I know this will sound like a silly question, but what do you suppose might go right in the financial services industry over the next twelve months? The consensus answer seems to be “nothing.” Most observers apparently expect the industry environment—and the stocks’ prices—will be driven by four iron, bearish facts:
- Credit quality will continue to deteriorate. Nonperforming loans, net chargeoffs, and loan loss provisions can only go up, which means earnings expectations can only go down.
- Home prices will continue to fall. Which is why loan losses will keep rising. It doesn’t matter which region, or market, or neighborhood, prices are on a one-way escalator down, down, down. “By at least another 15%,” some wag somewhere will be happy to predict.
- Book values can’t be relied upon because unforecastable losses will continue to erode book value. Endless losses of course mean endlessly collapsing book values. So don’t even try to estimate how low the numbers will be by the time all this is over.
- More financial companies will have to cut dividends and raise dilutive capital. No matter how much capital the industry has raised already, it needs to raise more. Total size of hole to be filled: $850 kubujillion.
The Bubble Case
How bad can things get, then? There is no limit, say the bears. What I find amazing about their stance is their absolute insistence that future losses cannot be reasonably estimated. Until fundamentals show an actual, material improvement, they seem to think, near-term valuations can only fall.
Phooey. As I’ve said before, future losses at most companies can be reasonably (even conservatively) estimated. And if you go through the process yourself, you’ll see that in the vast majority of cases, losses are overly discounted in the stocks’ prices. Soon enough—given how far the stocks have come down—investors will shortly realize that. Which is one reason I suspect July 15 represents the low for the stocks.
So, anyway, what might go right? Actually, quite a lot—whether it’s been discounted into the stocks’ prices or not. Let’s take a look at some of the possible news I think is likely to be reported in coming months that could provide the beginnings of the fundamental basis for a new bull market in the financial stocks.
- Data in the monthly mortgage services reports continues to get better.Last Friday, mortgage servicers released data regarding performance of securitized assets, through June 30th. The reports continue the trend we’ve talked about for months: a slowdown in the inflow of new problem loans, and lower roll rates into late-delinquency buckets. Fewer near-term delinquencies means lower chargeoffs down the road. Our conclusion (again): the pig (bad loans) is steadily working its way through the python.
All this should give investors confidence that the extremely high forecasts for losses from subprime mortgage loans, second mortgage loans, even Alt-A mortgage loans are excessive.
- Earnings reports from non-bank financials should be encouraging. Believe it or not, over 95% of the banking industry (measured by assets) has reported second-quarter earnings. And you know what? They weren’t all that bad. The biggest surprises have been a) the improvement in the inflow of new problem loans (for those that reported it), and b) the extent to which banks have been aggressive in taking writedowns and building reserves.
Next come earnings reports from the non-bank financials. Most notable, in our opinion, will be the releases by the financial guarantors. After dramatically increasing reserves and impairment charges in the last two quarter, the guarantors will likely announce much smaller charges this time around, I expect. That should provide some confidence that credit quality is not spinning out of control.
- Oil prices could continue to decline. Historically, changes in financial stocks haven’t correlated particularly closely to changes in oil prices. Not so recently, however. I’m no energy expert, but it certainly seems possible (even likely) that the slowdown in world economic could bring with it softening energy prices.
- The good bank/bad bank structure makes a comeback.At the end of the last bear market for bank stocks, some institutions elected to take one last, big charge and move their troubled assets into a separate bank altogether. That allowed investors to better value the on-going earnings stream of the healthy part of the companies. There are many variations of good bank/bad bank theme; I wouldn’t be surprised if a few institutions made such announcements in the coming months. Given current valuations, investors will likely view the announcememnts favorably. If nothing else, the emergence of good bank/bad bank transactions will mean the deterioration has entered its final stages.
- Bulk foreclosed property sales continue.Investors want to see banks continue to shed their problem assets. It’s possible that the pace of bulk problem asset sales, which have lately been reported by banks such as Synovus (SNV), Colonial BancGroup (CNB), AMCORE, (AMFI) and others, could pick up. That would be viewed favorably by investors, in my view.
- Continued asset sales ease capital pressures at many institutions. Citigroup, for one, has already reduced its assets by $99 billion, with more sales on the way. With each disposal, the company’s capital ratios improve. Last week, the Wall Street Journal reported that some regional banks are considering selling all or part of their asset management businesses. While such sales reduce each company’s future earnings power, they strengthen their capital ratios near term.
- Long-term mortgage rate ease. Given the turmoil surrounding Fannie Mae and Freddie Mac, long-term rates on conventional mortgage have risen recently. Now that the housing bill has been signed, such rates will likely come down in the coming weeks. That can only help the housing market.
- The rate of home price decline slows; investors remember that there really is no such thing as a national housing market.Just 18 months ago, everyone believed that housing markets were local by their nature. Late last year and early this year, every one of those markets seemed to be in a free fall. More recent monthly sales and pricing data show once again that housing activity is very localized--not just by MSA, but even by neighborhood. I expect the national statistics on home prices to show that the rate of price decline is falling, and I expect the media to pay more attention to the disparity of sales and pricing activity among different markets and neighborhoods.
- Bond insurers and investments banks commute the CDS contracts they have with each other. As I’ve explained before, it makes a ton of sense for the bond insurers and investment banks to tear up some of their CDS contracts on CDOs. Because the guarantors have been downgraded, the investment banks have had to mark down the value of the CDO on their books, and mark down, as well, the value of the CDS they purchased from a guarantor. I expect both sides will agree on a cash settlement that will results in big GAAP earnings gains for both the bond insurers and the investment banks. (Count this prediction as good given the agreement announced Monday night by Merrill Lynch (MER) and SCA.)
- Investment banks that report in September will show stable earnings.Over the last few quarters, the dominant driver of earnings at the investment banks has been realized losses from deleveraging and mark-to-market losses. It’s possible that for the current quarter, the investment banks that report earliest, in September, will show markedly lower such losses. Eventually, the long, painful process of deleveraging will end. We’re getting closer.
- Bank executive talk about stability in September. Several large, high-profile investment conferences take place in September. I expect that at the conferences this year, bank managements may discuss signs of stability in credit quality. They might not say they’re seeing out-and-out improvement, but they will likely indicate that the inflow of new problem loans is slowing.
Look back at that list for a moment. Is there anything on it you think is unlikely to occur? From what I can see, all those items are either distinctly possible to downright probable. And yet the market doesn’t seem to think that any of it will happen any time soon. I don’t buy it.
I believe the financial stock bear market is over. Even so, no one expects (least of all me) the stocks to go straight up, given the weak economic environment. But as I look forward, I see the upcoming news as being incrementally positive. That should turn the “bounce in a bear market” into the beginning of a new bull market.