The stalling out of the post-November rally and the retesting of psychologically important lows on the S&P 500 Index and the Dow Jones Industrial Average are direct results of uncertainty about the proper level of government participation in fixing the US financial system.

Ultimately, the US and the global financial system will likely be restructured around principles and regulations modeled on systems such as Canada’s and Spain’s, as former Federal Reserve Chairman Paul Volcker posits here and Harvard historian Niall Ferguson surmises here.

Officials of the G-20 will gather in London March 14 to begin a process of designing regulatory and risk-management systems that could prevent another financial collapse. Tiff Macklem, an official in Canada’s Ministry of Finance, will co-chair a G-20 working group tasked with enhancing the regulation of financial services and improving transparency.

Canada’s prominence on this issue strongly suggests outgoing US Treasury Secretary Henry Paulson’s observation that certain segments of the financial sector should be more “utility like” will become reality. The ability of Canada’s Big Five banks to endure, thus far, the economic slowdown validates such a model.

The first quarter numbers from the Big Five will likely reveal continuing profitability, but that won’t persist unless the root cause of the global meltdown is addressed. First comes the rescue of the US banking system, then we can talk about stabilization and recovery for Canada’s and the world’s economy.

To Canada via Sweden

“The principal cause of the economic slowdown was the collapse of the global credit boom and the ensuing financial crisis, which has affected asset values, credit conditions, and consumer and business confidence around the world,” said Federal Reserve Chairman Ben Bernanke in remarks prepared for delivery before the US Senate Committee on Banking, Housing and Urban Affairs Tuesday morning.

The financial system is not functioning properly. Stabilizing it is a prerequisite for ending the recession. The work must begin in the US, with Citigroup (NYSE: C) and likely Bank of America (NYSE: BAC) as well.

The basic problem yet to be addressed is the pricing of structured finance assets—in other words, the so-called toxic mortgage-backed securities that continue to lose value as the economy worsens and homeowners lose jobs. Banks’ ability to lend is hampered because these assets are killing their balance sheets. That inability to lend is exacerbating the economic slowdown. This is the essence of the negative feedback loop Bernanke described to the Senate Banking Committee Tuesday morning.

Let’s first dispense with one particularly useless canard advanced by ideologically stilted elected officials and pundits more interested in perpetuating a revolution that long ago collapsed under its own hypocrisy and ineffectiveness, with the assistance of Nobel Laureate, Princeton economist and New York Times columnist Paul Krugman:

We are not talking about fears that leftist radicals will expropriate perfectly good private companies. At least since last fall the major banks — certainly Citi and B of A — have only been able to stay in business because their counterparties believe that there’s an implicit federal guarantee on their obligations. The banks are already, in a fundamental sense, wards of the state.

And the market caps of these banks did not reflect investors’ assessment of the difference in value between their assets and their liabilities. Instead, it largely — and probably totally — reflected the “Geithner put”, the hope that the feds would bail them out in a way that handed a significant windfall gain to stockholders.

What’s happening now is a growing sense that the federal government, in return for rescuing these institutions, will demand the same thing a private-sector white knight would have demanded — namely, ownership.

Right now, under the existing regime, the government has all the responsibility–hammered home with daily vows “to use every tool to stem the crisis”–and none of the equity.

But the US government nationalizes banks all the time. In fact, it’s been doing it at a rate of about two a week for a good stretch now. If you have a Blackberry, iPhone or other cool PDA, go ahead and sign up to receive e-mail alerts from Marketwatch.com; every Friday night–during your commute home, while you’re munching pizza with the family, interrupting happy hour–your little siren will sound, spreading the news that the Federal Deposit Insurance Corporation (FDIC) has seized a bank in Oregon, Illinois, California, Nebraska, etc.

One way to discover the value of the bad assets on banks’ balance sheets–and to therefore determine which institutions will be nationalized–is to conduct an examination, a stress test, if you will.

The phrase “Swedish model” has lots of folks excited, not, however for reasons you might suspect (or hope, perhaps). But the experience there provides at least a useful starting point for dealing with the 20 institutions the federal government has identified as “too big to fail.”

Sweden first issued a blanket guarantee of all bank liabilities, a move designed to restore confidence and prevent runs. The next steps were to recapitalize and establish bad banks that held toxic assets.

As for the bad bank concept, it’s in all of our interest to get bank management back to the business of building deposits and making loans, not disposing of impaired securities or repossessed collateral. Removing bad assets in concert with recapitalization is necessary because managers would otherwise be focused on handling non-performing loans, rather than making new loans. The bad banks can be structured specifically to dispose of loans and collateral.

Obviously the hard nut here is how to value the bad assets. Treasury Secretary Timothy Geithner’s Feb. 10 lead-balloon speech described a mechanism that might have promoted a private market for these assets–low-interest loans to make the purchase, essentially a public-private partnership. But that hasn’t happened. Whether there’s no appetite for that kind of risk or no, it seems we’ve stepped directly into the stress-test phase. There is no private market for these assets; with these assets on their books, there is no market for the big US banks.

In Sweden, the price of the assets the bad banks purchased from the good banks was determined with the help of consultants and government examiners who tried to apply a value as close to pure market value as possible. The two banks that form the guinea pigs for the Swedish model were both government-controlled following nationalization, so there was no issue of taxpayer subsidy from overpaying or capital depletion from underpaying. We have experience with this type of resolution–in fact, it was called the Resolution Trust Corporation.

Sweden’s finance minister anticipated from the very beginning of the operation that even with the blanket liability guarantee, the government would have to inject substantially more capital into the banks. The banks would be nationalized, because the government fully intended to buy common shares and to exercise its ownership rights. But this didn’t prove necessary. The big Swedish banks that didn’t require such extensive assistance had enough time and creditor patience because of the blanket guarantee to restructure on their own. They established their own bad banks then obtained new capital from private investors.

The Swedish worried, as Americans do now, that banks would reduce lending in order to rebuild capital and to avoid nationalization. The blanket guarantee mitigated deleveraging pressure somewhat. Loan growth would have fallen anyway due to the reduced credit-worthiness of so many Swedish borrowers. Large Swedish corporations were insulated somewhat by the availability of capital markets financing outside Scandinavia.

Is there enough private money out there to affect a recapitalization? One potential source, the sovereign wealth funds, has already been burned. Other parties are doubtlessly waiting out the government: Why pay now for the whole, including the bad assets, when you can pick up the good assets when the government re-privatizes institutions in a few months.

The balance sheets must be cleansed; once you clean the balance sheets, the banks’ll be attractive to private capital. The government’s going to buy the bad assets, one way or another, so it should participate in the new upside as well.

The market-friendly solution is temporary nationalization.

Still Profitable

Canada’s banks are actually expected to report fiscal first quarter profits when the numbers start coming out this week, although the consensus expectation is for an aggregate 13 percent year-over-year decline in earnings per share.

“Canada is relatively less infected, for reasons that are consistent with the direction in which I think the financial markets and financial institutions should go,” said Mr. Volcker to an informal gathering in Toronto last week.

“It’s interesting that what I’m arguing for looks more like the Canadian system than the American system,” Volker said.

What Mr. Volcker describes are strong banks focused on traditional commercial banking practices such as accepting deposits and then providing credit rather than complex, mathematics-modeled securitization torched Wall Street.

Toronto-Dominion (TSX: TD, NYSE: TD) opens first quarter reporting tomorrow and is expected to show a CAD1.28 per share profit. That would mark a 12 percent year-over-year decline. Royal Bank of Canada (TSX: RY, NYSE: RY) will follow on Thursday with an anticipated 17 percent quarterly decline; Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) is likely looking at a 25 percent year-over-year decline to CAD1.52 a share.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS) and Bank of Montreal (TSX: BMO, NYSE: BMO) report March 3. Analysts expect Scotiabank, geographically diversified but still focused on deposit-based growth, to report a 10 percent earnings decline. Bank of Montreal will see a slide of 21 percent.

Canada’s Big Five have so far held dividends steady and still have room to ride out a weakening domestic and global economy. JPMorgan Chase’s (NYSE: JPM) 87 percent “precautionary” dividend cut, however, could prove a harbinger of things to come for even well capitalized, operationally sound banks.

Bank of Montreal, for example, currently yields north of 10 percent, well above a traditional level of around 3 to 4 percent. That implies a cut could be on the way, despite the fact that no Big Five bank has cut since World War II. But these are, as we’re all constantly reminded, no ordinary times.

The Big Five certainly must be noting the performance of JPMorgan’s stock today in the wake of its dividend cut: The market has rewarded Jamie Dimon’s “precaution” with a more than 7 percent rally.

Here’s to the new prudence.

Speaking Engagements

There are few better places to combine work and play than Sin City: Join Canadian Edge Editor Roger Conrad and The Energy Strategist Editor Elliott Gue for The Money Show Las Vegas, May 11-14, 2009, at The Mandalay Bay Resort & Casino.

With Elliott’s and Roger’s sage advice, this is one trip to Vegas that won’t make a wreck out of you.

To attend as Roger’s guest, click here or call 800-970-4355 and refer to promotion code 012649.

And make plans to join Roger, Elliott, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23, to Saturday, April 25.

Roger, a steady hand through many market events such as the one we’re dealing with now, will talk about Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street, the in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. These guys love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Canadian Edge discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.

The Roundup

Conservative Holdings

Consumers’ Waterheater Income Fund (TSX: CWI-U, OTC: CSUWF) cut its 2008 payout ratio to 92.2 percent from 98.9 percent a year ago and posted steady cash flow and sales growth in the fourth quarter. It also pushed through a 3.9 percent rental rate increase for its waterheaters while growing its customer base by a slower but still steady 1.4 percent. And cash flow covered interest expense by a lofty 6.6-to-1 margin.

Net earnings for 2008 grew by 6.9 percent on a 7.4 percent increase in revenue. Distributable cash was up 8 percent to CAD69.3 million. The fund also completed a CAD330 million long-term debt refinancing this month. Those are pretty compelling statistics auguring for stability at this utility-like trust. Consumers’ Waterheater Income Fund is a buy up to USD10.

Macquarie Power & Infrastructure (TSX: MPT-U, OTC: MCQPF) generated distributable cash flow (dcf) of CAD52.2 million (CAD1.05 per unit) in 2008, compared with CAD48.8 million (CAD1.21 per unit) in 2007. The fund declared distributions of CAD52.5 million (CAD1.05 per unit) for a payout ratio of 100 percent.

Though total power generation for the fourth quarter declined slightly, revenue for the period was flat with the year-ago total on price increases at the Cardinal facility. Fourth dcf was CAD14.7 million, while declared distributions were CAD13.1 million, for a payout ratio of 89 percent. As at Dec. 31, 2008, Macquarie Power & Infrastructure had working capital on hand of CAD51.9 million; the fund sports a conservative debt-to-capital ratio of 46.4 percent. Macquarie Power & Infrastructure Income Fund is a buy up to USD10.

Conservative Holdings’ Reporting Dates

·          AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) Feb. 27, 2009 (Estimated)

·          Artis REIT (TSX: AX-U, OTC: ARESF) Mar. 18, 2009 (Confirmed)

·          Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) March 30, 2009 (Confirmed)

·          Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) Mar. 2, 2009 (Estimated)

·          Canadian Apartment REIT (TSX: CAR-U, OTC: CDPYF) Feb. 26, 2009 (Confirmed)

·          CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) Mar. 2, 2009 (Estimated)

·          Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF) Mar. 11, 2009 (Estimated)

·          Keyera Facilities (TSX: KEY-U, OTC: KEYUF) Feb. 24, 2009 (Confirmed)

·          Northern Property REIT (TSX: NPR-U, OTC: NPRUF) Mar. 2, 2009 (Confirmed)

·          Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) Mar. 5, 2009 (Confirmed)

·          TransForce (TSX: TFI, OTC: TFIFF) Mar. 12, 2009 (Confirmed)

Aggressive Holdings

Penn West Energy Trust’s (TSX: PWT-U, NYSE: PWE) early 2008 acquisitions of Vault Energy Trust and Canetic Resources Trust have had good and bad consequences. Total production during the fourth quarter was up 44 percent, and funds flow rose 40 percent, but the trust’s Finding, Developing & Acquiring (FD&A) costs had reached uncomfortable levels. FD&A has come down, however, to CAD18.94 per barrel of oil equivalent (boe) from CAD29.05 in 2007 as the trust has focused on its existing undeveloped assets.

Funds flow for the fourth quarter was off 12 percent on a per unit basis on a 16 percent decline in netback per boe. The payout ratio was 80 percent for the fourth quarter, 59 percent for 2008.

The trust trimmed its distribution to CAD0.23 per unit from CAD0.34 per unit in January in an effort to preserve cash for long-term development projects. Penn West has been able to access both debt and equity markets in 2009, and has ample room to maneuver with its existing credit lines. As with all oil and gas producers, the key issues remain a return to normal economic growth and the prices of crude oil and natural gas. Penn West Energy Trust remains a buy for those who don’t have a position up to USD20.

Aggressive Holdings’ Reporting Dates

·          Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV) Mar. 6, 2009 (Estimated)

·          Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF) Mar. 13, 2009 (Confirmed)

·          Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) Mar. 5, 2009 (Estimated)

·          Enerplus Resources (TSX: ERF-U, NYSE: ERF) Feb. 26, 2009 (Confirmed)

·          GMP Capital Trust (TSX: GMP-U, OTC: GMCPF) Feb. 27, 2009 (Confirmed)

·          Newalta Income Fund (TSX: NAL-U, OTC: NALUF) Mar. 4, 2009 (Confirmed)

·          Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) Mar. 11, 2009 (Estimated)

·          Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) Mar. 5, 2009 (Estimated)

·          Provident Energy Trust (TSX: PVE-U, NYSE: PVX) Mar. 12, 2009 (Confirmed)

·          Trinidad Drilling (TSX: TDG, OTC: TDGCF) Feb. 26, 2009 (Confirmed)

·          Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) Mar. 2, 2009 (Confirmed)