It wasn’t bailout that caused Monday’s market surge — 3 other factors

Since the $700 billion bailout was first proposed, whatever the stock markets did, much of the press took that as a sign that the market wanted more government intervention. The markets sinking on Sept. 29, the day the House voted down the first bailout bill (although much of the sinking was before the bailout was defeated), was a sign that markets needed the bailout. Then, when it went up about 500 points the next day, it was somehow explained as anticipation of Congress passing a new bailout.

The press was somewhat at a loss for words when the market tanked all last week, just after the bailout had been passed. But yesterday, when the Dow Jones Industrial Average zoomed up 900 points, the explanation was that the markets just loved the forthcoming global bailouts and partial nationalizations. Comedy Central’s Stephen Colbert, as he so often does, cleverly mocked this conventional wisdom. On last night’s Colbert Report, he reported on “Henry Paulson’s plan to change his plan to whatever the Europeans are planning is working.”

Or not. As of this writing, after Paulson announced details this morning of a $250 billion capital injection in banks in return for preferred stock, the Dow and the Nasdaq are slightly down on this “good news”. Investors are weighing that whatever benefits this brings the banks in terms of new capital, they may be outweighed by the government strings attached such as dilution of existing shares and restrictions on paying dividends. This would make it harder for these banks to raise more private capital in the future. In fact, according to CNBC’s Charles Gasparino, many of the bank CEOs didn’t even want the capital injections, but basically “put a gun to their heads” and made them take it anyway.

Fortunately, aside from the counterproductive bailouts, there have been some recent positive policy changes that may continue to send the market and the economy higher if they aren’t outweighed by other bad policies. Despite the bashing of a largely mythical “deregulation” for causing the credit crisis, the crisis has forced regulatory agencies to modernize or sweep away some irrational regulatory or tax policies. Some of the recent positive action’s that likely played a role in Monday’s market surge include, in no particular order:

1. SEC’s lifting of short-sale ban for financial stocks.
It was claimed that a temporary ban on short-selling was needed for financial stocks to prevent markets from being too volatile. The list of stocks on the ban, which included ended of including such “financial” stocks as IBM, ballooned to more than 1000. At the same time, it did apparently little to stop volatility, as the markets and financial stocks went into a giant freefall all last week.

That freefall was, of course, used as an argument against lifting the ban by CNBC’s Jim Cramer and other short-bashers. But the SEC wisely ignored those loud and angry voices and let it expire late last week. Instead of further freefall, we had Monday’s 900-point surge.

No, lifting the ban shouldn’t be credited entirely for Monday’s recovery, any more than shorting is to blame entirely for a market fall. But sending the message that these stocks were strong enough that they didn’t need protection from shorting likely increased confidence in investing in them. As I wrote in Open Market when the ban was first announced last month, “If the SEC says financial companies are so fragile that they need to protected from any negative feedback, why would anyone invest in them or loan them money in the first place?” As Bill Cosby famously said about novocaine, banning short-selling doesn’t kill pain, it just postpones it. The drops, when they do occur, are more sharp and happen all at once instead of being spread out over time as they are with shorting. Now, with the ban lifted, investors have the confidence of getting the information about the companies that the price discovery of shorting provides.

2. SEC and accounting board’s “clarification” of mark-to-market accounting.
On Friday, the Financial Accounting Standards Board, the private accounting body that sets standards that are almost always adopted by the SEC and bank regulators, “clarified” its mark-to-market rules to say that not every distress sale of an illiquid fiancial asset should force other financial firms to take “losses” on similar assets they hold to maturity.

Like the earlier SEC “clarification” of mark-to-market, FASB said it was sometimes permissible to take into account other factors in valuing an asset besides fire sale prices. Investors were likey reassured that banks may not have to make further drastic reduction in their “regulatory capital” based on paper losses. But this hope could be short-lived, as I warned last week, because the SEC fine print adds that this guidance is no “safe harbor.” Congress and the agencies still need to act further to suspend and overhaul these rules.

3. Simplifying merger and investment rules for banks

Despite the complaints that this all the fault of deregulation, there are several antiquated rules that cause danger to the banking system by unnecessarily hindering banks ability to raise capital and merge. Fortunately, in the past month, two of those rules have been thrown out and revised.

One of those was a 1982 regulation stemming from the Bank Holding Company Act of 1956 that basically said that even investors who bought less than 25 percent of a bank had to be regulated as a bank holding company themselves. It also restricted these minority investors from serving as bank directors, even though their expertise could benefit the soundness of running the bank. This prevented a lot of willing investors, such as private equity firms, from injecting capital into banks and acquiring ownership stakes. Last month, the Federal Reserve finally liberalized this outmoded rule.

Similarly, the Internal Revenue Service changed its rule to allow acquiring companies to deduct the net operating losses of the companies they have acquired from their total tax burden. This makes public policy sense as the two companies are now one and the taxes they owe should be computed based on their total profits and losses. And this ruling, according to the Associated Press, likely enabled Wells Fargo to take over Wachovia at a premium for shareholders and without government backing.

So if there is any message on the markets, it seems to be: Go easy on the bailouts, but simplify the regs.