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

by: Whitney Tilson March 24, 2008 | about stocks: ABK / BSC / JPM / LEH / MBI / WB / XLF    

Whitney Tilson

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Well, I was right (so far) on no other bidders for Bear (BSC), but very wrong on JP Morgan (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

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This article has 14 comments:

  •  
    Mar 24 05:55 PM
    Good article and agreed. Bad global financials in the West and bring fascists and dictators to the military misadventure table. In the days of nukes I would say it may get very painful before it gets much, much better for our kids and grandkids. If we are seeing a similar repeat of 1929, depression and global war the only good news is it will likely not last a total of sixteen years. However, rebuilding from ashes this time will be God awful.
    Reply | Link to Comment
  •  
    Mar 24 06:10 PM
    i saw you on CNBC and i think you pretty much said the same thing. i was curious where you got the 2 million foreclosure number ? also i wonder what happens to a mortgage bond, if nobody pays interest on it for a couple of months. i guess eventually the house is resold and the payments resume. hmmm.
    Reply | Link to Comment
  •  
    Mar 24 06:54 PM
    To me the big difference this time is that so many mortgages were interest only or no down payment. A down payment of 20% basically makes it pretty tough to walk out on your house. Even a 10% or 15% decline in house values leaves you with skin in the game. That may be why 'this time things are different'.
    Reply | Link to Comment
  •  
    Mar 24 07:53 PM
    (Off subject a bit ) But if the Fed is "the wildcard" ,where does the FED derive the legal right to stick the taxpayer for non-regulated banking bailouts, that will supposedly keep the banking sector afloat?
    Details of the Bear/JPM deal are scant and very difficult for the general public (taxpayers) to understand.
    Reply | Link to Comment
  •  
    Mar 24 08:00 PM
    I have researched the RBMS and CBMS monthly default rates...looked at how they put together CDO's ...learned a new word...Tranches...and in all of these presentation and articles not one person mentioned that real estate --in my mind a renewable resource...should be devalued to pennies on the dollar...the property remains...someone will eventually purchase it...albeit at a discount to the loan value but still the asset or liability depending on how you looked it is still physically present...why not reconsider this write down mess based on real market values despite depressed prices and then realize that eventually the asset will move from depreciating to appreciating...

    Can you explain why the drastic writedowns? If not please let me know where I can purchase some of this real estate for .05 per dollar of value...regardless of the inflated price...lol

    Reply | Link to Comment
  •  
    Mar 24 08:08 PM
    There is another financial broohahah is brewing
    the collapsed Auction Rates Securities market which locked
    $330,000,000,000,000 in now absolutely illiquid securities.

    I guestimate that people who invested in them did not put the last cent into them and I use conservative 1/3 of their investment assets, which means -
    those investors control over 1 TRILLION dollars worth of investments and unless the matter is resolved soon,
    the steamy investors, me included, will move our portfolios from
    UBS, Merrill, Wachovia, Banc of America and put them with institutions who didn't soil themselves with those instruments.

    The one trillion dollars Exodus will be a one heck of a show to see.

    Here is the sccop and the debth of the problem:

    nothingcontroversial.c...
    Reply | Link to Comment
  •  
    Mar 24 09:05 PM
    "Auction Rates Securities market which locked
    $330,000,000,000,000 in now absolutely illiquid securities."

    $330 trillion????? Please.
    Reply | Link to Comment
  •  
    Mar 24 09:13 PM
    Sorry, my bad, $330 BILLIONS only.

    How many Bear Stearns those $330 BILLIONS buy even at the last month prices?

    Reply | Link to Comment
  •  
    Mar 24 11:09 PM
    can the fed buy/guarantee enough of the mortgage backed securities and not cause a meltdown in the dollar and inflation?
    Reply | Link to Comment
  •  
    Mar 24 11:28 PM
    flatman has a good point,
    they see now that a person with rotten credit who puts 40% down
    has the same default rate as an excellent credit who puts 0% down.

    FICO and the banks didn't think along those lines.

    Basically I think the problem is that if someone at an ibank
    comes up with some new clever idea he can get
    million dollar plus bonuses.
    If the idea turns out to be toxic it doesn't hurt him.

    There should be a clawback on the bonuses that
    were paid out to these white collar criminals the
    last 4-5 years.
    Reply | Link to Comment
  •  
    Mar 25 01:17 AM
    The FED cannot Legally buy mortgages. The Bear Sterns - JP Morgan 'merger' was also illegal. Stop this Illegal activity. Read and sign the petition at market-ticker.denninge.../
    Reply | Link to Comment
  •  
    Mar 25 01:24 AM
    phlash:
    The problem with mortgages is that the realistic value of property is 3x the average household earnings. in California and Florida the values are currently 5x or 6x, which means the price needs to come down about 50%. No, those lower trenches do not have any value, as they are the first to take any hit in value, and they will end up ZEROES.
    Reply | Link to Comment
  •  
    Mar 25 01:36 AM
    The key is the house price. If the price keep falling, it will lower the valuation of the CDO even further. That will make investor even more reluctant to invest in CDO until the price stabilised.
    Reply | Link to Comment
  •  
    Mar 25 01:08 PM
    Having read books by both Dremen & Whitman as well as a few interviews with Miller, Nygren, I kinda get the feeling that these guys are a little locked into their playbook right now -- i.e. buy beaten-down financials cause they always bounce back. Maybe they're right, but will the same old moves always work? Isn't this somewhat analogous to if Warren Buffett always bought newspaper stocks when they get killed because look at how the Buffalo Evening News and Washington Post paid off for him?

    Perhaps markets and economies evolve and some investors don't adjust as fast as others. This month's Smart Money has a face-off with David Dreman and Bruce Berkowitz about whether financials are a buy (Berkowitz is bearish). If you examine Berkowitz's portfolio at the beginning of this decade, you'll see it peppered with financial companies whereas now, it is weighted more toward natural resources.
    Reply | Link to Comment
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