A stock market rally, for no good reason

Investors seem to think Ben Bernanke told the Senate Banking Committee that nationalization was out of the question. Not exactly.

By Andrew Leonard

Published February 25, 2009 11:30AM (EST)

If the Dow really is "Obama's scorecard," then the president's grade for Tuesday should be at least a B+, in credit for the 235-point rise that almost negated Monday's drop to an 11-year-low. Never mind that the report card theory is bogus nonsense on its face; the financial press and punditocracy are paying obsessive attention to stock market swings right now, making each tick upward or tock downward part of the political discourse, and a potential influence on policymaking. So we must pay attention.

The financial press also universally attributed the Tuesday rally to comments made by Federal Reserve Chairman Ben Bernanke during a Senate Banking Committee hearing. First, in his prepared remarks, he predicted that that there was a "reasonable" chance of an economic recovery in 2010. But we can dispense with this, because, as I already noted today, he included a tremendous caveat -- the requirement that government action succeeds in stabilizing the financial system. There's also the little problem that his track record on economic forecasting has been quite poor throughout this crisis.

Afterward, during the question-and-answer session with the committee -- an exercise that frequently delivers more nuance and news than the prepared testimony -- he downplayed the necessity of "nationalization" for the big banks. And that, apparently, was what the market wanted to hear.

Are investors really such morons?

I noted yesterday that Bernanke is in a no-win position. If he told the Senate Banking Committee that Citigroup or Bank of America were likely to be nationalized, he would precipitate a shareholder dump of those two stocks that would obliterate both banks in a single trading session. As a responsible government official, therefore, he is effectively required not to say any such thing, until the time has come to execute the deed. For investors to take heart at his reiteration that the government was not on the cusp of taking over Citigroup and wiping out its shareholders is an exercise in wishful-thinking folly.

That having been said, Bernanke, in response to some tough, dogged questioning from Sen. Bob Corker, R-Tenn., did provide some more detail on how the government plans to approach the ailing financial industry. But I think that if investors took the time to review the implications of what he set out, they might not be so bullish.

Bernanke outlined a scenario in which the "stress tests" due to begin this week succeed in determining exactly how much capital the 20 biggest banks would need to survive a worst-case economic scenario. The government would then proactively advance sufficient capital to those banks that might need it, as a cushion to hold as reserves against potential losses, in the form of "convertible preferred shares." If the economy did continue its collapse, and the banks did need the cash, only then would it be converted into common shares that would give the government a partial or possibly majority voting stake in the banks.

(James Kwak provides a lucid, essential and up-to-date explanation of the relationship between preferred shares and common stock with respect to the government's new plan at the Baseline Scenario.)

Bernanke made it clear that the government will not allow the banks to fail: "We are committed to ensuring the viability of all the major financial institutions." But he declared flat out that "none of the major institutions" were currently in a situation that would require the government to step in and take over. (Though how he would know that, as Calculated Risk asks, before the completion of the stress tests, is a good question.)

In the meantime, Bernanke promised, the banks would not get a free ride: "We're not going to let them do what they want ... the regulators are now very actively engaged, particularly with the more troubled institutions, working with them to restructure, to sell assets, take whatever steps they need to take to get viable again and profitable again."

How the World Works doesn't often agree with Sen. Corker. But his response to Bernanke's testimony does not seem all that off the mark.

CORKER: But it seems to me that -- that this [strategy] has been creating this sort of dead man walking sort of zombie-like banking scenario. It seems to me that what you have explained is a creeping -- a creeping nationalism of our banks.

BERNANKE: I would call it private partnership. It's not nationalization because the banks would not be wholly owned or probably not even majority owned by the government. The government will be a shareholder along with private shareholders ...

I think Bernanke meant to say "public-private partnership." But Corker is correct: If the regulators are telling the banks what to do, and advancing them enough capital that the government will probably end up with significant ownership stakes, then that does constitute a kind of creeping nationalization. Except it comes without the management of banks in question paying the price that should be required for such government help -- including new management and government representation on the board of directors.

Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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