Bottom for the Banking and Financial Stocks?

By: Hans_Wagner

Investors who regularly beat the market are always careful not to jump into a sector to early. In the last few weeks there has been unprecedented action in the financial markets as several banks have received infusions of capital to help them cover their significant credit losses. Last month the Fed lowered the Fed Funds and Discount rate, increasing the slope of the yield curve which should help banks. They also opened its lending window to investment banks giving them a new, stable source of funding. Then the regulators allowed Fannie Mae and Freddie Mac to boost their investments in U.S. mortgages by $200 billion, trying to give the mortgage market a boost.

The markets responded with several up weeks lead by the financial sector. So have the financials hit the bottom and is the recent action a sign of the tipping point? To answer this question, let us look at the situation in more detail.

The Credit Markets

Peter Bernstein, publisher of Economics & Portfolio Strategy , pointed out that housing prices rose by almost 50% from 1998 to 2001. 50% in three years when the Fed funds rate was over 6% implies that people were ready to incur mortgage debt without low rates. Home prices continued to rise even as the Fed began to raise rates in 2005-6. It looks like the United States built 3.5 million more homes over the last ten years than was needed. Many were built during the period of higher interest rates as investors/homeowners expected the prices to continue to appreciate.

While low rates did help, the housing bubble was aided by poor lending practices. Mortgage brokers wrote these loans without proper documentation and at reduce rates to get the borrower committed to the loan. The rate on these loans either has been or will be adjusted up causing the borrower further pain. Rating agencies labeled these loans as AAA credits. Mortgage and investment bankers sold them to all manner of institutions. It now looks like two million people took out loans that they cannot afford. Many of these loans are headed for foreclosure. No one knows the value of these securities.

All these offenders took advantage of the low rates, but that was not the cause of the bubble. If proper lending practices had been followed, there would have been far fewer buyers and less building, less speculation, and so on. The current mortgage crisis would be much less of a problem.

The magnitude and depth of the credit problem is larger than many realize. The financial sector firms will continue to have to write down the value of their portfolios as new foreclosures take place and the real value of the underlying assets drops further.

Adding to the problem is the growing delinquencies in auto loans and credit card debt. So far the focus has been on mortgages. According to USA Today the average automobile loan today is for 63 months, with some going as high as 80 months, compared with an average of less than 48 months five years ago. In 1997, banks financed an average 89% of a new vehicle's price. Last year, it was 101% since consumers borrowed to cover the amount they were upside down on their trade-in. 40% of all trade-ins involve upside-down car loans. Though smaller than the credit problem, this looks like another credit bubble about to pop.

Then we have the credit card debt. The following statistics come from Hoffman Brinker & Roberts :

• In October 2007, credit card debt that was at least 30 days late totaled $17.6 billion, up 26% from October 2006. Some credit card companies, including Advanta, GE Money Bank and HSBC, are reporting a 50% increase in accounts that are at least 90 days late compared to the same time last year (SOURCE: Rachel Konrad and Bob Porterfield, Associate Press Writers)

• In 1968, consumers' total credit debt was $8 billion (in current dollars). Now the total exceeds $880 billion. (SOURCE: Federal Reserve Bank)

• Approximately half of all credit card holders don't pay the full amount of credit card charges each month. About 11% say they usually pay only the minimum monthly payment but not much more. (SOURCE: Experian-Gallup Personal Credit Index survey)

• According to the Federal Reserve Bank, 40% of American families spend more than they earn. (SOURCE: www.federalreserve.gov )

• Only one household in 50 carry more than $20,000 in credit card debt. However, that "one in 50 households" figure represents more than 2 million American homes. (SOURCE: Liz Pulliam Weston, www.asklizweston.com )

Much of the problem was driven by average US consumers, who have seen their incomes rise very little in real terms over the past six years. They maintained their spending patterns with debt of all types, and especially mortgage equity withdrawals. That source is going away. Consumer spending is going to come under pressure and with it the earnings of many corporations and businesses. 

The problems that created the current crisis and the incipient recession cannot simply be solved with lower interest rates. It is going to take several years to work off the excess inventory in the housing markets. It will take at least as long to get the credit markets functioning smoothly.

Positive Sloping Yield Curve

Recently CIT Group (CIT) reported that they had lost short term funding and Credit Suisse Group (CS) warned investors to expect a first quarter loss. Then Standard & Poor's placed the debt ratings of Goldman Sachs (GS) and Lehman Brothers Holding (LEH) on “negative outlook” due to weakness in their earnings. This came after these two firms reported better than expected results earlier in the week though those results were substantially lower than the same period last year. Since then Lehman issued a $4.0 billion Convertible Preferred to help shore up their capital base.

Many analysts expect the worse is over and that the banks will do better over the next 12 months. One of the biggest reasons they believe the banks will do better is the steep yield curve. Financial institutions make their money by borrowing short and lending long. When the yield curve slopes steeply upward, the banks can make a lot of money on the interest rate spread. For exampleon Thursday, March 20, 2008 the difference between the two-year Treasury note and the 10-year Treasury note was 1.78 points. Last year, this interest rate spread was negative, as we had a negative sloping yield curve. By the way a negatively sloping yield curve is a good indicator of a recession in the next 12 to 18 months. Looks like it worked again.

A steep yield curve has a positive impact on all banks. In past recessions, the Fed engineered a steep yield curve to help the banks and industry recover more quickly. As long as write-offs do not get worse, banking institutions should generate higher earnings from the positive yield curve.

Trust is Paramount

The banks face two problems that they must overcome before the positive yield spread will push up their earnings. First, they must be able to maintain the trust of the other banks. Any bank that looses that trust will quickly face a major liquidity problem face a run on the bank. This can cause banking customers to loose faith in the banking system. That is what the Fed tried to avoid when they intervened into Bear Stearns situation.

Anyone (hedge funds and banks) who needed Bear Stearns to provide loans, prime brokerage, leverage, etc. would have lost access to their cash. Since other lenders and banks would not know who had exposure to Bear, banking and lending would have ceased. If you don't know what your capital position is, you cannot lend, and you will not lend to someone if you don't know their position.

Bear would have been forced to raise money as rapidly as possible. This means margin calls to their client firms with solid credit, as they would have to reduce their credit exposure. When the margin clerk calls, you don't get to sell what you want. Sometimes you simply have to sell what you can. Since loans and credit assets would not be liquid, which means selling stocks and commodities.

The margin clerks at other banks would look to see what exposure to Bear their customers had. Any exposure would mean that customer had to provide more margin capital immediately. If none were forthcoming, then the margin clerk would start selling. In this case, you don't want to be the last one in line to get your money.

The other banks have to protect their capital positions. If the Fed were to allow Bear to go down, then it would only be a matter of time before others followed. The strategy would be to raise as much capital, call as many loans, and reduce leverage as quickly as you can.

As the margin calls come, more selling of liquid assets takes place. It becomes a viscous cycle that affects everyone. All assets are sold for much lower prices than they were just minutes before. Stockholders would see a crash in the prices of good companies. Everyone who has used leverage must sell assets. In this case, the most liquid assets, those that someone else might buy, are sold. The assets that have questionable value remain on the books. This vicious cycle continues until several institutions close their doors. 

If you believe something is AAA rated, you can buy it without a lot of research. The better the credit, the more liquid it is. Absent that trust, you have to do your own research. That takes time and money. It slows the process down and it means risk is priced differently and at a higher price.

If banks do not trust each other, then the financial system can collapse. In the case of Bear Stearns the Fed bought time for an orderly liquidation. It is going to take some time to get back to functioning debt markets and normal mortgage credit markets. The problem of bad mortgages, auto loans and credit card debt being written off by a host of institutions is still with us. We will see hundreds of billions of dollars of write-offs more than we have seen so far.

What is an Investor to Do?

As an investor, you need to plan for a rather long period of slack demand and slow growth, and think through how your portfolio will be affected. Not all bear markets go straight down. Many are characterized by violent swings up and down that essentially go nowhere. These swings are driven by good news that investors interrupt is the bottom of the market. Then bad news comes out and the market drops again. Sound familiar?

The best way to navigate this market situation is to remain flexible. Be prepared to buy good companies on the dips and then use various protection methods to avoid losses. When you have a gain lock it in and be ready to sell on the rise when your stock price hits resistance. You should also take advantage of covered calls, protective puts and trailing stops to help minimize losses and increase your overall return.

Eventually, we will leave this bear market and return to a nice and easy rising trend. In the mean time you have preserved your capital, made some money and are positioned to take advantage of the new bull market, when it finally gets here.

For more information on the Yield Curve and the Financial sector I suggest reading: Analyzing and Interpreting the Yield Curve (Wiley Finance) by Moorad Choudhry. It does a good job explaining how to trade and invest using the yield curve. Investors interested in the bond market will find this book helpful. And for those interested in learning how to analyze financial institutions from a fundamental standpoint I suggest reading Financial Institutions, Markets, and Money by David S. Kidwell, David W. Blackwell, David A. Whidbee and Richard L Peterson. The best book I can find on financial institutions including how they work and analyzing their statements.

And finally, there is an article on Investopedia titled “ Analyzing A Bank's Financial Statement ."

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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