Philip Gvinter

Why This Bailout Can't Work - And What Will

I disagree with your assessment of the rationale behind the bailout plan. The plan is not meant to prop up the many insolvent financial institutions with overweight exposure to questionable debt. Instead it is meant to provide a reasonable floor for the price of these questionable assets. Currently there is not a single buyer for these assets at anything but distressed prices which discount their fundamental value (in my opinion about 50% of par) even further and create transactions at 20% of par value. This forces other financial institutions to write down the value of similar assets below the reasonable 50% level all the way down to their current market price of 20% of par. This forces dilutive capital raises and ripples down through the financial system. The purpose of the bailout is to stop the collateral damage caused by such a situation by creating a fund for the purchase of these deeply distressed securities upon the failure or regulatory closure of these institutions. The many poison pills chief amongst them the equity position which must be given to the fund and the limits on executive compensation will make voluntary participation the equivalent of bankruptcy to participating institutions. In my estimation most of the ALT-A mortgage debt originated in Q2 2005 and later is garbage. This is approximately 2.5T of debt (please feel free to correct me if my estimate is off) the $700B would not cover enough of this to truly "bail out" any institutions. The point is to set a reasonable floor and take away the distress discount applied to these securities. I have no problem with that and feel that if priced appropriately we the tax payers may be able to make a small return on the purchase of these assets if we hold them to maturity or at least until the housing market has found a true bottom and the securities become easier to price fairly given an availability of reasonable predictions for recovery rates (currently unavailable because we do not know how far the value of the collateral in this cases houses and commercial properties will fall) thereby allowing investors to buy with a typical level of confidence in their risk adjusted rate of return.

Are Bank Stocks Buyable?

A large part of my bearish sentiment stems from the systemic deterioration of underwriting standards in the mortgage and commercial loan markets. Standards were relaxed on all programs including prime and AAA commercial credit. I believe that the true scope of the consequences of radically relaxing loan standards right before the economy heads into an average to severe recession will have. In my opinion default predictions for prime, prime jumbo, auto and credit card loans as well as small business loans, construction loans, and floating rate debt held by large corporations are still too low. From first hand experience I can tell you that a significant portion (greater than 20%) of mortgages underwritten and purchased by the GSEs would not have passed muster under any other period and is far from prime quality. While I agree that the more conservative banks stand to profit handsomely with the elimination of overly aggressive competitors and the availability of prime assets which would otherwise never be for sale at discounted prices. At the same time I feel that the credit contraction is only starting in earnest. The issue holding back a more expedient end to the necessary contraction is the low quality and illiquid nature of the assets which need to be liquidated off of bank and other financial companies' balance sheets. Because there are no willing buyers for the fixed income exotica created over the last four years it is incredibly difficult for institutions to fully clean out their balance sheets. Until we see some stable pricing and a slight increase in the number of large distressed debt deals in order to be able to ascertain the eventual trading prices of these massive piles of securities which will ultimately reveal the state of many banks real balance sheet health. Another key factor is the fact that there is no real way to at this point accurately predict where the unemployment rate and the housing drop will end. Until such data becomes a reasonable topic of discussion I feel that it is entirely premature to look for investment opportunities in the banking sector as the outcome of these macro events make such an investment perilously close to a roll of the dice.

Are Bank Stocks Buyable?

I am very bearish on bank stocks but do agree that these are good screening criteria. There are still four major factors which are likely to mean more trouble for banks.

The first is the negative equity in car leases. All truck and many car and luxury car leases written in the last three to four years have residual values significantly above the current market value of the vehicles, in many cases the difference exceeds $10,000 per vehicle (take a look at the prices of used luxury cars and mid size and full size trucks right now and compare them to what they were a year ago for vehicles of similar age and mileage, the difference is shocking) which is a tremendous hit to the institution which must take back and sell the vehicle.

The second issue is the upcoming recast of billions of dollars worth of Pay Option ARMs. These exotic mortgages allow borrowers to pay less than the interest due while growing the balance to a cap of 110%, 115% or in some cases an insane 125% of the original balance. When this cap is reached the payments more than double. Most of these loans were done with no documentation of income and are therefore as toxic as the subprime loans. This will add more foreclosure inventory to the already weak housing market and will severely punish those banks which hold these loans on their balance sheets. The biggest holder of these loans is WB with over $120B in their portfolio.

The third issue standing in the way in the way of a banking recovery is the performance of credit card debt. Because consumers used their home equity lines to pay down their credit card debt during the housing boom/bubble they have found themselves with one last avenue of available credit. Defaults in the credit card portfolios of COF and AXP have accelerated and in my opinion will continue to do so as cash strapped consumers use the credit cards to continue to fund purchases which they cannot afford. At this point these purchases are no longer limited to lifestyle desires such as eating out or new luxury goods but now include the increasingly expensive price tag of groceries and gasoline.

The fourth and final issue is the rising rate of unemployment. Increased unemployment means increased levels of default across all classes of consumer loans, and at some point begins to seep into commercial lending as a slowdown of consumer spending hurts small businesses. The continued rise in unemployment numbers and the acceleration of this trend does not bode well for the banking industry.

As I said before while I fully agree with the authors methodology I still believe that looking into bank stocks is premature at this point and will continue to be premature until a bottom is found in the housing market and a top has been reached in the accelerating unemployment statistics.