The Credit Crisis and Potential Shorts

Financial companies have seen severe declines over the past year and they still have the potential to go down a lot further. The reason financial companies are on such shaky ground is because the risk of rising foreclosures and loan defaults has resulted in a really severe credit crisis. For those of you who don't understand the current credit fiasco, I will try to explain it and show why financial companies still present good shorting opportunities.

Before I start I want to point out that the stock market surged on the Fed cut just like I predicted and also sold off quickly just like I predicted. If you bought financials Wednesday I hope you sold on the news and got out quickly. If you did play the short term volatility, I would recommend that you take new short positions in financials again. Now I'll go back to the credit fiasco.

The last time the Fed tried to fight off a recession, Alan Greenspan, who deserves some blame for the current credit mess, lowered interest rates to ridiculously low levels. Consequently, there was plenty of easy money to go around. Since interest rates were at extremely low levels, banks were happy to provide consumers with just about any type of loan they wanted without much regard to the credit worthiness of the consumer.

Consumers could buy cars with no money down and with no interest. Consumers could get interest free credit cards for a length of time and when the interest did kick in they could transfer their balance to another interest free account. Consumers could take out second and third mortgages on their house. Consumers could also get home loans with very little equity and at very low interest rates. This is one of the major reasons for the housing bubble.

Banks were willing to loan out so much easy money because they passed the risk on to other investors (other banks, institutions, hedge funds, etc.). Banks would pool all the loans together and sell them off as investment vehicles. When home prices were going up and the economy was growing, these investments seemed safe. They were also attractive because they paid a decent amount of interest. Now, however, these investments are turning toxic due to rising delinquencies and defaults.

The housing bubble exploded a while ago and home prices are crashing. A growing number of people who speculated during the housing bubble now have homes that are worth less than what they owe on them. Consequently, they are stopping payments on their mortgages and letting their homes go into foreclosure. To make matters worse the housing market is still far away from a bottom.

Furthermore, the economy is headed for a recession and commodity prices are at all time highs. This coupled with the fact that consumers are overleveraged due to all the money they borrowed means that delinquencies on loan payments and foreclosures are on the rise and going to increase. This is spelling doom for those companies that are overexposed to mortgages and loans and now have to raise money to shore up their capital base (ala Bears Sterns (BSC). Banks are no longer willing to buy these risky investment vehicles and they are not willing to loan money based on the value of these investments. Therefore, liquidity is drying up in the credit markets.

This is one reason why the Fed is drastically lowering interest rates (so banks will lend to each other). However, even though the Fed is making it cheaper to loan money it doesn't mean banks are going to be any more inclined to loan money to each other. I don't blame them. I wouldn't want to buy declining investments of questionable value or lend money to other banks using these grouped loans as collateral.

Since banks are not loaning to each other, the Fed is using another tactic to help the credit crunch. It is loaning money directly to banks and investment banks, effectively bailing them out with taxpayer money. However, I don't think this will inspire banks to free up their money either. Consequently, I think it's possible more banks or investment banks are going to go under. I think financials in general (XLF) are also going to suffer as defaults continue to rise. If you want to try to score a huge return, you may think about shorting Lehman (LEH) or UBS (UBS). I have read rumors they were on the brink of going under. You may also consider National City (NCC) or Washington Mutual (WM).

Disclaimer: I have no position in any of the stocks mentioned.

Comments

[ezrasfund:]

What is really causing the liquidity crisis? Could it be financial institutions always trying to get the biggest share of every asset class appreciation from the internet boom to the housing boom to the commodity boom. All of these "booms" had underlying good value. But financial institutions and speculators are driven to turn these booms into bubbles in order to try and grab the biggest slice of the pie.

How many times the real value of oil ( or gold or mortgages) that is being traded is represented by the value of the derivitives and futures contracts being traded? The liquidity bubble will be the last one to crash, and it too is a bubble.

ezrasfund

2008 Mar 20 12:07 PM

[fjd10595:]

It all sounded good, except when you ended with 'I heard rumors that lehman and UBS may go under". This is extreme, and it makes the reader wonder whether your other views are too extreme.

2008 Mar 20 02:42 PM

[Chemist29:]

shorting financials was the play almost a year ago...now is the time to pickover and go long, just like buying commodities and shorting the dollar was the play 5 years ago, chasing performance is why people dont beat the market.

2008 Mar 20 03:50 PM

[vboring:]

could still be a good time to short international financials. the best domestic financials to short would be those that will be hurt by declining commercial real estate loan performance.

far too few people are talking about the real estate bubbles that happened in most of the rest of the world.

2008 Mar 20 04:35 PM

[Fabien Hug:]

Beware the tricks. When housing was doubling in value, there was no inflation.
The pundits replaced the asset price with a rental equivalent and did not intervene. No that the price of these assets is dropping, we hear about deflation and not about rental equivalent anymore. This emergency allows the FED to change the rules, lending to brokers, Freddie and Fannie are the best cos. in the world, etc. As a matter of fact, no official will ever have the courage to say stop as long as he/she can pull up a trick from the hat. That's what is happening now and it seems that people are willing to buy it. I read that the FED has another $ 500 b of treasury to give away. It can surely increase the lending window from 28 d to whatever (week ens included). It still has a lot of tricks in its hat and I would be very careful to go against that.
Furthermore, like it or not, your money goes to Wall Street or comes from Wall Street, be it a check, a contribution to your 401k. You can't avoid them and the real economy is still running and feeding the machine.
Finally, beware of rumors. Lehman is still around, I am still waiting for Warren to buy WM and BS should be worth how much?

2008 Mar 20 05:30 PM

[triznix:]

Yes, unfortunately he ends the "analysis" with a recommendation based on rumors.

2008 Mar 20 05:58 PM

[User 166378:]

there is no thought in this article that we haven't read over and over in the last half year. i totally agree with chemist29.

2008 Mar 20 06:14 PM

[flatman:]

The analysis of the problems seemed Ok to me, but I still can't see how banks will make the kinds of earnings they have in the past. They are less well capitalized and many of the techniques they used to earn income will longer exist ( i.e. sub prime and collateralized debt). So unless they revert again to overly speculative investments - they just look moribund at best.

2008 Mar 20 08:01 PM

[Sunshine:]

This article reads like Finance 101

2008 Mar 20 09:50 PM

[vaduz:]

rumors are not a good basis for such dangerous plays as shortening.

2008 Mar 21 05:15 PM

[IDG:]

Risk vs reward does not favor shorting financials. I believe The cost of credit crissis is being guestimated by now with sizeable acuracy. So market will soon be more tolerent to such write offs. I am willing to rather buy at better price than risking byshorting.

2008 Mar 22 03:39 AM

[Purl Gurl:]

Ah ha! You boys are talking all around the true opportunity to make long term profits off this financial sector crisis. This true opportunity is to roll much of your money over into real estate.

Stock traders frequently chase around different market sectors based on anticipated better performance within a given sector. Stock traders often do not think of sectors outside our traditional stock market sectors.

Real estate investment will prove a very viable investment in the long term, with long term being a number of years away. The real estate market will recover, always does, but will recover very slowly as is expected and as is historical. There is a way to profit and multiply your profits in the real estate market. This method is to purchase rental homes for income.

Only trick to rental home investment is location, location, location. A typical three bedroom, two bath home is a more attractive neighborhood is an excellent investment; we have never lost money on income real property. Our equity value moves up and down in the short term, but long term growth is typically better than most long term stock investments.

Home prices have not quite hit bottom but are coming very close. Some micro-regions are now beginning to display increases in home prices, others have stabilized, most regions are still yet to fall another two to four percent. Timing of purchase of real property is not too important but is to be considered. This is a hot buyer’s market for real estate; prices will not be this low ever again during your lifetime.

Opportunity here is double. There will be equity growth plus enjoyment of monthly rental income. Equity growth will be somewhat slow to resume but monthly rental income is quite reliable; a virtual guarantee if you properly manage your rental homes.

Here in Southern California, an average home in a decent location will fetch a rent in the range of $1200 to $2000 per month. This is a decent fixed income. Demand for rental homes has skyrocketed right along with foreclosures skyrocketing. We enjoy a waiting list for our rental homes, a very long waiting list.

Of course there is upkeep, taxes and such. This carves out about one-fourth of yearly income.
Rental homes do require work, especially if you buy a “fixer upper” type home but there is no better money earned than sweat equity. Sometimes a headache dealing with tenants but income is very consistent, very reliable, very low risk.

Concept is, on the average, you enjoy ten percent growth in equity per year plus your annual income from rent collected. This is a very decent growth in your money. Equity moves up and down with market value but, historically, always moves upward. Rental income never moves downward and enjoys room for modest increases in rental fees, especially between tenants.

Our approach to buying real estate is to always pay cash. We have no mortgages making for an excellent equity position. However, most are not willing to work at real estate investment for decades to earn a position of being able to pay cash for homes. There is an alternative. This is to make a down payment of fifty percent then finance the rest. Typically, your rental income will pay your mortgage payment, with fifty percent down on the purchase price. If a lesser down payment, your rental income will not quite meet your mortgage payment which is a bit of negative cash flow but your equity growth compensates for this. Other words, your tenants pay a majority of your mortgage payment, you pay a little and realize gains in equity growth. More succinct, your tenants are paying for your purchased house.

This is an excellent time to roll your money over into real estate. Again, location of a home is extremely critical. A decent neighborhood is a must typically gauged by a location within a good school district and a safe neighborhood, which parents want.

A caution is some regions in our country will experience continued falling in real estate prices to a rather severe degree. Typically, rural, industrial and urban centers are not good locations. This is to be carefully considered and carefully researched.
Regions like Southern California, lower Florida, Las Vegas, Reno, Portland, Seattle, New York, Boston and other popular cities, out in the suburbs which are attractive to family living, these are types of micro-regions which will recover first and display the greatest growth over the years. In some cases, equity growth can be up to 15 percent to 20 percent per year, in a high demand location, often suburban areas surrounding major job market centers.

Real estate market crashes like today’s do not come around very often. Usually crashes like this are twenty to thirty years between. Chances are very high this is the best buyer’s real estate market you will witness during your lifetime.

Should you be looking to safely profit on this credit crisis, consider buying income real property.


Okpulot Taha
Choctaw Nation

2008 Mar 22 01:33 PM

[Saint Xinon:]

Please go through UBS/FNM/FRE accounts.
To be a bank or finance company you need a positive balance sheet.
They are great companies but for that positive balance sheet part.
but for sad knowledge of accounting I would have bought all the way all the stocks of them...
Even Enron was looking better in it's last days than these guys....
Anyway how many of you guys lost money in Enron or gained money by shorting it ?

2008 Mar 24 12:04 AM