Don’t let this stock market rally fool you — all isn’t well on Wall Street.

And that financial malady is now traveling to Main Street as banks – including the latest FDIC rescue operation here in Baltimore on Friday – crumble all around us. Here’s what you need to know to profit from this mess…

The market’s mood can swing between mania and depression over short periods of time, but over longer stretches, stock prices eventually reflect the real value of underlying businesses and whether that value is growing or contracting.

Many stocks will not revisit their lows forged during last fall’s panic, but many others will break to new lows. Right now, the market is positively giddy about the future earnings streams of banks and thrifts and has bid the stocks up in anticipation of a miraculous economic recovery…a recovery that will be weak and limited to few sectors – certainly not including consumer finance, retail, and real estate.

The next move in the financial stocks will be down and regional banks and thrifts will lead this move. As Chris Whalen, a leading authority on the health of the banking sector, notes in the lead quote above: “In bad periods, banks typically set aside twice as much as they charge off, but now a lot of them are at one-to-one.” Most banks are reluctant to book the provision expenses necessary to maintain loss reserves, because this cuts into net income. But delaying recognition doesn’t mean they’ll go away; delay just means that losses in the future could be bigger and exacerbate the trend toward tighter credit. The market for bank stocks is not discounting this development right now, but it will over time. None of these smaller institutions are “too big to fail,” so many will be resolved by the FDIC, and acquired or liquidated.

This month, we’re shooting for 150% gains in put options on a thrift that strayed from its humble roots and is now dangerously undercapitalized.

What we usually do in Strategic Short Report is a form of “time arbitrage.” We recognize that euphoria can push the stocks of capital-destroying companies far above what they’re worth and we take opportunities that the market offers to sell short over a time frame when we expect common sense to prevail and prices to fall. Sentiment toward the financial sector is positively giddy right now, and stock prices have rallied to levels that discount a swift return to happy days and tiny credit losses. But the recession is over, right? No way, if you’re measuring it honestly. And for the banking sector, it’s definitely not over.

Bank Profits Cannot Grow When Balance Sheets Shrink

Now that we’re in a new ice age for the financial sector, many banks will be shrinking their balance sheets. This shrinkage occurs as healthy borrowers pay down debts and are not interested in taking on more debt. With so much excess capacity in so many industries, why should entrepreneurs with good credit look to expand? Especially with the guarantee that if they grow, these entrepreneurs would be, in the eyes of a cash-strapped government, an even juicier source of tax revenue?

This is bad news for banks, because growing private sector demand for credit is the key for banks looking to “earn their way out” of their festering losses.

Such is the paradox of runaway government spending, which is so massive that it’s temporarily boosting GDP figures. But this spending is ultimately self-defeating: The more the government spends, the more the private sector will tap on the brakes. In my view, this is the weak link in Keynesian policies, which Washington, D.C., policymakers keep pursuing aggressively. The federal government is the only notable borrower with growing demand for credit, so lots of banks will wind up buying the bonds of a spendthrift government – hardly the kind of lending that infuses cash into productive private investments and private sector jobs.

This leaves the banking system in a situation in which most borrowers seeking new loans or refinancing are not good credit risks and the borrowers who are good credit risks are not interested in more credit. And let’s not forget the elephant in the room: residential mortgages. This is a problem that cannot be resolved by just refinancing at low rates, or extending terms, because most homeowners with mortgages do not have enough equity to refinance.

The biggest mistake the banking system made was believing that the average value of U.S. houses could never go down. This mistake would have been avoidable with a bit more free market discipline in the banking system, which would have slowed credit flows into mortgage lending once prices had detached from median incomes. It also would have helped if mortgage originators were required to retain a portion of the credit risk involved with each new loan.

Bankers aren’t the only ones to blame. Policymakers made a grave mistake by pursuing the goal of homeownership for everyone. They did not distinguish between homeownership and a “call option on homeownership,” which is a more accurate definition for a low- or no-money down purchase. With the benefit of hindsight, we know that not only did these call options on homeownership expire worthless, but with the smidge of equity gone, the incentive for many homeowners to keep making mortgage payments is also gone.

There are a few more assumptions that fans of bank stocks are ignoring at their own risk. These fans are looking at the experience of the sector during the early 1990s to draw conclusions about the likely trajectory of credit losses, recoveries, and spreads on future lending. They foresee a period of consolidation, followed by a return to the pleasant lending environment.

These bulls are misdiagnosing the situation, and here’s the main reason: The banking system has no experience managing through the current “negative home equity” environment. This is an environment in which mortgage rates are already about as low as they can get and consumer balance sheets are as stressed as ever. Due to the nonrecourse nature of mortgages, most borrowers have no financial incentive to keep paying. Many are choosing to mail the keys back to the lender.

This problem will cap the upside of bank stocks for years to come, and this sector will offer lots of short selling opportunities.

Regards,
Dan Amoss

August 31, 2009

Dan Amoss

Dan Amoss, CFA, joined Agora Financial from Investment Counselors of Maryland, investment adviser for one of the top small-cap value mutual funds over the past 15 years. As a buy-side analyst, Dan refined his value investing approach by meeting with corporate executives and sell-side analysts and writing proprietary research for the fund’s management team. Dan is the editor of Strategic Short Report.

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