Insider Protection on Wall Street

On Friday, May 8th, the unemployment numbers were released. In response to the tally of only over 500,000 lost jobs, the media rejoiced and praised the nebulous powers-that-be. Celebratory headlines chanted a harmonizing tune: “New Jobless Claims Plunge,” “Retail Sales Improve,” and “Job Figures Not as Bad as Feared.”

The number of headlines, along with enthusiasm over the so-called “stress test” results caused the S&P 500 to rally and close near its highs Friday. In the last hour of trading, the pit was full and everyone was waiting for the final hour break lower. The bond started spiking and traders were leaning short—but alas—the machines won out and bid the electronic S&P e-mini contract higher.

Here at Trade the Picture, there is no doubt that the worst of the headlines—at least in terms of the recession—are behind us. We will not see jobless claims in the 700,000’s like we saw in January, nor will we see further contraction in the economy. The decline has peaked.

That said, we are still far from a new decade of greed. There are a myriad of other concerns that deserve our attention. The first item relates to the news that started pouring in after the bell on Friday: the stress tests were rigged. Hold your shock and dismay. After all, when you allow the banks to bargain over the parameters of the tests and to negotiate the capital requirements that result, the info cannot possibly be reliable.

I quote from the Wall Street Journal: “Banks Won Concessions on Tests.”

“The Federal Reserve significantly scaled back the size of the capital hole facing some of the nation’s biggest banks shortly before concluding its stress tests, following two weeks of intense bargaining.”

“In addition, according to bank and government officials, the Fed used a different measurement of bank-capital levels than analysts and investors had been expecting, resulting in much smaller capital deficits.”

The Economist sums it up best in “Stresses and Strains.”

“The stress tests have worked in one sense. They have produced a credible estimate of the likely losses banks will face. But the second part of the test—establishing a buffer big enough to allow banks to absorb those losses and command confidence without state support—looks to have been fudged. It is still hard to imagine the banking system being able to stand on its own two feet without explicit state guarantees of debt issuance and the implicit understanding that the government would step in again. As Mr. Geithner admitted, we are only in the “early stages of repair.” The mechanics should keep their spanners at the ready.”

The amount of capital that has been raised for the banks and REITs into this run-up is stunning. In hindsight, this era will be viewed as one of the largest coordinated public shillings ever witnessed in finance.

I stated earlier that the worst of the recession is behind us. However, that does not mean that common stocks (especially of banks) are the asset class to own in the here and now. The banks will almost certainly need more support from the government. In the event that this is not the case, your primary consideration should be which asset classes you want to own during a tightening cycle. When it comes down to it, rates can only be manipulated lower for so long; inflation abounds at some point. You do not want to own banks during a tightening cycle.

Considering persistent bank debility, the amount of money raised through bank and REIT secondaries is criminal. The public is buying these secondaries, if not outright, then through mutual fund purchases in their 401k plans. When bank shares trade at far lower levels, it is the public that will be left holding the bag. While the government is protecting insiders, who is protecting the public–the outsiders?

Indeed, we are witnessing a very dark era on Wall Street.