Overreaction by the Financial Sector to the Upside

In the meltdown of the past year, financials plunged as investors feared many banks would fail, much like Lehman Brothers. As the market realized that the government was able to prop up the weakest of the “to big to fail” banks, some level of confidence returned. Beginning in March, the financials lead the rebound becoming the best performing sector in the S&P 500. XLF has been the best performing ETF of the S&P 500’s primary sectors.

Like the plunge in the financials, the rebound has gone too far. Most of the banks still have significant problems and cannot count of trading profits to help them recover. The positive sloping yield curve should help the banks today, as long as they are able to lend. However, many of the banks are curtailing their lending activities to help shore up their capital position. When they lower their asset base, their capital ratios increase.

Then there is the ongoing credit problem. According to RealtyTrac^® (www.realtytrac.com), reports that August 2009 foreclosure filings were 358,471 during the month, a decrease of less than 1 percent from the previous month. Moreover, this is an increase of nearly 18 percent from August 2008. Banks are facing higher foreclosure problems now than they were a year ago. Add in growing problems in the commercial real estate sector and you may wonder how so many people believe the rebound in the banking sector is sustainable.

Any hint of higher inflation and interest rates will rise harming the financial position of most banks as short term rates will rise faster. As the yield curve flattens, the ability of the banks to generate solid net interest rate margins will plunge. As a result, the banks will face a slower revenue growth before they will have recovered from the massive credit problem. Yes, the Federal Reserve is holding short-term rates low and will do so into early 2010. When they begin to raise rates, the banks will be one of the first to feel its affects.

The rebound by the financials overstates the strength of the recovery of the market. Any sign of weakness in the financial sector will cause a drop in the value of the banks, negatively affecting the market. Do investors realize the financials remain weak? Eventually they will and that could be the catalyst for a pull back in the markets.

Comments

[whisperonth...:]

Compared to August 2008, everything is at least 18% worse. That only proves that everything crunched. Putting a negative spin on that decrease overshadows the increase we've seen. It may be too much of an increase, there may still be some negative numbers to unwind, but comparing anything to August 2008 will only start another panic. Yes, we saw that. We lived it. We are still digging out of the rubble. But perhaps we need to start looking for the sunshine instead of always predicting rain.

Sep 26 10:02 AM

[Old Trader:]

John Lounsbury has an interesting piece today on the securitization of mortgage debt, and how it relates to foreclosures. It points out out recent developments in Kansas, relating to the rights of holders of securitized mortgages to foreclose on delinquent homeowners.

As I read it, this development is a sort of "good news/bad news" for the banks. (Actually, its more a case of "bad news/worst news".) According to the article, banks won't be able to foreclose, due to questions as to their legal standing to do so (the "good" news, as it will drive down foreclosures...the "bad" news , I'd think, is that rather than merely suffering a "hair cut" by taking a hit on the difference between "book value" of the mortgage, and what's derived through foreclosure/sale of the underlying asset, they'd have to write the mortgage down to ZERO!, since they're not able to foreclose and recover at least some value).

Sep 26 10:19 AM

[BRUCE E. W.:]

I don't ordinarily buy the top down posture of economic health, but this is a balanced and thoughtfully dilligent presentation of the dillemma we are facing. The question arises then, if propping up the financials is actually a false lead and the cake will fall. It is true that there is a serious threat to stability on the markets if finacials begin to weaken; but should that kind of dependency push the line still further? Isn't this an indication that unless the bottom line is protected from the baseline real assets side (demand side); than all fiat assets will eventually implode?
I appreciate your pragmatic assessment without bias to ivy tower dogma. This is the type of assessment that seems to be missing from the various points of the circular fireing squads. Thanks!

Sep 26 12:54 PM