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.