A Bet Against the Banks

Aside from our main investments in gold, silver and uranium, we have taken a speculative position on the U.S financial sector.

The problems of the financial sector begun with the sub-prime crisis, but we believe it will spread to all areas of real estate and this will have a massive impact on a myriad of financial sectors, such as bond insurance companies, all across the world.

It is clear to us that this Bernanke led Fed committee is nothing but a one trick pony when it comes to solving economic turmoil. The base rate is already below the rate of inflation and although the Fed can continue to cut interest rates as much as they like, the question is: Will banks lend money below the rate of inflation?

In reality this would be equivalent to throwing away money; blatant, deliberate loss of wealth.

We don’t see how the banks can escape more massive write downs and gigantic losses. If they lower the interest rates on their loans as the Fed cuts rates, the rate will drop below the rate of inflation, and so the banks will be losing money hand over fist (in real terms) everyday. If they choose to hold their loan rates as the Fed lowers the base rate, then they will be faced with more loan defaults and repossessions by people who cannot afford the payments. These repossessed properties will not fetch nearly as much needed to cover the reckless loans made the banks in the first place. So either way, they lose.

The bottom line for these reckless financial companies cannot be avoided. The bottom line is that they have made bad loans and risky investments which have turned against them and they will lose money. Big time. There is no coming back for the financial sector, not for a long time.

But its not just the banks that made bad loans that are suffering. These loans were packaged up into separate entities and then sliced up into bonds. These bonds were insured by companies such as Ambac (ABK) and MBIA (MBI) against default, insurance companies with AAA ratings from agencies such as Standard and Poors. As these “bonds” were insured by AAA rated bond insurance companies, rating agencies automatically gave the bonds AAA ratings. So investors and investment banks across the globe saw these AAA rated high yielding bonds and jumped at the chance to get aboard the doomed ship.

Then the music stopped.

Home-owners started to default on their loans, which meant the insurance companies were forced to pay out on the home loan backed bonds they had insured. A multitude of pay-outs meant these insurance companies didn’t look as healthy on paper so the rating agencies started to question their AAA ratings. As the bond insurers get downgraded from AAA, so do the bonds they have insured. Therefore these bonds are far less attractive to investors, who stop buying them, sending the value sharply south. In addition to this, many investment funds are forced to dump the bonds as soon as they are downgraded from AAA, as their brief only allows them to hold AAA rated investments. This sends their value even further down and so the balance sheets of every bank, investment bank and investor who bought into this dream money machine, get extremely ugly.

Taking a look at the financial sector as a whole via the chart of Financial iShares (IYF) above we can see that it is not a pretty picture. Financial iShares is an ETF (Exchange Traded Fund) that tracks the progress of the U.S financial sector. The MACD and moving averages have given bearish crossover signals and the STO, as well as other technical indicators, are heading south in a determined downtrend. The represents what has happened across the board in the financial stocks with exposure to the crisis.

This crisis is far from over. This is why we have begun to build a speculative short position on U.S financial stocks. We bought a position in an ETF called Ultra Short Financials ProShares, (AMEX:SKF) Friday at US$110.36. We have had an eye on shorting U.S financials for some time now, but we were waiting for the right opportunity. However the STO is heading higher and the MACD has given a bullish signal for SKF after the ETF corrected from making a high of around US$130.

We are comfortable with buying an initial position at these levels and we may increase this position if the opportunity presents itself. For those not familiar with these financial instruments, an ETF trades exactly the same as any other stock. Each share represents a holding in the fund, and the share price varies depending on the value of the fund’s holdings. In this case the fund’s holdings are designed to offer an inverse relationship to the Dow Jones U.S Financials Index with leverage of 200%. So if the Dow Jones U.S Financials Index falls 10%, SKF should rise 20%, in theory. In practice the ETF will never follow its underlying index exactly, nor trade at the NAV of its holdings 100% of the time, but it is usually close. It should be noted that at any one time this fund holds a variety of options and futures contracts and also has the right to hold derivatives in order to meet its brief of providing an inverse relationship with the Dow Jones U.S Financials Index with leverage of 200%.

The top holdings of the Dow Jones US Financials Index include names such as Bank of America Corp. (BAC) (7.08%), JPMorgan Chase & Co. (JPM) (5.63%) and Citigroup Inc (C) (5.58%). We feel that with the continuing credit crisis and severe recession that will set in this year, these companies and this index will suffer greatly, which will push SKF much higher. In fact in our opinion this “credit crisis” is not about credit at all, it is about solvency, and many financials are simply going bankrupt and so we have begun to build a short position to profit from this.

Ultra Short Financial ProShares has a market capitalization of $1.59 billion with 14.35 million shares outstanding, the stock closed on Friday at $111.02, with the average volume being 5.23 million.

Comments

[ponchovilla]

On the assumption that the substantial profits from most of the "sophisticated financial instruments" have vanished, or over the next five years are significantly reduced, where do the profits come from for that nasty little ratio of P/E ? This may be a long slooooooooooooow grind (5 yrs +) for the financials in general and possible short quick grind (1 yr) for a few.

[globalmacro]

I hate to be the one to break it to you but I think you're a little late on this trade. Most active followers of the investment marketplace and the economy have known about the problems that banks and other real estate lenders would have related to bad loans for over a year. Many of the weaker non-diversified lenders like New Century, Accredited Home Lenders, and Countrywide have already gone bankrupt or been acquired at fire sale prices. So, the companies you are shorting now are much more diversified financial entities that have already been clocked to the tune of 30-80%. You're shorting them right in to an environment where the Fed and the government have already made it very clear that they are going to do anything and everything necessary to put a floor under prices.

There are certainly major problems with many of this institutions. But there is often very little correlation in the short to intermediate term between economic performance and share prices. EVERYONE is already bearish and has been short financials for months, who else is left to push the prices lower in order for you to profit? Are the trillions of dollars sitting in money markets (not to mention the money in dreadfully overpriced Treasuries) going to continue to earn an inflation-adjusted negative return forever? I think not. The bull/bear ratio is showing that we are at or near a short to intermediate term bottom and new money coming in to the market will inevitably find its way in to banks like Citi and B of A. The better risk-return setup is to go long the leveraged financial ETF, UYG. UYG probably has no more than 5-10% downside in the short-term with 20-100% upside in the next 12-18 months. You may ultimately be right with this trade but I think you will be stopped out long before that happens (if it happens).

[User 124595]

globalmacro,

Definitely agree that a lot of carnage has floated to the surface. However, the banking sector still has a long way down. JPMorgan, for example, has $7.8 TRILLION in CDS exposure which needs to be marked to market. The monoliner issue is not one that won't be resolved with massive writeoffs affecting most major institutions. The property markets are not close to bottoming. The consumer spending slowdown is just starting and job layoffs will take time. This is not going to be resolved any time soon, and over the medium term shorting financials will be a very good trade. There are still quite lot of bulls - only when everyone is bearish will a potential bottom be reached.

[CrossProfit]

User 124595,

"$7.8 TRILLION in CDS exposure"

Your source is ___?

CrossProfit

[liquid_eagle]

Found the reference to the 7.8 Trillion in the NYTimes, story dated today:

www.nytimes.com/2008/02/17/business/17sw...

[Barry Robbins]

I have owned SKF since September 2007. I feel the trade is getting a little bit old, but there is no way I can close it out before there is full recognition of the problems with the monolines (MBIA & Ambak).

[globalmacro]

The property markets in Southern California, Florida, and parts of the East Coast may not be close to bottoming. But parts of Oregon, Washington, the Midwest and Sunbelt are continuing to do fairly well. Many of the markets in the middle of the country never went up very much in the first place and are now experiencing a tremendous agriculture boom. There was a recent article in the Economist that talked about the geography of recession. I think people forget that not all of Bank of America's customers live in San Diego and Miami.

The housing market in aggregate across the country definitely has a bit more to go and therefore I'm not advocating buying the homebuilders yet (although many homebuilder stock insiders seem to be doing so). But some banks represented in the index that the author is recommending shorting do not have that significant of an exposure to the toxic stuff. Many others have already written off quite a bit of it. The stock markets won't wait until the banks give the all clear signal. It may not be next week but they'll be moving up before the author has enough of a return on the short side to justify the risk in this trade.

[globalmacro]

One comment on user 124595's post : from a historic standpoint, the fact that 36% of money managers are currently bullish is not "quite a lot of bulls". Within the last few weeks the number has gone as low as 20% at about the time the market briefly dropped several hundred points only to snap back and finish the day in positive territory. Immediately following the beginning of the Nasdaq selloff in March 2000, after the Naz had already fallen 1200 points to 3,800 (from over 5,000), 60% of money managers were still bullish. It was fairly obvious, if you tracked valuations and sentiment at that time that the market had more room to fall. And of course the Naz finally bottomed several thousand points lower. Although I haven't yet seen it modeled by a timing oriented manager or analyst, I think if all you did was buy the indices every time only 40% of money managers were bullish and sold them back every time 60% were bullish, I think you'd make quite a bit of money. Everyone is expecting some sort of cataclysmic final sell off to signal a bottom and sometimes the bottoms are a lot quieter and less obvious than that.

[helplessobserver]

Wow, that NYT article is a killer. Imagine, the only viable CDS contracts are with those who hold the bonds and can deliver, the rest who think they have a big CDS profits with no bonds to deliver, are out in left field and don't even know it. It's all insane, worthless bonds selling at high prices.

[globalmacro]

Here is a quote from the article user posted: "the top 25 banks held credit default swaps, both as insurers and insured, worth $14 trillion, the currency office said, up $2 trillion from the previous quarter".

The point that needs to made is that 7.8T in exposure is not the same as 7.8T in losses. Banks have been using CDS instruments to play both sides of the market as the insurer and as the insured. So, simply stating that someone has CDS exposure and that's bad is akin to stating that I must be in trouble because I have 1M in equity exposure and the market is going down. If you took the time to look at my equity exposure more closely, you might notice that it is divided almost evenly between longs and shorts (call it a long-short strategy). So, the fact that I have 1M in equity exposure, in and of itself, says nothing about how I should perform in the market.

So, all red herrings aside, if someone wants to do an analysis on net exposure of JP Morgan's aggregate CDS portfolio, I think it would be very illuminating. What you might find is that alot of the exposure is simply hedging against potential negative outcomes in its regular business activities. In effect, much of JP Morgan's CDS holdings could be bearish in orientation. The scariest thing in all this uncertainty is that I don't think anyone really knows the answers to some of these questions. But stating that JP Morgan has CDS exposure, no matter how large the number sounds, is not going to be enough to convince me that this exposure is somehow harmful or that it will drive its stock price lower.

[Blair]

The posting below disappeared from my screen -- I don't know whether or not it was sent out. So, if there is a duplicate posting, I apologize.

I think the crunch time will be this spring, say May - June, when the economy runs out of financing that was put in place 12 or so months ago. Then, there will be a black hole regarding jobs, etc.

Looking at point and figure charts of the principal indices (Dow, S&P 500 & NASDAQ), they all count down to the 2002 bear market low using the May - Dec 2007 top. These lows match the 75 year uptrend from the 1932 low. So, one can make an argument that those numbers should represent a major support point. Of course, don't even talk about the consequences of that level not holding. (There is Blair's (?) axiom that the longer a trend is in effect, the more significant is its breaking.)

The other issue relates to the credit of the US. There was a comment in the Wall Street Journal that with all of the Fed commitments, that Fed bonds would lose their AAA rating if nothing is done about the spending/taxing situation. See the previous paragraph.

On the point of the Fed credit, I think that the credit rating institutions will be intolerant of giving the Fed a bye because of all the criticism of their missing the boat on the sub-prime situation. In other words, they won't give the Fed any benefit of doubt as to cleaning up their act.

It always gets down to when is too low is too low to go into cash. Perhaps this is one of those times that one should just go into a deep hole for a while.

[Rhodomontade]

globalmacro, your case sounds persuasive but your analogy between equities in the stock market and credit default swaps is problematic because they are radically different things.

I see your point that if Morgan's swaps are properly balanced, they are hedged and the risk is minimized. But it's not that they bet the wrong way that's the danger.

The danger is a cascade of defaults, beginning say with the monoline insurers, or some other weak sister, spiraling out of control in a total derivative meltdown. Swaps from default parties are basically worthless, and does JP Morgan even know who all their counterparties are anymore? My understanding is these things can be sold at any time without notifying the other party to a third party. And so on.

Look at how much AIG had to write down out of their mere 78 billion in CDS. What if JP Morgan has to write down a similar proportion of their exponentially larger portfolio?

I'm no expert in these esoteric instruments, but even the possibility of such a catastrophe has me avoiding all financial equities at all costs.

[hysteria]

I definitely concur with this article.

globalmacro - the pain felt thus far in financials has come as a result of an average 10% drop in nationwide home prices. Granted, not all markets have fallen or need to fall. However, the overall market value of real estate in California, Nevada, Florida, the entire US Northeast, etc, is massive. These markets have more like 50-60% to fall to reach historic price/rent ratios.

Think about it, if all this pain has come from only a 10% drop in nationwide average real estate, imagine when we get to the 30-40% average drop needed to bring us back to historic norms. If you dont believe this is true, just google the Case Shiller National Home Price index. Although a particular house in Kansas may not need to drop this much, the AVERAGE, which includes this house, does.

I just dont see the pain ending until we reach these levels, so Ill also be holding my SKF position for the next 6-24 months, and slowly shifting profits into gold as Helicopter Ben steadily tries to inflate our way out of this mess.

[globalmacro]

If we have a "cascade of defaults" that "spirals out of control", then the whole system would melt down and many trillions of dollars in all types of assets would go up in smoke. I think that is exactly what government agencies are working so proactively to try and prevent. If you are arguing that this scenario is a definite eventuality, I think you would be in a small minority at the far fringes of the investment community -- kind of like the gold bugs who are always clamoring for people to run to the hills and take cash, canned goods, and a flashlight. I, for one, don't see this scenario playing out with quite the apocalyptic sort of outcome that you are forseeing.

I am very happy to see that everyone disagrees with my perspective. I've obviously found a very sound position that has a higher likelihood of success. I think you are all underestimating how many of you are thinking the exact same thing. The potential success of shorting the financials is becoming overly crowded and its chances of success diminishes by the day.

[globalmacro]

I just want to be clear that I'm not currently long the financials. I'm considering taking a position here but in the very short-term I'm much more comfortable staying long or getting longer ag commodities, technology, and EM (particularly India, Brazil, and the Middle East). Our biggest macro call in the last 6 months has been to go long ag commodities, which we did in DBA in mid October to the tune of 20% of our overall allocation. We've experienced about 32% upside. We also have owned DBC for 18 months. So, I agree that inflation is a likely outcome of all this. I just think that betting on more declines in financials is a -EV trade at these levels.

[globalmacro]

I hope you already took your gains when you had them. This trade is looking more and more like toast with every passing day. Nice lower high on the chart now.

[student]

Global macro. Yes most of the CDS derivatives are fairly balanced based on the Occ website. It seems JPMorgan and others have bought more CDS derivatives than they sold. I guess the problem will be if there are credit events will the seller be able to pay any money? HSBC, wachovia and fifth third bank sold more than they bought.

What is your take on tier 3 assets?

[globalmacro]

I try not to spend too much time thinking about things that are impossible to understand. I'm not smart enough to trade around a black swan. But ag commodities still look like the best bet regardless of what happens with CDOs. I've also been buying infrastructure, solar, and anything I can find related to the Chinese consumer.

[globalmacro]

It's funny that even the Mad Money guys are bad mouthing this trade now. Uh oh. Mad money is usually a step ahead of the masses (and a step ahead of Cramer). Look out below.

[globalmacro]

Are the lemmings bailing yet?