Dick Bove Says Banking Is Sound - Time to Buy Financials?

Punk Ziegel's bank analyst Dick Bove has issued another strikingly rational report that provides tasty food for thought. This one is entitled "Wait! Stop! Think!". In it he argues that the media is fomenting hysteria about the situation in the banking industry, which in reality remains quite sound.

Bove's been around long enough to have seen this before as an analyst during the 1990 bank debacle. While the media and government figures continued to predict dire outcomes and questioned the viability of the banking industry, bank stocks actually bottomed in late 1990 and appreciated smartly thereafter.

Is today's crisis worse than 1990? Bove points out several issues that were present then that aren't now:

Developing countries were nearly bankrupt

LBO's were failing

Commodities were deflating

Commercial real estate was in over-supply due to a change in the tax laws

The credit derivatives market was in dire straits mainly due to the junk bond fiasco.

THOUSANDS of banks and thrifts failed.

The only direct parallel today is the credit market implosion. The other conditions don't exist. Only 76 of 8233 banks are on the FDIC watch list. Hence, it would be up to the credit market collapse to take the system down, which Bove says requires an implosion in the single-family mortgage market.

He estimates that if 50% of the sub-prime mortgages behind the credit derivatives market fail, and the collateral value of these loans is reduced to the land only (the houses are worth zero), that the total write down might be about $500B. Although painful, this would represent only 1% of the total debt outstanding in the US economy. It would easily be absorbed by the system.

There are other issues weighing on bank stocks:

A recent accounting change requires banks to value assets based on "comparables" rather than predicted cash flows. A variety of indexes were created to support this pricing requirement, yet the indexes lack liquidity and can be (and Bove believes are being) manipulated. The index which represents Commercial Mortgage Backed Securities is reflecting a default ratio of 6%, while actual defaults are at 0.27%. Yet banks must mark some of their assets to these indexes whether they reflect reality or not, deflating their balance sheets for no good reason.

Bank cash flows and true capital (as opposed to accounting entries which reflect a variety of non-cash adjustments) are actually in good shape. The current liquidity crisis is being caused by institutions unwilling to lend to one another, not by a true lack of funds. As opposed to a crisis where funds simply don't exist, a "fear of risk" based crisis will cure itself as interest rates adjust. Bove believes this is underway and may resolve itself soon.Bove picks apart yesterday's article in the Journal entitled "New Spasm Jolts Credit Markets" which made the following statement:"Rates banks charge each other remain elevated" - false because 3-month LIBOR has dropped (from 5.34% to 3% over the past 12 months) faster than Fed Funds signaling banks' willingness to lend to each other.

"The Price of insurance against bank debt default is soaring" - The point the journal makes here is that such insurance costs 20x what it did last summer. As Bove points out, that means it was one lousy forecaster of default last summer, so why should we believe it is a good indicator now? It is in fact a lagging, not a leading, indicator.

Interest rates on a variety of instruments are being "pushed up" - Then why is it that six months ago, 30 yr mortgages were 6.46% vs. 4.88% now, and AAA bonds were at 5.73% vs 5.48% today?"Banks are constrained for capital" - actually, common equity+reserves as a percentage of assets is just below an all time high. Bove believes the Journal (much like other media outlets, as I have previously commented) wants to sell bank panic just as it did in 1990. He notes that when he is quoted by reporters lately they highlight the negatives and ignore the positives. Bove concludes: "There is a financial panic underway fed by a definable problem; a steady flow of misinformation; bad accounting rules; manipulated indices; a lack of understanding of bank cash flows and capital; a demand for higher risk-adjusted returns; and a lack of financial leadership."

He believes that bank stocks in general should be bought. None other than Warren Buffet agrees, as he bought shares of Wells Fargo (WFC) last quarter (I own WFC in some of my managed accounts). I know that when most everyone is leaning one way and sentiment becomes extreme in one direction, my gut instinctively tells me it's overdone and that the smart thing to do is be a contrarian. At the very least, be wary of taking media reports and market zeitgeist at face value. Conversely, I pay close attention to the few rational intelligent voices willing to go against the herd.

Disclosure: I own shares in Wells Fargo.

Comments

[john haskell]

these are not the only differences between now and 1990:
Then the President was George HW Bush, now George W Bush

In 1990 Paula Abdul was a top rated pop star, now she evaluates pop stars

Michael Milken wore a toupee, now he doesn't.

But the point is not that 2008 and 1990 are different. The point is to establish what losses banks will suffer in a system-wide flight from risk and refusal to lend (which we didn't have in 1990!) Commodities were in deflation in 1990, fine, but houses are in deflation now and houses are a much bigger balance sheet item for this economy than commodities. This essay needs to be rewritten.

[flatman]

1990's references always bring me back to Boston when the Bank of New England failed and 10,000 people were out on the street. Home prices had dropped after the big run up. If you bought in 1987 you were underwater until 1995. The S&L's were in liquidation mode. Anybody but me remember those days? Sometimes I wonder.

[Bob Carl]

The decrease in consumer wealth due to the collapse in home equity is a huge negative for 2008 versus 2007. I do agree that much of the panic in banking is due to inane accounting that - in effect - relies on market sentiment rather than rationality in valuing financial assets.

[irondoor91]

Reading from my 30 year mortgage rate sheet this morning, I find that the interest rate on a conforming loan (under $417,000) for an individual with a credit score above 680 would be 5.875%-6.00%. That assumes the loan officer/broker does it for free. Add the usual costs for legal, title insurance, closing, etc, and you will have an APR of around 6.125%.

Contrary to what this author states, there are no 30 year fixed mortgage at 4.88% unless you are willing to pay cash at closing to buy the rate down. If the borrower wants to take out cash, pay interest only, borrow in excess of 70% of the appraisal or achieve some other individual goal, then the interest rate will be higher.

Mortgage rates are around 1% higher today as compared to mid-January.

[Major Kong]

Mr. Bove announced just a few months ago that there was no way 'C' was going to cut their dividend. We see how well that prediction worked. Now he's a great grandfather figure but he's been dead wrong about the financials. It's about the direction of their balance sheets and their ability to roll their short term debt.

[whidbey]

Interesting thesis, but Bove is early on this one. Maybe XLF is "OK" for testing the water, but only a couple of small toes. If gaters don't snap them off, maybe some regional names. I worry that there is some large scale grief still in the bushes, maybe Fanny or Freddie, or both?

[User 162615]

If in 1990, anyone had told me that a recession is underway while Cu was at $3.90/lb, I would have thought wierd stuff.

I still do.

[Fat Arby]

recession hasn't started. just warming up . smile

[pravchaw]

Bove is not the only one. Pzena is buying financials as well. One thing is for sure, they are closer to the bottom now than 3 months ago.

[pravchaw]

Now we are even closer.

[wcvarones]

Ha! Nice call, Dick.