading. In my opinion, Wall St. now believes we are at a large crossroads. Earnings came in better than expected and the jobs report today was bad, but better than expected. So now the market is asking itself "where do we go from here?".

The big crossroads that the market is pondering is this: Are we in the early stages of a recovery or are we just keeping our head above water for now before we head into a deep recession?

I of course believe the latter and believe this rally will fade in time as the data continues to get worse. The market is rising on weak data and this often turns out to be a suckers rally. In fact, over half of the largest one day rallies in the stock market happen during bear markets.

There were many huge rallies during the Great Depression. Many of these were due to new ideas and legislation that failed to materialize into any long term recovery. I see a lot of parallels like this today. It seems almost daily that the government has a new idea to save housing and the banking system.

The problem like I said yesterday is this massive debt bubble will eventually suffocate us.

Here is a good example of the pressure the banks are under:

The banks have raised $125 billion through these hybrid security sales. This makes for a great headline when new capital is being raised by a bank. The problem is the banks have to pay an arm and a leg to get this capital. From the article posted above:

``The fact that the market has continued to provide as much capital and liquidity to the large financial institutions as they have is pretty impressive,'' Merli said. ``That's the half-full version. The half-empty version is it's become increasingly more attractive from the buy-side's perspective and increasingly more expensive from the issuer side.''

Hybrids typically allow issuers to defer interest payments without defaulting and rank behind senior bonds for repayment in a bankruptcy. The securities may have no maturity and credit- rating companies usually give the securities equity credit, meaning only a portion of the money raised is counted as debt on an issuer's balance sheet."

So in other words, yeah this is capital but its expensive capital. If things in the housing market continue to deteriorate, this capital could turn into a liability because of the interest rate payments and whatever other terms these desperate banks agreed to.

S&P and Moody's both see thtough this and Moody's is coming out with new guidelines. Same article:

"Banks and brokers may be too reliant on this form of capital, said Tanya Azarchs, an analyst at S&P in New York.
``It's a lesser-quality form of capital than straight equity is and so we don't like to see more than a certain amount of each type of instrument in there,'' Azarchs said. ``A lot of it that's been recently raised we're not counting.''

Moody's Limits

Citigroup has about $47 billion of preferred and hybrid capital and only gets equity credit from S&P for $28.5 billion of it, she said. S&P assigns varying amounts of equity credit to different types of hybrids. Issuers may have as much as half of their equity in mandatory convertible preferred shares and as much as 33 percent in perpetual preferred securities, she said.

Moody's said in March it was limiting the amount of equity credit granted to hybrids to 25 percent of a company's total equity. Merrill, which issued $2.55 billion of perpetual preferred shares this month, has too much hybrid capital and must raise common equity to bolster its ratios, Moody's said in a report this month. Moody's is reviewing New York-based Merrill's A1 rating for a downgrade.

"The whole issue with hybrid securities is the banks can elect to stop payments in times of stress without precipitating a default,'' Azarchs said. ``Banks are very reluctant to do that. They'll pay the preferred dividend even when they can't cover it with current earnings and it's usually at a regulator's encouragement that they stop payment on a preferred and at that point they're already in trouble.''

My Take:

Well the way I see it, these capital raising's will turn up the pressure on the banks because they will feel tremendous pressure to pay the interest payments they agreed to on the new capital they raised(See the last paragraph above) Some have agreed to 8% interest rates and higher.

Banks like Citi will pay these dividends even if they are near insolvency in order to look like they are in a strong capital position. Remember folks, its all about confidence. This new capital could someday be one of the catalysts that could take down a bank.

This gets back to my point about the debt bubble being to large to sustain. The banks are so desperate right now that they are willing to accept all this guido capital at horrible interest rates and othet terms so they can cover all of the bad debt that they are holding on their books.

The capital raising's are desperate attempts to stay solvent. With the housing downturn accelerating, there will come a point where the banks simply get to the point where they are insolvent due to all of the bad debt on their books combined with attempting to fulfill all of their obligations to all of the investors that are involved in this new capital.

These raising's have looked great in the news and financial stock prices have moved considerably higher based on the fact that these banks look much healthier. When you dig into the numbers, you see how desperate these banks really are for cash.

The pressure on the banks going forward will be enormous. Another big leg down in housing and its good night Irene for some of these institutions.

Bottom Line:

Be careful out there in the investing world. Cash is king in my opinion right now. This rally looks tired and stocks are reversing from a big rally early in the morning.

The jobs report was still minus 20,000 jobs in April and wages increased only .1%. That doesn't help you much when inflation is soaring. We are getting poorer by the minute as long as wages stay flat and prices continue to rise.

I hope everyone has a great Friday.

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