The “Stress Test” Challenge: Transparency & Intellectual Integrity

FDIC Chairman Shiela Bair said last week that the “stress test” would help the government determine how the big banks will fare in the event that the economy worsens. But before we get to any forward-looking measurements, the investing community deserves an update on the current status of the balance sheets of Wall Street’s once-elite financial institutions. As one critic of the banking stimulus plans in the UK questioned over the weekend, “how can the regulators decide whether the banks need to be nationalized or not without a publicly verifiable valuation methodology?” To which, this writer should add: Does anyone in authority have the audacity, since audacity is what is required now, to define a methodology, in written form, in the first place?

For all practical purposes, the stress test to be fully disclosed shortly, in one form or another, by Treasury Secretary Timothy Geithner will turn out to be a Trojan Horse, deflecting the market’s attention away from the factual reality of today to a set of “what-if” assumptions derived from forecasts on the domestic and global economy. The constituents of the stress on the financial system are well-known at this juncture: (1) a sharp deterioration in counterparty risk; (2) trillions of derivative contracts which defy any mark-to-market quantification; (3) collapsing asset values right across the investment spectrum; and (4) hopelessly inadequate loan-delinquency provisions. So what is required is comprehensive disclosure on the health of balance sheets within the context of facts as they present themselves today, not on the basis of what may or not happen in the future.

In fact, it is difficult to figure out how the Treasury, the Fed and the FDIC priced investments in and guarantees for troubled financial institutions in the first place. “It is impossible to find one document which clarifies, in mathematical terms, the fundamentals upon which regulators spent taxpayer dollars in buying common shares and preferred instruments in recent months,” said a trader who has been shorting banks for a New York hedge fund at the close of trading on Tuesday. “In the absence of details, why should anyone by buying Bank of America (BAC) and Citigroup (C) today?”

Tuesday’s buying of bank shares may well have been, in part, technical in nature. But, by all accounts, Wall Street is also hoping that Secretary Geithner’s announcements this week calm the nervous and set the stage for near-term stability in the financial sector. The problem is that, whatever that stress test turns out to be, the key systemic risk deeply embedded in the financial system, i.e. leverage, will not be addressed, let alone acknowledged. Because if leverage is fully recognized, shares in some of the major banks are actually worthless, and taxpayer funds are being spent on the back of serious, even irresponsible, over-valuations. What the future brings to the equation is an entirely different story altogether, a subject for another forum.

On a more significant note, it is apparent that financial journalists have been rendered ineffective in a climate where government spokesmen keep changing the rules of the game by the hour and attempt to bring a sense of false complexity to the situation. For example, nobody challenged Ms. Bair when she said that the “stress test will help policy makers to determine what type of additional capital investments the government may need to make.” What exactly have government officials been doing thus far? As another example, no member of the press pool appeared willing to push White House spokesman Robert Gibbs for specifics when he stated yesterday that the “Obama administration is going to help the banks through the crisis, but nobody imagines nationalizing banks.” If the members of the financial think-tank inside the Obama administration are still not sure about the results of the stress tests, how can they “imagine” anything at all–nationalization, partial nationalization or simply a partnership with private capital?

For many months, this writer has held the view that the bank rescue exercise is, in its entirety, a fatally-flawed, trial-and-error process lacking in transparency and devoid of an understanding of what a properly structured de-leveraging entails. Now the writer is convinced that it also lacks intellectual honesty.

At the risk of sounding repetitive, the stay-short-financials recommendation remains intact. Watch for rallies as long-term value investors find cause for optimism in the stress-test declaration later this morning, and in positive interpretations of that stress-test in forthcoming days.

US Government Recreating Leverage; Trade Windows Open

Fox News anchor Megan Kelly was visibly amused by two of her guest who predicted on this past week that the S&P 500 would fall below 600, but only after it rose by 30% from current levels during the course of this year. And, without doubt, many Fox viewers must have concluded that the bare assertions of the two asset managers border on insanity. But the Treasury and the Fed are on the verge of creating another leverage bubble and, as a result, the 700-to-900-to-600 scenario for the S&P 500 may not be as crazy as it sounds in the first instance.

The Obama Administration’s programmes to immediately engage the securitization market for a variety of consumer and small-business loans, and to force the restructuring of mortgages, are obviously designed to ensure that “credit flows through the system”. But in a climate where declining share prices and home values have caused a $13 trillion destruction in household wealth and where the jobless rate is severely curtailing family surpluses, the availability of additional (easy) credit, or the extension of contracts in default, is bound to generate new systemic risks within the American financial matrix. Credit apart, what the $1 trillion-plus which the government plans to inject into the consumer and housing market will certainly result in the flow of systemic risks right through the business spectrum.

American consumers are already leveraged. What is desperately needed now is a deliberate and structured de-leveraging, and a recognition that the state of the global economy is calling for a broad contraction in consumer demand. But, that said, this flow of credit may well support widespread upward revisions in corporate earnings in forthcoming weeks, and the predictions of the two Fox guests, as ridiculous as they sound when contextualized in fundamental terms, could start to gain currency. Another credit bubble is in the works, there is ample money sitting on the sidelines, stimulus spending is on the way and there are ample Wall Street analysts who are ready to advance the value-investing proposition with renewed vigour at the earliest opportunity.

From this writer’s perspective, a 30% increase in the major market indices (DIA, QQQQ, SPY) is almost unimaginable at this juncture, given that it is more than apparent that nobody in authority has been able to acquire a thorough grip on the banking crisis and given that neither Ben Bernanke nor Timothy Geithner displayed any grasp of the global nature of the problems confronting them at yesterday’s hearings on Capitol Hill. But the stage is indeed being set for some type of rally in the very foreseeable future, and the challenge will be to time both shorts and longs.

There is simply too much negative news still to unfold, both on the domestic and international front; so no rally can be sustained. The tension between the fundamentals on one hand and the short-term impact of government intervention on the other is offering new trading windows, not grounds for medium-term positioning by any measure. For example, gains in excess of 10% need to be sold into with the intention of covering shorts on periodic pullbacks. Gains in excess of 15% need to be sold into aggressively. Moderate longs are warranted if the indices drop by more than 10% from Friday’s closing levels.

What is important is discipline. In view of the fact that investors generally are unaware, and largely unprepared, for what lies in store in the months ahead, bouts of panic selling on bad news are inevitable; such bouts are going to be for limited periods and they must be used to cover shorts.

Arguably, the definition of “bad” is a relative one today. Investors are becoming almost immune to adverse economic data on the domestic economy and they will only rush for the exits in the face of substantive and significant events, e.g. Ukraine and Hungary defaulting on IMF commitments, a zero GDP growth confirmation from India or China, or a breakdown (for all practical purposes) of the European Union.

The writer’s bearish bias is intact, due to a number of well-founded reasons detailed in earlier articles posted by this writer However, the facts as they present themselves today are telling us that there is much more money to be made by trading the market from both sides in comparison to any medium or longer term strategy.

India’s Budget Stimulates Votes Amidst Negative Growth

For all practical purposes, India is in negative-growth mode. Industrial production is down for the first time in two decades. Exports fell by 20% last month. At least 1.5 million officially employed workers are expected to lose their jobs within this quarter; the comparative figure from the casual-labour sector will exceed 10 million, and another 12 million Indians will enter the workforce this year. In the diamond polishing industry alone, 14,000 factories have been shut down; another 10,000 will follow suit in forthcoming weeks. Thousands of small-scale outfits supporting textile and machinery exporters have entered bankruptcy. How, you may well wonder, are New Delhi spokesmen adamantly maintaining their target for 7.1% GDP growth in 2009?

“We have entered an extraordinary situation,” Finance Minister Pranab Mukherjee declared in the Indian parliament, referring to November’s terrorist attacks in Mumbai. “Extraordinary times call for extradition measures.” The Interim Budget announced by Mr. Mukherjee yesterday provided for a 35% increase in defence expenditures; for the full year, defence spending is targeted to rise by a remarkable 80%-plus.

A worried market analyst at the Bombay Stock Exchange who was looking for additional measures directed at stimulating the Indian economy questioned why “the government failed to incorporate any genuine economic stimulus in the Interim Budget, and why the focus was on defence and agriculture?”

She probably ignored the fact that the biggest challenge for the Congress-led government is to find a way to win the forthcoming general elections, due in April-May, not the Indian economy. That focus on votes was evident in the crop-price support mechanisms and farmer-debt write-offs in the Interim Budget. Indian National Congress strategists concede that winning over voters in India’s cities and townships has become a messy proposition, given the continuing (and sporadic) popularity of right-wing Hindu extremists, regional and caste-based parties, and of mainstream communist and socialists. So, as a prominent Congress cabinet minister concluded, “we must go back to our base, the farmers.”

Not only does the agrarian hinterland offer the current government a valuable vote bank; with some luck, it might serve to boost the national GDP-growth number. The farm sector should contribute between 18 and 21 percent to India’s 2009 GDP. Over the last four years, agriculture grew at an average rate of 3.7%; while revised price support levels will no doubt underpin the size of the agricultural sector, Mr. Mukherjee and his colleagues must pray that the good weather continues. The flawed development in agricultural infrastructure since Indian independence in 1947 has ensured that the seasonal rainfall is the single largest component of farm output.

It does not take a genius to calculate that the final GDP product will depend, almost entirely, on defence spending and a favourable monsoon season; the former is a certainty, the latter is in the hand of the gods.

Obviously, those buying India in the belief that the 7.1% official growth target is highly impressive in the current global environment need to examine the contents of the Interim Budget in the requisite degree of detail. More specifically, it is important to note that a good part of the defence budget is now being allocated to fighting an insurgency led by the Communist Party of India (Maoist), which exercises varying degrees of influence in at least one-quarter of India’s villages. “If we cannot abolish poverty, we are certainly facing a Nepal-like scenario in the next year or two, at least in four states,” a Congress veteran conceded last week. In Nepal, a Maoist party is in control of the country’s parliament; the Nepalese communists are closely affiliated to their Indian counterparts.

As far as the threat from cross-border terrorism is concerned, it is difficult to see what India can do stem the tide. Two weeks ago, the Pakistani government was forced to make a peace deal with Taliban elements in the picturesque valley of Swat, a mere 150 km from the capital of Islamabad. Pakistan’s President Asif Zardari, who publicly announced that militant Islam is the biggest threat to his nation’s stability, is now asking the IMF for a further $5 billion worth of assistance to fight terrorism. And, according to reliable observers, the training camps run by radical Kashmiri jihadis along the Line of Control with India are still packed with recruits.

The conclusion: stay short India ETFs/ETNs (EPI, INP, PIN, ICN) and, if you do have access to the US$/Indian rupee far forward market, short the Indian rupee. The election results in May could present a profitable exit window.