Market Thoughts – What Jean-Baptiste said in 1803
January 22, 2009
In general, January has not been a good month for the banks. Already grappling with a mountain of bad debt, the financial sector was hit with a succession of policy statements and initiatives over the past few weeks that have sent a chill through investors:
1) Mortgage Cram-down- At the very start of the new congressional session in the second week of the month, legislation was introduced in the Senate that would allow bankruptcy judges to change the terms of mortgages (i.e., adjust the principal or payment amounts of mortgages). Since the 1970s, such action by the courts were not allowed, which in turn reduced risk for lenders and helped to expanded investors' willingness to underwrite home mortgages. All of this would change if the legislation passes and the so-called mortgage cram-down is made legal. Of course, banks currently have the right to adjust terms of mortgages, but forcing them to do so will undermine the quality of those loans. Investors are in the process of pricing in the reduction of banks' property rights in home mortgages, which has caused an accelerated decline in stock prices.
2) De Minimis Dividends - As outlined in the Lowdown on January 12th, the Obama Administration has gone on written record as demanding that banks that receive TARP funds should pay only a "de minimis" stock dividend. Page 3 of the attached letter from the Obama Administration highlights the key passages. "De minimis" means nominal or token, such as 1 cent. When a major U.S. bank cut its dividend to 1 cent on Jan 16th, which was shortly after it received more TARP money, investors immediately observed that the government was implementing the "de minimis" standard (please check the newswires for the name of that bank).
All bank shares immediately collapsed because one of the main attractions of these equity securities has been dividend yield. If the government were to force all TARP recipients to reduce their dividends to 1 cent, then there is much less incentive to invest funds in these securities or institutions. Under these forced conditions, it is unclear how point number 5 of the attached letter will be accomplished. What is the profit motive for "private investment" to replace "investments" made by the
3) TARP Legislation - Rep. Barney Frank's proposed legislation includes provisions that prohibit the payment of “any bonus or incentive compensation to the 25 most highly compensated employees” of TARP recipients. Furthermore, the legislation would install a government "observer" at the meetings of the board of directors of all recipients of TARP. There are other restrictions in the bill that are too numerous to list here.
Investors have observed the actions of policymakers in
Given the extraordinary political risk in the
In 1803, Jean-Baptiste Say made an insightful observation about attempts to "help" borrowers with forced mitigation of loans:
"The resort to personal restraint against insolvent debtors has been generally considered as injurious to the borrower; but is, on the contrary, much in his favour. Loans are made more willingly, and on better terms, where the rights of the lender are best secured by law. Besides, the encouragement to accumulate capital is thereby enlarged; whenever individuals mistrust the mode of investing their savings, there is a strong inducement to everyone to consume the whole of his income, and this consideration will, perhaps, help to explain a curious moral phenomenon; namely, that irresistible avidity for excessive enjoyment, which is a common symptom in times of political turbulence and confusion."
Written over 200 years ago, the stated principle is equally valid today. Keep this in mind when new legislation or new rules are promulgated in the stated intent to strengthen the financial system. (As a related aside, Say's quote made me wonder if the next growth industry will be in "superfluous" luxury goods.)
