By Jon Markman | 9 May 2008
Short-term rallies and wishful thinking have buyers ready to pounce, but the end of the credit mess isn't yet here [[indeed; not even on a VERY LONG shot! : normxxx]] In the meantime, here's some speculation on bank stocks. The major stock indexes blasted to two-month highs last week in defiance of wretched news on the economy, one of those reverso-world moves that the market gods use to keep the public wrong-footed. It seems negative sentiment is so pronounced right now that every time the news is one lumen brighter than total blackness, buyers emerge from their foxholes to nibble.
Yet Satyajit Das, an independent debt derivatives expert who for years has warned of an impending disaster in credit markets (most recently also in the stock markets— well ahead of the 1Q2008 tumble), doesn't buy it. I caught him at his Sydney, Australia, office a few days after he emerged from a three-month backcountry trek, and he leapt at the chance to scoff at U.S. bank presidents' vows that the worst of the credit crisis is over. Paraphrasing Winston Churchill, in a voice dripping with Aussie irony, he quipped, "This is not the end, nor even the beginning of the end, though it may be the end of the beginning."
Das, who wrote the global credit derivatives business's most widely used textbook, argues that no matter how much equity investors try to ignore the imbalances in debt that continue to weigh on banks' balance sheets, the problem won't go away. "Given that the bank presidents have been consistently wrong about everything they've said about their losses until now, why on earth would anyone believe them now?" he asked.
Tip Of The Credit-Crisis Iceberg
Das' point was driven home last week by Citigroup's (C) announcement of the sale of an additional $4.5 billion worth of shares— its fifth attempt to raise capital in the past five months, each of which management hinted would be the last.
The troubled bank has now raised $40 billion in the most expensive possible way— diluting current shareholders— while contending that everything's fine. Analysts at Goldman Sachs said they were surprised at the paltry amount raised in this round, suggesting it was the best the bank could do for now given its worsening prospects.
Why would anyone want to purchase Citigroup shares on the open or private markets? Buyers believe banks such as Citi have, at their cores, outstanding franchises that the hyenas who have run them recently haven't entirely ruined. Sellers disagree, with Das in particular contending that such wishful thinking ignores the massive "de-leveraging" of the global financial system under way now that threatens to impair banks' ability to lend and grow for years to come.
To believe the worst is over, Das notes, you would have to believe that bank managers have obtained a firm grip on their credit-related losses and have written down at least half of the ultimate total, and that declining home values won't create more losses. He thinks this is impossible because the banks own many of the same losing securities yet have variously written off anywhere from 30% to 80% of their face values[[, i.e., of the same losing securities! : normxxx]]
Das figures that since few banks, if any, likely overestimated their losses, the variance in the write-offs means most banks continue to underestimate their losses. Thus he calculates that the $200 billion raised from outside sources so far is just a down payment and that banks have up to $700 billion more to go— an amount far in excess of their total earnings over the past half-decade.
And it's not just losses on current holdings that are the problem. Das wishes to remind investors of the $1 trillion to $3 trillion that's still in the process of moving back onto the banks' balance sheets from related entities where they were hidden. These 'off-balance-sheet' units were created to permit banks to buy vast sums of credit derivatives that they had designed in exchange for big fees [[and bonuses: normxxx]]. The holdings of the units, called structured investment vehicles, or SIVs, were then used as collateral to do more borrowing from money market funds, generating more fees and bonuses.
Keeping these highly leveraged units off the books meant banks did not have to counterbalance them with any permanent capital, or equity. This was a crucial link in the global liquidity factory that provided funds for this decade's credit bubble [[totally outside of any restraints from the Federal Reserve System: normxxx]].
The Cost Of A Broken Lever
Now that money market funds have stopped buying the commercial paper [[aka, 'crap': normxxx]] issued by SIVs, banking regulations and prior agreements require the banks to bring them back onto their books, and that means they must shore up their capital base by selling new shares or shedding other assets. Every dollar that is used for this purpose is a dollar that can't be used to make loans for corporate buybacks, commercial customers or hedge funds. Without such loans, banks' earnings growth [[and, indeed, the entire economy : normxxx]] will be greatly impaired.
Worse still, the buying power of two key drivers of the last bull market— hedge funds and corporate Treasurys— has been crippled because the leverage they've used to reap big profits has suddenly turned against them. Here's an example of how that leverage works: Assume a hedge fund has $20 of real capital. If a bank allows it to leverage five times its capital, the fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Now assume the assets fall by a mere 10% in value, or $10. The hedge fund's leverage suddenly increases to nine times— that's $10 of equity (the original amount less the loss) and $80 of debt now supporting $90 of assets.
If the permitted leverage stays constant at five times, then the hedge fund must sell $50 of assets, or 50% of its holdings. If lenders more realistically reduce permissible leverage to three times the loss, then the hedge fund must then sell $70 of assets, or 70% of its holdings. This process is bad enough in normal markets, but when buyers are scarce, prices of these involuntary sales are knocked down to levels that can wipe out the fund.
This scenario continues to play out across the global economy with occasional timeouts. As hedge funds deleverage in fits and starts, much of their inventory is going back to bank balance sheets. This is known in the banking business as 'involuntary' asset growth, and it isn't good. It forces banks to issue more new equity to comply with international capitalization rules, further undermining current shareholders [[moreover, if these assets were entered onto the books at true value rather than face value, many of these banks would already be insolvent!: normxxx]]. Deleveraging is going on among corporations and individuals as well, leading to less buying power for everyone. That leaves less money available for homes, cars, televisions and travel, further leading to the sort of buyers' strike characteristic of long periods of slow or stagnant economic growth [[stagflation, anyone?: normxxx]].
In sum, it's easy to get carried away with the idea that stocks can levitate from extreme lows as greed kicks in and kindles buyers' interest for bargains. But the borrowed money that previously bulled stocks toward last year's high is gone, and so are the earnings-growth confidence that's necessary to push price-earnings multiples higher. It appears that a real secular, or structural, change has occurred that makes our past understanding of how banks perform outdated. So Das suggests you enjoy occasional two— to three-month advances as the speculative opportunities that they are, but don't be surprised if permanent improvement is much more elusive as financial stocks remain under pressure for at least an additional year or two, and possibly longer.
Still, anytime there's so much hand-wringing about a sector, there are bound to be opportunities for speculators. Want to try your hand? Here's an idea, courtesy of Rich Gula, a veteran analyst and portfolio manager. Back in the early days of Batterymarch, a pioneering quantitative fund where he started, managers would buy an equal-weighted sector portfolio in which at least half the stocks were in horrible downtrends and half were neutral or positive. Gula says you can expect a couple to go bankrupt, most to trade in line with the market and a couple to rise by 200% or more. On average, after two years, he says, it's likely to be a winning speculation. Here are my picks for the experiment:
| Company | Market cap | May 6 closing price | 1-yr. price change |
|---|---|---|---|
$3.6 billion | $9.84 | -56.4% | |
$3.9 billion | $6.17 | -83.1% | |
$3.9 billion | $8.00 | -67.1% | |
$10.7 billion | $22.94 | -57.8% | |
$17.7 billion | $27.33 | -59.2% | |
$8.1 billion | $40.86 | 52.6% | |
$9.9 billion | $19.15 | 44.5% | |
$7.8 billion | $82.14 | 46.3% | |
$13.7 billon | $116.27 | 58.9% | |
$12.0 billion | $53.89 | 63.1% |
Markman's presentation on "What I Am Trading Now" will be available via a live webcast from 2:15 to 3 p.m. Wednesday, May 14. To register in advance, click here.
To sign up, call 1-800-970-4355 and mention priority code No. 009552, or register online.
At the time of publication, Jon Markman did not own or control shares of any company mentioned in this column.
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Normxxx
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