Rhetorical Recapitalization

Tuesday was the kind of day in the market that might make some with weak stomachs want to take some motion-sickness pills. The day started off rather weak, but roughly 40 minutes before the close, the broad market rallied over 4% for a dramatic finish.

Why the big rush north? Well, as always, it can be exceedingly difficult to pin such a short-term move to one cause, but it appears a contributing factor was EU finance ministers emerging from a meeting and claiming they had an agreement. An agreement they hadn’t done enough to satisfy investors of European banks’ safety and plans on further recapitalizing them, that is.

Now you might be thinking, “Well, duh.” Did it really take government officials this long to figure out investors are concerned (whether justified or not) with the capital levels of the European banks?

Of course these officials knew of the concern (see stress test versions one and two). It’s just that steps to address this or create a backstop have been rather slow in coming. They’ve created a bailout fund (the EFSF) for insolvent governments, but the banks that lend to those governments via bond purchases have long remained a major question mark they’d only partially addressed—and only very recently at that. That uncertainty likely contributed to the nervous sentiment as many hunted for Lehman, part deux.

Today’s news doesn’t fully solve this problem, as many questions remain over how large a recapitalization might be, how it could be executed and more. In fact, today’s news really isn’t very surprising. Most everyone agrees Greece will at least partially default on or “restructure” its debt (to what degree is still in discussion). The trick is to have that happen in an orderly manner and erect firewalls to further protect the financial system. In our view, providing some type of backstop for the banks when this occurs should the need arise has been highly likely for weeks, if not months. Now we’re just starting to see it take shape.

It’s quite possible officials have been planning this for some time and they simply must navigate the (considerable) bureaucracy of the EU. Approving the EFSF to buy government bonds in the secondary market and recapitalize banks required approval of the member states, and that took time. Now that it’s been approved for such activities (particularly by Germany who will bear the brunt of any payment from the EFSF) perhaps it shouldn’t be surprising officials are contemplating a bank recapitalization. Some believe it could take a form similar to the US TARP after the 2008 downturn, but only time will tell. (Hopefully they avoid all the counterproductive shifting sand in terms of the direction the US version took back then.)

Other forms of support for the banks are also likely to begin to emerge. This can be seen in France and Belgium backing a failing (and already largely government-owned) bank today and discussing creating a bad bank to take its troubled assets, or Germany announcing it would reactivate some of the supports it had in place for the banking system after 2008.

If this continues to take shape in a logical and transparent manner, it should help mitigate a source of major uncertainty in the capital markets. It remains to be seen to what degree EU finance ministers’ statement was simply talk versus action. In reality, what seems to be moving markets most of late—in either direction—is talk and rumor, not fact. But as uncertainty gradually lifts, it’s likely more folks begin looking past what amounts to simply words and focus on reality. And as we’ve written here often, beyond the rumor, wordplay and seemingly incessant politicking, economic reality is largely better than is currently widely appreciated.