by Mike McDermott
After the worst financial scandal this generation has ever seen, it appears that investors are once again willing to forgive past wrongs and plow headlong back into the financial sector.
Just take a look at the charts of a few off the largest US financial institutions and you will see a picture of improvement, redemption, recovery or any other heart-warming label that could be used by Geithner, Bernanke or any other member of the unofficial plunge protection team:
But are US banks really as safe as they appear? Have we already moved beyond the age of “toxic assets,” and alphabet soup risks like ABS, CDO, MBS, and all of the other variations?
Headline earnings figures present a picture of improvement and profitability. For instance, over the last four quarters, JPMorgan Chase (JPM) reported earnings growth of 72%, 76%, 23% and 49% (year-over-year). But according to a recent Wall Street Journal article, these earnings only tell part of the truth.
At issue, are residual toxic assets that typically do not hit the income statement unless the bank believes they are “permanently impaired” and not likely to recover in value. Since this is a perception issue, financial institutions are able to continue to report strong earnings which mask the true risk in play.
…banks still hold plenty of the bad assets that once spooked investors: mortgage-backed securities, collateralized debt obligations and other risky instruments. Their potential impact concerns some accounting and banking observers.
In part due to those bad assets, the top 10 U.S.-owned banks had $13.8 billion in “unrealized losses” that have lasted at least a year in their investment portfolios as of Sept. 30, according to a Wall Street Journal analysis. Such losses are baked into banks’ book value, but don’t get counted against earnings as long as the banks believe the investments will later rebound. If those losses were assessed against earnings, it would have reduced the banks’ pretax income for the first nine months of 2010 by 21%, according to the Journal analysis.
For the nation’s largest financial institutions, it’s difficult to put too much emphasis on the risk that these toxic assets represent. We have seen clearly that the Fed will support the Goldmans (GS), and Morgans, at the expense of taxpayers.
But for smaller banks without the implicit backstop, the risk is all too real.
Earlier this year, we took a look at three regional banks with significant balance sheet risk related to mortgage securities and foreclosure uncertainty. As legal battles determine whether these banks have the right to foreclose on properties, regional banks are unable to begin recovering losses associated with delinquent mortgages.
This leaves the banks in limbo when it comes to recognizing losses on these securities – and to a certain extent, leaves investors in the dark when it comes to understanding the true risks carried by the banks.
A quick look at the SPDR Regional Bank Index (KRE) shows a potential short opportunity developing. Stock prices for regional banks have improved since September 2010, as investors key off of improving economic indicators and broad optimism / complacency.
But over the last six weeks, the ETF has become range-bound while fundamental risks mount. The longer these toxic assets stay unchecked on the balance sheets, the more dangerous they become once the risks finally matter to investors.
A break below $26 would be a clear indication of weakness for this group – and a good catalyst for taking short exposure in a number of individual stocks in this group.
Speaking of individual banks, Associated Banc-Corp (ASBC) looks particularly bearish as it has established a clear pattern of lower highs and lower lows.
The bank was featured in our Strategic Intelligence Report which noted asset sales that may have left the bank holding the weakest loans in its portfolio, along with a recent increase in charge-offs.
We’re hesitant to short this name without first seeing weakness confirmed in the broad regional bank group. But once the dam breaks, ASBC could be an easy “go-to” name for building quick exposure in the area.
Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.