The Danger in Financial Stocks in 2009

I was recently perusing some investing blogs and ran across an article I feel adequately captures my concerns (and belief) that financial mass destruction is probable in 2009. Rakesh Saxena, the article’s author, does a good job explaining the unbelievable amount of financial engineering by the likes of Citigroup (NYSE: C), JP Morgan (NYSE: JPM), Bank of America (NYSE: BAC), Lehman Brothers, Bear Stearns, and many others. Reading this article, as well as the insightful comments, reminded me of two specific reasons why I urge everyone I know to stay away from financial stocks - even shorting them.

What Do Banks Do?

In the aforementioned article, one part I found particularly amusing was Vikram Pandit’s response to a question posed at a Town Hall meeting:

Responding to a rhetorical “What does a bank do?” question at a Town Hall meeting last November, Citigroup CEO Vikram Pandit explained that “a bank takes deposits and puts them to work by investing and making loans.”

Unfortunately, Mr. Pandit, that’s not entirely true. The truth is that large banks in their current form, especially Citigroup, deal in some of the most complex derivatives the financial world has ever seen.

Famed investor Warren Buffett has always maintained that he only invests in businesses he understands very well. I do the same. While I certainly understand a (very small) portion of the large and complex derivatives market, there’s little chance of me explaining it adequately to a novice. In fact, the vast majority of people on this planet probably could not do so, besides (maybe?) the individuals who designed them. Honestly, I doubt Mr. Pandit could even explain them.

So there’s strike 1 against investing in financial stocks; they’re nearly impossible for even Wall Street veterans to understand.

It’s the Government, Stupid

If the free market forces had their way, Citigroup and a large majority of banking institutions would be gone within the year, or at least reduced to a shadow of their former selves. So theoretically, shorting these stocks might be a very good idea. In fact, I believed shorting financial stocks was a great idea back in November, 2007. I was quoted in Business Week here, for my article: Profiting from the Housing Bubble. In the article, I recommended purchasing shares of Ultra Short Financials Proshares (AMEX: SKF) exchange traded fund (ETF), which shorts financial stocks.

Do I still recommend SKF? Theoretically, yes, but practically, probably not. The issue now is summed up quite nicely in a response to Mr. Saxena’s article, courtesy of Crocodillian:

“At this point, though, while all of these firms deserve to go broke, going short is risky– their fortunes now rest in the political arena, not business logic. On what terms will Citi be bailed out? Who can say? It is as much in Washington as on Wall Street that this will be decided.”

Bingo. There are two forces at work here. One is the free market, which dictates that these financial institutions are technically bankrupt (they have insufficient assets to cover their liabilities), and the other is the government, which is keeping them afloat with bailouts. Which one will win? I don’t have the faintest idea.

The Bottom Line

It seems to me that the government will be unable to prevent a wave of financial institution bankruptcies from happening in 2009, which is why I favor shorting over going long, but there are just too many unknowns and what ifs to do either. There are too many great companies out there at bargain prices to gamble on financials.

Comments

[Victhom:]

You forget WFC..BBT...USB...??? Wondering why?? LOL

Jan 05 05:49 PM

[gparmar16:]

It's true Buffett owns WFC & BBT, even though he hates financial derivatives. But on other accounts he has claimed that banking is a cash cow and it would be worth understanding the industry. He is also in the Insurance business which i believe WFC & BBT do offer, so some of the operations are within his circle of confidence. It is true he hates the new complex derivatives probably due to not understanding them and also due to their possiblity of destruction ("Financial-WMD"). But I would bet that he has some if not quite a bit of control over WFC & BBT and how they operate as a business (probably including the quality/quantity of financial dervivatives they take on), hence his investments in those firms. If I'm not mistaken though Buffett safely reduced his shares in those firms Q3 or Q4 of 2007, including shares in housing stocks and his car dealership.

Jan 05 06:43 PM

[SugarDaddy:]

I'm very negative the financial arena. But, unless they fail in big groups of 2-3 or more, I think the Fed can maintain perceived stability with their blatant propping program.(BPP)

As an aside, guys like Buffet, throw a lot of dart's, they all don't hit paydirt. Ask him how wise he was on the 950 Million Netjets purchase a few years back, still bleeding cash......

Jan 06 12:21 AM

[Anthony Alfidi:]

Large banks still face enormous risks from credit card debt at risk of default. A huge unknown that discourages shorting is the prospect of further bailout attempts that can temporarily prop up a bank's stock.

Jan 06 01:39 AM

[M-P:]

This is a good summary. It's hard to disagree with points made. Many of the banks will have challenges in maintaining their revenue streams - more charge offs on CC's, less mortgages/loans being done, and overall margin-rich fee revenue down - along with asset write-downs/offs. All of us have to question to ability of the banks to understand their own risk (e.g., level 2 and 3 assets). I'm not sure they do understand their book - their underwriting standards across assets are in question. Time will tell if the big banks can exploit the synergies with recent acquisitions. The next year is likely to be bumpy and who knows how the government intervention will turn out. Lots of uncertainty - more cash sitting on the sidelines.

Jan 06 08:33 AM

[Smalltownba...:]

As a small town banker on the mortgage side I don't know a great deal about derivatives. I do know what their purpose is. My concerns are more direct. The credit card money market is getting tight. I spoke with the owner of a local tire store today who told me that my 800 credit scores would not get me credit to buy tires today through GE Money Bank where he goes to finance the purchases of customers who can't pay cash.

How long will it be before the credit lines start getting cut off that are already in existence for example on my credit cards, HELOC, etc?

Was the flow of credit improved by EESA/TARP or was the collapse just prolonged at an extraordinary cost?

Will any of the mortgage modifications done to date keep the buyers in the homes or will they all fail resulting in significantly higher losses than would have been incurred without intervention?

Are we fixing anything or just prolonging the pain?

Jan 06 08:49 AM

[Ryan Freund:]

Those are really good questions, tcornelison. I wish I knew the answers, but I don't. And until I do, I'm staying far away from financial stocks.

Jan 06 10:38 AM

[Trinitymaster:]

I tried buying puts on a couple of financials. Imagine my mixed emotions when the Banks lost billions of dollars, but still went up in value- All because "things couldn't possibly get any worse."

Jan 08 12:30 AM

[Ryan Freund:]

Yeah, Trinity. That's exactly what I'm talking about. Realistically, these companies should be dead, but they aren't! It's absurd!

Jan 08 12:53 AM

[Kunst:]

SKF should have been a great buy in a year when many financial stocks dropped 90% in value. But if you bought it a year ago and held it to today, you would be DOWN 5%. Unbelievable but true. The geometric compounding and internal inefficiencies of the ProShares ultras and especially ultrashorts make them unsuitable for anything but very short-term bets on market or segment direction.

Examples, previously posted on other SA articles:

Examples, 1/1-12/29/08:
China: FXI and FXP are both down 50%.
Oil industry: DUG and DIG are BOTH down, 25% and 75% respectively.
Financials: UYG is down 85%, SKF is up 25%.
Real estate: URE is down 80%, SRS is DOWN 45%.

DOG (ProShares 1x short Dow 30) is up 20%, DXD (same except 2x) is only up 15%. The single-leverage did better than the double!

These are not suitable vehicles for long-term trend bets. You can chart pairs and watch their cumulative intersection points sink farther and farther below 0%, even in 5 or 10 day charts. These ETFs are dangerous. Handle with care, if at all.

***
Here's another one for you. Pull up a 3-month chart of FXI (1x long China) vs. FXP (2x short China). FXI is down about 3%. So you would expect FXP to be up, right? Wrong. FXP is DOWN about 68%.

This is Russian roulette with 5 out of 6 chambers loaded.

Jan 08 03:01 AM