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In last Friday’s “Four In Four” I told investors to increase allocations to Cash to 75%. Bank Failure Friday continues to drain the Deposit Insurance Fund (DIF). Goldman Sachs is the tip of the fraud allegations iceberg.

Shifting Investment Strategy to “Sell Strength”; In last Friday’s “Four In Four” I told investors to increase allocations to Cash to 75% and said, “This is an historic time to raise cash to 75%.” I justified this by stating that all eleven sectors were overvalued, and that stocks were overbought on all time three time horizons: daily, weekly and monthly.

Today I show the weekly chart for the Dow Industry Average, which shows a test of the 200-week simple moving average at 11,133 last week with a high for the move at 11,154.55. The 61.8% Fibonacci retracement of the rally off the March 6, 2009 low from the October 2007 high comes in at 11,263. My proprietary analytics shows a “Wall of Resistances”; 11,169 weekly, 11,228 monthly, 11,235 annual and 11,442 semiannual. Being overvalued and overbought with all of these resistances are the justifications for the market call, “Dow 8,500 before Dow 11,500” and now I specifically say that we are in a “sell strength” mode.

click to enlarge

Chart Courtesy of Thomson / Reuters

Back on February 8th after the Dow dipped below 9,900 to 9,835 on February 5th I shifted to a balanced model portfolio overweighing the ValuTrader model portfolio to the long side. Today, the model portfolio is 84% to the short side.

Bank Failure Friday – Eight banks were closed by the FDIC on Friday, three of which were publicly-traded and on the ValuEngine List of Problem Banks. To obtain this list go to ValuEngine.com and subscribe to the Quarterly FDIC Report.

  • Only 25 banks failed in 2008, as the FDIC was slow closing community and regional banks.

  • There were 140 bank failures in 2009 with a peak of 50 in the third quarter.

  • In the first quarter of 2010 there were 41 failures, and so for in Q2 the total is 9.

All eight of Friday’s bank failures were overexposed to C&D and / or CRE loans with a loan versus commitment pipeline between 81.1% funded to 100% funded, when a healthy pipeline is 60%. The publicly traded community banks were; Lakeside Community Bank (MCBP.PK) in Michigan, Tamalpais Bank (OTC:TAMB) in California, and City Bank (OTCPK:CTBK) in Washington.

My predictions remain that 150 to 200 banks will fail in 2010 on the way to 500 to 800 banks by the end of 2012 into 2013. Since the end of 2007 there have been 215 bank failures. Community bank failures are a big deal, as small businesses on Main Street look to them for their financial needs. When a small business seeks a new banker they typically face tougher lending standards.

The Deposit Insurance Fund (DIF) was tapped for $6.5 billion in the first quarter of 2010 and another $1.1 billion so far in Q2. This brings the estimated DIF deficit to $28.5 billion excluding the prepaid $46 billion that sits on the sideline for 2010 through 2012. Another prediction still stands is that the FDIC will tap its $500 billion temporary line of credit with the US Treasury this year. After applying the $15,333 billion prepaid assessments for 2010 the DIF is in arrears by $19.7 billion.

Bank Name

Closing Date

DIF Cost

Beach First National Bank

9-Apr-10

$130.3

Lakeside Community Bank

16-Apr-10

$11.2

First Federal Bank of North Florida

16-Apr-10

$10.5

AmericanFirst Bank

16-Apr-10

$6.0

Riverside National Bank of Florida

16-Apr-10

$491.8

Butler Bank

16-Apr-10

$22.9

Innovative Bank

16-Apr-10

$37.8

Tamalpais Bank

16-Apr-10

$81.1

City Bank

16-Apr-10

$323.4

Total Cost to DIF Q1,2010

$6,510.20

Total Cost to DIF Q2,2010

$1,115.0

Courtesy of the FDIC

DIF 2009 Q4

($20,850)

Cumulative Loss

($28,475)

2010 Fees

$15,333

Estimated DIF

($19,652)

2011 Fees

$15,333

2012 Fees

$15,333

2010 - 2012 Fees

$46,000

Estimated DIF

$17,524.8

Goldman Sachs is the tip of the fraud allegations iceberg. The SEC has charged Goldman Sachs of securities fraud claiming that the investment banking giant created and sold a mortgage investment that was secretly devised to fail. According to the SEC Goldman profited by shorting the very derivative mortgage securities it sold to customers. What illegibly happened was that a hedge fund owned by John Paulson paid Goldman $15 million in 2007 to create a derivative security structure tied to mortgage-back securities that the hedge fund thought would decline in value as subprime mortgages submerged.

As an engineer with a master of science in operations research, systems analysis I was always opposed to the derivatives markets since they began their development in the mid-1980’s. Back then the firm for which I was Managing Director of the US Government Bond, Agencies and Mortgages was involved with the first agency CMO, which was just a three Tranche structure. The problem with derivative structures is that the sum of the parts is greater than the whole, which is great for Wall Street commissions, but it’s next to impossible to put these Humpty-Dumpty pieces back together again.

The only derivatives that can be reconstructed are US Treasury Strips, which take a US Treasury Bond and separately trades each six month interest payments and the principal of the bond. If you accumulate all the interest payments and the principal you can re-create the original bond. This cannot be done with mortgage-backed derivative structures, which is why banks are reluctant to help homeowners refinance mortgages if they were securitized. We did not need these types of derivatives prior to the 1980’s, and we do not need them now. They should be banned, or marked to market daily on the balance sheets of banks that know have them hidden off balance sheet.

Since 2001 the notional amount of derivative contracts originated by FDIC-insured financial institutions has grown 370% from $45.4 trillion to $213.6 trillion and this leverage is still a major hangover that will bite the banking system from time to time for many years.

At the end of 2009 there were 1,124 FDIC-insured financial institutions reporting derivative exposures. The total assets and deposits for this group are $10.57 trillion and $7.34 trillion respectively. Within the Derivatives among FDIC banks are $179.6 trillion are tied to interest rates to which $142 trillion are swap transactions. To think that there are no time bombs ticking is naive. If the banking system and regulators are saying “no problems”, then establish a mark-to-market with these structures on the balance sheet. Only then, will our nations banks be fairly valued.

Keep in mind that recent auctions of toxic assets by the FDIC have bought in just 22 cents on the dollar.

Disclosure: No positions