'Panics Do Not Destroy Capital'

“Panics do not destroy capital; they merely reveal the extent to which it has been destroyed by its betrayal into hopelessly unproductive works.”  (Mr John Mills, from Credit Cycles and the Origin of Commercial Panics)

The first day of trading once the short-sell ban was lifted gave Wall Street a taste of reality. I am convinced that the naked-short is not the cause of the pressure on this market. But, the FEAR of naked-shorting has definitely put the bear rally crowd on notice. Sure there was additional news like a $3.00 up-tick on a decrease in oil inventories, John Deere (DE) missed earnings, and a second rally day for metals, particularly gold. (I was able to turn my hedge of AngloGold Ashanti Limited (AU) 1/25s short into a 44% profit. - since Friday.)

I am a Midwest type of guy, and I have always thought of California as the most concentrated spot for nut jobs per capita in the United States. So it came to no shock when I learned that the Mortgage Crisis there has spiraled OUT OF CONTROL! According to Calculated Risk, California was foreclosing houses as a pace of 1,000 per day back in April. That was only 5 months ago... and let's face it... things couldn't get worse right? Wrong. Today, California topped the 1,300 per day foreclosure mark! A 30% increase in an already UNBELIEVABLE number!

Let's face it, Wall Street took everything in stride for a while. Another report came out Monday from Zillow suggesting that one-third of the houses purchased in the last five years are worth less than the purchase price. I wonder how many of these folks maxed themselves out with a home equity loan so they could buy a jacuzzi, pool table, or had simply taken that well-deserved vacation. It is a bit late for banks to cut home equity lines now, the rabbit is already out of the bag.

A segment of clients was recently notified of a change in the status of their home-equity line. This is due to a change in property value and/or their credit profile. (source)

This leads us back to the last place for credit: you guessed it, credit cards. According to Accounts Receivable Management, credit card debt is growing at a 7.1% rate in the United States. Couple that figure with $3.00 + gasoline, higher food prices, rising unemployment, and a tapped out consumer, once again we have the perfect storm scenario. By the way, most readers do not realize that banks package this debt and even sell it as asset backed securities [ABS]. This is just another sub-prime mess waiting to happen all over again.

Implications

As a result the financial sector is under additional scrutiny. Specifically, Bank of America (BAC) and Capital One Financial (COF) have continued risk. Not only is BAC in the unenviable position of now being the nation's largest mortgage writer (next to quasi-government institution like Fannie Mae (FNM)), they are now dealing with an extremely large exposure to credit card risk.

At the same time, COF who has some down-right scary exposure to bad debt is not sitting any better. Many would argue that COF is in worse shape. Barring the wave of Bernanke's wand, or a rabbit from Paulson's hat, credit cards are in for the beating of their life. There will be no bail out from Congress on this one either;  credit card companies, and their practices have put them in the same category as loan shark.

Disclosure: Author holds short positions in some of the above-mentioned securities

Comments

[Frank Rong1:]

Credit card underwriting is based on the ability to pay, sumprime, no underwriting standards. credit card- high barriers to entry. Mortgage lending - no barriers to entry.

Mortgage messes are expected. rising home prices made homebuilders rish, then they build more until we had too much inventory, then the bottom felt out.

Credit card business are entirely different. few large rational players. During last two recessions, profits in industry did not get affected.

Your linear thinking is absurds

2008 Aug 14 08:26 AM

[CLH:]

I guess I see things a little different then you. The damage has been done and people are correcting it now. There is no chance of more debt --credit card or any other kind. People are paying down debt (where most of the stimulus went). Saving will go up and debt down during this correction. Yes bankruptcy is getting rid of debt.

I look at this correction as a positive.

Using credit cards does not mean more debt. I buy everything with credit cards and have NO debt. Besides I get a large check from my credit card each year.

You assume everyone is stupid---not true.

2008 Aug 14 08:34 AM

[Jimmy Lathrop:]

Frank - if the Democrats get voted into Congress and President Obama repeals the Bankruptcy Reform Act of 2005, will your opinion change?

2008 Aug 14 08:36 AM

[Al Bondigas:]

I cancelled my BAC credit card when I found out they were issuing them to illegal aliens. BAC deserves what they get if all those cards go SOUTH, so to speak.

2008 Aug 14 09:05 AM

[prescient11:]

Sorry but that's ridiculous. Fear can destroy capital. End of story.

2008 Aug 14 09:53 AM

[chtrplyr:]

looks like the authors puts have done poorly - you have to wonder why these guys can do fundamental research on the stocks they bash...

2008 Aug 14 10:42 AM

[Brian A. Davis:]

Dear Readers,

Panics to not destroy capital. Panics simply put a lender on notice as to how many bad loans they have already made. For instance, in California when thousands and thousands of (bad) loans were made to high risk borrowers, that was the point where capital was lost. Now that the financial market is approaching the "Panic" stage (and things will get worse before they get better) lending institutions are simply realizing now how much capital that has been put into "unproductive works."

While some readers will contend that it is a good business to see their fellow American in a debt ridden situation, and finally relying on credit cards for necessities, it is a perilous position for the companies and borrowers who are involved in this practice.

Finally, I firmly believe credit card issuers (and any other loan originators for that matter) and their clients have a business relationship. However, should the clients fall upon hard times (see the state of the U.S. Economy) credit card underwriters are in an extremely unenviable position.

Respectfully,
Brian A. Davis

2008 Aug 14 11:07 AM

[chtrplyr:]

To be blunt - if you don't even know the provisioning levels/forecasting models of the companies you bash and trash how do you determine they are in an unenviable position? You might be underestimating someone like Ken Lewis of BofA who cut his teeth as a credit analyst and has a company that has managed very well through some conservative reserve building, and obviously navigated much better than you had expected judging by some of the short positions you took. A good read of the provisioning would be in order and then some basic DDM valuation modeling before you jump to the conclusion that everything financial is over-valued carte blanche.

The fact that more people will be using CC's for a while and re-learning how to manage their finances is not necessarily a bad thing for BofA

2008 Aug 14 12:05 PM

[5kDow:]

We're seeing a deleveraging of the consumer and these bulls are out of control. Sure we all want things to get better but there is no need to be premature when it comes to getting long this market. Ultimately when everyone gets back from the beach in Sept we'll see the selling start again. It's unfortunate that CNBC is always telling the public to buy buy buy!

2008 Aug 14 01:27 PM

[turb0kat:]

rabbits come out of hats, cats come out of bags

2008 Aug 18 02:18 AM