Get Ready to Short the Banks

There is, of course, no consensus on the potential impact of the $10-$11 trillion worth of outstanding residential mortgages on the banking system in the event of a delayed recovery. The Obama administration, preferring not to indulge in any negativity, has a simple theme: just keep the mortgage sector alive long enough for an economic turnaround to remedy all the inherent problems. But eating away at the dubious merits of the wait-and-hope approach are the mathematical realities which have not been factored into the government’s foreclosure-prevention exercise which, according to Treasury officials, is getting an enthusiastic response.

Treasury Secretary Timothy Geithner announced last week that 500,000 financially-troubled homeowners were now participating in the government’s foreclosure-prevention plan. Under the plan, those behind on their mortgage payments and those facing imminent default can apply to reduce their monthly payments in line with monthly incomes. Bank of America (BAC) and Well Fargo (WFC) have begun “trial” modifications for 11% and 20% respectively of their eligible borrowers who are at least 60 days past due; Citigroup (C) has started modifications for 33% of its eligible borrowers, and JP Morgan (JPM) for 27%.

But is the Obama administration’s focus on capping debt service by income creating unrealistic “implied” valuations? Are traditional LTV (loan-to-value) measurements no longer workable propositions? And is the loan modification scheme simply deferring the substantial systemic risk which continues to threaten bank balance sheets?

Firstly, on all present indicators, income-linked monthly installments are likely to cause a forced extension of loan maturities, dramatic changes in the medium-term yield curve and unwieldy maturity mismatches on bank books. Secondly, the foreclosure-prevention plan does not aim to answer the most politically-sensitive of questions: how many eligible borrowers are living in homes they just cannot afford and what are the affordability benchmarks banks are currently using? Thirdly, how and when will banks make further provisions for loan delinquencies if a sizable proportion of trial modifications fail to result in final loan restructurings?

A BofA executive working on the plan helpfully suggested that “only 50% of the trial modifications should result in full modifications.” He acknowledged that even the 50% estimate was predicated on ongoing government assistance; for reasons which are obvious, he did not want to predict how home prices will react to the highly unlikely event of a large-scale unwinding of government intervention.

In fact, in a scenario so heavily dominated by government intervention, it is difficult to see why analysts are making calls on the housing market. One proposal in Washington is for the lowering of monthly payments by borrowers to below the 31%-of-income standard for the foreclosure-prevention plan. Another proposal gaining favour amongst lawmakers is the extension of an $8,000 tax credit to first-time home buyers; Rep. Eric Cantor (R., Va.) wants that amount raised to $15,000!

Without doubt, the Obama administration is preparing for further unprecedented measures if the situation so demands. “The government answer to the challenges in the housing market remains a work-in-progress, at best,” said the manager of a Geneva-based hedge fund. “There is no evidence to show that anyone has a complete grip on the problem.”

This writer was aggressively shorting banks during the first half of this year, expecting that a broad nationalization would reduce private equity in some of the banks to zero. But governments all over the world managed to devise rescue programmes which kept banks afloat on taxpayer dollars and which, at the same time, left room for shareholder gains. As a result significant profits on shorts were wiped out in the March rally.

Today, major banks are nearing price levels which cannot, by any measure, be justified by the earnings-potential matrix created by “partial nationalizations” and which will be seriously threatened by the failure to bring a measure of realism to valuations in the housing and consumer sectors. As this week’s earning reports (JP Morgan on Wednesday, followed by Goldman Sachs, Citigroup and BofA) will show, Wall Street’s risk-friendly investment banking model has been decisively shelved for now; so don’t look for any above-average gains from the derivatives complex.

Disclosure: No position in tagged counters; looking to build shorts in the event of 5-10% gains from Friday’s close.

Comments

[TradingHelp...:]

I agree a lot of bank stocks have rallied beyond reasonable valuation.

But the herd instinct is strong and a lot of cash is still coming into equities so keep those stop-losses handy.

Oct 13 04:06 AM

[Jasper M:]

I think a key tactic might be to try and ID the 'political threshold' - the level below which negative equity banks will not be kept alive by government fiat. Short the ones beLow that.

Yes, the others will fail to, in time, but traders are an impatient lot.

Oct 13 04:23 AM

[Roger Knights:]

"Goldman Downgraded as Meredith Whitney Abandons Last `Buy' Recommendation":

www.bloomberg.com/apps...

Oct 13 06:40 AM

[RonB:]

Ahh, another article desparately written by someone who missed the rally and wants a lower entry point. Full of broad-brush generatlities. Specifics matter here. Wells Fargo is a good example. Wells has pre-tax pre-provision earnings power well above $40 billion. It will do $40 billion this year. In a more normal environment, after the current spate of writeoffs has subsided, provisions will be under $10 billion. A $10 billion provision level would result in after-tax income of around $4.20 to $4.30 a share. At a historically low PE multiple of 12, you have a $50 stock price. Wells is now trading at $30. Which is why it is the largest holding in my personal and client portfolios, and it is why Warren Buffett and Prem Watsa own so much of it.

Ron Beasley
Investment Advisor
rwbi.net

Oct 13 09:40 AM

[bassmaster17:]

Yeah, it may be a good time to short based on the law of gravity, but Ron has a very good point. Despite the rapid increase in share value a lot of these things are cheap and were priced for Armagedon. I don't know what makes Whitney so great for putting a buy on GS when it was in the toilet bowl. Great investors like Warren Buffett saw value way before it went to panic levels. It should have never gone to $50 and now it may be over done soley on technicals. Buffett has not sold...the list of analysts who bask in one good call is endless...there's only one who consistently is right and he's not with a Wall Street firm.

Oct 13 10:30 AM

[Rakesh Saxena:]

Dear Ron: Just to clarify, I am not looking for a lower entry point; I am looking to short. My issue with the "specifics" you mention is the extent to which they are shaped by government intervention. In any event, your point is well taken. - Raklesh


On Oct 13 09:40 AM RonB wrote:

> Ahh, another article desparately written by someone who missed the
> rally and wants a lower entry point. Full of broad-brush generatlities.
> Specifics matter here. Wells Fargo is a good example. Wells has pre-tax
> pre-provision earnings power well above $40 billion. It will do $40
> billion this year. In a more normal environment, after the current
> spate of writeoffs has subsided, provisions will be under $10 billion.
> A $10 billion provision level would result in after-tax income of
> around $4.20 to $4.30 a share. At a historically low PE multiple
> of 12, you have a $50 stock price. Wells is now trading at $30. Which
> is why it is the largest holding in my personal and client portfolios,
> and it is why Warren Buffett and Prem Watsa own so much of it.<br/>
>
> Ron Beasley
> Investment Advisor
> rwbi.net

Oct 13 10:37 AM

[Swashbuckler:]

Talk about broad-brush generalities. You have concluded that the author is desperate, missed the rally, and wants a lower entry point. You know nothing about the author. Because if you did, you would know that he was short financials last Fall, last Winter, and into the first of March. When he covered his short positions. Don't take my word for it. Read his earlier posts available on this site. In fact, of hundreds of authors on this site that I read, he is IMO the most accurate in terms of market action overall and the financial sector in particular. Along with Paul Lamont and Reggie Middleton. Notwithstanding your opinion of Mr. Buffett. Incidentally, WEB does not have a divine touch.


On Oct 13 09:40 AM RonB wrote:

> Ahh, another article desparately written by someone who missed the
> rally and wants a lower entry point. Full of broad-brush generatlities.
> Specifics matter here. Wells Fargo is a good example. Wells has pre-tax
> pre-provision earnings power well above $40 billion. It will do $40
> billion this year. In a more normal environment, after the current
> spate of writeoffs has subsided, provisions will be under $10 billion.
> A $10 billion provision level would result in after-tax income of
> around $4.20 to $4.30 a share. At a historically low PE multiple
> of 12, you have a $50 stock price. Wells is now trading at $30. Which
> is why it is the largest holding in my personal and client portfolios,
> and it is why Warren Buffett and Prem Watsa own so much of it.<br/>
>
> Ron Beasley
> Investment Advisor
> rwbi.net

Oct 13 11:50 AM

[DonFurio:]

I wish the author would be more specific in what he's looking to do. Are you going to short the XLF, KBE, or are you going after selected companies. Personally, I believe that even if you are right in the short term, this is a bad long term play. Look at the potential earnings power for the 5 biggest. Even if you're right, what are you looking at a max of a 10-20% drop? That's nothing compared to the fact that some of the banks have the potential to be up 60% or more in the next year or so.

Oct 13 04:14 PM

[DonFurio:]

I wish the author would be more specific in what he's looking to do. Are you going to short the XLF, KBE, or are you going after selected companies. Personally, I believe that even if you are right in the short term, this is a bad long term play. Look at the potential earnings power for the 5 biggest. Even if you're right, what are you looking at a max of a 10-20% drop? That's nothing compared to the fact that some of the banks have the potential to be up 60% or more in the next year or so.

Oct 13 05:02 PM

[fwi:]

I agree with swashbuckler. Author has been very timely and accurate. I am still short the financials as I do not believe these so called "scrubbed earnings". The off balance sheet liabilities are enormous, and yet they are treated by the Street as if they were not there. Exit the Fed, and all of a sudden, they would loom very large. My mistake was that I did not believe that the Fed Govt would be this involved for this long.

Oct 13 07:35 PM

[Rakesh Saxena:]

I am looking at a 50% drop, in broad terms; of course timing of specific entry points needs to be ascertained. As far as upside is concerned, let's not forget that there would be no upside without those billions of taxpayer dollars!! Many thanks - RAKESH


On Oct 13 04:14 PM DonFurio wrote:

> I wish the author would be more specific in what he's looking to
> do. Are you going to short the XLF, KBE, or are you going after selected
> companies. Personally, I believe that even if you are right in the
> short term, this is a bad long term play. Look at the potential earnings
> power for the 5 biggest. Even if you're right, what are you looking
> at a max of a 10-20% drop? That's nothing compared to the fact that
> some of the banks have the potential to be up 60% or more in the
> next year or so.

Oct 13 09:49 PM

[Stockmajor:]

Let's see what the earnings reports say this week. With the very large bonuses being paid out by the big banks, I must assume that they are having very big earnings. I am long these financials in the short term. And I am also long in the long term. I don't believe we will see a big downturn. The big government supported banks are being given the time and opportunity to earn their way out and slowly reduce their bad assests pools. And that is a good thing because I don't think we really want to go through a Great Depression take two. Shorts will have to cover this week.

Oct 14 03:33 AM

[buyitcheap:]

This bonus payout is an absolutely criminal act - and these bankers should be looking at jail time instead of new Maseratis.

Having been short anticipating all of the things you cite above, I have had my arse handed to me. You are fighting the fed who will do whatever it must, anything, to preserve the pretense of stability in the banking system. No matter how Orwellian it may seem, the big banks, will not fail, unless the entire system fails. Period.

Oct 14 09:01 AM

[DonFurio:]

Haha, the XLF is around 15, it will never get to 7.5 again, that was at a panic level, there are many people that will buy the xlf like crazy if even gets to 11.50 again.

Besides, how about those JPM earnings today...


On Oct 13 09:49 PM Rakesh Saxena wrote:

> I am looking at a 50% drop, in broad terms; of course timing of specific
> entry points needs to be ascertained. As far as upside is concerned,
> let's not forget that there would be no upside without those billions
> of taxpayer dollars!! Many thanks - RAKESH

Oct 14 09:14 AM

[75 Year Old...:]

Yes 1 Year later All is Well, Well NOT REALLY its just that All that's Well is reported , All Those Nasty Bad home loans and credit card defaults Well they just Don't LOOK At THEM ! Its like a Guy whos got Tons a bills but just doesnt open them , wife asks how are we doing he says Great ! Eventually of course All Those Bills Come due and Eventually the Banks and Financials will be forced to Report there Bad debts ,, but NOT today or anytime soon that will be left for another time when most of the People responsibe for the Mess have got away ..

Oct 14 10:38 AM