Sunday, November 21, 2010

Trading The Financial Sector

As the SPX has powered higher and higher each day, the financial sector has done the complete opposite. The financials simply have not participated in the rally. In 2007 prior to the SPX highs, the financials lagged for five months until the entire market finally rolled over. The ultimate bullish signal would be a financial sector rally.
Well, we have seen such a rally recently with the XLF up 6%, BAC 11%, JPM 10%, WFC 11% all in the past six trading days. Is this move the start of a true bull leg up in the sector or an extremely oversold bounce?
The financials clearly were due for a bounce as shown by the XLF below with an 18% drop from its April 15 high (tax day nonetheless) to its September low.
When QE 2 was announced the 30-year treasury sold off as the Fed said they would not be buying the long end of the curve. The result was a favorable yield curve for the financials combined with news the following day that the Fed would soon allow “strong” banks to increase their dividend. I take issue with the notion of an increased dividend anytime soon. If cash was so plentiful then why is BAC talking about paying bonuses in company stock this year? There is no way dividends are increasing anytime soon.
When I look at financials all I see is a business model that is struggling with an unfamiliar task of turning a growing REO inventory. I see vast headwinds, questions of the industry’s ability to generate positive cash flow, years of litigation and a balance sheet where value is questionable at best and ready to experience another contraction.
Home prices are double dipping:
Read any report, even the out of phase Case Schiller Index and prices have clearly begun a new leg down. Zillow’s recently presented the following chart:

There is currently a shadow inventory that would take over six years to deplete. Six years! That’s assuming no more homes are foreclosed. Not a very good assumption. Amherst’s Laurie Goodman has put out a report calling for 20% of homes to eventually be foreclosed, without government intervention. Assume limited impact due to foreclosure concerns and mortgage put backs (again not a safe assumption), this REO increase alone will crush the bank’s capital structure. High unemployment is here for many years (once discouraged workers come back unemployment should easily exceed 10%) and with supply far exceeding demand, bank REO inventory will be moving in a very unfavorable direction.
Mortgage-gate / Robo Signing:
When this news first broke the media reported this as a simple technical issue with no repercussion to the banks. Over the past few months it has grown into a far larger issue that goes beyond a simple moral issue of failing to pay one’s mortgage for years. What have developed are clear signs of fraud, improper documentation and failure to meet simple warranties and representations. From originator to servicer to trust, the entire MBS process is now being called into question. There is no question that the vast majority of foreclosed homes will and should result in the person living for years without payment being removed. The problem is the process the servicer (hired by the trust) has used to initiate foreclosure.
Just recently an AZ judge ruled that Bank of NY Mellon (servicer) must produce the custodial records in a case against an AZ homeowner, thereby producing the note and mortgage. The judge refused a transfer in bearer paper, and demanded endorsement specific to the trust. Will we sacrifice the integrity of our legal system to maintain the capital structure of the banking industry?
What the above case highlights in addition to a flawed foreclosure process is also failure of conveyance of the note and mortgage to the trust. This is the very basis for investors to demand a put back to the originator.
Lawyers on both sides will argue possibly for years security put backs on a note-by-note basis. This is the process the banks want as referenced by BAC on a recent conference call. Worst case the banking sector is looking at hundreds of billions in put backs at par plus interest. Best case, banks will incur vast legal expenses, a far more expensive MBS process (if one remains as currently defined) and increased reserves for both legal and put back exposure.
Generating Cash Flow:
Banks simply are not creating new credit as shown below. Recent reports show bank lending standards are loosening but there is simply no demand. Surveys of business owners continually show that lack of customers is their biggest issue, not lack of credit. The most recent bank earnings missed on the revenue side and only beat on the bottom line due to reversing reserves. Even during the prior quarter conference call Jamie Dimon said this type of earnings beat was not good.

I see no argument beyond a trade for a long-term investment in the financials right now. Banks need to clean up their balance sheets, improve their operational efficiency and address their vast legal problems. Everyday a class action suit is brought against a major bank, self-imposed foreclosure moratoriums are still in place and even JPM is facing RICO charges for silver manipulation.
For the sake of full disclosure I am short banks via short calls and have been for the past six months.


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