Bank stocks: April Fool or the real deal?

right now the banking sector and the housing market are linked in a vicious cycle. the higher rated mortgage bonds that banks own could repay in full if housing prices stabilize or completely write down if prices keep dropping. here is the rub – without lending what is to stop housing prices from further declines? so real estate prices depend on new bank lending while the values of the bank portfolios are driven by the levels of real estate prices. given current housing prices there is little reason to lend – the US consumer is simply not a creditworthy borrower as they can’t afford the current housing prices. another 20% down and we are back to pre-bubble affordability but the declines could be 5%-10% higher once we factor the inevitable deep recession. unfortunately, these numbers imply that at the end of the correction many banks will be bankrupt. right now desperate or naive banks are probably eager to take on more risk in order to unlock credit markets and protect their portfolio values – sort of like sending good money after bad if you haven’t forgotten the super-SIV idea. ufortunately that strategy requires other people to jump on the bandwagon and, equity markets notwithstanding, “dumb” money has proven to be scarce. injections from sovereign funds and outside investors are not sufficient to adequately recapitalize the banks and especially their counterparties such as monolines or long hedge funds. finally even if this obviously pessimistic outlook is wrong let’s not forget we can afford a big margin of error when we are talking of bank stocks, or first-loss positions in entities that are leveraged 17 to 30 times. so April 1 resurrected a major shorting opportunity.

in my opinion the solution:

Fed prepares for major bailout (many times bigger than the resolution trust of the 80s). to reduce costs Fed needs to bail exclusively the deposits (however to restore confidence in the banking system all deposists regardless of size), no bail out for bank common and preferred stocks, unsecured debt, secured debt beyond the value of specific pledged collateral, and, that is very important, obligations to derivative counterparties that are not depository institutions. Fed also needs to specifically proclaim the limits of such bail-out now in order to burst the bubble in our irrationally exuberant stock markets.

Government needs to prepare to floor housing values through some sort of mortgage bail-out, but it is critical they don’t act too early. Floor prices before they have reached affordability and you will have credit losses continue for years with a couple of subsequent vintages of bad mortgage production and ultimate bankruptcy of the financial system. At this point the US government will be so financially strained from the incessant subsidies that it will have to raise taxes and engineer inflation to have its obligations repaid. This is a nightmare scenario where we regress back to the pre-Regan years. Having prices overadjust below affordability levels (or what i call “speculative contraction”) is also not desirable as would reduce confidence and raise cost of capital for US corporate borrowers assuring sluggish growth in the next decade. the gist of the bail-out is to support the “core” mortgage borrowers by reducing their mortgage principal and interest payments through some form of discount purchase from the lenders, mortgage restructuring, neg equity certificates etc. The “core” borrowers are the good guys who played by the rules which is evidenced by the fact they posted real equity (20%+) and fully documented their income to purchase first home. i don’t care that people live in the house if they posted no or little money down and “stated” their income – if you have only nominal amount of money at stake you are a speculator whether you occupy or not, so you shouldn’t qualify. it is important this bail-out doesn’t prevent adjustment to affordability as this is not intended to save the homebuilders (as far as i am concerned they can all go bankrupt and be replaced by new companies at very little cost as if you can’t keep cash reserves after several years of extraordinary profitability you probably deserve to cease being a going concern anyway). in that context as a requirement for the bail out participating and benefitting lenders should commit to extend new lending only contingent on affordable house pricing including commit to review not just the borrower but the property and its appraisal and make sure maintenance payments are capped so builders don’t burden new first-time buyers with unrestructured commercial mortgages on newly developed properties.

A final note: if you find my solution heartless please note, the Democrats conveniently miss the point when they speak of people losing their houses – it is not your house if you posted 10% of its original price, it is the banks house; so the only thing you lose is your downpayment and you are getting switched into the still cheaper alternative of renting which is good for you….

All depends upon the investor’s estimate of political events. If the Wall Street banks can keep someone like Greenspan, who never saw a regulation he wanted to enforce, and the poliaticians keep murmuring “What is good for Wall Street profits is good for everyone – even if they do not think so” then bank stocks are a good buy. Any losses will be absorbed by Uncle Sap (i.e. the people). If the investor thinks Congress will finally mandate some regulation of the financial cowboys then the bank stocks are not good buys.

good opportunity to short some more
put put put

anyways

good luck

Sucker rally in my opinion.

Is the worst over for banks?

I am thinking that it is possible that massive right downs are almost at their end (although I am not personally betting on it), but that doesn’t mean all is fine for the banks. It might be well and good that they are gaining trust and liquidity to lend back and forth to each other again, but in the long run (oh, that silly concept again), they have to make money outside of each other and that means making loans (mortgage or revolving credit) to the population at large.

As far as I can tell, our large population (and the skinny ones too) all have their own personal credit crisis to deal with. Too many just can’t make yet bigger credit card payments, too many have too much debt to qualify for standard mortgage (and lier’s loans are out of favor), and they don’t have any equity to refinance out more money.

Combine that with expectations that defaults on both mortgages and revolver credit is going to continue to rise and I gotta wonder where bank income, much less profits or growth, is going to come from in the next year.

Business borrowing? Not by any small business I know. Sales/work is down, expenses are up and concerns over the future are high. They are battening down the hatches and tightening the belt for a hard landing.

My vote: April fools. Fools.