Banks: One Size Does Not Fit All

by: Soos Global Capital

One of my investors sent me this article as an FYI. I have to say, and this might be considered heresy by my good buddies who are still in the big-bank biz, there's a lot right about Wilmers' view.

That said, I actually don't think it's so black and white, that one can say that all derivatives and all trading is of no value to proper banking. There is some meaningful benefit to hedging activities, and liquidity provision, and trading just to know what markets believe are the current clearing prices for assets. But I do believe that at times it goes too far ... and when it does, I'd point my finger at one thing: Compensation systems. Quite often, they continue to motivate behavior into short-term, high-risk efforts with very little accountability for longer term consequences.

Readers of my articles probably have guessed, I'm a very laissez faire economic school kind of guy, and believe generally in smaller government and less government -- but when it comes to financial markets where taxpayers are guaranteeing deposits of institutions, those institutions should most definitely adhere to prudent guidelines for safe banking, which first and foremost can be motivated thorough compensation systems. Until that changes, and I believe the government lost its best-ever chance at doing it in '09 and '10, the risk-machines will keep on truckin'.

As you saw on Friday, the bank stocks finally got a bid and there's just a little follow-through today. But I'm not convinced yet that they're out of the woods. With so little sponsorship for the sector among money managers, we're sure to get bouts of "it's bottomed" and everyone will scramble to grab cheap bank stocks. But when the regulators, states attorneys general and the politicians are still gunning for the banks, it's going to be tough for them to rally hard. (See: "Buying Banks? Better Know How to Play 'Whack-a-Mole'.")

That said, I'm watching them very closely -- because they have so massively underperformed that at some point there is likely to be a proper bottom or at least a "buy the bottom" rally that will stick for at least some time. Also, there are gems among some of the regional banks that have high quality mortgage portfolios and/or rely more on the credit card business.

Regarding the latter point, there’s more and more research being done on the moral hazard that is quickly taking shape across the country, where troubled mortgage borrowers are more apt to just stop paying their mortgages (believing that the government will force banks to lighten up on them and will make it harder for banks to foreclose) and instead are using that “new-found cash” to spend with their credit cards on which they are very unlikely to miss payments. That has favored bank stocks that are more heavily reliant on credit card business than mortgages.

Elsewhere, I came in after a weekend full of reading all kinds of market commentary and research, and probably more importantly, kicking the tires by getting as much anecdotal feedback from friends and family that I saw as to what they're seeing in their respective businesses and experiences. The signs of life in various areas of the US economy range from nascent to crystal clear, but nonetheless, the market does not seem poised for a moon-shot on the heels of Friday’s momentum. My sense is that the US economy is chugging along but the worry-ometer is swinging more widely now, with higher gas prices, food prices, real-estate taxes, lower home prices, etc. That augurs for a pretty choppy ride, even if ultimately we do move higher.

The strong start this week is already petering out a bit, so with housing in the pits, consumer confidence lousy probably due to higher gasoline and food prices, with employment probably blah at best, we might just muddle for a while, or whip up and down in a range for a while.

Ultimately, to move meaningfully higher, a number of events might help such as seeing the euro hold together, the EU and IMF et al. save Greece and the others, and the US get serious about deficit cuts and borrowing limits. The private sector in the US, I believe, is well positioned to pick up where the government sector will fall short. Corporations have tons of cash and are running lean and mean, so as government finances get more under control through fiscal austerity and some form of revenue raisers (tax hikes), the private sector should be able to step up hiring and investing.

I'm no fan of tax hikes, but with the gridlock in DC, I don't see how we'll get credible spending cuts unless there's some give on the tax front. More importantly in my mind is the certainty of the tax environment. It is virtually impossible for businesses (and individuals) to invest long term if they have no idea what the tax structure will be in two years. Cap gains tax rate? Allowable deductions? Corporate tax rate?

Lots of economic data this week, but obviously the NFP will be most closely watched.

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Disclosure: I am long JPM.

Additional disclosure: Also long other large global banks and some regionals. Positions may change at any time without notice.