Strings Attached

Story Highlights:

• We've mentioned before in this space the major stimulus plans will likely ultimately succeed in turning the market and economy, but not without consequences.
• Already, there are encouraging signs the stimulus is working, but we are also starting to see signs of those forewarned consequences.
• It's hard to say at this point what the government will do next or how its actions will further affect the banking sector, and these inconsistencies and uncertainties leave investors in limbo.
• But history shows trouble in one sector doesn't mean markets overall can't recover.

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The federally orchestrated TARP is proving to be quite a tangled web for participating banks—and the government appears to be weaving both visible and invisible strings.

We've mentioned before in this space the massive combined global monetary and fiscal stimulus plans will ultimately turn the stock market and economy, but government financial sector "rescues" (i.e., TARP) do not come without consequences. Already, there are encouraging signs the stimulus is working, including thawing credit markets and falling lending rates. Unfortunately, we are also starting to see signs of those forewarned consequences.

There are visible strings attached to TARP—it was never free money. Banks applied for TARP's federal aid knowing in return they must provide the government with preferred bank shares and adhere to various restrictions. Initially, those restrictions seemed to mainly center around banks' executive compensation. After not seeing a desired level of lending improvement, Congress and President Obama are now demanding new disclosures from banks already receiving TARP loans and tying more restrictions and conditions to the second round of TARP funds. For the land of the free, the government sure makes no qualms about exerting control.

Maybe more dangerous, the government and TARP are also spinning invisible strings—spools of unintended consequences. The government scared off virtually all sources of private capital to financial institutions through its muddled and inconsistent actions last fall (allowing all Lehman stakeholders to be wiped out is the most egregious example). Private investors will likely be wary to hold bank shares for some time—the government, holding preferred shares, is paid before common shareholders. Paying the government dividend returns may also limit banks' use of capital. Additionally, the government may dictate to whom and when banks lend, possibly forcing banks to bow to agreements not necessarily in their own business interests. Moreover, some question whether TARP effectively targets all underlying causes of banks' current problems, including inopportune accounting strictures.

Certainly, tightening the visible strings around banks will just splinter off more of these invisible strings and generate uncertainty. All this is further complicated by the administrative transition and current lack of leadership—Hank Paulson is gone, and Tim Geithner is still awaiting congressional approval. TARP has already undergone some transformations and for all we know, it may see a few more facelifts under the new administration's knife. Generally, being dynamic is fine and good, but these adjustments are another round of the rampant inconsistencies seen last fall and leave investors in limbo.

Maybe it's not surprising bank shares have seen increased volatility lately—there are many dislocations in this sector. Expect this and more in the short term. It'll likely be some time before the banking sector can find stable footing. Still, though you'd never know it from today's headlines, frozen credit markets have thawed somewhat since the crisis' peak—lending activity recently rebounded and credit spreads narrowed. As this process continues, markets will begin pricing in a recovery long before anyone—especially bankers—wave an "all clear" signal.