A few weeks ago I watched the documentary No End in Sight. The film analyzed the current war in Iraq. While watching I realized I had never seen much footage of Iraq. Like others in the U.S., I have seen the 10 second video clips and narrow lens snapshots, but I don’t know Baghdad or Fallujah as detailed as New York City, San Francisco, Miami, or the suburban and rural landscape of the States.
Given my ignorance of Iraq, I have failed to appreciate the complexity of warring there. Like other US citizens, when President Bush declared victory in May 2003, I believed the war in Iraq was over; however, the worst was yet to come. Similarly, although bulls on Wall Street are declaring that the credit crisis will be defeated in early 2008, the objective data continues to indicate the worst is yet to come.
Like my ignorance of the Iraqi landscape, most U.S. residents appear to be completely ignorant of the banking landscape. Most of my friends (including doctors, lawyers, PhDs, other professionals, and even some in finance) are what I call “financially retarded”: they spend more than they make, or save less than needed for retirement; they are ignorant of the Federal Reserve, how money is created, and exactly how a bank makes profits; and, they have no clue how many variables affect money and the economy. Consequently, we are still far from accurately pricing banking and financial stocks because many people still have no idea how bad things may become.
At the moment, banking and financial stocks seem to reflect issues caused by the housing market. However, do they reflect the full decrease in revenue from the credit crunch? Have shares been discounted to account for the possibility that commercial real estate may stage a similar performance? Are dividends safe at these tempting levels? What about the increasing defaults on credit card debt? How about issues with small business loans and accounts if a recession arises? And what if a recession causes paycheck deposits to decline when unemployment rises? Basically, since we price stocks based on future performance, do you believe banking and financial stocks are priced to reflect all these future risks?
Like the war in Iraq, initial positive press releases about the banking crisis are overly bullish. For example, last Friday an Associated Press headline stated “CEO: Wachovia (NASDAQ:WB) Well Positioned for ‘08.” I immediately laughed out loud because I was just reading over a chart of CMBS loans that showed Wachovia as a leader in exposure to issues in the rapidly deflating commercial real estate market, and at the foot of my shredder was a Wachovia credit card solicitation (see “Unpaid credit cards bedevil Americans: Americans’ see their debt woes expand as unpaid credit card bills are on rise”).
Adding to the folly was the article in which CEO Ken Thompson stated:
I’m expecting a slower growth year than we’ve experienced anytime over the last five or six years … We’re still in the midst of a housing correction, which is impacting the real economy, but I do not expect a recession.
If Ken expects the slowest growth since our last recession, why doesn’t he expect a recession? That logic doesn’t pass the laugh test.
He goes on to note:
I think lenders made loans to people who should have not received loans.
Since Wachovia is one of those lenders, Ken was in charge of a company that loaned money to people who could never afford to pay back the loans. This is the CEO of the fourth largest bank in the U.S. and he allowed his employees to issue loans that could not be repaid! But he wants us to remain confident in his company’s stock?? Ken, give me one reason why I should own a bank whose CEO lends money to people who cannot service the loan? All CEO spin aside, such action is called a “gift” and savvy investors don’t invest in companies that give billions of dollars in gifts.
Similarly, in this week’s Barron’s Rich Pzena of Pzena Investment Management (NYSE:PZN) went on record recommending banks and financials. When Pzena was asked why investors should snap up battered shares of bellwether Citigroup (NYSE:C), he offered what I consider tremendously weak reasoning:
Citigroup is everywhere. It is a massive global franchise that will grow in line with global financial growth … There is some short-term downside risk. Looking out three years-plus, you have a really spectacular risk/reward trade. The odds that Citigroup sells for less than 30 in three years are very low, and the odds of it selling for substantially above that are very high.
Three years ago, what were the odds C would be trading below 30 in 2007? And if Pzena sees short-term downside risk, why recommend shares here? I’ll give you a clue: Pzena’s fund didn’t beat the market this year (it lost money) and he made huge bets on C and Fannie Mae (FNM). Sounds like someone wants to help keep shares propped up – so I would take these recommendations with the Dead Sea’s supply of salt. Further, the last time I heard fund managers asking investors to “look out three years-plus” was when the dotcom bubble was busting. If you followed that advice and bought bellwethers such as EMC (NYSE:EMC), Cisco (NASDAQ:CSCO), or Yahoo (NASDAQ:YHOO), your investments still may be underwater. Thus, when Pzena says to “look out three years-plus,” I simply say look out.
On Saturday, a more accurate article about the banking crisis appeared in The Telegraph (a UK newspaper). Below are some highlights:
The Bank of England knows the risk [of a worsening bank crisis]. Markets director Paul Tucker says the crisis has moved beyond the collapse of mortgage securities, and is now eating into the bedrock of banking capital. “We must try to avoid the vicious circle in which tighter liquidity conditions, lower asset values, impaired capital resources, reduced credit supply, and slower aggregate demand feed back on each other,” he says.
New York’s Federal Reserve chief Tim Geithner echoed the words, warning of an “adverse self-reinforcing dynamic”, banker-speak for a downward spiral. The Fed has broken decades of practice by inviting all US depositary banks to its lending window, bringing dodgy mortgage securities as collateral.
Glance at the more or less healthy stock markets in New York, London, and Frankfurt, and you might never know that this debate is raging. Hopes that Middle Eastern and Asian wealth funds will plug every hole lift spirits.
Glance at the debt markets and you hear a different tale. Not a single junk bond has been issued in Europe since August. Every attempt failed.
Europe’s corporate bond issuance fell 66pc in the third quarter to $396bn (BIS data). Emerging market bonds plummeted 75pc.
“The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history,” says Thomas Jordan, a Swiss central bank governor.
“The sub-prime mortgage crisis hit a vital nerve of the international financial system,” he says.
Despite all the optimistic crystal ball predictions for 2008, those doing battle in the financial trenches are telling a much more ominous story. So long as the full platoon of risks is not fully appreciated, stay bearish on banking and financial stocks. As savvy investors, don’t get suckered into buying calls or shares while the negative data shows no end in sight.