Mixed signals from Treasury are disturbing

The market swooned yesterday on rumors that Treasury would not allow big banks to repay their TARP money—it would instead force the conversion of the non-voting preferred stock that the government received in exchange for TARP injections into common stock with full voting rights. The forced conversion would apply to banks that fail the Treasury’s stress test, whose results are to be released early next month, presumably in order to assure the banks’ survival. Fear levels surged on other rumors that the vast majority of banks had already failed the stress test.

Stocks rose today after Treasury secretary Geithner said that “the vast majority” of the nation’s banks have sufficient capital to pass the test, even though Treasury yesterday inferred that they hadn’t yet conducted the tests. He later said that any bank not passing the test would have the “option” of deciding whether to convert preferred to common stock, or to raise additional capital by other means.

Are these people just making it up as they go along, floating trail balloons and then reversing themselves when the market reacts adversely? You have to wonder. Converting preferred stock into common stock doesn’t add a dime to the effective capital on a bank’s balance sheet, but it does dramatically dilute current shareholders, and it gives the government much more control over how the bank operates. As Larry Kudlow notes, it is simply a backdoor nationalization of the banks. Which banks would want to voluntarily choose such a course of action?

The potentially sinister motives that are hiding beneath the surface acquire credibility given the obvious intentions of the Obama administration to assert more and more centralized control over the economy (e.g., autos, banks, incomes, healthcare, energy, and most recently CO2). This helps explain why the stock market is having trouble following the corporate bond market higher.