Streetwise for Sunday Mar 1, 2009

Streetwise

Lauren Rudd

Sunday, March 1, 2009

Seldom Have So Many Said So Much About What They Know So Little

OK, let’s stop and get a grip on reality. Seldom have so many said so much about a subject of which they know so little. Yes, we are in the midst of a major economic downturn. Although there are many resulting ramifications, from a financial security perspective your investment posture is critical. Unfortunately, it appears that Chicken Little was an amateur.

There have been eight official recessions in my lifetime and this one is probably the worst, although 1974 and 1982 were not exactly a pleasure ride. That the economy was headed into a storm was no secret, I wrote that over two years ago. However, while no one forecasted the level of ensuing damage, it will not become another Great Depression.

Cyclical bubbles are endemic in our economy, though greed and stupidity have certainly aggravated the impact of this one. As to fault, that is best answered by a 1970 quote from Walt Kelly, creator of the old Pogo comic strip, "We Have Met the Enemy and He Is Us."

The crux of the problem was the deregulation of financial institutions, which began during the Clinton administration and was carried to the extreme under that of George Bush. Over ten years in the making, correcting the problems will not happen overnight. According to Fed Chairman Ben Bernanke, the recovery is unlikely to begin until 2010. However, Wall Street is a forward looking indicator with about a six month look ahead, which means that stock prices are likely to recover well in advance of that date.

Although creating jobs and stabilizing the housing market are paramount to the recovery’s success, neither will happen without a stable banking system. In unequivocal terms, banks will not be nationalized, period. This has been reiterated time and again by the Fed and the Administration.

A particular bank’s soundness is separate issue. Under international agreements, referred to as Basel I and II, the strength of a bank is measured by its Tier 1 risk-based capital ratio. Tier 1 capital includes common stockholders' equity and non cumulative perpetual preferred stock. Assets are risk weighted and a U.S. bank needs a Tier 1 risk-based capital ratio above 6 percent. However, assets that seem safe during normal periods may not be safe during risky periods.

The measurement now in vogue is tangible common equity or TCE. Equivalent to tangible common equity divided by tangible assets, it excludes both equity from preferred shares and intangible assets such as goodwill and mortgage servicing rights. Critics argue that intangible assets have value even in bad times. Furthermore, tangible common equity treats all assets as being equally risky.

As of Dec. 31, 2008, Citigroup had a Tier 1 rating of 11.9 percent and a TCE of 1.5 percent. For Bank of America, it was 9.2 and 2.8, while Sun Trust, a large regional bank had numbers of 10.9 and 5.4 percent. If the Fed converts its Citigroup preferred to common, Citigroup’s TCE rises dramatically.

The Fed just announced that it plans to assess the ability of larger banks to cope with a recession scenario using as benchmarks real GDP declines of 2 percent and 3.3 percent, unemployment numbers of 8.4 percent and 10.3 percent and a decline in home prices of 14 percent and 22 percent. Those banks in need of help will find it forthcoming.

After cutting through all the hyperbole, if you are still mourning the loss of some paper profits and apprehensive over the viability of the banking system, the economy or Wall Street, with the idea of exiting stage left, I would encourage you to carefully rethink such a move.