On July 18, 2007, I went on Larry Kudlow’s CNBC show to warn that a “trillion-dollar AAA asset bubble” threatened the banking system, warning investors to get out of financial stocks. I was much too early.
The BKX index of bank stocks never gained its July 19, 2007 level of 113, but was still trading around 110 in early October. Each time the Fed did something to amerliorate the problem, the shorts got the stuffings beaten out of them. As strategist for a credit hedge fund, Asteri Capital, I recall vividly how terrifying it was to keep short positions going against the efforts of the central banks to shake us out. We stuck to our guns and our investors came out with a profit.
On Jan. 18, 2009, I announced in this space that financial equity was the hottest ticket in the world.
That turned out to be good advice, but one needed a strong stomach to hold that position through the nationalization rumors of early Spring. The Obama administration’s bumbling and incompetence through those weeks made things worse, as I reported at the time. Between Jan. 19 and Friday’s close, the BKX rose by 45% vs. 12% for the DJIA. But as of March 6, the BKX had fallen by 40% from its Jan. 19th level.
It never occurred to me in July 2007 that investors would assume that the Fed could wave a magic wand and make a trillion-dollar hole in bank balance sheets go away. Nor did it occur to me in early 2009 that the market would fail to see the twin elephants in the parlor:
1) Toxic assets could throw off enough income even under very stressed scenarios to give banks positive cash-on-cash returns (ignoring mark-to-market losses), and
2) After the Fed committed trillions of dollars of balance sheets to bail out the banks, the US could not let the banks fail without impairing the sovereign credit of the US. Prior to this commitment, nationalization would have been possible (for then federal resources would have been poured into the nationalized banks after the fact). But not afterward.
Before long the market came to see it my way, and I can’t complain about my own returns (I had bought Citigroup preferreds (C.P) at a low dollar price and benefitted from the conversion)–but it wasn’t the easiest money I’ve ever made.
Now I am being flooded with proposals to buy into TALF funds in which the federal government provides cheap financing to banks as well as an agreement to buy back the assets being financed. Levered up ten times, these funds might pay out 12%. That’s precisely the business plan of the Bear, Stearns subprime hedge fund that levered up supposed AAAs, and went bankrupt amid charges of fraud in 2007. This time, the federal government and the big banks are running it together.
The result is that the price of toxic assets–the very same ones I saw as a source of cash flow for the banks earlier this year– has risen to the point that it makes no sense to buy them. Single-A tranches of commercial mortgage backed securities deals (a tranche that begins to lose cash flow with a 10% or even smaller loss to the pool) were trading in the low 20s when I liked bank stocks in late January. Now they are trading in the low 40s. That’s another breed of pig ().
After banks take out 2 or 3 points for fees (for doing absolutely nothing but bidding for whatever might be out there) I would be lucky to make 8% or 9% on such funds, even assuming that default assumptions hold up. And the CMBS analysts are somewhere between gloomy and apocalyptic in their view of forthcoming defaults.
Funds of this sort are a bank-in-a-box. The Treasury designed them to provide liquidity to banks who want them off their books, by creating a fund that acts just like a bank.
Now, if I can’t make money as a private investor buying into these funds, why on earth should I own equity of banks who are doing the same thing, and presumably can’t make money either?
Probably I was too early, again. I took profits on almost all of my Citigroup position, just when Jim Cramer and some of the bank analysts are pushing the stock again. My only comfort is that Cramer and the bank analysts have proven excellent contrarian indicators in the past.