Financials: The Dangers of Zero Weight

A few months ago I was critical of the many CNBC guests who seemed to be ignoring what clearly looked like the start of a bear market. There was a lot of "looking across the valley" sort of talk which I think did a disservice to people.

It wasn't so much the 'looking across the valley' so much as leading off with that like it was the most important thing. I would have liked to have heard a little more realistic thought, but that is probably just me being naive.

So, as far as looking across the valley goes, there is this recap of the Lone Star purchase of a chunk of Merrill's (MER) mortgage backed portfolio for $0.22 on the dollar. Lone Star didn't buy them because they think the paper is expensive and ripe for an implosion. It could happen of course but the deal, based on price and all the concessions Merrill is giving them is attractive relative to some period of time, in their opinion.

This bring us to the financial stocks. For anyone in the 1+1=11 brigade, I am underweight, as I have been for years, and am not buying more exposure (it may grow larger here if the sector rallies). Throughout the entire crisis, or whatever we should call it, I have made clear that I think underweight as opposed to zero weight accomplishes the goal of missing a chunk of down a lot, without the risk of missing some massive counter-intuitive rally, should one ever come along.

But for anyone who is zero weight and afraid of missing some sort of massive counter-intuitive rally, most of the names (the vast majority really) will survive this and live to make bad loans in the future.

At this point the sector is down a lot, there will be survivors, and when the bottom does come (this is not a prediction of when) there could be a furious rally. Anyone wanting to go from zero to underweight might want to add some exposure, again anyone with zero exposure going up to underweight.

There are plenty of banks with no headlines related to the crisis (although they are probably down a lot) that would be good places to start looking. There many foreign banks that are much simpler businesses than the companies we read about every day that could be a good place to look, too.

A third possibility would be some of the single country or regional funds that have a disproportionate amount allocated to financials. Anyone going this route would want to look under the hood and if two or three banks weigh prominently, learn a little about those banks to try to minimize getting blindsided.

The big macro here is probably that after the crisis, the world (the sector) will go on. My expectation is for more downside in the sector from here, but not a lot more (sector, not certain specific names), and the risk associated with zero weight is much greater now than it was six months ago.

Comments

[G23ROCKS:]

Why add now after many of these names have made 50%+ moves over the past two weeks and are coming up against overhead resistance against the moving averages?

2008 Jul 31 06:49 PM

[mals:]

Mr. Nusbaum, I read and enjoy most of your articles. However, you could have suggested an ETF or two that investors like me could buy into. Having said that your article is right on the money.

2008 Jul 31 07:19 PM

[Ishortyou:]

To all Banks and Broker Firms: just FIRE SALE all your structure finance vehicles i.e.: CDO-ABS-MBS-SIVs if you want to live period!

2008 Jul 31 08:15 PM

[surgcare:]

Its my guess ,that with the inability to execute those exotic loans of the past , the banks or financials are already over-valued based on future earnings , if there is any .

2008 Jul 31 09:41 PM

[evilll:]

To Ishortyou:
You are making an idiot of yourself by posting your stupid warnings after each and every article.

2008 Jul 31 09:42 PM

[Ultraman:]

Mr. Nusbaum, you seem like the person who know his stuff. I have this nagging question which I hope you could shed some light into. Recently Merrill sold their CDO portfolio for $0.22 on the dollar and there are report of some banks marking down their holdings to near zero. If I'm not mistaken, CDO stand for collaterized debt obligation meaning the debts are backed by some properties. Now, if the debt is defaulted on, isn't the holder of the CDO entitled to the property collaterized. Are we saying the value of all this properties are now at 22%-0% of their original valuation? I don't remember reading anywhere that the values of property have plummeted to such extend.

2008 Aug 01 03:59 AM

[Roger Nusbaum:]

Ultraman, the easiest take away is that these are panicked times so a departure between perception of value and the real value seems very plausible. Look at foreclosure stats. They have skyrocketed but the percent is still tiny. What I think the 0.22 acknowledges is the need to deleverage right here right now for the firm in question to restore (or try to anyway) capital ratios. I don't know when but at some point $0.22 will turn out to be a great price.

Bluedog, in 1990 Citi bottomed out around $5. From 1990's bottom to mid 2000 the stock went up 3000%. The first 30-50% off of the $5 bottom meant nothing. While I would not bet on 3000% again if a bank stock goes up ten fold in the next ten years will buying at $30 versus $20 matter?

2008 Aug 01 12:24 PM

[User 68127:]

Ultraman,

If there are home equity loans or piggyback loans in the portfolio, they are probably worth zero. Simply put, if the borrower is underwater on their home, the first lien takes a loss but gets whatever they can for the property and the second lien gets nothing.

Also, what if the appraisal was unrealistically or fraudulently high? In that case, even a first lien could get next to nothing. Are you beginning to get the idea?

Roger: a ten-fold move in C would imply $180/sh some time in the next ten years. Of course, with a lower earnings base now, there is no guarantee that C will even reach its prior peak in EPS within ten years...much less have the kind of PE expansion that would be necessary to reach this level...

2008 Aug 01 02:28 PM