Everyone knows that the Fed's money printing spigots are on. The underlying question is why? The party line has been a concern about inflation being at lower than desired levels. However, many people, myself included, are seeing signs in other markets that would suggest otherwise. Gold, agricultural commodities, basic materials, and energy are all screaming that we are more likely facing an inflation problem than a deflation one. The one market that still seems to be stuck at zero is housing. Real estate problems are the worm that gets chopped in half, and instead of dying just grows another tail.
We can all recall the first round of housing woes -- the subprime loans that blew up in everyone's faces. Instead of dealing with the problem and ring-fencing these assets or selling them to the government (a plan which was considered and eventually rejected in favor of capital infusions), the banks took write-offs but held on to many of the loans. And the worm that we thought we killed has grown back. It turns out that not only were many of these assets in default or worthless, they actually may be a liability to the banks. Because of the numerous revelations regarding robo-signers, improper documentation, and erroneous foreclosures, these banks may actually owe the original book value of these securities to their investors.
While the market seems to have digested the latest news, it is clear to Bernanke that there are still minefields. With persistently high unemployment, demand for housing is not getting any better. So any loans or securities on a bank's books that are still 'optimistically priced' are not any more realistic today than they were a year ago. At the beginning of November, Wilmington Trust bank was acquired at a 40% discount to its market value. That is because the actual underlying value of its portfolio (real estate loans in particular) was drastically overstated by the market. A year ago, shares of the stock were trading at about $13. Just before the offer, they were trading at about $7, and the deal was struck at less than $4. Bank of America shares were down about 11% last year -- is that enough?
Bernanke has ordered another round of stress tests on the 19 banks that were initially tested. He is trying to get an assessment of just how bad things are. What is telling is that the results are not going to be made public. While some saw the first stress test as a bit of a public relations stunt to reassure markets, that this one is behind closed doors suggests a more serious, candid evaluation. Because financials are still such a big part of our economic engine, Bernanke likely wants banks to raise capital and strengthen their balance sheets so that they can start lending again. But he needs the stock market to go up so that they can do so in a more sanguine environment.
PIMCO has had an audience with the government in the last couple of years, advising them on TARP and even managing their MBS purchases. Isn't it telling that they are seeking to raise billions of dollars to establish a fund to buy troubled assets from banks? They are signaling that these assets are still out there, and the banks need to get rid of them...to the tune of trillions of dollars. In the 70s, 80s, and 90s, bank assets as a percent of GDP were in the 50-60% range. By the height of the housing bubble, this figure had climbed to about 85%. Today, despite what feels like an endless slew of write-downs, we are still at 80%, with at least 40% of those assets related to housing and construction. I don't want to own the bank stocks in front of this liquidation tsunami.
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