Coping With Stress

Story Highlights:

• Banks have been hesitant to participate in the Legacy Loans Program.
• The program typifies the ambiguity and unintended consequences inherent in government intervention of free markets.
• Lack of demand for the program is a sign Financials aren't facing the Armageddon once feared, and a positive one for markets.

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As the NBA playoffs roll on and the Stanley Cup Championships begin, many players struggle to perform under the stress, wilting under the white-hot spotlight. But the megastars "survive and advance." Since September, a similar spotlight has been focused on Financials. And while some institutions did indeed fall victim to the pressure, we may be seeing signs some financial institutions will indeed persevere, and without as much government aid as presumed necessary last fall.

The Wall Street Journal reported Tuesday the government is expected to delay the Legacy Loans Program, part of the Public-Private Investment Program. This program was designed to allow banking institutions to sell corporate and residential mortgages to investors (backed by the Federal Deposit Insurance Company [FDIC]), thereby freeing banks of these depreciated assets while providing needed capital—all with the aim of unlocking frozen credit markets. Based on government estimates, the program might have led to the purchase $100 billion to $500 billion of "legacy assets."

However, banks haven't been banging down the FDIC's doors to participate for several reasons. First, the largest financial institutions seem to be in better shape than they were last fall. All 19 of the major banks passed the government's "stress test," though some, like Bank of America, were required to increase capital reserves. But instead of selling their currently degraded debt, Bank of America was easily able to raise capital to improve their balance sheet.

Further, perhaps banks can't stomach the prospect of selling depreciated assets at a deep discount to the government—or anyone else for that matter. The vast majority of these mortgages still generate income, and the assets often hold higher intrinsic value than their current market value. Banks know those once-toxic-now-legacy assets will in all likelihood be worth much more if held to maturity (as they were originally intended). How else can you explain banks lobbying for the ability to get in on the auction themselves—buying legacy assets from other banks?

Although financial institutions are not out of the woods by any stretch, they appear to be on better footing than thought last fall. The delay in this program is one more sign Financials aren't facing the Armageddon many fear. They've certainly been in the spotlight, but the survivors seem to be hanging tough, and markets will be cheering them on.