No End in Sight to Banking Crisis

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 (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 (PZN) went on record recommending banks and financials. When Pzena was asked why investors should snap up battered shares of bellwether Citigroup (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 (EMC), Cisco (CSCO), or Yahoo (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.

Comments

[soma6]

Two words, Sovereign Funds.

Do you think the emerging markets & oil markets are going to let the financial system go down the tubes? Think again. There is more private money floating around the world that we don't know about than money we do know about. This mess will be over as fast as it appeared. The press has been making a mountain out of a mole hill for far to long.

The last recession in the US lasted barely 6 months. As I see it, we are already in a recession and as the housing numbers just released Friday indicate, we may have hit bottom. What is needed are buyers and confidence not more doom & gloom. Jobs numbers are still up.

Get over it, move on, go out and start a company, buy a house damn it.

Cheers

[[e-mail]]

Rock, paper, scissors. Paper only doesn't do it.

What is the underlying cause to the current problems?

On a surface level it looks like the United States is going through what the U.S. claimed to do to Russia in the 80's, let war undermine the USSR's own economy.

Additionally, some entities out there are trying to squeeze the shrinking american middle class by charging credit card interest rates that are basically illegal.

If a bank has a growing customer base that owes credit card debt that will take 10-20 years to pay off and they are about to give up so they can make their mortgage payment, why not convert this growing debtor customer base into a group that pays off their debt in the next 3-5 years with a zero percent interest rate? What makes this idea even more logical is the banks will probably be able to collect slightly larger monthly payments than the minimum they are currently requesting.

This idea is so logical that the primary reason it is not being done is because either it has never been tried before. Or perhaps the banks have somehow created stock portfolios that increase in value as more of their own customers fail. A bit treasonous if you ask me.

www.credit-card-cap.co...
www.credit-protector.c...

[The Sky is Not Falling]

This is some very illogical writing. A few examples:
*****
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.
***
So, by the author's logic, there is no year between successive recessions when the growth rate is still positive but lower than all of the other positive years. The natural conclusion of this twisted logic is that we are always in a recession, otherwise we would have to be between recessions, but that is not possible. Hmmmmm. Nice logic.

Next:
*****
And if Pzena sees short-term downside risk [in owning Citi], why recommend shares here?
********

Ummm, because EVERY INVESTMENT has short-term and long term downside risk EVERY INVESTMENT. EVERY. You just have to weigh the down-side risks against the upside potential and that is what Pzena was doing. Now, if the author had said that "it is obvious the downside risks outweigh the upside risks", then he would have stated something at least logical. But his analysis is laughable. We have someone pretending to understand investing but claiming that any investment with a down-side risk is not a good investment. He doesn't even graso the investing 101 concept that all investments are about weighing upside potential against downside risk.

There are other examples of this author's clear lack of understanding of basic investing concepts. What a joke.

[Georealist]

Interesting analogy...the housing baloon has only partially deflated. The real rubber will hit the road when renewed Spring optimism turns into the muck of huge new home inventories sucking up additional capital and existing home sales plodding along at a rate that doesn't allow those owners to move up. This is a housing food chain that is seriously impaired..and half wittedly urging people to "get over it" is worse than useless.
As for solutions...banks will only adopt/create them when squeezing money politically out of the system doesn't work..or when the Fed demands it before further relief (credit dreation) is dispensed.
The nastiness will really start when home builders start collapsing financially..and no one (including the lenders that really own them) want the home inventory they've left behind....try to get over that one.

[Tim Eriksen]

The only thing more illogical than the writing of the author is the fool who posted as credit-card cap.com. A quick glance of the site shows a person completely ignorant of finance. For example he says to look at your credit card statement if you carry a balance. If the amount of interest you pay exceeds the amount of principal then, he says, you are paying more than 100% interest. What??? Try looking at your mortgage statement, by his logic a new homebuyer is paying nearly 1,000% interest. Grab a clue about basic math, please.

[philly jim]

Please excuse my ranting here...

An even more interesting economic landscape to observe will be the Asian financial lending culture. How much data do we have on this? Go lend money to a Thai or Chinese relative if you have any, then wait, and wait, and wait to see repayment, I doubt you ever will see any payment from any individual.

If history is correct which it is proving to be with an X factor of Asia, we have the U.S. economy in a downturn and typically two quarters later we have a Euro/British downturn. Now, we have to wait and see how Asia will deal with their downturn which may or may not be inevitable being that it has never been a major working mechanism in the Western dominated world economy until the U.S. consumer turned into an obese Walmart slob. Yes, all the new high rises built from slave labor in Asia look nice but isn't that just "face"?

One example I will offer of why I think many in America are experiencing credit problems: I have a credit card account with Citi Bank, I have never missed a payment yet my interest rate went from 9.99 to 14.9 over a six month period and now is 29.9% and all for no apparent reason, just an addendum of fine print included with my monthly statement telling me so and offering me a chance to close my account if I don't accept the new terms. I guess they need to pay off those billions lost somehow, why not pass it along to the U.S. consumer? Someone has to pay for all those banks they are buying in Taiwan! Why not the Walmart slobs!

Another example is that salaries in the U.S. are not rising with global inflation. The same entry level job that starts at 25-30k is still, 10 years later, 25-30k.

It's interesting to see how the Federal Reserve which is funded by taxes from U.S. citizens, lends money at very low interest rates to banks which then lend to U.S. citizens at very high interest rates and Congress somehow expect this process to encourage consumers to spend more and keep the American economy stable? That doesn't make sense!

And finally, what's up with these SWFs (Sovereign Wealth Funds)? I totally support their desire to invest abroad and generate additional sources of income for their governments but there is practically ZERO transparency with these investment vehicles. What happens when Islamo or Communist facist A decides to buy national security interest B through SWF C run by D Corp. LTD? Who the hell knows what is going on, the CIA sure won't and we all figured out that after 9/11.

Oh boy, I just wish we had another poet of economics running the reserve and a president who had original thoughts.

[NoFate]

Bottom line ...US houses inflated in value about $6 trillion in the past 6 years (nearly double):
- Much of this money was withdrawn and spent.
- Many houses will end up underwater (debt > house value).
- Much of this debt was handed out to people who can't pay ...so the banks and investors will eat it.
- All historical fundamental comparisons such as rent, median income, building cost indicate it is too high.
- The Case-Shiller CME futures market currently indicates a bottom in 2010 or 2011.
- The ARM resets for the next 6 months are far greater than the last 6 months.

Further, Commercial Real Estate usually follows Residential by 12-18 months ...and sure enough that shoe is starting to drop.

This is far far from over people. We might be in the 2nd inning.

[[e-mail]]

credit-card-cap.com here. I never stated 1,000%, I stated that if one pays more in interest every month than what is going towards principle the person is paying 100% or more in interest. Just because you've let the banks brainwash you into thinking you are not paying 100% in interest is exactly why I started the website.

If you then want to make the additional mistake of comparing a CREDIT CARD DEBT to a HOME MORTGAGE, you have been additionally duped by the banking industry. A credit card purchase devaluates and obsoletes over the short term with Virtually NO HOPE of ever increasing in value, whereas a home offers potential on many levels, the mortgage offsets paying rent, there are tax deductions, equity is created, and eventually ownership.

Credit Card Debt should not cost as much as a mortgage plan does in interest, yet it costs more, and in a deceptive way.

[SmartGuyStocks.com]

As usual, the permabulls can't tolerate a look at the issues our economy faces. The Sky is Falling, it is possible that the issue here is bad grammer on Ken's part -- not mine. I read his statement as saying the current growth rate is AS SLOW AS it was during our last recession. If Ken expects slower growth than any time over the last 6 years, than he is saying the current growth rate is as low or lower than it was in 2001, when we were in a recession. There is nothing twisted here. I am not trying to twist anything because I am a trader and care not whether we are in a bull or bear market. In fact, I would prefer a bull market. As you can see at smartguystocks.com, my open positions (SmartGuyDH) are long.

As for risk-reward, you are the one who needs the econ 101 lesson. All I ask is WHY we should simply buy shares based on someone's comment that the long term reward of a 3 year hold outweighs major short term issues. You should have learned in your investing class that 'price paid' determines ROI. So, I ask again, why buy now if even Pzena thinks C will be cheaper in the short term (it's already cheaper than when he recommended). Moreover, if you believe our economy generally grows over time, than any moron can recommend stocks saying "the long term reward outweigh the short term risks," BUT, that is not a savvy way to maximize ROI. As I noted in my article, that didn't work out well for anyone who bought EMC, YHOO, and CSCO when permabulls used the same thesis in 2001. And, only a major contrarian would have passed on C using Pzena's logic three years ago. Here's a hypothetical analogy using the same logic as Pzena in 2004: "Given strong global growth and the exploding housing market, I believe C will be trading higher in 2007." Again, was that a good investment? Than why should that type of framework be acceptable now? If that works for you, good luck. But the rest of us are trying to BEAT the market.

And Tim Eriksen, what's illogical about my article? If you see a bottom in the credit crisis, then why are the banks selling off today? Please note some data that shows spreads normalizing and banks starting to rake in profits. If it exists, I will happily go long banks. In fact, I am hoping that things do stabilize so I can recommend going long KBE at some point in 2008. However, the point of my article is that I do not yet see an end to the crisis, and thus SAVVY investors should still wait before going long OR continue MAKING MONEY with short term bearish trades.

IMO, the only people who challenge the issues EVIDENT in the financial sector are those holding shares long. In a few days I will be posting an interview at smartguystocks.com where I speak with a hedge fund professional in the debt markets that will make it crystal clear how bad the credit markets are.

I welcome lively debate, but please provide some data to support why we should all be bullish on banks. My friends are some of the most successful traders on Wall Street, and I don't know anyone who has yet gone bullish on banks. Maybe they will in 2008, but not yet ...

[jack kreg]

I love poster who write a few million words. The article is way tilted, like an editorial. I use both sides to make investment decisions. this author does not. I will buy all the shares of WB that the author wants to sell, with the price under $40. The author is badly mistaken about the real long term value in WB's securities. They are cash flowing at values much higher that they are trading at.

[jack kreg]

SMARTGUY---NOT, you are abusing this site, by mouthing off like a commercial advertizing wonk. Don't use this site to promote your business.

[SmartGuyStocks.com]

I said I will be buying banks as soon as their share prices start reflecting the increasingly negative risks. Why do WB shareholders not listen when I say I will be a buyer WHEN THE END IS IN SIGHT? My thesis is that it is still too early to buy banks -- not that banks will never be a good buy. Please read and digest the article before bashing simply because you are long WB and cannot stand the truth about the company to be discussed in public.

Jack Kreg, you are another reminder that the same bashers came our during the tech bubble when people started getting bearish on tech. Like I asked before, please provide data supporting why banks will go up rather than continue going down. Otherwise, you are the editorial writer for your own long shares. And why can I not promote my business? That's what this site is for: writing blog entries about finance. What do you want me to write about? How great WB is? I will do that as soon as they get their ship in order, not because of cash flow at the beginning of a weakening economic environment and credit crisis.

[User 135949]

I won't go anywhere near the financials until they begin to rise as a sector. I don't expect that to happen anytime soon, perhaps not this year. As Baron Rothschild once said in response to an inquiry regarding why he wasn't more heavily invested in the market, "I would rather be out of the market, wishing I were in, than in the market, wishing I were out."

[Zeppelin]

I have a Pen and need $5Mil. I have no credit and I make $100K per year. Will someone please lend me the $5Mil ? I want to buy a $1Mil home and a Lamborghini. I figure I can invest the other $3.75Mil and pay back the loan off the Dividends. My name is Black Hole...

[SmartGuyStocks.com]

WB is testing 34.50. Guess all the bulls were wrong ...

[healthy sceptic]

Why is it that most Americans can't accept the idea that there could be a recession and that it is the natural consequence of a credit binge which is now causing an economic hangover. It seems to me that the whole edifice of the financial system in America is based on a false reality which is crumbling before our eyes. However millions are still denying it and after spending themselves into oblivion they expect the Chinese, Saudis and Singaporeans to bail them out. What America really needs is a deep recession in the same way that a spoilt child needs to be caned to knock some sense into him. We've had our fun and it's now payback time. Let's face the coming inevitable recession like real men, not contemptuous fools who want gains but no pain and never learn from adversity. The author of this article is telling the plain truth, which is why it hurts some of the posters here so much, to judge from their comments.