Why You Should Avoid These 5 Banks

Includes: BAC, C, GS, IYF, JPM, MER, MS
by: Glen Bradford

Let's start with the bottom line: The way things are now for financials isn't sustainable. Even so, extend and pretend is an excellent way to project future theoretical cash flows, albeit with ignoring this sustainability issue. The stock market still has a strong bias to extend and pretend and I'm voting against it. In the land of systemic risk, I want to draw light on what is effectively a balance sheet recession, what I think is causing it, and why what appears cheap from a SEC filing perspective and from average historical valuation statistics isn't actually that cheap. A few years ago I came out and said that I didn't hate the banks because they could effectively cheat the system. This is simply an update on my perception that there is a harsh reality that appears to be catching up with them.

One assumption that I am making for this article is no additional governmental/fiscal stimulus. I am assuming that we will get some of that as things deteriorate. But until then... This is at least the direction that things are trending. This assumption is likely to be incorrect as it is the tendency for governments to meddle in the private sector these days to postpone and exacerbate future financial pain.

Bank of America (NYSE:BAC): Prediction - Bankrupt.
I'm probably going to get put on a list where Bank of America tries to 'accidently' foreclose on my residence for this public opinion. Fortunately you can foreclose on Bank of America. That is, of course, if they haven't beat you to it. Bank of America has a lot of exposure to real estate prices. As people strategically default on their homes and Bank of America pretends that they will still make payments, you effectively make things harder for the bank to catch up to reality, and reality is deteriorating faster than the bank's models. This call is in my anticipation of another banking crisis and that Bank of America has the most exposure to the sector causing it. Combine that with the fact that the foreclosure market doesn't work like it should and that banking models still pretend that it does. Either Bank of America is going under or it will be bailed out again at the expense of taxpayers.

JP Morgan (NYSE:JPM): Not Enough Loan Loss Reserves
I don't think that JP Morgan is correctly managing its loan loss reserves and this is overstating its profitability. This is like me running an insurance company and forecasting that the probability of tornado damage in Kansas is on par with the risk of tornado damage in Alaska. Sure, it works out to your advantage in the short term and your boss thinks you're a hero. But in the long run, if you haven't set enough aside for a rainy day, look out below.

Goldman Sachs (NYSE:GS): Flawed Business Model
With the global economy slowing down, the market for taking private companies public should shrink. I covered Goldman Sachs a while back saying that it would likely get to $170. It appears to have petered out at around $175 and has fallen since then --- mostly because the risks I am describing in this article are real. I believe an integral part of the business model for Goldman Sachs is the ability to rip off its clients --- and two years later Goldman gets subpoenaed for this kind of activity.

Citigroup (NYSE:C): False Global Growth Paradgym
Citigroup thinks that on a forward basis it will be getting most of its profit growth from emerging markets. Can it not see the bubble? My prediction is similar to the prediction of Mr. T: Pain.

Morgan Stanley (NYSE:MS): King of the IPO
Presently, Morgan Stanley is doing a great job lining up the best of the IPO market. How much longer are we going to take companies public at unsustainable and unreasonable valuations? My guess is that it's not going to last six months, and for this I applaud any social networking website that goes public ASAP. Regardless, I'm seeing this leg down as the markets come off recent highs supported by unsustainably high corporate profit margins.

Unpriced Systemic Risk:
Systemic risk is the risk that everyone tries to assess but most fail to do so. It's the type of risk that is written off by popular musings much like, "Well, nobody else saw it coming --- how was I supposed to know?" I believe that there are a lot of risks that have a multiplier effect that are still not priced into the market, leaving the entire market overvalued. Job creation still isn't likely until we stop diverting private sector productivity into public sector misallocations. The world economic picture still needs to price in China choking on its own infinite growth story --- because that is exactly what it is, a good bedtime story.

Three Notable Bubbles:

1. Housing - Europe, China, U.S.A., Australia.

2. Commodities - Industrial commodities thanks to China's insatiatable appetite for rewarding negative ROI asset backed provincial loan programs.

3. Corporate Profit Margins - Nearing historic all time highs and in terms of mean reversion --- this is the definition of it. If you use mean reversion as your guide and cut corporate profit margins in half, stocks aren't so cheap.

It's not only bad news, however. Multi-family residences in the middle of cities, I think, are a bright spot in the housing market. I think that a lot of this is due to higher gas prices and higher unemployment. Five years ago, it was far more common to be located half an hour outside of the city where you worked and commute to work, than it is today. This was awesome for the construction companies that were building out suburbia. That said, higher gas prices and the push to ignore the fact that prices can go down if supply exceeds demand popped this bubble. The bad news is that the banking sector 'didn't see this coming.'

Another note is that the media now seems to me to be pervasively negative. Everyone is coming out talking about slowdowns and risks. Where were these people a few months ago? Here I was. Odds are that at this point in time, things appear to stabilize before the next leg down.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.