Is There A Bull Case for U.S. Financials?

"The complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined 'probably forever', Moody's Investors Service said on Monday. 'It is extremely unlikely that in today's markets we will ever know on a timely basis where every risk lies,' analysts at the ratings agency, led by chief international economist Pierre Cailleteau, wrote in a report." (Reuters, January 6, 2008)

Just for the record, in our view the above statement attributed to officials of Moody's Investors Service (NYSE:MCO) is self-serving nonsense. The growing risks which beset the financial markets today have been obvious, even screaming for attention, for many years, at least to those willing to see them. To say otherwise seems to us incredible and an amazing confession of incompetence.

Just a year ago, investors believed that trees grow to the sky and, more important, that any market disruptions would quickly be followed by a timely rebound, even in ersatz markets for things such as complex structured assets. This undying belief in the certainty of a bounce even enticed seemingly rational foreign and domestic investors to go long distressed financials before the New Year.

British financier Joseph Lewis raised his stake in Bear, Stearns (NYSE:BSC) to over 11% of total outstanding at or around $100 per share. At that level, you could make a case that BSC is good value, especially if you believe as we do that the Bear's risk management culture will rebound strongly from past missteps. But at yesterday's close of $71, BSC looks even better.

And our friends at Warburg Pincus, in a display of almost unimaginable generosity and holiday spirit, plunked down $1 billion in new capital for bond insurer MBIA (NYSE:MBI) before Christmas. Warren Buffet then decided to create a de novo competitor for MBI and peer Ambac (NYSE:ABK). Hit the bid.

A number of readers ask if this is not the time to get aggressive and go long financials, a derivative version of the "must bounce" mindset. If you have deep pockets and lots of patience, the answer may be yes, but we continue to believe that financials will be net consumers of capital for much of 2008. Just look at the mounting number of banks announcing capital raises and tell us that the US economy is not already receding as sectors like real estate and home building sink deeper into the mud.

Take, for example, National City Corp (NYSE:NCC), the $150 billion asset Cleveland-based bank holding company that was trading just shy of $40 a year ago and closed yesterday at $14 and change or 0.7 times book. After announcing a cut in its dividend and large scale layoffs, NCC disclosed that it would be retaining Goldman Sachs (NYSE:GS) to raise capital. Good luck.

With an ROA of 0.66% and ROE of 6.75%, NCC is a full standard deviation below peer on both counts. More significant, though, are signs that the bank, like many of its peers, is losing access to the brokered funds market, as illustrated by the more than 100% jump in FHLB advances to $6.4 billion at the end of Q3, some 4% of total assets compared to 1% a year ago.

The thing to remember about NCC and most other US banks, however, is that the fun is just starting. NCC's three subsidiary banks only reported 57.5bp of aggregate default (annualized) as of Q3 2007, this compared to the seven-year peak default experience of 100bp in Q1 2002. If we're right about 2008-2009 containing a "perfect wave" of credit losses, then the 100bp threshold for total loan and lease defaults could be exceeded by a wide margin.

Keep in mind that the "must bounce" mentality is reflected in or a function of (take your pick) of low past default experience. As of Q3, the IRA Bank Monitor generates a Maximum Probable Loss for the bank subsidiaries of NCC of 105bp, roughly equal to the 2002 peak, but we believe that the actual default level for 2008 could be 2x that rate or higher. Layer that future loss experience assumption across the entire US banking sector and efforts to raise capital for such institutions could prove an exercise in futility.

Richard Bove of Punk, Ziegel & Co. writes correctly that NCC should be putting itself up for sale rather than seeking new capital, but the real issue is where adequate sources of new capital will be found for literally dozens of undercapitalized US institutions in the large bank peer group. Raising equity for non-bank financial firms is relatively easy compared to selling stock in a regulated bank, especially when the "fair value" of the bank's assets is in doubt.

The painful irony we face in 2008 is that now that commercial bank valuations make sense for the first time in half a decade, M&A activity may be muted by the relative lack of excess capital held by many large domestic acquirers and the rising tide of credit losses. Just as ersatz derivative assets such as Collateralized Debt Obligations are now illiquid, commercial banks as an asset class may be perceived to be damaged goods for much of the next year or more.

Before this trough in the credit cycle hits bottom, Washington may face at least one large bank insolvency and will be forced to orchestrate bank mergers en mass. The banking industry which emerges from this process will be smaller in number and more conservative than banks are today, with business models less reliant on the trading book for profits. Such a result implies a substantial and permanent net reduction in credit availability for the U.S. economy.

At some point in the credit adjustment process, it will be time for investors large and small to take a bull view on U.S. banks and financials. But not yet.

Disclosure: none

Comments

[Pj568]

Chris. My first thoughts were that yes the Moody's comment is self-serving and "BS" to your comments of advanced risk warnings being made. However I did go to the IRA website and browsed the article catalog where I found several dealing with everything that is currenly imploding, i.e. hedge fund leverage, credit risk, CDOs, subprime, regulatory issues, etc dating back several years. Good Stuff. Impressive.

[SmartGuyStocks.com]

Excellent analysis. Thanks!