You really need a scorecard to follow the flippings and floppings of our government officials over the past week, as Treasury Secretary Henry Paulson, Federal Reserve Chief Ben Bernanke and their minions made a spectacle of themselves with conflicting comments about the condition of Fannie Mae (FNM) and Freddie Mac (FRE).
They can’t seem to get their story straight on whether the government will take the two battered bastions of the residential housing market under its wing in a conservatorship, let them die in the wind to teach bankers and investors a lesson or slowly asphyxiate them in a sort of medieval torture.
Former Fed governor William Poole got the latest phase of the debacle rolling on Wednesday when he said that FNM and FRE were insolvent under new accounting guidelines. Then Bernanke went to Capitol Hill and told congressmen that the banks were at the very least undercapitalized and needed more funds. Then the New York Times and Bloomberg put icing on the cake Thursday night with online articles claiming that the government had decided to take the banks over, essentially making their stocks worth nothing.
Shares of the two banks plunged in early trading on Friday, even more so after Paulson announced that Treasury supported them in their “current form”—meaning he actually had no plans to sweep them under government control.
Later in the day, though, a rumor emerged that suggested Bernanke would allow FNM and FRE to borrow capital from the Fed’s discount window. That theoretically would provide them with enough capital to limp forward, but there is a huge stigma attached to this action, as it implies that a bank can’t get loans anywhere else.
On Saturday, a new rumor emerged that the U.S. Treasury would directly lend $15 billion to the two institutions. And then on Sunday night we learned that the Federal Reserve and Treasury had decided to allow FNM and FRE to borrow money from the government as if they were commercial banks, but with the caveat that they’ll be under closer government supervision.
What we know for sure is that Fannie Mae and Freddie Mac need lots of capital to shore up their base after withstanding massive defaults of loans they have either guaranteed or hold.
Here’s The Problem
The problem is, they’re not alone—far from it…
Bridgewater Associates has estimated that U.S. and European banks need $1.6 trillion to fill the hole blasted by losses in mortgages. But the smart analysts at TIS Group in Minneapolis believe the real amount of new capital needed is $3 trillion to $5 trillion.
I know what you’re thinking: What??!!
Yet this makes sense when you understand the leverage.
Here’s how TIS Group figures it: Assume that U.S. banks have $1 of capital. Most people assumed that FNM and FRE used a leverage ratio of 12:1 to 16:1. But new figures released last week make it look like the ratio of capital to loans, or leverage, was more like 30:1. So if there was $900 billion in U.S. bank capital when the bubble began to burst, banks only needed to lose 4% on the loans for all that capital to disappear!
Since corporate defaults run at 4% in a recession, according to TIS Group analysts, the U.S. banking system is going to have to raise truly massive amounts of capital or they will have to very rapidly dial back their lending to levels seen before 1995. And you just have to wonder where this new capital is going to come from.
The sovereign wealth funds of Asia and the Middle East are already down 40% to 70% on the purchases of Citigroup (C) and UBS (UBS) that they made in December and January. As mentioned yesterday, my sources say they are in no mood to throw good money after bad. Maybe the Russian energy oligarchs will put up rockin’ amounts of rubles, doubt even they are so crazy.
Now the only way out appears to be some sort of scheme where the government nationalizes part of the U.S. bank system and prints money to do so, according to TIS Group analysis, and I agree. That way they can directly inject money into the banks, while wiping out current shareholders.
Something like this happened in Japan a few years back, and it worked to an extent. I mean, no one really wants the United States banking system to fail. But you can bet that even after this month’s debacle in the group, most banks and brokerage are far too expensive to touch. They may have fat dividend yields and low price/earnings multiples, but they are going to have to lower current earnings estimates to big losses and cut their dividend payouts completely.
The Bottom Line
More government regulation of the banking system is not a positive, as federal bureaucrats are no more capable of being successful than profit-incentivized executives. And no one really knows where these actions will lead, as we are groping in an unknown territory where unexpected consequences lurk.
Uncertainty is a fact of life in investing, but confusion is usually lethal. I think most banks can easily see their shares drop another 50% or more. So if you own shares in one, plan accordingly.
This article was written by Jon Markman, contributor to InvestorPlace Media. For more actionable insights likes this, visit www.InvestorPlace.com