Highlighting the sorry state of the field (some might still call it a science) of economics is in, The Washington Post Online published this opinion piece (registration required) today providing yet another suggestion for "saving the banks" without addressing the real underlying issues. Mr. Caballero, head of the Economics Department of MIT, has suggested that the US Government commit to purchasing stock in banks equivalent to two times the existing number of shares within the next five years. He contends that this would have several benefits; first, it would put a floor under the price of the stock. Second, it would allow (force?) the banks to raise additional equity privately, and somehow just by this act the market's negativity will reverse course and the market will rally.
While it's clear that Mr. Caballero means well, it's also quite clear that at the very least the market will not respond favorably in the event that this proposal comes to pass. Having a look at the last five days of trading when the market has been abuzz with bank nationalization talk should present a pretty clear picture of how the market will react to this type of program.
I'm also unconvinced that this type of program would actually help bank stock price very much. The bank would have to issue so many additional shares in such a short period of time (somewhere in the order of 10x the current number of shares) in order to prevent themselves from being nationalized that the price of the stock won't move very much. The reason for this is that the simple process of adding capital to an overextended bank does not suddenly make its Earnings Per Share number increase. Until that number increases, the bank shares will not go up—with one exception. That exception is housing prices stop plummeting and foreclosure rates return to normal. Why?
It's pretty simple really. The toughest part about being an investor, or day trader or banker even is controlling risk. It's easy enough to throw money at equities until something "hits" and then reap the profits if there is no risk to the funds that you are investing. In many cases even it's possible to lose more than you have invested if you are not careful. You control risk by knowing what it is that you have bought and understanding the possible scenarios arising out of that purchase, and pricing accordingly. Unfortunately, many of the RMBCDO (real-estate mortgage backed collateralized debt obligations) that the banks in trouble have purchased as investment instruments cannot be valued properly because the current housing situation and foreclosure rate makes it impossible to determine whether the underlying mortgages have any value or not. Therefore these CDOs have little market value where their "realized" value may end up much better.
Given that large banks still have an unknown number of these on the books, and the potential liabilities for these securities may be substantial, there valuation of the bank itself suffers. Additionally, they can't help improve their valuation by issuing loans and generating revenue because they have to keep as much capital as they can on hand to prevent another re-run of the massive de-leveraging that happened in 2007, again out of fear of what the housing market will do.
In the end, it's all about risk. Until risk is a known, or returns to known levels, the banks will be in trouble. JP Morgan and Citigroup seem to have seen this. They have ceased foreclosures and will be working with their borrowers per the Obama Administration's initiative. This initiative, if implemented properly (the details are still pretty non-existent) will hopefully put a floor underneath the housing market. When this happens, we will be well on our way towards recovery. Throwing more capital at the banks at this time will not solve the problem. By doing this, we would be trying to cure the symptom, and not the underlying disease.
[Stay tuned: I'm working on a much larger discussion of CDOs, risk and who I think has the most responsibility for the mess we are in]
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