Bank Stocks Will Return to Prior Norms

Includes: BAC, C, GS, JPM, WFC, XLF
by: Jason Schwarz

Alan Greenspan, in his book called The Age of Turbulence, said,

Crisis, at least for a while, destabilizes the relationships that characterize normal, functioning markets. It creates opportunities to reap abnormally high profits in the buying or selling of some goods, services, or assets. The scramble by market participants to seize those opportunities presses prices back to market appropriate levels...

Newton’s third law is happening before our eyes in the financial sector, ‘every action has an equal and opposite reaction’. The mark to market accounting regulation that was officially implemented on November 15, 2007 has taken down the bank stocks with chilling velocity. It’s hard to believe that it has been less than two years since investors assumed that money invested in a bank stock was a low risk proposition.

Personally, I never touched bank stocks because they never seemed to move. For years, JP Morgan (NYSE:JPM) hovered around $40, Wells Fargo (NYSE:WFC) around $30, Bank of America (NYSE:BAC) around $45 and Citigroup (NYSE:C) around $45. It was one of the guarantees in life: death, taxes, and low volatility bank stocks. On November 15th of 2007, all of that changed for the worse. This new accounting rule tied bank balance sheets to illiquid mortgage securities. As a result the banks had to raise capital to cover the short term losses at a ridiculous pace; you know the rest. JP Morgan now resides around $25, Wells Fargo at $18, Bank of America at $7 and Citigroup at $3.

On April 2nd, FASB will vote on the proposed alterations to this nightmare mark to market regulation. We have heard rumors of two new proposals. The first will change the requirements for actually taking a writedown and the second will allow companies to determine whether a particular market is active or inactive and they will be able to declare a related security as ‘distressed’. I love these new proposals because they maintain transparency for investors but the new regulation won’t force the bank to raise capital during times of short term overreactions. This solves a big problem for the banks.

The question on investors' minds is how will the new mark to market rules affect the plan of the Treasury, Fed, and FDIC to pump trillions of dollars into purchasing these toxic mortgage securities? Many investors are confused because it appears that all of this money won’t be needed because of the regulatory change. Let me tell you why it is still needed. These toxic assets need a pricing mechanism. Geithner, Bernanke and company have put into place the necessary components to bolster the market for these securities. Banks won’t want to sell them off because of the new mark to market rules but there will still be trillions of dollars of demand for them. Huge demand with no supply is superb news for the banks and for lending. It’s exactly what the government wants. These toxic assets won’t be toxic any longer. Writeups will replace writedowns and bank share prices will return to prior norms. This solves another big problem for the banks.

The government is in the process of eliminating negative balance sheet pressure for the banks and at the same time they are solidifying the pricing mechanism for these toxic securities by maintaining and strengthening the market for them. It is a brilliant plan. It is the solution we have been waiting for and it has created the buy of the year.

Disclosure: Author holds long positions in BAC, C