The Banking Emperors' New Clothes

How can you tell when a banker is lying - a major, top five, money center bank CEO? Their lips are moving, Jamie Dimon (JPMorgan Chase) excluded of course.

With mark to market rules changing today - probably -- the ban stocks are back! The bank stocks are back! As a trade, not an investment -- so please read on about the banking emperors and their new clothes. Or lack thereof - and for you younger people with the new American education, look up Twain, Mark to learn more about emperors' clothes at Citigroup and Bank of America.

I write about these two embarrassingly discredited CEOs and their companies because the ultimate lie - the changing of mark to market rules - will come about today under Congressional interference with a supposedly independent group, the Financial Accounting Standards Board. The new rules essentially say a bank can use their own model if an asset is to be held for a long time and is illiquid. The market is way up pre-open, banks stocks are rising, everyone is happy.

Of course, the emperor - in this case, emperors Pandit (Citigroup) and Lewis (BOA) - have no clothes. My teenage twin sons understood, over dinner last night, what was going on and figured out the banks are using the change to avoid mandatory increases in capital - and this move will actually repel private capital, the intent of the administration. Better yet, once the stress tests are complete and the toxic asset auctions begin, the rule changes will boomerang on Citi, BOA and other banks sing them. How so?

Once the auctions are in place, how can banks claim they are illiquid? Once the stress tests are done, the debate on the definition of core capital will accelerate and where will the banks hide? But, more importantly, once the auctions begin, banks that aggressively dump toxic assets and take their hits will have far more transparent books and will be able to attract private capital. At the same time, banks that obscure and obfuscate and continue to hide bad assets inside of their own models will not be able to attract private capital - now. And their stock prices will fall as investors assume not just dilution in the future but a re-casting of current profits sometime in the future when they finally sell assets they said they were going to hold for a while and have to adjust previously declared profits.

If you think I am wrong about this, consider how Citi dealt with its near insolvency when Mexican bonds blew up in the late 1980s - even backed by Brady bonds it took them, if I remember correctly, five to seven years to write them down. And those were pocket change compared to what they are sitting on now.

Vikrim Pandit said his company, Citigroup, was profitable in January and February. Dimon said March was rough - and based on history, who are you going to believe? Not to mention Pandit was talking about operating profits - without write downs of those annoying toxic assets. Pandit failed to discuss the $1.2 trillion dollars in off balance sheet assets of unknown quality never, and I mean never, discusses in public. In addition to the two trillion in assets everyone is worried about. If they are great assets that could support his Tier I capital, why are they not on the balance sheet Mr. Pandit. He also did not mention how much they are losing in earnings power with the end of their broker franchise, now part of a joint venture with Morgan Stanley. I still have most of my liquid assets at Citi - my broker and his entire group of eight left for Well Fargo and Wachovia Securities. Like many others at Citi - of course, he too will be moving on once Wells is forced by circumstance to sell Wachovia's brokerage operation.

Ken Lewis was on CNBC this morning and I had to turn it off or lose my breakfast. Everything is about to get sunny - sort of - according to Lewis. The same man who bought Merrill Lynch for ten times it's value, did not know what was on their books but went ahead and bought the company anyway using shareholder money to fulfill his personal ambition. He now has his fully diverse bank complete with legendarily avaricious stock brokers - a model that worked real well for Citigroup, right? In the interview he talked about an economic turnaround sooner than any CEO should and also bragged about paying back $400 million in TARP money. If memory serves, he got $20 billion - so he paid back two cents on the dollar and is bragging about it. I am also a BOA customer - in their private banking program - excuse me, I was in their private banking program. I was kicked out because I don't have a quarter of a million in a Merrill Lynch brokerage account. I called my banker - of fifteen years - and learned if I moved assets over to stay in the program, and I want real banking information, about mortgages and such, my broker will refer me to an 800 number. Good move Ken. I am moving on - looking at the private banking program at a smaller regional bank.

The bottom line: the Wall Street Journal article this morning talking about how investors are getting back into Citi "because it looks cheap and I am down 50%" points out the reality - that stock, and to my mind many other bank stocks are trades, moving on headlines and technical factors. They are terrible investments with another trillion dollars in write downs and greatly reduced earnings power for three to five years due to their own mistakes and the recession.

Wells Fargo - What is Real, What is Not

Wells Fargo -- what a press release, eh?

The company blew some serious smoke last Thursday to brag about earnings and indirectly tout its stock. "Brag" and "tout" are strong words - and purposely chosen. The focus on "three billion in profits" and "fifty five cents per share" and some of the adjectives in the press release sent the stock soaring this morning. I tend to focus on some other things -the balance sheet among them - and I zeroed in on "provision expense of approximately $4.6 billion, including $1.3 billion credit reserve build, bringing the allowance for credit losses to $23 billion." Twenty three billion, wow, what a big reserve! Not really.

Wells bought Wachovia and with that purchase came options ARMs - lots of option ARMs, the majority (analysts estimate 60%) in California. Total exposure at Wells to option ARMs was $122 billion at time of purchase and if I read their incredibly complex financial documents correctly their exposure is now between $90 and $100 billion. Let's say $95 billion. Wells stated $59 billion were "credit impaired" and wrote down $24 billion in Q4 related to the Wachovia purchase. They are forecasting a 29% default rate going forward. Wow! Aren't they conservative. Home owners whose option ARM mortgages that will reset in 2009 and 2010 face an average monthly mortgage payment increase of 63 percent. These resets peak - get this - in August of 2011 based on the dates option ARMs were let. So, given these realities, what is the ultimate default rate going to be in the coming quarters? is it going to be just 29%?

Ratings agency Fitch sees it at around 45%. Goldman Sachs says 61%. Whitney Tilson, an analyst with Amherst Securities covering this market better than most, believes option ARM defaults, as a class, could go as high as 70%. Moody's recently downgraded Wells in part due to option ARMs, saying the 29% number is probably too low and will have to continue to mark down assets through 2009 and 2010.

Who is right, Wells at 29%, Fitch at 45%, Goldman at 61% or good old Whitney at 70%? Fitch is a ratings agency, Goldman makes money trading these forecasts, so, let's split the difference and say it is 53% of $95 billion. That is roughly $50 billion - or $20 billion dollars more than their internal models are projecting.

Those projections have prompted them to reserve $23 billion for future losses - in everything, not just option ARMs. The bank also held $118 billion in home equity lines and $138 billion in commercial real estate loans at yearend 2008. Simply put, WFC has a great many more write downs coming and their shareholders will be significantly diluted as they raise more capital either from Uncle Sam - most probably the case - or the private sector, although I don't see Warren Buffet stepping to the plate with more dough, do you?

Agreed, their write downs will come over time as they hold these mortgages and these only have to be written down as they are truly impaired. That means shareholders face many more quarters of greater than anticipated write downs.

Bottom line: I believe WFC is blowing some serious smoke here. The operating earnings they discussed are real -- but the possibility they will need more capital never made it into their press announcement. Stay away - and when the market stabilizes a bit, put WFC on your short list of short prospects.

The Transparency Squeeze

Yesterday was not a technical correction - we saw the first major move down in financials due to the coming transparency squeeze. This squeeze is being driven five factors - bank earnings' announcements, new mark to market accounting rules, the coming stress tests, the also future toxic asset auctions and the recent raise of new capital by Goldman Sachs.

Earnings: The market not only does not like the fake earnings from Citi, BOA and Goldman - accounting plus one offs equal profits at these companies - but is really upset about the small reserves being set aside going forward. Simply put, these banks are not making any effort to be more transparent and by doing so investors are assuming the worst. The market voted today yesterday - it thinks there is a large amount of bad stuff on their balance sheets - no kidding - in part due to a blog post that may or may not be real. The poster said they had seen the stress test results and 16 of the 19 banks were insolvent and there was an unspeakable amount of derivatives and other potential losses facing the banks, losses that would put the FDIC under water in no time.

Assuming the blog post is false, the current lack of transparency and the small reserves being set aside are ridiculous enough to drive bank stocks lower. They are almost funny. BOA set aside just two and half percent of assets - in a deep, deep recession with derivatives exposure as well?

Mark to Market Rules: They have changed but have actually hurt the banks more than they have helped. Yes, they let the fictional earnings statements seem brighter -- good for a headline and a trade - but they make investors, and the public, ask the question "Oh, those assets are illiquid, eh? Sure they are not impaired?" And once all the banks declare what is impaired versus what is illiquid, investors can compare and contrast.

Stress Tests: Unless the government fiddles them, some banks must come up losers - and again, since the tests are being run with the same criteria, more data for investors to compares and contrast regardless of their conclusions. Stress tests of 19 banks balance sheets are about complete with results to be released on May 4. In total - but over time individual results will be made public by the feds or the companies themselves as they are material to shareholders.

Toxic Assets Sales: Assuming they take place, these will a) produce clear marks for illiquid assets and provide b) a market for illiquid assets. You see where I am going with this - the mark to market accounting rules are mooted once an asset in a class is sold. No more illiquid assets - a bank can sell them at auction.

Goldman's New Capital: Goldman raised capital and the fall in the stock price was within a hair of the amount of dilution. And Goldman is valued as the best bank and the best brand in the industry. This means new capital coming to other banks will have at least that effect - and probably more given the perceived value of the Goldman franchise.

The transparency squeeze now makes it a transparency race. The government wants private capital to remake the banks - and they have created a transparency squeeze to get the ball rolling. Your point Shulman?

The IMF says we are $1.3 trillion down a $4 trillion write off. I believe them - and let's say it is only $3 trillion, that is $1.7 trillion more to write off or more than double the market cap of the industry. Capital will have to be raised and with that comes massive dilution of shareholders. Maybe even bondholders will have to take a hair cut.
With the stress tests half political and half real, it is hard to say which banks will bounce when - we do know Citi, Wells, JPMorgan and BOA have a lot of stuff on their balance sheets that needs to be written off. And many other banks as well. So, a short right now of an individual name may be difficult, or just volatile, but a short of the entire industry through pus on industry ETFs or the purchase of inverse ETFs on the segment is a great trade.

Potential Pandemic Flu Shorts

Everyone is looking at speculative opportunities stemming from the possibility of a pandemic flu outbreak. The obvious longs - vaccine and treatment companies - and the obvious shorts - travel and some agricultural commodities - made their moves yesterday. Is there anything left to short or even go long?

Profiting from the Swine Flu Pandemic from InvestorPlace Media on Vimeo.

It all depends on the severity and duration of this outbreak. Mexico is a third world country with a marginal -- and I am being kind - public health infrastructure and a capital with incredibly poor air quality, a probable factor in the death rate of people with the flu and living in Mexico City. And to better understand how this could progress, or end, let's look at what is going on.

Swine flu, first identified in Mexico, has spread to the US, Canada and many other countries. It is killing people - more than 150 in Mexico, according to press reports - and has raised the threat of a pandemic flu epidemic. What makes pandemic flu more dangerous than regular flu is its virulence - it kills - and the inability of current vaccines to prevent the spread of the flu? The last great pandemic - the 1919 outbreak that some people believed killed more than fifty million worldwide - was a strain of flu that was very virulent and, perversely, hit the healthiest he hardest. Signs that this may be the case with the current flu strain are making public health officials nervous.

The problem these authorities face is the lack of treatments and the lack of vaccines. The lack of treatments is a physical problem - Tamiflu has worked, to date, on this strain but governments stopped adding to stockpiles less than two years after the last scare. The US has at least 50 million doses and we are better off than many 00 in Mexico, the situation is so amateurish and chaotic family members of victims were not given Tamiflu. Another approved treatment, Relenza, is even in shorter supply. Prospective treatments such as Peramivir from Biocryst are just that, prospective. What about mass vaccination? A vaccine for this variant of HN51 does not exist and cannot be produced in volume for many months, despite the claims of some soaring little biotech companies.

Speaking of companies and investment or short side opportunities - what of them? The pandemic flu scare a few years back put may companies on traders' radar and these stocks ran Monday morning. If the pandemic breaks out they are going higher - but if things calm down, some are shaping up to be great short opportunities.
Biocryst (BCRX): They have a flu treatment - pandemic and regular - in mid stage trials. Due to previous trial for an oral version of the product - this one needs to be injected - this treatment, Peramivir, will get approval eventually. It is much more potent than Tamiflu. Under bio-defense legislation passed after the anthrax scare, Uncle Sam is allowed to stockpile and use a treatment after it has passed a twelve-person safety trial - and Peramivir has done this. In a real emergency the government could legally distribute this treatment.

Novavax (NVAX): This vaccine company says it can make a new flu vaccine in roughly thee months - seeing is believing. They have a novel vaccine manufacturing system that enables the rapid manufacture of vaccines and are working on their own as well as assisting other companies. They burn cash faster than my twin sons (catcher, lacrosse goalie) in a sporting goods store and have committed heavily to a new development program India with a pharma company partner, Cadila.
Crucell (CRXL): Their business model is to become the "Intel inside" for vaccine makers. Their cell line technology platform - they create vaccines in the synthesized equivalent of a human retina cells - is many times more efficient than traditional egg based vaccine production. Crucell is partnered with most of the major players in the vaccine business.

Cerus (CERS): This company has the system - INTERCEPT - to clean blood and make it free of infectious pathogens independent of the health of the donor's blood. INTERCEPT has been shown to work on HN51 flu strains in laboratory work that has been published and subject to peer review. The system has been approved in 18 countries.

Gilead (GILD): Tamiflu works on this strain of flu --- it is made by Roche but Gilead is the actual inventor of Tamiflu and receives a roughly 20$ royalty on sales - 100% pure profit. Any uptick in government purchases for stockpiles or use puts a new floor under Gilead' already incredible profits, earnings and real cashflow.

What to go long, what to short? If this potential pandemic gets too real, these are all longs. But if its does not - let's hope so - the shorts here are Novavax and Biocryst. They do not have revenue, NVAX needs to worry about cash, BCRX does not, but these stocks have exploded and would probably sell off. The other companies - GILD, CRXL and CERS - continue to pop this week, and then this scare goes away, they too may be short candidates. Check back later.