European Innovation Shows Us the Future of U.S. Financials

Oct.31.08 | About: Financial Select (XLF)

Europe is showing exceptional innovation in its efforts to confront the financial crisis.  First, it began injecting cash into the banks instead of buying troubled assets.  This decision caused Hank Paulson and the US to follow suit.  Brilliantly, this took the threat of bank failure off the table and allowed the large banks to de-leverage overnight.  When an institution is leveraged 30 to 1, rather than buy up assets to improve the leverage to 27 to 1, it makes more sense to increase the cash side of the equation.  Double the cash and you immediately de-leverage down to 15 to 1.  Why didn't the U.S. think of that?

Now Europe is at it again with its revision of mark-to-market accounting regulations.  Under the EU commission's new proposals, banks and other companies can optionally reclassify assets from the "held-for-trading" category to the "held-to-maturity" category, avoiding the trap of illiquidity. "The current financial crisis justifies the use of reclassification by companies," the commission said in a statement. "In these circumstances, financial institutions in the EU would no longer have to reflect market fluctuation in their financial statements for these kinds of assets."

The commission's move comes just eight days after EU finance ministers first proposed the reforms at an October 7th meeting. "By adopting these amendments, the commission has responded in record time to the request of the [finance ministers]," internal market commissioner Charlie McCreevy said.

European banks soared on the news.  UBS was up 7.3% in Zurich, Santander (STD) rose 4.6% in Madrid, and Societe GeneraleLY.PK)  rose 10.0% in Paris. Deutsche Bank (NYSE:DB) investors cheered as it posted a surprising rise in third-quarter profits, thanks to the new accounting rules that limited its write-downs to 1.2 billion euros ($1.5 billion). Shares of Deutsche Bank soared 14.4%, to 28.37 euros ($36.68) in Frankfurt. 

U.S. mark-to-market accounting regulations were recently debated at a public forum at the Securities and Exchange Commission, which is under pressure to suspend or repeal mark-to-market accounting for certain financial instruments. Congress ordered the SEC to examine the matter and provide a written report by Jan. 2. SEC Chairman Christopher Cox said regulators will hold a second public session on the topic on Nov. 21, and seek written input from the public through Nov. 13. 

Don't be surprised to see similar adjustments as we saw from Europe this week.  Timing will play a major part in all of this.  Hank Paulson wants to put off an accounting revision until his $700 billion (bailout) superfund has officially acquired the stock warrants of those banks participating in the $250 billion capital infusion.  The deadline for banks to apply for the program ends on November 14th. 

We expect that the written report from the SEC on January 2nd will suggest a change in current accounting procedures and as a result our financial stocks will rise just as those in Europe have done. The Financial Select Spider (NYSEARCA:XLF), which has its largest holdings in Bank of America (NYSE:BAC), JP Morgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC), is the best way to play this coming event. Only three months ago the XLF was over $22 a share, now it lingers near its 52 week low in the $14 range.  Lone Peak Asset Management has issued a buy rating on the XLF with a price target of $22 a share.  Investors should average into the position ahead of the January 2nd catalyst.  

Disclosure: Long XLF, BAC.