What Can Go Right for the Financials? Quite a Bit, Actually

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:

1. 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.
   
2. 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.
   
3. 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.
   
4. 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.

1. Data in the monthly mortgage services reports continues to get better.Last Friday, mortgage servicers released data regarding performance of securitized assets, through June 30^th.  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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.)

10. 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.

11. 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.

Tom Brown is head of BankStocks.com.

Comments

[1worldcurrency:]

You're really entering into the absurd here. Big earnings gains for investment banks like Merril Lynch???
They just announced a loss of 4.4 billion on "super senior" junk which they "sold" at 20 cents on the dollar. Except they didn't really sell it, as they got only 25% up front and loaned the rest. If the loan isn't paid, their only recourse is to get the junk back. Oh but last week when they filed Q2 earnings thye junk was worth 4.4 billion more.

This is reducing exposure?

Dumping troubled assets in a bad bank and keeping a good bank?
Does that not stink of fraudulent conveyance?

Quit this shill game, stoner.

2008 Jul 30 03:12 AM

[Steven Hansen:]

tom, thanks for the detail this time. you have fleshed out your reasons for declaring 15 JULY the bottom. the problem all along has been the uncertainty. the financials which have come clean about what is going on appear to be rewarded even if the news is bad. although you may be correct about 15 July, there is still too much uncertainty, and uncontrollable and unforeseeable events will really be the umpire who calls the bottom.

2008 Jul 30 03:36 AM

[debtacid:]

Tom, you just don’t get it. Your "financials" have destroyed the housing market. I have delayed buying a home for 4 years because I knew the bubble was bound to burst and prices would drop. Why should I pay 3 to 10 times more for a home just so scum bankers can collect outrageous compound interest for 30 years? You boys had all the power and all the money and now all my neighbors are broke, lining up to sell me their “million dollar” houses. And you and your Wall Street cronies are excluded from the deal.

2008 Jul 30 03:43 AM

[pochovilla:]

Bill Miller + Tom Brown + Larry Kudlow = ?
Most of us know the answer !

2008 Jul 30 04:55 AM

[fxtrader07:]

Tom, appreciate all your articles here, but i have to disaggree with you here.
The point is that the recession is just beginning. the 100bn checks that were sent out just postponed the inevitable. JPM's Dimmon stated that a recession will be much more painful for the banks than the mortgage/subprime related stuff so far.
And those pains would come on top of a depleted capital base, beaten down stocks (diminishing the capability of more equity offerings) and an already strecthced consumer. Talk about consumer loans and commercial loans to get into trouble. now, how will you value and estimate that going forward?
Bottom line: if the u.s. were otherwise sound and at the brink of another economic expansion, i would agree with you. But they aren't. bank lending got hevaily restrictive and way down precisely when it was needed to keep the economy growing. the u.s. consumer is maxxed out. who shall fill the gap? imho you are pretty much underestimating the macroeconomic picture., much as you did in 2007 and you are therefore way too early calling The bottom for banks, even though they might rally for a couple of months.

2008 Jul 30 05:08 AM

[buyitcheap:]

Jul 15 would be a low on heavier volume, so that might have been the pivotal day. Tom is more of a technician than I thought previously.

If this news going forward for financials basically doesn't stink, this sector's going back up... Merrill taking it's big bath (I hope) and cleaning up its balance sheet may be a key event that keeps this sector going north.

2008 Jul 30 07:11 AM

[fatcat:]

I think Tom is trying to write his way to a spot on Kudlows show!

2008 Jul 30 07:43 AM

[Archman Inv...:]

Are we changing the name of this web site from Seeking Alpha.com
to Tom Brown Pumping the Financials everyday.com ???

The man has written more articles pumping the financials over the past 3 weeks than he has written over the past year.

His hedge fund must be down huge thus far for the year.

2008 Jul 30 07:46 AM

[CLH:]

Good post Tom. I agree with most of it. No body left to sell means these stocks can only go up but it may take a while.

2008 Jul 30 11:46 AM

[Tim Plaehn:]

Tom, your well reasoned articles have no effect on the ostriches, but the market seems to agree we have seen the bottom. So far this year only 7 banks have gone under and most are still profitable. Here at SA, just go back to the last article touting the financial double inverse ETF, SKF on July 16 by Jimmy Lathrop. Note the date.

Over the next few months if house prices bottom (I think they will) it will all turn upward very rapidly. Bubble leading real estate markets like Las Vegas, Phoenix and Sacramento are showing rapidly increasing home sales. Those on the sidelines waiting for the price bottom will jump in at the first indication of price stability.

Final note to commenters, please learn the difference between brokerages and banks. I know many blur the line, but companies like Merrill live by entirely different rules than Bank of America.

2008 Jul 30 12:03 PM

[User 68127:]

"Bank executive talk about stability..." is an indication of a bottom?

Tom, are you really this gullible? What did John Thain recently say about no more need for capital? Lehman didn't need any more capital either. Has ANY happy talk or reassurance from financial executives proven accurate over the past year?

And please, dispense with the "victory dance" about the bottom being made on July 15. Two weeks of being correct after months of being wrong constitute bragging rights? Very amateurish. Let's see how your prediction looks in a couple months...

2008 Jul 30 02:46 PM

[1worldcurrency:]

bear stearns didn't need capital. Fannie and Freddie don't need capital. "Rapidly increasing home sales in Las Vegas"? Do you mean foreclosure sales? Be specific as data can now be verified by the masses via this new internet thing.

2008 Jul 31 02:17 AM

[DSB:]

Great post Tom; I really like you, and I think that your opinions are revolutionary. You have really opened my eyes to the way of things. Keep on posting solid gold baby.

2008 Jul 31 02:40 PM

[Bonanza36:]

"Are we changing the name of this web site from Seeking Alpha.com
to Tom Brown Pumping the Financials everyday.com ???"

Now thats funny!! My sentiment exactly

2008 Aug 03 01:08 PM

[jjason:]

I must respond.... In 1989 I lived in CT. Real estate values were quite nice. A $95,000 house, bought in 1974, was worth $330,000 ( so I was told by a real estate broker ). Sorry, that broker was me. He He.

Then in 1990 all hell broke lose. Banks in New England started failing. One Monday morning, Danbury Savings and Loan did not open. The FDIC shut DS&L down. I had no money in the bank but DS&L held my mortgage.

Then, I was busy doing real estate appraisals...very busy...for about three years. I figure the housing market bottomed around 1994.

A neighbor had a house that he purchase around 1987 and in 1991 he lost his job. He had made improvements that cost big bucks and he listed the house for sale at around $350.000 around 1992.

For about a year he paid his mortgage and reduced the selling price twice. I think it was 1993 when he reduced the price a third time, still had no buyers, and could no longer pay his mortgage. The lender foreclosed. My neighbor had move to VT. He lost his house. I guess the lender auctioned the house off in 1994 and the winner told me he paid $200,000.

In 1991 I asked a friend ( also a real estate broker, developer and industrial/ commercial property owner ) "how long did he think it would take to see 1989 prices again" His answer " TEN YEARS ".

He was right.

So, are things better or worse than 1989-90? I think things are worse. And we are only,what, one or two years into the downturn?

Sorry, Tom, but I am not optimistic about a bottom in housing in 2008 or 2009....Maybe the bottom will be in the spring of 2010.

2008 Aug 04 09:39 AM