Bearish on Banks - Why Now Is the Time to Sell

I think it should be abundantly clear that I am bearish on financials given my sell equities call two weeks ago. After all, it was the banking sector which I was most bullish on in April – August. They are also the stocks that have run up the most as well. But now is the time to sell. Why? The conditions which created the bull run are effectively over. Here was the notice that put me over into the bearish camp. It came last week:

US banks will have to pay $45bn in up-front fees to the Federal Deposit Insurance Corporation under a plan presented on Tuesday to shore up the FDIC’s depleted deposit insurance fund. The agency warned it will run out of liquid funds early next year due to bank failures, and said the estimated cost of expected failures from 2009 to 2013 had increased to about $100bn from an earlier estimate of $70bn. Most failures are expected this year and next.

Paying $45 billion in capital is an enormous impediment to increases in capital for the financial sector and the worst-case scenario for credit growth. This is very bearish for bank stocks and the broader economy as well.

I see it as a tad ironic that the agency tasked with seizing insolvent banks has run out of money and must tap the very pool of institutions for accelerated payments.

The FDIC chose this option for political purposes as their options were limited.

1. Borrow from the banks. Their was a leak by the New York Times last week that the FDIC was considering borrowing from the very companies it regulated in order to recoup lost funds. I criticized this proposal harshly because it could only lead to regulatory capture at the FDIC – the least captured of America’s regulators. The general public reaction was wildly negative to the leaked information. This is a crazy but legal idea that Sheila Bair was forced to defend – but reject as not ‘serious in the same breath (see my comments here).
2. Borrow from the Treasury. The Obama Administration was able to get Congress to authorize the FDIC a $500 billion line of credit back in May. This seemed like a great fallback then. But, with the Federal deficit spiraling out of control and people yelling about government intervention in the healthcare debate, no one in Washington wants to be seen tapping what could be construed as taxpayer money. Bair said “I think there’s some recognition that . . . everyone’s got bail-out fatigue and should be extricating themselves from government support, not getting in deeper.”
3. Tax the banks in a special assessment. I say ‘tax’ because the special assessment idea which was being considered was bad for optics. Banks are not lending because they ostensibly have a weak capital position. So, you want to go in and weaken that base further by ‘taxing’ them? OK, now we know who to blame when the double dip recession happens.
4. Get the banks to pre-pay. This is the option chosen. Let’s be honest, there is zero difference between this option and the third option above except this is couched as money the banks will have to pay anyway. Not a very good option, really. But, are there other choices?

Now, if you are running a bank and still expecting a decent number of writedowns in commercial property, residential mortgages, and credit cards, you are not too thrilled to have to pre-pay your FDIC insurance premiums. Then you hear Dick Fisher of the Dallas Fed and Don Kohn the Fed Vice Chairman jawboning in a hawkish way like they are going to raise rates. Not that you believe them, but still. If Sheila Bair comes around asking for a pound of flesh, you are already feeling a bit beaten down. I guarantee you this is not going to be good for lending.

But of course, there’s always the government spin:

John Dugan, an FDIC board member and the comptroller of the currency, said he supported the “thoughtful” proposal.

The only downside, he said, was that the cash provided to the FDIC would not then be used by the banking industry to provide loans. “This may not be likely to have a material effect on credit availability . . . but I think this is an important question,” he said.

OK. Keep telling yourself this won’t affect lending. But, owners of bank shares have to look at the situation a bit more dispassionately. Back in April, I said:

Despite obvious problems with the bailout packages provided by the U.S. government and a huge amount of writedowns still coming due, I now fully anticipate that 2009 will surprise to the upside in financial services… I see financial services companies shedding troubled assets, not marking other assets to market and having an enormous margin spread due to ridiculously low interest rates. To me, this is a huge buy signal.

And the rally has been MUCH more than I expected.

Amongst larger banks, Bank of America (BAC) is at $16 and change from $2.53, up over 600%. JPMorgan Chase (JPM) is up almost 400% from March lows. Wells Fargo (WFC) is up over 300% from the lows. Even Citi is up over 400% –and I thought they were dead money.

Amongst large regionals, you have Fifth Third (FITB) up over 900% from a near bankruptcy valuation. Zions (ZION) is up nearly 300%. SunTrust (STI) is up more than 300% too.

I think you get the point. There has been the mother of all rallies for bank stocks. But, this is going to change. The low-hanging fruit (government bailouts, subsidized borrowing, low interest rates, huge spread margins, bonus payments for lending) has been picked.

Prepare for tough headwinds:

1. A flattening yield curve
2. FDIC pre-payments
3. A withdrawal of subsidized borrowing
4. Larger commercial mortgage losses

I expect the momentum born of upside earnings surprises to turn to the dread of earnings warnings.

Comments

[Scott Diering:]

Although I agree with you, and I am shorting financials (RFN), I remain concerned about the deftness of the financial elites to pull the strings of their elected puppets and keep the trough open. And, I question their willingness to pump-and-dump their own stocks. But, it is not beyond the possibility.

Oct 05 11:34 AM

[jackooo:]

The economy doesn't recover until the banks do. Period.
If you think the recession is starting to subside then the only way to go is banking stocks.
Commercial losses have been talked about for over six months and the larger banks continue to increase in value.
You can write all you want to about them but they have an unlimited supply of money. Congress!!!

Oct 05 11:40 AM

[waf76:]

I couldn't disagree anymore about your statements regarding the FDIC borrowing from banks. I didn't click to see what your additional comments were on it but borrowing from the banks will surely happen. Concerns about regulatory capture at the FDIC will be trumped by the need for money. Any bank that has received an enormous favor, (i.e. FDIC's seizure and JPM's purchase of WaMu) will be first in line to help out. But who knows I could be wrong.

Oct 05 11:43 AM

[buddhabill:]

Mad Hedge copped a mea culpa plea in a recent post on his persistent calls to buy TBT. He said something like "I am never wrong, just sometimes early."

Hell, I've been early on this entire frickin' rally, but doggone it I think your call is right, but 2 months too early.

Until another Lehman or AIG goes down in flames, and yes the fuse it lit with the quintuple-trillion derivatives Ponzi, bigger, smarter money will suck more retail cash in. Plus the Fed is a bottomless backstop, and with free money plus mark-to-fantasy rules how do they NOT show hefty profits?

Your last line of earnings warnings - where are they coming from? Are you referring to future quarters? Yes, the alarm should be sounded over the whole stinking mess, but where is the near-term downside impetus?

Oct 05 11:46 AM

[carey_jim:]

Martin Weiss has just pointed out that Congressional Budget Office itself issued a report that included this information:

1. Last year, banks provided new credit at the annual pace of $472.4 billion in the first quarter and $86.7 billion in the second. This year, they're not providing ANY new credit — they're actually LIQUIDATING loans at the rate of $857.2 billion in the first quarter and $931.3 billion in the second. So if you're running a business, you may want to think twice before asking your bank for more money. Instead, they may decide to TAKE BACK the money they've already loaned you!

2. Ditto for mortgages. Last year, mortgages were being created at the annual clip of $522.5 billion and $124 billion in the first and second quarters, respectively. This year, on a net basis, mortgages haven't been created at all. Quite the contrary, the Fed reports that, on a net basis, they've been liquidated at an annual pace of $39.3 billion in the first quarter and $239.5 billion in the second.

3. The U.S. is deep in debt to the rest of the world, and on page 48, it provides the evidence: total liabilities to foreigners of $7,898,435 million (nearly $7.9 trillion)!

4. This isn't a new record. It was actually slightly more last year. But the fact is NOTHING has been done to reduce our debt to foreigners. Quite the contrary, it is the deliberate policy of our government to pile up more — to sell foreign investors and central banks on the idea that they must continue to lend us money.

www.moneyandmarkets.co...

Oct 05 12:04 PM

[Benny D.:]

I think that canadian banks have a little more value (TD Bank, RBC etc.). A commenter on another post said something to the fact that Americans look down on Canada, saying that they are socialist.

Well I think if a little bit of socialism is what it takes to have an efficiant banking system it wouldn't hurt to impliment it here as sort of companion to capitalism. BD

Oct 05 01:56 PM

[aarc:]

If you are trendtrading the banks medium term; definitely, the trend for $BKX is still bearish based on the monthly chart with an ADX reading of 44.97.

But if you are trend trading short term; the trend is definitely more upsides just by using the fast MACD on monthly chart which has just reached new momentum high. Meaning, $BKX will still make higher highs on daily and/or weekly charts before a divergence sell signal on the monthly chart can lead to a major pullback or sell-off.

As for being over-bought; it is simply not true. $BKX was only able to recover 30% of it's total losses from January 2007 to March 2009. Basically $BKX went down by 85.33% from it's Jan 2007 high of $121 to Mar 2009 low of $17.75.

Today it is still selling at 62% discount from it's highs. That is not an over-bought condition. So for longer-term hold; buying $BKX or XLF at these levels is still buying at a discount of 62%. You cannot be paying at an over-bought price with that kind of massive discount.

Some banks made several hundred percent rallies off their lows and may need some correction or consolidation ranges in order for them to sustain their rallies; but many of them are still way below their Jan 2007 highs.

What is $45B anyway to the total size of the banking sector? I don't know; but comparing the $700B TARP in which the government is expected to get a sizable profit; then what is $45B?

How about way back late 2008 and early 2009 when banks were willing to pay 15%, 20%, and even 25% premium on their bonds? That would translate to more than $45B premium if they were able to raise even half as much as what TARP provided on an annual basis.

FDIC which is a government agency will get itself (and the US government) definitely hooked into the banking sector if they charge that $45B upfront fees.

Could this $45B be a "cheap" insurance for the banks to get the government's unbridled support hook, line, and sinker?

Is that not a good news?

Oct 05 02:22 PM

[KirbyJF1:]

Before a bank can lend, they have to have a prospective borrower that has the where with all to afford the payments. Also the collateral must be credit worthy or are you suggesting we go back to the last 5 years of no underwriting & 100% loans? As far as the prepayment of the FDIC insurance, it is basically an interest free loan that would be expensed monthly so there wouldn't an issue of impairing capital. Also the FDIC is funded entirely by the banks so it is their interest that the fund is solvent.

Kirby

Oct 05 02:42 PM

[Edward Harr...:]

Your comment is on the money. Goldman's upgrade of TBTF banks shows that shorting could cause some serious pain. If you own shares, taking out an out of the money put would be a better way to proceed. If you want to get some speculative exposure on the short side, again puts are better.

Clearly, the key constraint to what I am saying is that the gov't sees the financial sector and TBTF banks as THE key to recovery and will do anything to support them. I think the recovery is well progressed enough that the props are going to be removed and this will be negative for the banks.

On Oct 05 11:34 AM Scott Diering wrote:

> Although I agree with you, and I am shorting financials (seekingalpha.com/symbo...),
> I remain concerned about the deftness of the financial elites to
> pull the strings of their elected puppets and keep the trough open.
> And, I question their willingness to pump-and-dump their own stocks.
> But, it is not beyond the possibility.

Oct 05 02:43 PM

[bbro:]

The cash flow of banks indicate they will survive....

Oct 05 03:34 PM

[Edward Harr...:]

A friend just sent me this link of Chris Whalen apoplectic that Goldman is upgrading the banks:

finance.yahoo.com/tech...

Tomorrow, you will probably see a post I wrote about Goldman.

Oct 05 03:50 PM

[Madcow2:]

Massive short squeeze in Real Estate?

If its true that, for every 20 homes, there are 80 homes-worth of fractional ownership claims upon those underlying assets, then one of two things would need to happen:

1) 80% of the value of fractional ownership disappears (the bonds and derivatives get smoked); or

2) The value of the house (undying real asset) goes up 500%

A nifty tool for the deflation fighters if there ever was one –

Oct 05 04:26 PM

[sethmcs:]

Because of the rules of accounting the prepaid FDIC assessment will be recorded as an asset and expensed over the next three years. It will not negatively affect earnings but it will affect cash. This was the choice most bankers favored. With the wide positive interest rate spread I would be afraid to short banks. Positive earning surpise are possible.

Oct 05 06:01 PM

[Tack:]

In addition to the banks sitting on all-time record levels of cash, the indices (www.mlindex.ml.com/GIS...) used as proxies for the over-ballyhooed "mark-to-market" asset values --that critics insist demonstrate that banks are insolvent-- are moving higher each month. This means that the gap between the banks' mark-to-model valuation approach and the mark-to-market values is decreasing, even as banks have increased reserves. Eventually, this means that banks will, at some point, likely be reversing reserves back into earnings.

As this proceeds, the insolvency argument will be imitating the Cheshire Cat, and eventually the only thing remaining will be his grin.


On Oct 05 03:34 PM bbro wrote:

> The cash flow of banks indicate they will survive....

Oct 05 09:33 PM

[derryl:]

Tack wrote, "As this proceeds, the insolvency argument will be imitating the Cheshire Cat, and eventually the only thing remaining will be his grin."

The insolvency is merely transferred from US banks to the US government. Check out carey_jim's comment and link above.

Oct 06 12:22 AM

[Tack:]

The "insolvency" was/is an artificially-created fiction, masterminded by shortseller traders, who deciphered that under the lax rules in place debt assets could be shorted into oblivion, while, correspondingly, the traders could take out huge CDS positions on the bonds of the same companies whose debt was being shorted. It was entirely a contrivance.

When, the financials were near death, the same traders tried to pick off the ridiculously undervalued assets of their targets by lobbying Congress to force the banks and other lenders, under penalty of law, to disgorge their debt assets at prices that truly would have destroyed the American financial system. No small thanks should come from anybody enjoying a decent lifestyle that this effort failed.

Having seen that this approach was not bearing fruit, the traders decided, correctly, that if they couldn't get their hands on the devalued assets directly, then, the next best thing was to load up on the shares of the companies holding these very same assets that they'd shorted to death. And, that's been confirmed by the publicized holdings of several large traders and hedge funds.

The entire episode surrounding this latest financial crisis would have been but a small ripple in the pond of financial affairs if the banks had been left alone to manage an entirely manageable subprime folly. They would have taken some temporary losses, increased reserves and ridden out the consequences of some silly lending. In reality, this was a small part of their overall business.

Instead, the traders induced mass hysteria, causing no debt asset of almost any class to have any sensible value, according to the marketplace, and inducing the public and business into a massive, hysterical contraction. Now, that hysteria is abating, and things are returning to more normal conditions, mostly because there was little reason for them to have departed, en masse, from there to begin with.

The massive increases in money supply that currently sit in banks coffers will either be retracted by the Fed, as the recovery ensues, or it will flow into the economy, surely inducing inflation as normal demand patterns resume, but the world finds itself awash in currency. The question is whether the Fed and politicians have the discipline to withdraw excessive funding before the inflationary spiral takes hold. History isn't very encouraging in this regard.

Those aligning their investment portfolios for years of recessionary economy and deflationary conditions are going to be in for a rude surprise, in my estimation.

Oct 06 05:14 AM

[Did U Think...:]

On Oct 05 02:22 PM aarc wrote:

"As for being over-bought; it is simply not true. $BKX was only
able to recover 30% of it's total losses from January 2007 to March
2009. Basically $BKX went down by 85.33% from it's Jan 2007 high
of $121 to Mar 2009 low of $17.75.

Today it is still selling at 62% discount from it's highs. That
is not an over-bought condition. So for longer-term hold; buying
$BKX or XLF at these levels is still buying at a discount of 62%.
You cannot be paying at an over-bought price with that kind of massive discount."

You talk like the highs were something other than a credit Ponzi. You make it sound as if it was normal for banking to be 25%+ of GDP. Don't you understand that they don't add any economic benefit? They are money changers, not producers of anything. They are scam artists and the scam is bust. They will NEVER return to their old highs and in fact they will be lucky to stabilize at 20% of their old highs once this depression really plays out.

Out of control fractional reserve banking was a scam that was allowed to run amok as long as it goosed the economy but now that banks won't loan and people won't borrow it is foolish to look for some return to the old days or anything close to it.

Oct 06 08:33 AM

[Anthony Har...:]

It sure is time to dispose-off banking stocks. The rally that these stocks showed in the past few months has helped make a quick buck. Personally I had given up on most banking stocks quite a while ago. Our team had conducted a research a couple of weeks ago I am confident that some of our largest money center banks are in dire problems, at least on an economic basis.

Take JP Morgan as a prime example. This highly respected and highly rated financial giant holds nearly $80 trillion in derivatives (notional value), ahead of Bank of America’s $75 trillion and Goldman Sachs’ $48 trillion. This notional value of JPMs derivatives is nearly 39 times its total assets, 850 times its tangible equity and six times the US GDP. Though notional values do not present a true picture of the risks involved, it does give an idea of the leverage the firm has engaged in.

And here’s more:
• In terms of gross market exposures, JPM’s gross derivatives receivables stood at $1.8 trillion as of 2Q09 (19x times its tangible equity) and its gross derivative payables stood at $1.7 trillion (18 times its tangible equity).
• Of the net derivative receivables exposure of $97 billion, non-investment grade derivatives stood at 22.9%, enough to wipe off 23.6% of the bank’s tangible equity in the event asset prices moved significantly south. This is an exposure a large bank can’t afford to assume under the current and volatile market conditions.
• In addition, the quality of JPM’s derivative exposure is even worse than Bear Stearns’ and Lehman’s derivative portfolio just prior to their fall. We all know what happened to Bear Stearns and Lehman Brothers, don’t we???

There are other large hurdles that JPM faces which, under normal circumstances (without excessive government support), could very well spell doom for a bank. Here’s the link to the public excerpt of our proprietary research that throws light on JPM’s unconsolidated off balance sheet VIEs, its deteriorating loan exposure, skyrocketing charge-offs, compressing net interest margins, volatile trading revenues, rising VaR and many other insights:
boombustblog.com/index...

Oct 06 09:29 AM

[bob adamson:]

Benny D -

You observe that Canada is more ‘socialist’ than the US. As a Canadian I would put it differently. We tend to choose the middle way and are open to the adoption of measures that give a real prospect of working without undue concern where these measures fall in the right/left spectrum. We also tend at all times to look seriously at the experience of other countries.


On Oct 05 01:56 PM Benny D. wrote:

> I think that canadian banks have a little more value (TD Bank, RBC
> etc.). A commenter on another post said something to the fact that
> Americans look down on Canada, saying that they are socialist.<br/>
>
> Well I think if a little bit of socialism is what it takes to have
> an efficiant banking system it wouldn't hurt to impliment it here
> as sort of companion to capitalism. BD

Oct 06 07:25 PM

[meridian575:]

Great Overview. Yahoo Finance has a link discussing the Canadian banking sector in light of the weak U.S. dollar: Take a Look:
finance.yahoo.com/news...

Oct 07 01:42 PM