Treasury To Capitalize Banks By End of October, Then What?

Reuters claims that the Treasury Department plans to start directly injecting capital into US banks in the form of preferred shares as early as the end of October.  Reuters is citing a source "familiar with Treasury Secretary Hank Paulson's thinking."  The Treasury is aiming to follow the lead of the British government which pledged $87 billion in capital to its own banks in return for preferred shares.  According to this "source familiar with Paulson's thinking", the Treasury is working extremely fast to put together the capital injection plan.  On one hand, it may be advantageous to get this plan underway, I don't know, perhaps tomorrow, as the market is acting suspiciously as if it might pull one of its famous Black Fridays.  On the other hand, bank stocks get cheaper every day so it behooves the Treasury Secretary to wait to get a better deal.  No word from "the source" on whether the US plans to guarantee interbank lending, which is the next extraordinarily drastic action the Fed is likely to take.  Although I'm not intimately familiar with Mr. Paulson's thinking, I suspect if these two actions fail to restore calm to the capital markets he may turn to his buddy Mr. Bernanke and say "Fine!  You win.  Cue the helicopters!"

Some banks may choose to bypass the Treasury and raise capital in more ingenious ways.  Having missed the brief opportunity to issue equity when its stock was in the 20's while the short sale ban was firmly in place, Citi got distracted by its battle with Wells Fargo over Wachovia.  Citi has thrown in the towel and let Wells Fargo walk away with the prize.  Of course while Citi dilly-dallied, its stock was cut in half, so an equity issuance at this price is not particularly appealing.  After witnessing the bludgeoning of Bank of America's stock as it struggled to raise $10 billion, Citi is looking for another way to shore up its balance sheet.  So, it is taking the low road and suing Wells Fargo and Wachovia for $60 billion.  In times like these, an extra $60 billion could come in really handy.

A lack of confidence continues to permeate throughout the capital markets.  Banks aren't lending because of legitimate counterparty risk fears (see Iceland's implosion.)  Shares in Morgan Stanley have received a drubbing based on who knows what?  Rumors are circulating that the Mitsubishi investment may not go through and that the investment bank may not make it (CDS in MS are trading at distressed levels and the stock continues to come under attack every day, reminiscent of Lehman and Bear.)  Furthermore, insurance stocks have fallen off of a cliff in the past two weeks as investors become concerned about the fixed income assets on their books.  But hey, it's just a continuation of the financial beatdown due to frozen lending markets, yada yada yada.  Why were stocks like Exxon and Chevron down nearly 10% apiece while crude was only down 5%?  I suspect it was related to  hedge fund liquidations.  The long commodities/short financials trade was very popular with hedge funds this year and seemed to be the only money making game in town for awhile.  However, in the past month the commodity sector has gotten drilled due to fears of a global economic recession and hedge funds have suffered large losses.  Hedge fund redemptions have soared as investors have grown increasingly nervous about taking risk, forcing these leveraged players to liquidate.  As a consequence, many of the big momentum names from this year have suffered extraordinary losses just in the past month (POT, MOS, FCX, just to name a few.)  

What's an investor to do?  Due to my options trading background, I like to look to the VIX, which surpassed 60 today, an indicator that is flashing "PANIC PANIC PANIC!"  When the short-sale ban was originally announced, I put up several posts castigating the SEC for attempting to manipulate stocks higher.  I predicted that smart financial institutions would issue equity during this period (which they did) and that the market would crash after the short-sale ban expired.  Instead, stocks cratered while the short ban was in place after the initial pop on expiration Friday when financial stocks surged to absurd levels (Wachovia at $24?  Washington Mutual at $5, neither of these institutions made it, by the way.  Thanks Chris Cox, you've been very helpful.)  Stocks continued to crater today as the short-sale ban expired.  I crawled into my bunker a few weeks ago when the short-sale ban was enacted and asked that someone call me when the VIX hit 60 and so it has.  While I'm certainly not going to call the bottom, I will say this:  If tomorrow really is a Black Friday, it may be worth it to anyone with a strong stomach to buy a few shares of stock in the panic.  I'm not recommending that investors do this, I'm just saying that I probably will.

My regular readers should understand that this is a fairly bold pronouncement from a curmudgeon who has been consistently and unwaveringly bearish on the market since I began this blog (and for some time before.)  Unlike most of the equity investment and pundit community (yes that includes you, Jim Cramer) who have called the bottom over and over again and thought that stocks looked cheap with the Dow at 13,000, 12,000, and 11,000, I couldn't buy into the notion that a massive contraction in credit could lead to higher stock prices.  I certainly believe that there are significant risks, but the risk reward equation has altered so much in the past several weeks that it has begun to look tempting to dip your toes in as others panic.  Furthermore, the Fed and Treasury are jumping through hoops to stimulate the market, and at some point the gears will start to move again.  I would still hold lots of cash in FDIC insured accounts, maybe some gold and perhaps some Damien Hirst artwork.  For those unfamiliar with Mr. Hirst's art, he puts dead animals into glass cubes filled with formaldehyde and calls it art.  Sotheby's held an auction where people tripped over themselves to pay $10's of millions of dollars apiece for dead animals in formaldehyde.  So, you see, this might be a really great store of value, tradable for canned goods in the event that the entire world collapses and we're left with nothing but a barter system.  I'm not saying I'll be sinking all of my money into Mr. Hirst's art, only that the neighborhood cat better watch out.