The Banks - Deja Vu All Over Again

My hero - Yogi Berra - said it best. "It ain't over 'til it's over."

The market disagrees with him - at least right now. There is a collective sigh of relief that the stress tests will be more cartoon than non-fiction and the banks will not be nationalized, de facto or otherwise. And that is drawing in not only traders but some investors.

I write this today just because the stress test results are imminent but because long only money mangers are beginning to recommend the banks - especially those managers who do not read the numbers that go along with bank earnings statements. I appeared on the Fox Business Channel yesterday - they have really upped their game, you should check them out - and argued for a few seconds with a nameless but not blameless money manager who kept quoting headlines numbers about bank earnings. He seems to have overlooked that Goldman forgot to report earnings for December, Wells and Citi used accounting changes to generate profits that were not real operating earnings and Bank of America made money because of spectacular one-off trading results at Merrill - plus accounting changes. Not a solid foundation for an investor. Reminds of a great Yogism. "Mr. Berra, do you want your pizza cut into eight or six slices?" "Six, I could never eat eight."

We were debating this because stress test results will be released Thursday after the close and while long awaited the details are either known through selective leaks or are meaningless - at least based on what has been leaked. After the tests were announced, it became clear to the administration Congress would not be forthcoming with more funds to re-capitalize troubled banks and a decision was made to soft peddle the results - perhaps even modify them by modifying the test parameters - in order to prevent another financial panic. So instead of being near the end of the game - what do the banks should and what are these assets really worth - we are back to the third inning or so.

Do I exaggerate? Hardly. The situation is so muddy but so clear it is best to turn to Warren Buffet's most recent comments to see how people talking up the banks are doing so out of both sides of their mouth. He said the banks do not need a great deal of capital, if any, they can internally generate what they need and he also said the economy was not going to heal itself at as fast a rate as pundits and administration officials are now offering up to the public. Well, Mr. Buffet, you cannot have it both ways - the banks will not be able to re-capitalize themselves without a bottoming in loan defaults -mortgage, credit cards, commercial real estate - and these will not bottom unless the economy turns pretty quickly. Numbers don't lie - the commercial real estate loan portfolios of major banks, especially Wells Fargo, are overly large compared to their tangible core equity and current and future projected default rates. Not to mention the next mortgage tsunami has begun and will accelerate and continue, with Alt-A and option ARM resets hitting a peak in 2011. As Yogia would say,it could be "deja vu all over again."

So let's say I am right and the banks do need more capital than is revealed by the stress tests -- the IMF puts the number well north of a trillion. If they slow roll it - and right now they have to with Congress fed up and private investors avoiding them, the Goldman Sachs capital raise being a one-off - they can get it by a) converting preferred to common and b) doing it slowly, using accounting gimmicks and some real earnings to slowly build reserves. That will take years - for some banks easily more than a decade - and they will tighten lending as they do this. If and when they convert preferred shares, the dilution will hit common shareholders and the stock price; as they slow roll generating capital internally, their stock prices will fall as they demonstrate they have no real earnings power. The bottom line: current shareholders are going to take a hit.

Let's re-cap the logic:
• The stress tests are a fudge at best because a correct conclusion would require far more capital than the banks can raise either from Uncle Sam or the private sector.
• Some banks will convert preferred to common equity will massively dilute existing shareholders and with that comes a falling stock price.
• Other banks will slow roll raising capital, suppressing economic activity and perpetuating their misery and that of shareholders as reserves counter profits for many quarters
• No matter how you slice it, lousy assets need to be replaced with fresh capital and the creation of new capital will require existing shareholders to take hit.
• The amount of hit they will take will be determined by the amount of capital hey need and we do not know that because the stress tests and their earnings statements do not speak to the quality of those assets.

Should any investor put money to work in the third or fourth inning of a game with no real score? Not unless Koufax was on the mound - and he retired along time ago, Ken Lewis and Vikrim Pandit are hardly the guys you want pitching for you right now. Right Yogi? He would know -- eleven World Series rings,more than anyone else in baseball history.

But the stocks are running - should you run with them? I stick to fundamentals, not short term charts and another popular Yogism - "The place got so popular nobody goes there no more."

The bottom line: for traders, the big bank stocks are pure trading vehicles based on expectations of the market's reaction to the stress test results. If you are a longer term long or short side player, please, think twice and read a lot more before going long and after you get nauseous you might consider going short the entire segment through an ETF such as the SKF, a double inverse ETF mirroring the Dow Jones Financial Index.

Realpolitik Killed The Bank Shorts

Elizabeth Kubler Ross' classic work, On Death and Dying, is a misused and misquoted book - it is about a topic far more serious than making money - but she has provided a great framework to evaluate and accept the realpolitik that destroyed many short positions in the banks. These positions were killed by stress tests that were somewhere between worthless and fraudulent - at least to people who passed fourth grade math - although very useful to the psyche of the market and the American public. So good job Mr. Obama - Roosevelt did the same thing when he closed and then re-opened the banks in 1933. Of course, the system then went on to see many thousands of banks fail and it took a world war to pull the country out of a credit starved depression.

Denial: As it first began to dawn on the Street that the stress tests were going to be meaningless puff, I kept telling myself this could not happen, Obama and Bernanke are too smart to hand the country a zombie banking system. I overlooked the political reality - the realpolitik of the situation - Congress was not going to be forthcoming with more money should the stress tests be truly rigorous or objective when there was no money to re-capitalize them. How could they given the reckless behavior of the banks and their craven behavior since the fall of Lehman. I was in denial of the real politik of the situation.

Anger: I then stormed around my house, boring my children and thoroughly annoying my overly patient wife ranting about such untimely concepts such as economic fundamentals, honest accounting, Citigroup's off balance sheet debts and so on. I wrote a great - I mean terrific - piece for this blog while riding back from a Fox Business television interview about my book, Sell Short, and, appropriately enough, we hit a bump, my hand did something stupid, twice, on the keyboard and the piece evaporated into the digital heather. But it did dissipate my anger.

Bargaining: I then got cute and tried to bargain with the fates. I picked apart the guidelines for the stress tests when they were released and wrongly concluded Citigroup was a great short because the Fed's guys were going to include analyses of off balance sheet assets. As far as I can tell, Citi has more than a trillion of them as of November of last year they had more than $1.2 trillion of them) and off balance sheet assets are off balance sheet for a reason, usually not a good one. So I told my subscribers to consider shorting, short term, this month, Citigroup, through the use of puts. I never recommend that an individual actually short a stock.

Depression: The stress tests results were leaked - brilliantly - and then reported out - a non-event--and I got depressed. As an advisor, I had let my subscribers down; as a citizen with many friends and family out of work or having their businesses foreclosed, I now knew that realpolitik had condemned the country to several, perhaps many years of zombie banks, generating capital through obscene credit spreads and writing off bad debts over too long a period of time.

Acceptance: You cannot fight the tape and since Wall Street right now is dumb enough to trade headlines and run when the news turns bad, you cannot short the banks short term. I accept this, accept we will have zombie banks and we may even need another financial crisis to fix the problem. I even accepted how the Feds originally wanted Citi to raise $35 billion in capital, as reported this weekend in the Wall Street Journal, and punked out, costing my subs a lot of money. Longer term, the banks have little real earnings power, many may yet require TARP II or its equivalent and with a zombie banking system the recession will last much, much longer - and corporate profits will be much, much lower - than Wall Street expects, setting up great long term short positions. Maybe we can use the money to put real people back into real jobs rather than have them suffer due to realpolitik.

Forgive my cynicism - there is a bright spot to all this, and that is the realization that despite my harsh words we do live in a civilized country regardless of what you may think of Congress and politicians. If we truly lived in a country driven by Bismarck's definition of realpolitik - like Russia or China, perhaps Venezuela - you would not see many bankers complaining on Fox Business or CNBC, you would be seeing their widows at memorial services on the evening news. And those of short sellers as well.

Summarizing the Case for Long Term Short Positions

As technicians, fundamentalists (and I am not talking about religious types) and almost anyone else will tell you, the market is trading by its own internal logic that is pretty hard to elucidate. Let me try.

First, Wall Street sees a bottom at yearend and an upturn in Q4 GDP. The seriously foolish see this as a real bottom and a real upturn in GDP; the savvier fools see this as a statistical bottom they can trade and have done so for the past two months. This latter group is not really made of fools - they have just cost my subscribers a lot of money and I am mad at them.

Second, technicians and historians are using past market performance to say we hit a certain bottom, we are going through a retracement to his and a return to that. All based on rational history. Then you ask them about corporate earnings and the multiple of the market and they ask have you seen a good ball game lately. You then ask them if equity markets have ever risen in the face of rising interest rates and they cough and ask you to leave.

Third, the market is now behaving like on great day trading pit - a piece of news, let's rally or slide and let's hang on, if you get in before the pop, collect your winnings before the window closes and get ready for the next horse race.

But all of this would not hold and would to push the market up as fast and as fast as it has - if people did not want to believe in a good news story and want the market to go up - the history of the Street since trading was actually conducted in the street. Independent of your politics or how you view his initiatives, Obama has proven to be a remarkable, no, an extraordinary leader with outstanding ability to calm people - even those who dislike or hate him - and make them feel better about the future.
This may explain the current market. Now let me present the summary for the bearish view. It all begins - and will end - with housing.

Point Number One for the Great Short Trade: The feel good part of Obamanomics has people investors, traders, pundits and politicians believing housing will bottom this year or early next. Maybe in 2012 - just do the math on foreclosures (they are rising), unlisted and empty housing (as much many as 13 million units according to the New York Times), recent Case-Shiller data shows the worst decline in housing prices ever with more to come. When Americans feel good about the value of their home and can get a home equity line, they spend money. When they don't, they don't as much - and in this recession, they do not and will not. And as consumer spending goes, so goes the economy. And within that economy, good bye to any growth or serious profits from direct beneficiaries of residential and commercial construction (more on that later) - think Sherwin Williams, Whirlpool, Louisiana Pacific, other suppliers.

Point Number Two: The housing bubble was really the tail end of a credit bubble that is over for between a decade and a generation. Do I exaggerate? The nation's banks are on the way to pulling in two and a half trillion in credit lines via credit cards. Two thirds of people with a mortgage on their home had less than 15% equity in that home as of the end of last year so at the rate the Case Shiller index is going that will mean two thirds of all mortgage holders will have not equity in their homes by this time next year. Almost all increases in consumer spending were fueled by credit expansion since 2001 - remember, the cheerleader in chief did not ask for new taxes to pay for the war on terror, he told us to go shopping? That's leadership.

Point Number Three: The banks cannot lend more vigorously as they are, for the most part, based on real world accounting standards, broke and getting broker. For the next twelve quarters, at least, they will be carefully managing down existing toxic assets - anyone read anything about the PPIP program lately? - and using profits to offset write offs for these and newly made toxic assets. The new wave in toxicity will come from more mortgage meltdowns - worse than subprime according to many analysts - commercial property write downs - did you know Wells Fargo has almost $350 billion in commercial property loans - and private equity disasters - every here of Chrysler? Well, Chrysler has many smaller cousins. And as some banks disappear, Uncle Sam will use funds to prop up the FDIC and the longer we keep the zombies in business, the more expensive this will be.

Point Number Four: The bottom line is corporate profits are going to take a hit - Stephanie Pomboy, credit and market analyst extraordinaire, in an interview with Barrons, spoke to the big rise in corporate profits since 2003-2003 as being directly linked to the radical expansion in consumer and other credit. Contracting credit means contracting profits.

And - markets always regress, for some period of time, not just to the technical mean but to the mean of corporate earnings. Moderate analysts put S+P earnings this year at $55. This gives the market a current multiple of 18-20 - a multiple appropriate for a 3.5% plus growth economy. Put a recession multiple - 9 to 11 - and, well, you can do the math. Of course, I think corporate profits will be lower but even at $55 you get an S+P of 600 at best. Or a 33% decline from where are right now.
Bulls argue with interest rates so low there are no historical comparisons - the same bulls who use historical comparisons to support technical arguments. I guess we now know why bulls are called bulls.

So I, the great agnostic, believe the rally could last quite a while but the market cannot escape the economy and the economy cannot escape consumer spending and the banks and consumer spending and the banks cannot escape housing. And every time I make this argument I become persona non grata at yet another meeting or party.

Anything specific to short?

First, check out, and check the technical's and whether manic sentiment has left, the suppliers to new housing and remodeling - Whirlpool , Sherwin Williams - and some dodgy home builders like Toll and KBH.

Second, there are some banks still overvalued you can short - take a look at Wells Fargo, it selling at multiples well above the segment, has (or had at the end of last year) roughly $90 billion in option ARM mortgages and almost $350 billion in commercial property loans. And I still think Citigroup will break itself up and shareholders could get the shaft.

Third, the ultimate consumer discretionary stocks - luxury and unnecessary, companies like Tiffanys, Coach, Harley Davidson. HOG has just rolled over, it deserves special attention.

Last point - if you don't think housing will take at least two more years to bottom and want to write a comment - please do so - but please, prove your case. Mine is based on the dates mortgages were let, their dates for being re-set, which are in the middle of 2011, and given that defaults and foreclosures happen 3-6 months after re-sets, and then the foreclosed house hits the market - well, maybe it is 2013 after all.