The Credit Crisis and Potential Shorts

by: Phillip Lyon

Financial companies have seen severe declines over the past year and they still have the potential to go down a lot further. The reason financial companies are on such shaky ground is because the risk of rising foreclosures and loan defaults has resulted in a really severe credit crisis. For those of you who don't understand the current credit fiasco, I will try to explain it and show why financial companies still present good shorting opportunities.

Before I start I want to point out that the stock market surged on the Fed cut just like I predicted and also sold off quickly just like I predicted. If you bought financials Wednesday I hope you sold on the news and got out quickly. If you did play the short term volatility, I would recommend that you take new short positions in financials again. Now I'll go back to the credit fiasco.

The last time the Fed tried to fight off a recession, Alan Greenspan, who deserves some blame for the current credit mess, lowered interest rates to ridiculously low levels. Consequently, there was plenty of easy money to go around. Since interest rates were at extremely low levels, banks were happy to provide consumers with just about any type of loan they wanted without much regard to the credit worthiness of the consumer.

Consumers could buy cars with no money down and with no interest. Consumers could get interest free credit cards for a length of time and when the interest did kick in they could transfer their balance to another interest free account. Consumers could take out second and third mortgages on their house. Consumers could also get home loans with very little equity and at very low interest rates. This is one of the major reasons for the housing bubble.

Banks were willing to loan out so much easy money because they passed the risk on to other investors (other banks, institutions, hedge funds, etc.). Banks would pool all the loans together and sell them off as investment vehicles. When home prices were going up and the economy was growing, these investments seemed safe. They were also attractive because they paid a decent amount of interest. Now, however, these investments are turning toxic due to rising delinquencies and defaults.

The housing bubble exploded a while ago and home prices are crashing. A growing number of people who speculated during the housing bubble now have homes that are worth less than what they owe on them. Consequently, they are stopping payments on their mortgages and letting their homes go into foreclosure. To make matters worse the housing market is still far away from a bottom.

Furthermore, the economy is headed for a recession and commodity prices are at all time highs. This coupled with the fact that consumers are overleveraged due to all the money they borrowed means that delinquencies on loan payments and foreclosures are on the rise and going to increase. This is spelling doom for those companies that are overexposed to mortgages and loans and now have to raise money to shore up their capital base (ala Bears Sterns (NYSE:BSC). Banks are no longer willing to buy these risky investment vehicles and they are not willing to loan money based on the value of these investments. Therefore, liquidity is drying up in the credit markets.

This is one reason why the Fed is drastically lowering interest rates (so banks will lend to each other). However, even though the Fed is making it cheaper to loan money it doesn't mean banks are going to be any more inclined to loan money to each other. I don't blame them. I wouldn't want to buy declining investments of questionable value or lend money to other banks using these grouped loans as collateral.

Since banks are not loaning to each other, the Fed is using another tactic to help the credit crunch. It is loaning money directly to banks and investment banks, effectively bailing them out with taxpayer money. However, I don't think this will inspire banks to free up their money either. Consequently, I think it's possible more banks or investment banks are going to go under. I think financials in general (NYSEARCA:XLF) are also going to suffer as defaults continue to rise. If you want to try to score a huge return, you may think about shorting Lehman (LEH) or UBS (NYSE:UBS). I have read rumors they were on the brink of going under. You may also consider National City (NCC) or Washington Mutual (NYSE:WM).

Disclaimer: I have no position in any of the stocks mentioned.