The Next Leg up in Financials

Includes: BAC, C, ETFC
by: Jason Schwarz

Asking the right question at the right time is not an easy thing to do, but when investors can do it, big profits will follow. Currently, the most important question not being asked is this: ‘What happens to bank financial statements when a toxic mortgage gets refinanced?’

The implications of this question may very well pave the way for the next leg up in financials. At a time when most analysts are expressing concern that record amounts of refinances at such low rates will negatively affect bank earnings in the long run, I have a different take. I believe that these record number of refinances are more important than any government program to lead the way out of this crisis.

When a toxic mortgage has been written down to .40 on the dollar, why would a bank sell it through the government's program of TALF or PPIP for .60 on the dollar? Sure they make up some of their loss, but there is a better way. When that loan simply gets refinanced, the original loan comes off the books and is replaced by the new loan which is now fully priced at 100 cents on the dollar. The implications of refinancing are massive for the banking sector. In a crisis that was caused by toxic mortgage securities, the solution can be 100% accomplished by refinancing the toxic. You wonder why nobody is jumping out of their seats to participate in Geithner’s rescue plan? It’s because the banks can fix this thing by themselves and they can do it better.

The #1 item on the agenda for bank CEOs is to refinance every bad mortgage on their books. Not only do they collect the fees, but the effect of these writeups on their financial statements will restore them to full health. This is why Bank of America will rise from its low of $2.50 back to $20 and beyond. This is why companies like Citigroup and Etrade will return to prior norms as well. The banking stocks have been on quite a run lately and that run is going to continue. It’s important to remember that we began at distressed levels and it will take time to climb back up. This isn’t going to be a two week rally.

Analysts on the street were confused as to why Etrade decided to restart mortgage lending last month. The consensus feeling was why would they ever want to get back into the business that took them down? Some thought it was an effort to increase their chances to receive TARP funds, but they’re missing the key issue. It’s because they want to refinance every single loan that they have on their books. Etrade isn’t even doing it themselves. They hooked up with a third party mortgage outsourcer PHH Corp to do it for them. Etrade announced that the program will be targeted to current customers! Ding ding. This allows them to transfer the toxic stuff to PHH for 100 cents on the dollar. The best thing our government has done is to manipulate rates lower. By so doing, the banks control their own destiny towards recovery.

From now on, when you hear the reports of record numbers of refinances you will view it from a new perspective. When you see Bank of America CEO Ken Lewis smiling as he says Countrywide is totaling $5 billion per day in refinances you know what he’s really thinking. His loan portfolio contains $700 billion in loans that have been aggressively written down. Refi, refi, refi...

Disclosure: Long C, BAC, ETFC