Washington’s Voodoo Economics Explained

Boy, the government is smart. We bet even the great illusionist David Copperfield couldn’t have pulled of a trick quite as intricate, quite as convincing.

Since their March lows, bank stocks, as measured by the Philadelphia Bank Index (BKX), have risen 126%. But aren’t these the same banks that investors sold off in panic back in September of 2008? And don’t they still have the same toxic assets rotting on their books?

The answer, bizarrely, is yes. Nothing has changed at the banks except investors’ perception of them. Of course, the banks, aided and abetted by the Department of the Treasury, the Financial Accounting Standards Board, the Fed and the other failed regulators at the FDIC and the Office of Thrift Supervision in charge of the fudge tests, have sprinkled as much fairy dust in faces of investors as they can get away with.

Starting with a ‘leaked’ memo proclaiming a return to profitability at Citigroup and culminating with today’s fudge test results, the tag teaming between Washington and Wall Street has been a marvel to behold. We take our hats off here at Notes. We enthusiastically applaud the show.

Of course, just when David Copperfield ‘disappears’ the Statue of Liberty in front of gawping crowds, we’re all too aware that what we’re witnessing is sleight of hand, not the real deal. The toxic assets still sit and fester. New capital “cushions” are still desperately needed. Sustainable profits are still elusive.

But like a dues ex machina, the government has changed the rules. And it occurs to our poor abused minds here at Notes that it’s the government, not the banks, that investors are betting on. Mr. Market, it seems, has had its own epiphany. It’s realized that the government has got the banks’ backs no matter what. And the grand finale is yet to come. You see, the bank bulls are true believers. They know that the time is fast approaching when the great prestidigitators in Washington will, with a characteristic flourish, vanish the last remaining toxic assets from the banks’ books and surreptitiously deposit the entire stinking mess in the unwitting hands of the US taxpayers.

If you don’t believe in magic, consider Bank of America’s new plan to raise capital. The government says BoA needs to raise $34 billion in equity capital to absorb future losses. You’d think that would mean the bank would have to go to the market for this money, right? Think again…

Thanks to some high-grade accounting hocus-pocus, BoA can simply convert the $45 billion in preferred stock that it received from the generous US taxpayer to common stock. As Barry Ritholz at The Big Picture says, “Even the magician David Copperfield would be in awe.”

However, Ritholz also points out that “Until the banking system starts replacing debt with equity by either exchanges or by dramatically shrinking their balance sheets, all the capital raises are more about plugging holes and hoping for the rain to stop as opposed to lowering the overall leverage of the banking system.”

Still, you gotta love the spectacle of it all.