TAP the TARP

Treasury Secretary Henry Paulson was seen as the US government’s front man as the credit crisis escalated. But then the whole debate on the rescue bill tainted his image as the financial wonder-boy from Goldman Sachs. As investors stared into the abyss and contemplated the “Second Great Depression” a new hero emerged—it was Federal Reserve Chairman and Depression-expert Ben Bernanke.

Yesterday, it was Ben’s turn to explain the government’s new plan to the world. He penned an opinion piece for the Wall Street Journal called “We're Laying the Groundwork for Recovery -- The necessary policy tools are in place.” (With all due respect to Bernanke, he is an economist, not a tabloid headline writer!) The article was published a day after the US announced a sweeping plan to stabilize the banking system.

Following the lead of the UK and other countries in Europe, the government said that it would TAP the TARP this week to bolster the banking industry. Uncle Sam will invest $250 billion into the nation’s banks in exchange for preferred stock. Half of the lump sum was directed towards large banks- Bank of America, Citigroup, JP Morgan Chase and Wells Fargo and all will get $25 billion, Goldman Sachs and Morgan Stanley, the country’s newest bank holding companies, will pocket $10 billion, Bank of New York and State Street are due to receive $2-3 billion. The government will also guarantee all senior debt issued by banks over the next three years and will provide unlimited FDIC insurance to all noninterest-nearing accounts, which are used primarily by businesses.

Mr. Bernanke assures us that these actions, combines with all of the previous efforts, will be able to meet the challenges in the
markets and in the economy. “We will not stand down until we have achieved our goals of repairing and reforming our financial system, and thereby restoring prosperity to our economy.” Time will tell if he is right, but as we entered last weekend, it was clear that the government’s previous efforts were not working fast enough, as interbank lending was under increasing strain, equity market volatility was reaching all-time highs and credit markets were making new lows. In Bernanke’s words, “clearly the time had come for a more comprehensive and broad-based solution.”

The global action was needed to reduce systemic risk and to restore the functioning of global financial markets. Indeed the plan may eventually accomplish this lofty goal, but it will be a long process. Mr. Bernanke himself acknowledged that “at the root of the problem is a loss of confidence by investors and the public in the strength of key financial institutions and markets.” Confidence is a funny thing—it takes a lifetime to establish and a moment to evaporate. The coordinated global effort was necessary to stabilize the financial system, but it will now take time for investors and citizens to trust that we are on the road to recovery.

Ben speaks and the market actually rallies!

I woke up yesterday to more bad news: the overseas markets were taking a beating as investor anxiety over the credit crisis and upcoming earnings season were gripping traders from Tokyo to London. The domino effect started in the US on Monday after negative news about the mortgage lenders hit the wires. When nerves are raw and emotions are high, problems can catalyze downside action in a matter of minutes, but in this environment, it feels like seconds.

The trouble started after a Lehman Brothers report estimated that mortgage lenders Fannie Mae and Freddie Mac could be forced to raise approximately $75 billion ($46 billion for Fannie and $29 billion for Freddie) in capital, diluting existing shareholders, if a proposed accounting rule change were enacted requiring companies to move certain off-balance sheet securities onto their books. These were the investment vehicles that were used to sell off, or securitize debt instruments such as mortgage securities. Even without the rule change, some analysts believe that additional capital will be a necessary ingredient for each company’s ability to survive the housing crisis and the associated credit losses. Still, it was the Lehman report on Monday that did the most damage, as both companies fell to their lowest levels in more than 14 years--FNM dropped more than 16% to $15.74 and FRE fell nearly 18% to $11.91.

The selling continued overnight and into Tuesday, as the news sunk in about the two mortgage giants. To add insult to injury, the FDIC announced that it would bar IndyMac Bancorp from making new mortgages, which further fanned the flames for jittery financial sector investors. Japanese markets tumbled Tuesday after a one-day respite, and resumed their two-week slide, sending the Nikkei 225 Stock Average 2.5% lower to close at 13033.10, after falling below the 13000 level intraday for the first time in nearly three months. The results were similar across Europe and within a couple of hours of the US opening, things looked pretty messy.

That’s why the timing of Fed chief Ben Bernanke’s comments at a mortgage-lending forum hosted by the FDIC was particularly fortunate. Bernanke described a plan to expand the central bank’s authority over financial firms and “In doing so, we aim not only to make the financial system better able to withstand future shocks, but also -- by reducing the range of circumstances in which systemic stability concerns might prompt government intervention.”

Given the news swirling on Tuesday morning, investors could be forgiven for being hopeful that Mr. Bernanke would succeed in making “the U.S. financial system itself more stable.” After his comments, the market opened to the upside and traded higher throughout the day, with the S&P 500 closing up 1.7% on the day. Some of that action occurred on the back of nearly $6 drop in crude oil, but for a change, Bernanke’s comments definitely got the day off on the right foot. Of course a day does not make a trend, but it sure is preferable to the alternative!