On the cusp of the first anniversary of the Lehman bankruptcy, the accompanying chart of the KBW Bank Index (BKX) since January 2007 helps frame the long train of events that led us to that disaster, as well as the emerging recovery since it occurred.

What's striking is both the depth and duration of the decline, as well as the strength of the subsequent rebound. On February 20, 2007, the BKX peaked at 121.06, several months before the SPX peaked at 1565 on October 9, 2007. In July 2007, the BKX 50-day, 100-day, and 200-day moving averages (the purple, green, and yellow lines, respectively) converged at the 115 level and began their long decent.

In an article here last month, we noted that the Federal government’s TARP-related investment in America’s banks had become a sweet investment for taxpayers. In particular, we estimated the government earned an average annualized return of nearly 18% on its investments in the 10 banks that had repaid TARP funds. And we argued that rather than being the bailout the administration and Congress continually insist that it is, the TARP program was really a way for the government to hedge itself on the downside in amid the financial panic, with taxpayers reaping the rewards.

Now, State Street Corporation (STT) reports that it has repurchased its associated warrants for $60 million; the company is first large-cap financial to come to terms with the U.S. Treasury. When we last ran the numbers, we estimated that State Street’s warrants were worth $68.8 million. What’s changed? Did State Street pay a fair price? And given recent controversies (pricing transparency, complexity, worries that the government wouldn’t be repaid its full due), what are the indicated values of the other companies’ outstanding warrants?

It's said that exercise relieves stress, but that nothing relieves the exercise.

Monday morning’s leaks erased all doubt that the stress tests of 19 financial institutions have become a political test, not a regulatory one. Timed to coincide with Bank of America’s (BAC) annual meeting of shareholders, reports that Bank of America is “billions” short on capital probably influenced the final vote, perhaps costing Ken Lewis his chairmanship. Still, given that last year more than 40% of shareholders voted to strip him of that job, it surprises that only a bare majority agreed this year, given all that’s happened.

As we prepare for next week’s release of stress test results, we should keep in mind that stress tests, by definition, lack rigor. They can be designed to support any conclusion. Not stressful enough? Dial up the stress. Still well-capitalized for regulatory purposes? Then disparage the capital structure. In short, change the rules.

The Federal government continues to prove itself a poor partner, as inconstant as the moon.

First, the Congress famously changed the TARP rules and replaced business decision-making with parochial politics. Now, the Treasury announces that it will break with long-standing practice and disclose examination results of its stress-testing of the 19 largest U.S. commercial banks. This is not only a particularly poor precedent, but unless all the banks score above average, it holds the promise of damaging investor confidence and destabilizing financial markets.

If U.S. commercial banks are as weak as many allege – insolvent, filled to the brim with “toxic” assets, over-leveraged, etc. – why is it that just released 1Q09 lending data reveal no particular capital or other constraint on the banks’ lending abilities?

If the new administration’s plans for you and me are so good, why has the market’s reaction been so consistently bad?

I’ll add my observation to others’ that, since President Obama’s election, the wealth destruction has been staggering. As of March 20, the S&P Index is down 23.6%, and the KBW Bank Index (BKX) has declined an even more remarkable 58%. That works out to a $446 billion fall in the market capitalization of 24 money center and regional banks.

Well, someone was listening.

In recent Congressional testimony, Ben Bernanke, Sheila Bair, Tim Geithner, Mary Schapiro, and other regulators have all taken reasonably constructive positions on reforming FAS 157 and Fair Value accounting, also known as Mark-to-Market. While they all say they see great conceptual value in mark-to-market accounting (for its “transparency” and “clarity”) and wouldn’t support a rescission or suspension of FAS 157 per se, they support “tweaking” it, or changing to reduce its “pro-cyclicality,” or allowing greater management judgment in determining marks and preparing associated disclosures. And we now know that the Financial Accounting Standards Board plans to issue a new disclosure draft for public comment on proposed changes within weeks.

Fair value accounting has hijacked GAAP accounting. It is one of the great ironies of the day that the Financial Accounting Standards Board’s own rulemaking has managed to undercut public confidence in financial statements prepared in accordance with Generally Accepted Accounting Principles, turning financial reporting on its head. Value is now based on a bankruptcy model, one that assumes that a firm’s value is only that in distressed liquidation, rather than the net present value of cash flows generated as a going concern. The damage to our economy and its growth prospects is enormous and gives life to many of the misguided, unhelpful policy prescriptions (the recent push for a general bank nationalizations being one), that would take a bad situation and make it worse.

In last week’s piece on the economic value distortion and havoc caused by FAS 157’s mark-to-market accounting, I cited Capital One’s (COF) 2008 10-K to show how a company can be well-capitalized and solvent according to GAAP, but simultaneously insolvent from the point of view of many market participants. Several readers requested the pro forma balance sheet effect. Here goes:

When an organization exists to make rules, don’t be surprised when it makes a lot of them. So it is with the Financial Accounting Standards Board. But one should at least be able to expect that the rules FASB makes are well-developed, do no harm, and support the general proposition that financial statements provide clarity and transparency.

On this score, though, FASB hasn’t done so well in recent years. For example, through FAS 140 and FIN 46(R), FASB allowed off-balance sheet “qualifying special purpose entities” (structured investments vehicles, variable interest entities, and the like) that make leverage non-transparent and reward risk-taking through gain-on-sale accounting. Through exposure drafts proposing the elimination of QSPEs, FASB has admitted its rulemaking missed the mark. Similarly, it’s time to admit that its FAS 157 rules for valuing illiquid and hard-to-value financial instruments are half-baked and have contributed more than their share to the current financial crisis.

They’ve likened the economy to a nasty car crackup, so it’s fair to ask whether our Congressional/Treasury/regulatory authorities are hauling the wreckage off the highway so traffic can start moving again, or whether they’ve blocked the highway with their emergency equipment and made the backup worse. I’m not optimistic. Let’s look at what’s been done, proposed, and what’s next in store:

Treasury Secretary Geithner did no one any favors Tuesday when he served up an all-bun bank-stabilization plan; it lacks essential details and sufficient scope. Judging from the market’s reaction, it won’t likely have the effect that Geithner intends. Thus did the administration waste an opportunity to improve market confidence. And Geithner’s presentation skills make Henry Paulson’s look smooth by comparison. Is Geithner enough of a politician to be a successful Treasury Secretary?

Clearly, much of the “plan” has yet to gel. With regard to the private-public fund, for instance, no analysis is possible. Stress testing banks that seek additional public assistance isn’t a plan, it’s a technique--and not a very reliable one, at that. There’s no aggregator bank, or asset-guarantee program either. Where, indeed, is the beef?

Congress is known for serving its legislation half-baked, so it’s surprising expectations are relatively high that it might dish up a palatable “aggregator” bank--that is, one that can be a practical mechanism for buying distressed bank assets, freeing up balance sheet capacity, and enabling lending. The practical problems are formidable; they don’t involve how to structure a “bad bank” (that’s been done before), but rather how to price and purchase securities and loans without making current bank solvency problems worse.

Structurally, the Resolution Trust Corporation (RTC) is the model for most proposals being aired. Recall that the RTC, which Congress created in 1989 to dispose of the real estate assets and high-yield securities of insolvent thrifts and savings institutions, was so successful that it closed shop after only five years, having disposed acquired assets of nearly $400 billion from 747 failed companies.

Ah! Government sponsored enterprises! Last year saw Freddie (FRE) and Fannie (FNM) come to grief. But 2009 could be the year of the 12 Federal Home Loan Banks, wounded already by falling MBS values and the merger and resolution of several large shareholder/members and borrowers. Just what the financial system needs.

You’ll be forgiven if you’re not familiar with the details of this particular corner of the federal banking system. The Federal Home Loan Banks make up a $1.4-trillion (asset) lending cooperative originally chartered in the 1930s to facilitate mortgage lending. The banks’ shares don’t trade publicly; instead, shares are owned by 8,154 insured commercial banks, thrifts, credit unions, and insurance companies. But while the system may be semi-obscure, some of the industry’s largest institutions rely on it heavily for funding, often those banks and thrifts having the weakest deposit franchises.

When more than half of lenders’ “home retention actions”—that is, loan modifications—re-default within six months, it’s worth wondering why mortgage foreclosure mitigation doesn’t work, and whether the foreclosure crisis is worse for the loan mod efforts. It’s worth asking, too, whether the new Congress should direct billions more taxpayer and lenders’ dollars into this failed scheme.

Here’s a better idea, in my view: Rather than shovel billions toward mortgage mitigation, Congress (if it must spend) should use the funds to improve the economics of homeownership, perhaps through an increase in the deductibility of home mortgage interest, to 110% or 120% of the current allowance. This has advantages that other mitigation proposals lack, namely fairness, transparency, administrative ease, and reduced moral hazard. And when enhanced interest deductibility is no longer needed, it could be easily phased out.

Are U.S. commercial banks shirking their social responsibilities, happily agreeing to the Treasury’s capital investments but unwilling to lend? Here in Washington, the new 111^th Congress seems to have adopted this view as an article of faith. On Friday, House Financial Services Chairman Barney Frank introduced legislation that would retroactively modify several provisions of the Troubled Asset Relief Program (TARP), adding cavalierly, “If they don’t like it, they can give the money back.”

Will Bank of America (BAC) cut its common dividend, now yielding a hefty 8.87%?  

In recent comments to investors, the company repeated earlier assurances that it sees “no reason” to cut the dividend, unless the U.S. economy “deteriorates significantly.”  This is nonsense, in my opinion.  Past and pending acquisitions have stretched BofA's capital base. The economy, as well as the company's earnings outlook, continue to worsen. The dividend needs to be cut, and will be, in my opinion, probably by about 40%.

Ken Thompson is gone, but could it really cost Wachovia (WB) $50 billion to fix Golden West, as Jim Cramer asserted last week?  This top-of-market acquisition ranks with the worst, but twice the price tag?  It’s worth running some numbers. Here’s a recap of the October 2006 transaction: 

• The $24.3 billion deal generated $13.8 billion in intangibles and another half billion in restructuring charges.