Investing in the Banking Industry

Aug 10th, 2007 | By Christopher Hancock | Category: Investing Strategies

Wall Street took it on the chin again this week.

Yesterday, in the wake of the Bear Stearns meltdown, French banking giant BNP Paribas announced it was suspending three of its asset-backed securities funds, saying it could no longer value them accurately because of problems in the U.S. subprime mortgage market.

The bank cited the “complete evaporation of liquidity in certain market segments of the U.S. securitization market” as the crux of the problem.

Later that day, insurance giant AIG, the world’s largest insurer that also holds exposure to subprime loans, jumped to the mike to assure investors the company “doesn’t need to liquidate any of its investment securities in a chaotic market.”

Roughly 31% of AIG’s $19.2 billion real estate portfolio remains invested in the subprime market.

As the subprime mortgage collapse rolls on, investors keep whistling in the dark for the Wall Street firm immune to this nasty little cold. But so far, we have no takers. No one really seems to know how far this can go.

Our friends at the Rude Awakening were quick to point out that the credit derivatives market has increased, globally, from something like $1 trillion dollars in notional values five years ago, to something like $34 trillion currently. So you’ve taken a market that barely existed to something that is more than three times U.S. GDP.

The fear seems to be… No one really knows what these collateralized debt obligation (CDOs) are really worth. No one really knows who owns what. A farmer in France knows he holds a pension, but what that pension may be worth is anybody’s guess.

That has many investors scared…and rightfully so.

Following the total destruction of Alt-A lender American Home Mortgage last week, all eyes have now shifted to ACA Capital, the global credit derivative insurer.

The reason: Earlier this week, Barron’s referred to ACA as the “Ticking Time Bomb,” calling the company’s stock “the ultimate derivative for the subprime-mortgage market.”

According to Barron’s, the firm’s CDO exposure totals an impressive $61 billion dollar value. Not bad for a company with a market cap just over $250 million.

Barron’s notes: “that should ACA buckle under this outsized burden, all $61 billion of the exposure it has insured would come cascading back on the balance sheets of the aforementioned firms (names like Bear Stearns, Merrill Lynch, Lehman Brothers and Citigroup) and some 25 other Wall Street counterparties with which ACA deals.”

As you can imagine, big financials didn’t fare too well late this week.

When others are fearful, it may be time to get greedy. I’ve got all eyes on the banking sector right now. While the big Western banks grab the headlines, I’m turning my focus to Asia.

It has now been more than six months since China lifted the final major obstacle to foreign banks, offering full RMB services in China. Multinationals are now allowed to compete for the nation’s $2.2 trillion of household deposits.

The Chinese market looks extremely attractive for commercial bankers. Unlike Americans, who spend well beyond their means, the Chinese save. In fact, personal savings rates are estimated to be upwards of 40% of an individual’s annual income. That’s great for a business dependent on low-cost funds for loans — one of a bank’s most profitable businesses.

In the latest issue of Free Market Investor, I argue that only a handful of banks will find much success in the Chinese retail-banking sector.

Specifically, do you think people in China want to stow their money in a place called Bank of America? That’s like asking an Iowa corn farmer to hand his assets over to the Bank of China. You get the point.

Now it’s no secret that many of us maintain a general distaste for large financial companies, especially the larger institutions. They’re viewed as power-hungry, money-hoarding machines. They’re the ones who own your house. They’re the masters who sit in leather chairs behind large oak doors and pull the strings. And they’ve been doing it ever since man has desired to trade.

But as famed value investor Christopher Browne points out: “Banks are the one growth stock I’d love to own… The average person views banks as stodgy, old economy relics…but what would we do without ATMs, debit cards or credit cards?”

I couldn’t agree more. And what banks have a chance to grow? Well, we’re not going to give that away just yet.

Until Next Time,
Christopher Hancock
August 10, 2007

P.S.: As I mentioned above, I head the Free Market Investor, and I currently have a recommendation that will make this CDO thing look like child’s play. Just as Christopher Browne calls Banks the “one growth stock I’d love to own,” I have my own. I’ve been calling this specific company the “World’s Greatest Growth Stock” for a while, and I still think that it is one of the most solid picks in the world. I’ll give you more details in a sec… Read on…

Christopher Hancock

Christopher Hancock lives and breathes emerging markets. He travels extensively and utilizes his contacts across the globe to recommend the best international investments in the world. After working with Citigroup in Hong Kong on the challenges and opportunities associated with the forthcoming RBM flotation reform, Christopher left many of his friends behind and decided to return to the States to pursue a career in equity research.

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