Crisis Averted, Investors Wonder What's Next

What do you call it when, in a bear market, stocks have been falling so hard that investors can't stand the pain anymore? They've already lost, say, 80% of their money. But they sell, because the thought of losing 81% is just something they can't accept?

Students of investor psychology call it “capitulation.” Traders call it “puking.” A month after doing it, investors usually call it “selling the bottom.”

But if you're the U.S. government, you call it a “stress test.”

You take America's top 19 banks—every one of which you admit as adequately capitalized under current regulations, even after the economic catastrophe we've all be through—and you use a computer model to figure out what their capital would look like if things got even worse. And then you hold a gun to their head, and make them raise more capital than they legally need, so they'll have enough just in case—just in case!—things do get far worse.

And how do banks raise capital? They sell stock. If the economy really has hit bottom and is beginning to turn around, then the government is literally making banks sell at the bottom.

Sell to whom? Normally when companies need to raise money, they sell stock to the public. But nowadays banks are selling stock to the government. No wonder the government wants to force banks to sell at the bottom. It's government that's buying at the bottom.

If Tony Soprano did that, we'd call it racketeering. But when Treasury Secretary Timothy Geithner does it, we call it “saving the system” or “protecting the taxpayer.”

But markets do unexpected things. Bank stocks have rallied so strongly over the last two months as the economy has begun to visibly recover, that banks aren't going to have to sell the bottom after all. And they're probably not going to sell to the government. Suddenly, the public is clamoring for bank stocks.

Yes, government is still forcing the banks to sell. But now government isn't the only buyer—everyone is the buyer. That means there's competition among the buyers, and that means the banks will get a fair price. And that means that existing shareholders get a better deal, because the higher the price at which a bank can issue new stock to raise capital, the fewer shares of that stock it will have to sell to raise a given amount of money—so the less existing shareholders get diluted.

Not to give Tony Soprano too much credit here, but I suppose we could thank the government for the nice way this seems to be turning out.

First, when Geithner initially announced the stress tests back in early February, he laid out conditions for the government buying more bank stock that were really quite friendly—friendly, at least, for Tony Soprano. Geithner said that the Treasury would agree to buy preferred stock that could be converted into common stock at a fixed price. That fixed price was set as 90% of the average price for the 20 trading days ending Feb. 9. That seemingly technical matter of securities design turned out to be very important.

It meant that the government would take stakes in the bank that didn't immediately dilute the stakes of existing shareholders—because preferred stock doesn't dilute common stock. Then, if the bank ever needed more common equity in order to improve its capital ratios under a really bad economic scenario, the bank could then—at its option—convert the preferred to common. And it would do so at a guaranteed price—the February price—which was likely to be a lot higher than where a bank could otherwise sell stock in that really bad economy.

In other words, the government put a floor under how bad things could get for bank stockholders. Implicitly, the government was guaranteeing that bank stocks could only fall so far, and no farther. The Treasury did a particularly poor job of getting the word out about this. The horrific decline in bank stocks in March could have been avoided if investors had understood this better.

That said, there's another way that I think the government got this thing pretty close to right. By emphasizing the stress tests' examination of bank capital under a worst-case economic scenario, the government was able to demonstrate to the markets that banks are actually surprisingly healthy now.

Sure, they need $75 billion in additional capital to withstand the worst case, but that's far better than what a lot of super-bears have been saying. They've been saying that the banks are insolvent right here and right now. If they're OK now, and all it takes to withstand the worst case is $75 billion—and almost half of that is just one especially troubled bank—then we don't really have a whole lot of problems, do we?

Could it actually be that the crisis is over, and that we survived it?

I think so. But survival, like everything else, has a price. We'll be living with the consequences of having paid that price for many years, and that will no doubt limit how robust the next economic growth cycle will be.

For one thing, banks are going to have to figure out a way to pay back the hundreds of billions of dollars in capital that government has already made in them. That money is going to have to come from somewhere. It's going to come out of profits that bank shareholders would have otherwise expected, but now won't get.

And everyone is going to have to pay for all the things the Federal Reserve has done to keep the economy from falling into a depression. The Fed has pumped trillions of dollars into the economy, and thank goodness they did—but they're very likely to suck all the money back when things recover, lest they risk another downturn. That means inflation, pure and simple.

I'm a believer that we've seen the bottom in the economy, and in stocks. A year from now, when the gurus who officially call the timing of recessions call the bottom on this one, I'm pretty sure they'll say it was either this month or next.

But my guess is that the economic recovery off that bottom will be weak, and that stocks won't even get close to their old highs. But hey—it could have been worse.