Avoid Bank Stocks as Tail Risk Increases

Includes: AIBYY, BAC, BCS, C, LYG
by: David Urban

The French plan to roll over maturing Greek bonds will require banks to park the new bonds in special purpose vehicles (SPVs) removing them from the balance sheets of participating banks. The new bonds will also be marked as "held to maturity" escaping the need to recognize losses.

When combined with the new stress test results set to be released shortly (where no sovereign default or restructuring is assumed) one has to wonder once again about the amount of stress in the tests.

Just last year shortly after the Irish banks were given a clean bill of health they needed a bailout.

By placing the Greek bonds off balance sheet and into SPV’s and ignoring the possibility of a potential default systemic risk has significantly increased in the European banking system.

With questions regarding the ability of Greece to actually deliver on their austerity metrics after failing the first time one has to wonder just how the can has been kicked down the road.

The European Union is only kicking the can down the road until the European banks are strong enough to handle a default.

The French plan reminds me how U.S. banks hid numerous securities off balance sheet in SPV’s which later blew up in the financial crisis of 2008.

Fitch already considers the French plan a default and S&P and Moody’s guidelines regarding the definition of a selective default will be breached so one has to wonder if the rating agencies will stand up and call it a default or yield under pressure to let the restructuring slide.

By putting the default notice out into public discussion they are attempting to repair their tattered reputations after the CDO/CMO/MBS mess of 2008 and 2009.

Should they yield to sovereign pressure, they risk losing any goodwill built up over the past two years.

The Chinese rating agency, Dagong, will be looked upon closely as well as they have made numerous ratings pronouncements regarding the U.S. in recent months. The Chinese government has been actively supporting the Euro as a severe depreciation of the euro would cause harm to the yuan.

The Office of the Comptroller of the Currency released a report regarding first-lien mortgages in the United States which can be found here. The report covers approximately 63% of all mortgages, worth a total of $5.7 trillion dollars. As of March 31, 2011, 88.6% of the mortgages included in the report were current and performing. This means a significant amount of bad loans (11.4%) remain on the balance sheets of banks and in the system.

The percentage of mortgages held by reporting banks and thrifts that were delinquent in some manner came in at 19.7% for the first quarter of 2011. This is an improvement from a year ago but still an extremely high number.

The performance of government-guaranteed mortgages determined to be delinquent fell to 13%, an improvement from 14.6% a year ago.

These figures indicate that the amount of bad loans within the system continues to constrain banks and holding back their ability to allocate capital.

The third quarter is typically a good time to catch a 10% rally in financial stocks but this rally should be used as a time to sell holdings in bank stocks as tail risk stemming from Greece and the other PIIGS increases along with continuing high default rates at U.S. banks.

Stocks such as Citicorp (NYSE:C) and Bank of America (NYSE:BAC) should be avoided in the U.S.

Investors looking to possibly catch a falling knife in Europe as bank stocks have cratered would be well advised to wait until after the eventual default and the true losses can be tallied. Stocks like Allied Irish Banks Plc (AIB), Barclay’s Plc (NYSE:BCS), and Lloyds TSB Group Plc (NYSE:LYG) should be avoided.

Unless sovereign risk can be properly quantified on and off balance sheet investors should look elsewhere for decent returns.

It is likely that the crisis will not come to a head via kicking the can down the road but likely a black swan or an outlier where a small to mid-tier European bank collapses causing ripple effects and widespread systemic damage to the European Union.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.