Why Stocks Scare Me Now

Sep.25.09 | About: SPDR S&P (KBE)

On August 27th, I wrote that the Fed may be buying stocks to reflate the banks. I can't wait to see, after being audited, what they actualy own. Today, it seems like my hunch may be starting to get some wonderment from others. If this is the case, make sure you do not own stocks. In fact, as I blogged Wednesday before the FOMC statement, it's time to get short. With the Fed now slowing their rate of securities purchased, they and the banks will have less fiat to buy and support this market. Judging by mutual fund inflows of late, they may be the only bid in the market. Look what others are starting to say.

With higher stock prices, banks can issue secondaries, thus flooding the market with shares and giving themselves cash to offset their balance sheet from bad loans. Also, since banks can't earn their way out of this mess via lending, the idea was tossed around that they are buying stocks for a massive profit. Stocks that they will sell and leave to the public, thus transferring the cost of the bailout to the public via the stock market. Take a look at the graph below from ZeroHedge.com, and then read the original article I wrote a number of weeks before:

ZeroHedgeClick to enlarge

I realize this may sound like a nut job conspiracy theory, but I am just thinking out loud and wanting to document when this was thought of.

Maybe, just maybe, the Fed is inflating the banks through stock market gains. Stay with me before writing me off as a quack.

On August 26th, Kate Berry from American Banker wrote an article titled "Postponing the Day of Reckoning" In it she stated:

[Banks also] are allowing borrowers to be delinquent for longer and longer periods of time before initiating foreclosures.

This absolutely jives with what I see on the street. I have two close friends who haven't paid their mortgage in 10 and 13 months. Yet, they don't hear anything from their lenders.

Is this because the banks don't want to book these non-paying loans as losses? The article continues:

Tom Booker, a senior vice president in the default information unit at First American Corp. in Santa Ana, Calif., concurred. "There are borrowers who are six or eight months in default; they may have exhausted their workout options; but they're put on a forbearance plan because it's an interim to a final resolution, which is foreclosure," he said. "Banks don't want to take the losses now."

Darrell Duffie, a finance professor at Stanford University's Graduate School of Business, said accounting rules give banks plenty of leeway to determine when to take losses.

"Banks are believed to be carrying a lot of loans at accounting levels well above their true market value," he said. "But once a property goes into foreclosure, their options have disappeared."

So the banks aren't realizing the losses, and they're doing nothing about it. People live in their homes for free, the bank loses thousands of dollars per client in interest income, but they are saved because they don't have to write off hundreds of thousands per non-payer in losses. Thus they preserve their capital ratios and allow them to live another day. Brilliant (tongue in cheek). And scary.

So here is a conspiracy scenario:

1. Banks make bad loans and are crushed when the market tanks.

2. Fed Prints money and gives to banks to keep them afloat.

3. Banks don't write down loan losses, so their capital is not hurt, but lose interest income from borrowers not paying their mortgage.

4. Banks need to earn an income to stay in business and "earn" their way out of these massive loan losses.

5. Banks trading units "invest" in securities and the market and the market ramps non stop, thus offsetting lost revenue from loans with trading revenue.

6. Banks eventually sell and leave investors holding the bag, thus getting their money anyway from the masses whom they lent money.

I know - sounds crazy. But Thursday I just read this from the UK Telegraph:

Mr. Steinbruck said the markets are awash with liquidity again, but little is going into the real economy. "The banks evidently prefer to put their money into securities rather then granting new loans because they can get a higher return. After two years of financial crises the gambler mentality is gaining the upper hand again."

The German authorities are deeply frustrated that so few banks have resorted to the rescue scheme to rebuild their capital base. Critics say the Bundestag imposed such stringent conditions that the lenders have opted instead to rein in lending.

Does this not sound similar to what could be happening here? I know it's a black helicopter/conspiracy theory, but it seems the Feds and US are desperate to do something to change the reality they currently face. What better way to save the financial system than by bailing out the banks and not forcing them to write off bad loans after 180 days like GAAP requires. Instead, let them gamble in securities, and maybe even stocks? It will be interesting to see how well the trading units of the big banks do in the next few quarters.

If this "highly unlikely" scenario is true, the banks will sell, have the cash they need to write off the massive loans, but will have sucked the money out of unsuspecting investors pockets. In the end - they will have won. They will have gotten the US investor, pensions, and retirement accounts to bailout their bad loans, and we can't get mad at the government because it didn't commit more taxpayer money to bailout more losses. Instead, asset price increases, and then selling those assets to investors, bailed them out. Or better put - investors "bailed" them out.

Unlikely... but interesting to ponder, no?

I have wondered how my friends can live payment free for over a year. This theory could be a reason, even though it seems unlikely.

In either event - remain cautious, and keep an eye on those bank trading profits.

Disclosure: Long SH, PSQ, UUP, DOG in client accounts