Financials Likely in Dead Cat Bounce, But Fed's Now a Wildcard

by: Whitney Tilson

Well, I was right (so far) on no other bidders for Bear (NYSE:BSC), but very wrong on JP Morgan (NYSE:JPM) increasing its bid...

Recent stock market moves have made anyone short financials look pretty dumb, but nearly every piece of data (with one notable exception -- see below) indicates that this is yet another dead cat bounce, to be followed by the fundamentals getting even worse, dragging stocks exposed to this mess down with it.

Today's announcement that sales of existing homes rose unexpectedly is likely the result of a rising tide of foreclosed homes sold at auction, which is horrible news, as this will crash prices -- see slide 15 of our presentation on what's going on in San Diego.

The one major exception is the intervention of the federal government -- this is the one wild card that I think could wreck the short thesis. Our country is big enough and rich enough to fix this problem -- but that's been true from the beginning of this mess, yet that hasn't saved financial stocks.

I'm stunned by the latest nonsense of having the government buy mortgage-backed securities. I shows that the government still doesn't get it, thinking that the problem is that the market has irrationally beaten down MBS's. While there may be pockets of irrationality (see the article below on where CMBS's are trading, for example), the main problem is not irrational markets -- the markets are, in fact, being 100% rational in correctly seeing the $1 trillion of bad mortgages train wreck that's still in its early stages.

What the government should be focused on is the genuine underlying problem: that nearly 10 million American homeowners are under water in their mortgages and approx. 2 million of them will be foreclosed on this year. Until they address this problem, this mess isn't going to get any better.

I read the latest OID yesterday and there couldn't have been more bullishness of financial stocks from some of the smartest value guys around: Bill Miller, Wally Weitz, Bill Nygren, David Dreman, Tom Gayner, Rich Pzena, Marty Whitman. Generally speaking, they don't deny that the fundamentals are bad and might even get worse, but think that valuations are so low that they will do well over time.

Count me a skeptic on the fundamentals; I think this time IS different. Though I didn't live through many of the previous financial crises, I don't believe that there has been anything like the bursting of The Great Mortgage Bubble. The leverage that built up in the shadow banking system -- such as $45 trillion in CDSs -- is unprecedented. Thus, I question whether tried-and-true value techniques such as buying financials at 50% (or more) of book value will work because, to take one example, I think Lehman's book value is likely to be severely impaired, given its exposures and reserves (or lack thereof). For another example, see Jonathan Weil's article on Wachovia.

If the bulls are proven right, I think it's likely to be for the reason none of them are admitting: that the govt. bails them out. Tom Gayner alluded to this when he said in the latest OID (from his 2/08 letter to shareholders): "The sober practices of today will restore profitability and normalcy to the system. We simply have no choice. The banking and savings and loan crisis of the early 1990's and its historical ancestors from 1974, 1929, 1907 and the 1870's give the government, individuals, corporations and the markets, plenty of time-tested approaches to heal the system. This time is not different. Fixing these problems is not discretionary now as it was not then. All of us will do whatever it takes...The current financial crunch will heal and pass as all others have done before."

Tom is right. This too shall pass -- but not without quite a bit more pain I suspect...

Disclosure: Short MBIA and Ambac