In a Storm, Both the Good and Bad Get Hit

There is a piece on this new blog (which is trying to create a sort of independent stock research center where the reports are written by users) about iStar Financial (SFI). Fair disclosure, I'm considering a debt investment in iStar.

Anyway, toward the end of the report, the author goes into a bit about how financial stocks are in the unenviable position of proving a negative. I want to explore this idea a bit more.

No one knows how far the residential lending contagion will spread. Are banks and brokers just taking a "big bath" right now, and are writedowns near an end? Or are there one or more large financials headed for bankruptcy? What companies may have invested in subprime related securities, from CDOs to SIVs? Who has counterparty risk with shaky partners? What companies are so reliant on securitization that they will face a liquidity crunch? Who may need to come to the debt markets now and pay unusually wide spreads, and what impact will that have on earnings?

Taking it a step further, how much will losses in home values impact consumer spending? What companies may be over-leveraged to the mortgage-equity withdrawal trend? Or consumer credit in general? What companies will be facing higher defaults from non-residential lending because easy credit has previously kept consumer loss rates low?

We are all struggling with these questions. I think I know the answer to some of these, but I must concede that my confidence level in any particular outcome is low. I think a lot of actual traders are struggling with the same problem. We know there is a lot of bad news priced into securities, but we also know there is bad news to come. And we can't be sure from where the bad news will hit.

So you take a company like iStar Financial. It is a commercial real estate lender. Now perhaps you have a "classic" reason to be bearish on iStar, such as you are bearish on commercial real estate. Fair enough. But in today's market, a legitimate concern is whether someone like iStar can weather a period where it is difficult to raise capital. And if you assume that it can survive such a period, what would its earnings look like?

But there is nothing iStar can do to prove it can survive a serious credit crunch except to go ahead and survive it. Investors are in essence saying "Prove to us you won't have a problem in this environment." But no company can prove any such thing, because we don't know how much worse the credit crunch might get. Or what other types of securities or loan-types might be hit next.

A myriad of other financial stocks (and bonds) are suffering through the same thing. We know that some are particularly vulnerable. Washington Mutual (WM), Countrywide (CFC), AMBAC (ABK), etc. But there is a large number of companies that haven't had any particular residential lending-related problem. There are other companies that have had some problems, but that isn't any particular reason to believe there will be more. And yet because the market is asking these companies to prove a negative, the stocks (and bonds) have been beaten up pretty badly. As long as subprime or contagion losses could crop up, investors are going to be highly skeptical.

One could say this is the nature of a bear market. Investors become more focused on their fears and less on their greed. Sometimes the innocent get punished. Sometimes the not-so-innocent are punished before their crime is fully revealed.

So if you are considering investment in any financial company's securities, bear this in mind. This thing is hitting all aspects of finance. On one hand, we have real losses on mortgage loans. On the other hand, we have a serious liquidity crunch. On our left foot, we have much wider credit spreads. There is no such thing as a financial company for whom none of that matters. Financials, by their nature, almost always take credit risk of some kind, and need funding of some kind. There are many companies being unfairly beat up right now, but which are the innocents and which are the not-so-innocent not-yet-revealed is a tough call.

Even if you are right about the particular company you are looking at, the fear of the unknown will continue to dominate markets until the pace of bad news slows down. Put another way, when a company is being asked to prove a negative, there is no catalyst that will accomplish this. Investing intelligently in a market like this requires patience, stamina, and constant re-evaluation.

Comments

[WAKEUP:]

"This thing is hitting all aspects of finance." Very true. The landscape is going to look very different, when the bloodletting finally subsides, in 2017.

2007 Dec 25 11:43 AM

[Arnold:]

Accued Interest; I agree with your assessments and as you allude these challenges are new navigations. And it is well to project cautions for investees and investors alike. However, there is an element whose genre you seem to ignore; the consumers who are in fact, infectees of this potentially sinuos financial delemma.

The challenge of predicting positive or negative fallout would be more accurate if a study of affected mortgagees were made apart of the equation. Since, at least in my lifetime, nothing similar of this magnitude has occured within the mortgage industry, forecasting without consideration of affected and potential foreclosuree's causes accuracy to be more ellusive, at best. Here's why!

Of the many ramifications caused by this ARM catastrophy is the realignement of mortgage credit approval criterium. For one thing beacon scores have a new threshold of 850 as against the old of 750. Whereas and since this new 'top-line' had widened mortgage credit models a change due to the ARM anomaly has up'd the 'good finance rate requirement' of a 600 score to 700; the number of potential mortgage approvals shall be restricted accordingly. In addition to that new criterium, many are suffering credit degradation which added the former increases the potential for additional mortgage application rejections, many of which are submitted seeking fixed-rate mortgage rescue from recent and near future ARM interest rate excess-ions.

As a stock holder (fortunately, I am not), I would be even more cautios and maybe even a bit nervous of the future health of vested interests.

2007 Dec 25 02:31 PM

[pochovilla:]

In this high risk questionable reward environment, would it not be more prudent to find a safe haven to ride out the storm? Let's assume the big banks "fix" the balance sheets in 2008. How much will they sacrifice to do so? What will be the quality of earnings? Can we assume their profit model will be decent with an infusion of capital?
I think next year will bring pack dog lawyers, congressional oversight and new regulations. I anticipate the evening news will be full of "sub-prime" related stories. This can't be a good environment for investment.

2007 Dec 25 05:06 PM