And maybe every other risk asset, like stocks, commodities, and risk currencies? Am I missing something? I must be. But what?
It’s remarkable how calm markets remain about the big banks.
Given that we’ve seen:
- An ~ 8% plunge on high volume of Bank of America (BAC), Citigroup (C), and Wells Fargo (WFC) last week and growing popular realization of the extent and risks in the budding bank foreclosure fraud scandal (aka “foreclosuregate”, “robo-signing“ scandal). Estimates of the damage vary widely but, as shown below, are potentially very significant.
- The banking sector as a whole has not been behaving well recently, failing to participate in the rally of the past weeks. XLF, the financial sector ETF, is in blue, the S&P 500 is in red. Note how even before the dive bank share prices took late last week, the sector was underperforming.
Daily chart for the past month of XLF (Financial Select Sector ETF)
I assumed that ETFs that short the banks would have spiked. Wrong. Check out the chart of the Proshares Ultrashort Finanicals ETF (SKF
). It is currently just a few dollars off its multi-year lows, down to just under $19 from late 2008 highs of close to $300.
SKF daily 2-year chart
The chart seems to scream, ‘crisis, what crisis?’ Amazing, not even a small spike in bank shorts? Huh?
True, JPMorganChase (JPM
) and Citigroup had decent earnings, though again there is the contribution from a drop in loan loss reserves. Am I the only one who finds that odd at this time given the above mentioned latest scandal?
So, here’s a very short summary of why and why not to short the big banks.
Why Not To Short Banks
- Essentially, TBTF (too big to fail): If things get nasty, Washington has to bail them out.
- Emergency measures will make it go away (mostly): The systemic risks involved in risking another deathblow to the critical banking and real estate sector, clouding titles and thus impairing transferability of literally millions of properties, a decade or more of lawsuits; well, desperate times will call for desperate measures. I believe the Federal government doesn’t even have jurisdiction, with the relevant laws under purview of individual states.
In sum, there seems to be an underlying assumption that in the end, nothing will be allowed to damage the banks.
Why Short The Banks
The Foreclosure Fraud Crisis Damages Are Significant But As Yet Unknown
- The big banks face financial damage that is still basically unknown, but estimates range from $20-$90 billion. A widely circulated report from hedge fund Branch Hill Capital suggested Bank of America’s exposure (from misrepresenting Collateralized Debt Obligations (CDOs) they sold that they knew to be bad) could be over $60 billion and result in its share price being cut in half. See here for details. Morgan Stanley (MS) has put aside an additional $1 bln thus far in additional reserves.
- The legislation is now in place to break them up. See here for details via Ellen Brown.
- Liability from assorted parties ranging from CDO holders, the Justice Department, etc, is very difficult to gauge.
Even Without The Foreclosure Crisis, Bank Revenues Plunging
- Bank asset returns are collapsing due to lack of lending business and falling returns on purchases of US treasury securities as yields on these fall. See here for details from David Goldman, here for details from Chris Whalen.
- Nonperforming loans are being carried on their books at above market value, with regulator consent. Old news but worth repeating.
Conclusion & Ramifications
With SKF near multi-year lows, this or other kinds of bank sector shorts seems to carry relatively low risk compared to the likely potential gain.
As others have already noted, the banking and real estate sector led global markets into and out of the crash of 2007. Oh, and European bank stability was at the heart of the recent global market swoon this past spring.
So if in fact the banking and real estate sectors are going down, can the rest of the developed world’s markets be far behind? If not, then stocks, commodities, and riskier currencies like the AUD, NZD, and EUR will suffer as well. Safe haven assets should do well, ironically that includes the USD, though the CHF is likely a better choice.
As for gold and other currency hedges, their fate will depend on whether either the USD or EUR is seen as at immediate risk. Recent history suggests the USD should rally, meaning the EUR should pull back.
Am I missing something? Please, I seek enlightenment. Thanks in advance for your kind assistance.
Disclosure: Author has a position in SKF