Of course, Jane’s personal consumption decisions were a microcosm and part and parcel of the national accounts, where her consumption of the snappy “made in China” cocktail dress she purchased at Target were financed by the Chinese government’s purchase of US Treasury bonds. After several consecutive years of “free money” the music inevitably stopped. In the aftermath, private creditors, large and small, were laid waste by the recognition that Jane could not pay her bills and the value of her largest asset, her house, was in a freefall. 

Currently, some of the nation’s largest not-yet-bankrupt depository institutions are the walking dead, zombie banks. Their earning assets (solid loans) do not accrue enough interest fast enough to plug the capital adequacy gap caused by other portions of their rapidly deteriorating loan portfolios. This phenomenon has forced the entire banking system into “capital preservation” mode. Of course, the vicious circle wherein credit contraction leads to a further decline in economic activity and, thereby, to more credit contraction is well under way.

Former Treasury Secretary Paulson’s about-face with the first $350 billion of the TARP (Troubled Asset Relief Program), which was sold to Congress as a way to get the bad assets off of the banks’ balance sheets, was recognition of the enormity of the troubled assets on a system wide basis. Instead of buying toxic assets as originally planned, those monies were used as capital injections to the most troubled institutions. This move was clearly a temporary “stop-gap” measure designed to buy some time, forestall systemic failure, and allow government to come up with a more permanent solution. The purchase of that time was an expensive one. Heck! With $350 billion, a brand new bank could have created $3.5 trillion in new loans.

Several weeks ago soon-to-be Treasury Secretary Geithner stoked the hopes of financial markets by intimating that the government’s new plan for financial stabilization would be far-reaching and effective. However, when Geithner failed to give plan specifics at a press conference two weeks ago, the equity markets began to decline sharply, lead by financial shares. Those declines were exacerbated last week as a result of the suggestion by such notables as former Federal Reserve Chairman Alan Greenspan and Senator Christopher Dodd that short-term “nationalization” or “receivership” of some institutions may be unavoidable.

Nevertheless, during his market-deflating press conference, Secretary Geithner did offer some hints as to what may be the underlying tenants of Uncle Sam’s new financial system stabilization plan. 

First, he cited a “stress test” designed to ascertain which financials could endure a further economic downturn. A careful interpretation of this hint reveals that Mr. Geithner fully understands that some institutions have been hiding behind an accounting rule that has allowed them to delay taking the necessary marks (write-offs) to their loan portfolios. At the heart of this issue is the idea of “fair value” accounting. Under current guidelines, assets held in the “current assets” portion of a bank’s balance sheet must be marked to market, or “fair value”. On the other hand, assets held “to maturity” or in the “long-term assets” portion of the balance sheet need not be reserved for until the asset has actually become impaired. 

Some institutions are holding many loans, such as home equity loans, as long-term assets and have not taken meaningful write-downs to these loans. With home prices plunging and unemployment increasing, these second-lien assets are hardly “money good.” At the same time, other institutions have aggressively taken marks to their portfolios for several quarters in a row, moving a large portion of their assets to the “current assets” portion of their balance sheet. Their capital has been depleted as a result. Nevertheless, on a go-forward basis, and despite their seemingly relatively weaker capital positions, these institutions may, in fact, be healthier than their accounting gimmick brethren. Mr. Geithner’s “stress test” recognizes this phenomenon.

Not surprisingly, Jamie Diamond, CEO of JP Morgan, appeared on television last week smiling like a Cheshire cat. Mr. Diamond’s bank has approximately half of its assets in the “current assets” portion of its balance sheet. What is more, his bank boasts the strongest capital position of any of the nation’s mammoth depository institutions. Furthermore, the terms under which Morgan acquired Bear Stearns and Washington Mutual were amongst the most favorable of many recent shot-gun marriages. 

During his interview Jamie went on to praise President Obama’s plan for mortgage relief as “elegant”. That may seem like an odd position for a conservative commercial banker. The plan does, however, emphasize elongating the term structure of mortgages, not an outright reduction in principal amount; this approach seems reasoned as it helps to transform Jane Q’s problem from one of immediate insolvency to one of the “time value” of cash flow. Better to get repaid over a longer period of time than not at all. To be sure, Mr. Diamond is the proverbial horse to watch.

During his now infamous press conference Mr. Geithner also suggested the ultimate solution to the financial crisis would involve a partnership between taxpayer money and private capital. Perhaps what Mr. Geithner meant to suggest was that private capital would be induced to purchase the banks’ toxic assets at a price which does not wipe out the selling institution’s remaining capital bases, and, in return, the government would insure any losses on that purchase beyond a stated amount. 

This type of deal would be tantamount to taking the capital injection deals Citigroup and Bank of America recently received from Uncle Sam one step further. By removing these toxic assets from their balance sheets (instead of just “guaranteeing” them), current “zombie” banks would boast healthy balance sheets and, as a result, would be able to renew their loan growth with vigor. 

In essence, this would mark the reversal of the securitization process which severed the lender-borrower relationship in the first place and ultimately lead to Jane Q’s demise. Economic activity would begin to rebound, along with corporate profits and equity valuations. One might even dare to call it a virtuous circle. Of course, those banks which have been most prudent in the past and/or have already taken the necessary marks to their portfolios would benefit the most in this next “would-be” credit cycle expansion phase.

Where are these toxic asset investors to be found? Oh, they’re there. Just ask the former hedge-fund managers and investment bankers who are itching to manage the trillions of dollars currently parked in money market funds and time deposits. Perhaps too Uncle Sam might go to Switzerland donning his “big extortionist stick”. UBS agreed last week to pay $780 million and identify some American clients with undeclared bank accounts. “Here you little tax evader, you, buy some toxic assets with those undeclared funds, lest cousin IRS come ‘a knockin’,” the good Uncle would be heard to have exhorted!

The modification of mortgages and a new credit cycle will require some time for their manufacture. In the meantime, President Obama’s recently signed stimulus law will help to supplant the temporary fall-off in private consumption. This plan too will have to be financed. Secretary Clinton’s appearance in China last week was no coincidence. “Have I got some Treasuries for you,” she might have been heard to whisper. The deal is done. China’s economy, which depends on exports for 30% of its GNP is toast without the world consumer, the most brazen of which is Jane Q.

Perhaps too it was no coincidence that President Obama followed tradition last week by making his first foreign trip a little jaunt to Canada. Ostensibly, much of the discussion between the Canadian Prime Minister and the President (who had his national security adviser in tow) centered on Afghanistan. However, it wouldn’t come as a surprise to a careful observer that the fly on the wall during said conversations overheard some talk about an increasingly healthy supply of Canadian “oil sands” petroleum finding its way south of the boarder. 

With the help of Uncle’s intervention in the futures markets, this increased supply may portend even lower oil prices; Jane Q’s new found mortgage relief may keep her in her home, but does little to increase her spending. Gasoline at $1.25 a gallon might be just the ticket to encourage her to sample the new cutting-edge fashions at Target. Notice too how any innuendo of a significant draw-down of troops from Iraq, with its own set of implications for world oil prices, has been absent from recent discourse emanating from “officialdom”. All in good time…

Not to be outdone, Federal Reserve Chairman Bernanke assured the markets last week that the Fed would continue to become more transparent with regard to its burgeoning balance sheet, and, despite rumors to the contrary, assured market participants that the Fed was not accepting the family farm’s goats and chickens as collateral for Treasury bonds. Mr. Bernanke went on to state that the markets should also rest assured that its alphabet soup of quantitative easing (TALF et al) could be rapidly unwound. 

Of course, Mr. Bernanke’s assurance might be seen as a wee-bit of prevarication. In fact, the Fed won’t start to reverse course until after the Chinese finance the stimulus program, the banks’ balance sheets are cleaned up and a new credit cycle has begun in earnest. Then, and only then, will President Obama have the breathing room to begin this nation’s exodus from Iraq. The price of crude will begin to increase as will long-term Treasury yields. Net interest margins at the banks will improve as the yield curve becomes more steepened and assets re-price more quickly than liabilities. The re-inflation backdrop appears to be taking form.