It Didn't Start with Lehman: Recovery Still on Track

On the cusp of the first anniversary of the Lehman bankruptcy, the accompanying chart of the KBW Bank Index (BKX) since January 2007 helps frame the long train of events that led us to that disaster, as well as the emerging recovery since it occurred.

What's striking is both the depth and duration of the decline, as well as the strength of the subsequent rebound. On February 20, 2007, the BKX peaked at 121.06, several months before the SPX peaked at 1565 on October 9, 2007. In July 2007, the BKX 50-day, 100-day, and 200-day moving averages (the purple, green, and yellow lines, respectively) converged at the 115 level and began their long decent.

Briefly recapping events:

• Financials had already peaked when, in the spring of 2007, several subprime mortgage originators fail (such as New Century Financial on April 2). This sets in motion a gradual collapse that would gather momentum and speed over time.

• In late June 2007, Bear Stearns reports problems with two subprime mortgage hedge funds; within a month, they are bankrupt.

• On August 9, 2007, BNP Paribas (BNPQY.PK) discloses that it cannot determine a value for investor holdings in its mortgage-related hedge funds, signaling an acute constriction in credit markets.

• Simultaneously, auctions of structured investment vehicles begin to fail, leaving previously highly rated and liquid investments unsalable and of questionable value.

• In August, the Fed responds by lowering the discount rate, but resists lowering the Fed funds rate until September, when it cuts the rate by 50 basis points, to 4.25%.

• In January 2008, Bank of America (BAC) purchases Countrywide Financial, preventing its collapse.

• In March 2008, JPMorgan (JPM) purchases Bear Stearns in an attempt stanch further erosion of market confidence. Immediately, Lehman's solvency becomes suspect.

• In July, IndyMac (IDMCQ.PK) falls into FDIC receivership. Speculation grows that Freddie Mac (FRE) and Fannie Mae (FNM) cannot avoid a government takeover.

• September 14, Bank of America announces its acquisition of Merrill Lynch. On September 15, Lehman Bros (LEHMQ.PK) files for bankruptcy.

• October 3, Congress authorizes the Troubled Asset Relief Program. Within two weeks, the Treasury announces its intention to use the funds to invest in preferred equity and warrants of U.S. financial institutions, rather than to purchase "toxic" assets for resale.

• On November 20, market volatility peaks at a record 80.9, as measured by the VIX.

• January 1, 2009, Bank of America completes its acquisition of Merrill Lynch.

• January 14, the Wall Street Journal reports that Bank of America would receive additional "billions in Federal aid because of losses at Merrill." On January 16, the company announces its fourth quarter earnings report.

• On February 10, 2009, the new administration's Treasury Secretary gives a speech announcing a vague public/private loan investment fund and bank stress tests, and seems supportive of bank nationalization proposals. Confused, world markets plummet.

• On February 24, Fed Chairman Bernanke testifies before the Congress, "I do believe our major banks have significant franchise values. And one of the things that we've learned is that when the government takes over a company that one of the things that happens immediately is that the counterparties start pulling away, the franchise value, the brand name starts to erode very quickly. I don't see any reason to destroy the franchise value or to create the huge legal uncertainties of trying to formally nationalize a bank when it just isn't necessary."

The momentum of the decline and the momentum of the recovery are obvious. The BKX reached a low of 18.62 on March 6, off a remarkable -84.6% from its 2007 high.

Since then, its subsequent recovery has been swift, rising 147% to end September 10 at 45.95, its highest close since December 10. Why March 9? There was no particularly noteworthy news. Investors seem only to have discovered that asset values of many stripes had been sold down to absurd levels, and the bear market ended.

In my view, the buy signal came on February 24, when Bernanke signaled that the nationalization of the banks and the destruction of wealth that would be entailed were off the table.

And the BKX? Its 50-day moving average turned positive at the end of March. The 100-day moving average turned positive in June. And the 200-day moving average turned positive this past Tuesday, September 8th, after 782 consecutive days of decline.

In short, this is a much more bullish configuration than financial stocks have seen in several years.

As in the early 1990s, we're seeing large market value gains as bank, insurance, brokerage, and other financial company valuations recover with the end of the economic recession. Financials led the broader market lower in 2007, and are market leaders in the recovery. A September market pullback, so universally forecast, has yet to materialize.

While unexpected developments or profoundly stupid policy decisions may yet derail the recovery in financial stock valuations, the market appears primed to the upside.

Comments

[a. palmer jr.:]

I don't call it a recovery when the U.S. economy sinks deeper in debt, unemployment worsens, housing foreclosures are continuing and personal bankruptcies I read, are at an all time high. As far as the stock market, yes it's coming up some, but as we all know it can go back down in an hour if some bad news hits. What I can't figure out is why interest rates are going up for borrowers but not for savers, and why, in this lousy economy, has store prices risen so much?

Sep 15 09:41 PM