The Markets could use some Pepto Bismol

As the stock market continues another whipsaw reversal of recent gains, counter intuitively 90 minutes after the largest deposit institution in the country reported double the profit from a year ago – I have one question: how is it possible that the markets, particularly financials, will not recover? Even disregarding the across the board strong profits of the remaining major financials in the last quarter, I defy anyone to explain how the fundamentals will not lead to a strong rebound in the mid-term (becoming shorter every day). Another interesting question is how much of the major bankruptcy and wealth destruction we’ve seen is a result of the bubble bursting versus people reacting to the bubble bursting? Washington Mutual for instance had significant write-downs on mortgages, but it also had $16b in withdrawals in its final week and a 90% drop in common share value over just 6 months. A situation like this will throw any company into trouble, whether it has a toxic or fortress balance sheet.

This is an especially interesting question because writedowns on assets are not losses. One, they are not realized, they don’t represent an actual outflow of cash, just a revised downward multi-year estimate which effects the current valuation, and two, they only really effect cash flow to the extent the market reacts adversely. Write-downs are serious and hurt balance sheets, but it is generally a very long-term signal with a lot of noise. Long-term because mortgages and bonds typically have a maturity lasting decades, and noisy because the characteristics of these securities as a whole is always changing based on the current underwriting standards of newly issued assets. But the market (read herd) takes this rather broad signal and immediately forces a translation into very short-term price signals. And I’m not sure the conversion factor is always spot on. To date the banks have written off several hundred billion in mortgages from their balance sheets, a significant shock no doubt, while the stock market has shed over $2 trillion in wealth. In other words, the market capitalization losses sustained is something like six times the actual writedowns. This is an even stronger shock when there is a run on existing contracts, from deposits to insurance product. The government realized in the 20s the unnecessary and preventable impact such reactions could have, and the FDIC has largely prevented it in commercial banks. That no such authority existed for multi-unit banking corporations like AIG or Lehman was rather remarkable considering how central to the financial system they had become.

Rather ironically, the only long term threat I see to robust bank recovery is the federal government. Unless people suddenly break a 10,000 year tradition, people will need shelters, likely, I know this is a stretch, in the form of houses. The rate of population growth and replacement dictates that about 1.3 million new homes need to be built in the U.S. as an annual baseline. In the last 12 months something like 400,000 were built. So the actual housing recovery timeframe is just a function of how big one thinks the bubble is, how big the surplus inventory is. I don’t think it’s much above 1 million, and we’ve already burned off about 900,000 of it. The rubber should finally hit the road soon. And once we get back to a supply-demand driven housing market, it’s hard to imagine that all these homes won’t require financing. In fact, 99.9% of them will. Pretty much everyone who doesn’t have a Louis-V with a milli in it like Lil Wayne will need the services of Bank of America or Citi or Wells Fargo. Thus, their first quarter earnings don’t seem to be mirage at all, more like a harbinger.

So there is more recovery in the pipeline, particularly when most of the recent earnings came from fixed-income arbitrage in a historically robust bond market. I have yet to hear anything close to a lucid argument that explains how housing and finance will not recover. And because prices have been falling for 16 months now, when it does turn it will likely have some strong inflection points. Balance sheets could reinflate relatively quickly as sideline homebuyers finally get on the field. The only potential long-term complicating factor here (assuming underwriting standards improve) then is the little issue of either servicing the government’s preferred stock loans, or worse selling off their common stock should they choose to convert it. The government should only consider converting their shares to equity if the stress tests show huge gaps that can absolutely not be filled any other way. And considering Citi, BoFa, JP Morgan, Wells all have 10% plus Tier I capital, and Treasury has $100 billion in the vault from TARP, and Goldman and Morgan already want to payback, I think the extent to which this has already been considered and bantered about as a serious idea is borderline irresponsible. We already know the market’s response to this rhetoric will dwarf the actual effects of any such real action. In fact, if the current sell-off continues investors can literally do whatever they want.

GM/White House need to think outside the box

The auto industry bailout should be a coordinated framework to re-imagine personal transportation in this country- including electricity providers and boutique next generation auto startups, not just two imperiled giants. Focusing simply on making GM and Chrysler cash flow positive with newly innovated offerings and lower debt burdens might do the job, but it ignores how integrated and market-infrastructure dependent the auto industry is. After this perfect economic storm, there will very likely be little space in the future for the government to intervene wholesale across the financial and auto landscape as they have in the last 6 months, and little opportunity to bridge the auto manufacturers and electricity producers’ interests.

The Administration only has so much credibility in lecturing the private sector how to make a buck, and only so much room to leverage the benefits of examining the sector in totality. By focusing on the manufacturers in isolation, the government risks supporting fuel efficient vehicles while leaving electric infrastructure developers on the sidelines. The Energy Department has $100 billion in new loan/grant authority, and could indirectly support the automakers by investing in companies like Better Place and Coulomb that develop the electric fueling stations that are a prerequisite for any true Detroit game-changers. The plug-in electric gas hybrid Chevy Volt will be substantially more expensive than an average car to begin with, curtailing sales and lengthening innovation cycles while stalling recovery. Costs will come down only with significant volume, which is a mere pipedream absent a national charging network. And in a world poised to add a billion new cars in China and India in the next 20 years, this is no longer just a matter of pristine design, but self-preservation. Making sure the market infrastructure is there when the new Volt rolls off the line is just as important as making sure they have competitive compensation agreements or streamlined supply lines.

Similarly, private startups operating today at the forefront of auto development, like Tesla Motors, could benefit from the breadth and relative financial depth of the big automakers, while the big automakers could benefit from their new platforms and next generation technology. Joint operating agreements or tech for equity swaps could speed up the bigs’ innovation while giving struggling and investment heavy startups (Tesla is asking for government cash) the market exposure they need to drive costs down. A note of caution however, this is not to say the government should impose anything. The big prize that awaits in the coming years and decades for clean energy winners, and the fierce competition among private actors it will engender, is a catalyst that should not be muted. However, the government and its auto task force is the perfect forum and moderator for getting these parties in a room to talk and see what pencils out. At a minimum they could talk about the non-exclusive aspects and infrastructure they will all need and brainstorm a general strategy, and at most cut some very lucrative deals.

It’s always the time for bold thinking, but very rarely is there the opportunity to actually implement it. The current public appetite for grand new economic architectures (whether TARP or TALF or the Legacy private-public partnership or the auto bailout or the Housing Plan or the Stimulus) is fast dissipating. Ad hoc investments in whatever the market would bare got the industry to this point, and ad hoc government negotiations and a spattering of tiny grants all over the place will just be further death by a thousand cuts.