Connelly on Commerce

We are approaching a pivotal time in the US financial markets, where things that have gone before will be forgotten and the future will become more clear.

Between April 27 ans May 4 — the time of a long road trip in the new baseball season — we will learn the following;
–1: Third quarter 09 GDP initial estimate;
–2; Federal Reserve interest rate decision and economic outloook;
–3: Chrysler bankruptcy, merger or both;
–4: Bank stress test results — first the leaks and then the real thing;
–5: April unemployment.

The key dates are Thursday, April 30 for items 1, 2 and 3, and Friday May 4 for items 4 and 5. But the dates are not nearly so important as the numbers and the directions to the economy and national policy that will be revealed.

And the market action may be more volatile and frantic in the days immediately preceding and following the official announcements.

What will be the difference between good results for the markets and bad one– or as the Las Vegas traders might say, what is the “over-under”?

(1) On the Q1 GDP: bearing in mind that the first estimate reflects merely an educted guess about the March contribution, any number “less” than a negative 5% (ie, -4.7%) would probably be considered a “win” for the economy, and a negative 6% or worse would doubtless be viewed negatively. Here is definitely a case where “lesss is more” — so let’s go with -5% as the tipping point.

(2) The Fed is surely going to leave interest rates unchanged, so the swing issue is how they will characterize the economy. Will the statement cite anything positive about the housing, credit or consumer markets (forget anything positive about the job market for now)? Noting the very recent drop in new home inventory would be good for starters. For once, the Fed’s statement will come after the GDP estimate is released earlier that morning, and they can craft their post-meeting words acordingly. Our bet — some reference to the Fed’s continuing commitment to do “whatever it takes” to restore the economy to health while inflation risks remain subdued.

(3) Chrysler: many are betting on a bankruptcy filing before Thursday — it could even be a “trial ballon” of sorts to scare the wits our of GM’s unsecured creditors and unions. Chrysler’s creditors are in the main secured, so they may even figure to fare better in a bankruptcy, even if their TARP-lender friends at the Us Treasury, which is also trying to resolve Chrysler, disagree. The US Government would seem to have more conflicts of interest in this situation than a rating agency back in the old days (say, 2006). But the truth is that the secured creditors are in the drivers seat here more so than Fiat or Geithner, so a deal will have to be made because the Treasury will not risk pulling their TARP out from under them or exercizing its inchoate equity voting rights to the detriment of other shareholders’ best interests (although that apparently was not the case last December with Bank of America and Merrill Lynch). Bet on a structured dismemberment of our generation’s Studebaker, with Fiat getting a reasonalby good deal.

(4) Stress test results are best kept between you and your cardiologist, but these results are going to be shared with the victims’ (oops, patients’) creditors. This would be like your primary health insuance carrier having a direct feed from you EKG and adjusting your premium rates accordingly. Since no one expects that any bank fingered for having serious capital adequacy problems would ever be able to raise it in the public or private markets, look for a couple of forced dismemberments or forced marriages (somewhat like Bank of America/Merrill, but without the subterfuge, since the results would be thoroughly disclosed). And some bank heads will roll in the process (the over-under is 1.5, like an NFL point-spread).

(5): Unemployment above another 600,000 for the month would be a clear negative to the markets, and less than 500,000 something of a positive, so let’s go with this range as the margin of the moment for the markets by next Friday, if all this has not been drowned out by the latest swine flu news — one enemy we can all agree on how to fight.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

When you or I take a stress test on the treadmill, the results of this “annual physical” routine are between you and me and our cardiologist. But if we need open heart surgery and a quadruple bypass, sooner or later somebody is going to know that we’re not fit for the annual corporate  challenge race. This is the dilemma some are now raising about the Fed’s “stress test” for the 19 largest financial institutions in the US.

While Federal officials have been at pains to point out that it’s not a “pass-fail” exam, still the intention is to give those banks that need more capital to handle the projected “stress” six months to find it and if not, then force them to take Federal money — all to accomplish the goal of not allowing any of these institutions to fail.

Some commentators believe that some of these institutions should indeed be allowed to fail, so for them the idea of disclosing stress test results should make elemental sense; the test will separate those out who might wind up like, say, Lehman or Bear Stearns, without additional capital, and the market will react accordingly, trash their stock, pull their credit, and low and behold, they will fail.

But Congress has yet to enact the new legislation to provide for an “orderly windup” of one of these gigantic holding companies , which do not fit within the existing FDIC “takeover and close down” structure: thus the Government is opting to provide for those at the bottom of the stress test pile with a six month grace period to put their balance sheets right by raising more equity capital.

But how in the world can they raise capital once the capital markets know how low they rank on the stress test? Lehman and Bear couldn’t raise capital when their problems were only rumors; what will happen to institutions where the rumors are confirmed by the US Government? They probably will not be able to raise even  their usual overnight operating funding, much less additional equity capital.

It would seem that the Government then will have no choice but to come up with the additional capital itself  — right now, not six months from now —  since it has no “orderly wind-up” tools in place as yet, and it has committed not to let these institutions fail and not to ‘nationalize’ them either. But it only has between $100 and $140 billion (depending on who estimates it) in TARP money at its disposal, which may not be nearly enough (consider that Citigroup already has $50 billion, which it is not about to return to Uncle Sam any time soon).

Something is missing from this picture. The issue cannot be resolved by keeping the stress tests results secret, now that the cat is out of the bag. Could it be that the stress test scenario will become a stalking horse for some “forced marriages” in the financial sector? Is it the case that the Chrysler-FIAT negotiations going on this week and next are the forerunner of what will come to pass after we know which financial institutions need some sort of “bypass” surgery? And if so, do the merged entities become yet another version of “too big to fail”?

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