In a Storm, Both the Good and Bad Get Hit

Includes: AMBC, STAR, WMIH
by: Accrued Interest

There is a piece on this new blog (which is trying to create a sort of independent stock research center where the reports are written by users) about iStar Financial (SFI). Fair disclosure, I'm considering a debt investment in iStar.

Anyway, toward the end of the report, the author goes into a bit about how financial stocks are in the unenviable position of proving a negative. I want to explore this idea a bit more.

No one knows how far the residential lending contagion will spread. Are banks and brokers just taking a "big bath" right now, and are writedowns near an end? Or are there one or more large financials headed for bankruptcy? What companies may have invested in subprime related securities, from CDOs to SIVs? Who has counterparty risk with shaky partners? What companies are so reliant on securitization that they will face a liquidity crunch? Who may need to come to the debt markets now and pay unusually wide spreads, and what impact will that have on earnings?

Taking it a step further, how much will losses in home values impact consumer spending? What companies may be over-leveraged to the mortgage-equity withdrawal trend? Or consumer credit in general? What companies will be facing higher defaults from non-residential lending because easy credit has previously kept consumer loss rates low?

We are all struggling with these questions. I think I know the answer to some of these, but I must concede that my confidence level in any particular outcome is low. I think a lot of actual traders are struggling with the same problem. We know there is a lot of bad news priced into securities, but we also know there is bad news to come. And we can't be sure from where the bad news will hit.

So you take a company like iStar Financial. It is a commercial real estate lender. Now perhaps you have a "classic" reason to be bearish on iStar, such as you are bearish on commercial real estate. Fair enough. But in today's market, a legitimate concern is whether someone like iStar can weather a period where it is difficult to raise capital. And if you assume that it can survive such a period, what would its earnings look like?

But there is nothing iStar can do to prove it can survive a serious credit crunch except to go ahead and survive it. Investors are in essence saying "Prove to us you won't have a problem in this environment." But no company can prove any such thing, because we don't know how much worse the credit crunch might get. Or what other types of securities or loan-types might be hit next.

A myriad of other financial stocks (and bonds) are suffering through the same thing. We know that some are particularly vulnerable. Washington Mutual (NYSE:WM), Countrywide (CFC), AMBAC (ABK), etc. But there is a large number of companies that haven't had any particular residential lending-related problem. There are other companies that have had some problems, but that isn't any particular reason to believe there will be more. And yet because the market is asking these companies to prove a negative, the stocks (and bonds) have been beaten up pretty badly. As long as subprime or contagion losses could crop up, investors are going to be highly skeptical.

One could say this is the nature of a bear market. Investors become more focused on their fears and less on their greed. Sometimes the innocent get punished. Sometimes the not-so-innocent are punished before their crime is fully revealed.

So if you are considering investment in any financial company's securities, bear this in mind. This thing is hitting all aspects of finance. On one hand, we have real losses on mortgage loans. On the other hand, we have a serious liquidity crunch. On our left foot, we have much wider credit spreads. There is no such thing as a financial company for whom none of that matters. Financials, by their nature, almost always take credit risk of some kind, and need funding of some kind. There are many companies being unfairly beat up right now, but which are the innocents and which are the not-so-innocent not-yet-revealed is a tough call.

Even if you are right about the particular company you are looking at, the fear of the unknown will continue to dominate markets until the pace of bad news slows down. Put another way, when a company is being asked to prove a negative, there is no catalyst that will accomplish this. Investing intelligently in a market like this requires patience, stamina, and constant re-evaluation.

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