Banks: The Best Short for 2010

| About: Wells Fargo (WFC)
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Most investors are now focused on the minutiae of earnings -- as if anyone can make any sense of bank earnings or balance sheets. And they are assuming at worst economic stabilization and at best economic growth in 2010. More than three quarters of all analysts have buy recommendations on most large banks and the sector in general. They are not just forgetting the words of the great banking diva, Meredith Whitney, they are forgetting the macro picture evident in readily available public information. So are public officials. And for this reason -- call it willful blindness, something that can lead to being charged with a felony in many states - another banking crisis brewing, a quiet one, since we all now know Uncle Ben will not let the system fail. Good for him, but not necessarily good for investors.

First, popular revolt against the banks is rising but has not crested on Main Street or Wall Street. The Obama administration and the FDIC (they are different) are both taking aim at changing the rules of the game for banks, in part to keep up with activity on Capitol Hill. Main Street populism against bailouts and bonuses is driving the political calculus. In reality, investors should take note this populism is long overdue and not misplaced; in fact, it is quite muted. To put it another way, if US banks had done to the Russian or Chinese economy what they did here, we would be talking about bailouts for widows and orphans, not banks.

The heart of this populism is the perception the banks, especially the big ones, were treated unfairly - overly fairly - during the bailout days. They were; the issue was systemic risk. Six-branch local banks do not create systemic risk. Fueling this populism are excessive bank salaries and bonuses, as they have been since the first of the great Wall Street partnerships began to go public in the mid 1980s and risk takers were rewarded for increasingly short term behavior using other people's money. And Obama and the FDIC are taking aim at the big banks. Obama is looking at more fees, depending on how big you are and the level of risk you are creating for the banking and financial system, and the FDIC is looking at higher fees if the compensation structure at a bank encourages too much risk taking.

Forget Kudlow's screams and Robert Reich's quaint, Depression-era editorials - these actions are the direct result of populism that could get out of hand if the government sits back and lets another crisis unfold as it is, more slowly than before, in residential and commercial real estate mortgages. Yup, here comes another one.

While everyone is focusing on commercial mortgage problems, the more important problem is residential. In the past, in the good old days, when someone fell behind on a mortgage for 30 days, there was a better than 80% chance they would catch up, keep the house and be tortured by their teenage children like everyone else. Today that number is below 30% and falling. Between 1.5 and 2.0 million homes will be foreclosed in the next 18 months adding to the inventory of homes and depressing home prices. Add to this the 600,000 -800,000 homes already foreclosed but not yet listed for sale. Then assume the tax credit for homebuyers is allowed to expire. It is politically unpopular, in April, just as Uncle Ben starts pulling back on Fed purchases of mortgages. Oh, one last wrinkle - after sub-prime mortgages went away, the geniuses in the mortgage lending industry created option ARMS - pick your payment mortgages. According to Fitch (see, only 12% of the 800,000 Option ARMs have re-set to date - and the issue here is not interest rates but terms of the loans which have allowed owners to roll interest into the principal. When they re-set, they will be seriously underwater. At the moment, default rates are north of 40% and climbing - and to date after resets 43% of option ARM mortgages led to a foreclosure. The largest issuer of Option ARMs was Golden West, bought by Wachovia and that bank was in turn bought by industry darling Wells Fargo (NYSE:WFC). Bottom line - another fall in home prices, lots more loan defaults, much higher than anticipated bank write-offs (especially the larger banks that hold lots of mortgage backed bonds).

Why is residential more important to banks and bank investors? First, they are not being discussed by serious people and are not currently factored into bank stock prices. Second, falling home values suppresses consumer wealth and spending, dampening economic activity, and fueling a cycle that will lead to more mortgage defaults. Third, there are no large vulture investors out there scooping up extra housing inventory - and this will not happen.

This mixture of populism and residential mortgage driven banking crisis means more than anticipated bank write offs and the need to raise more capital and dilute existing shareholders to head off problems with regulators. Bottom line: populism plus the crisis will depress the entire sector and hit selected names very hard as the year unfolds. A great place to troll for great short candidates.

Author's disclosure: None.