Get Ready to Short the Banks

Includes: BAC, C, GS, JPM, WFC, XLF
by: Rakesh Saxena

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 (NYSE:BAC) and Well Fargo (NYSE:WFC) have begun “trial” modifications for 11% and 20% respectively of their eligible borrowers who are at least 60 days past due; Citigroup (NYSE:C) has started modifications for 33% of its eligible borrowers, and JP Morgan (NYSE: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.