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Investing in Financial Companies

Written By Brian Hicks

Posted June 8, 2008

If you want to lose money, listen to the talking heads, CEOs and economists that would have you believe the worst is over. If you want to make good money, buy credit card stocks with no consumer debt risk, and short-sell the big financial names with heavy risk exposure.

Try as they will, financial stock CEOs are trying to convince Wall Street that the worst is over. It’s not.

When housing bottoms, financial companies will bottom. And that’s three years off.

Toll Brothers’ CEO Robert Toll, for instance, wasn’t ready to call a housing bottom because the "housing market could still get worse. Can the market go down another 10 to 20 percent? Sure," adding that the industry is in a depression and any recovery could be "two to three years away."

DR Horton could call the bottom either, saying the industry could face tough times until 2010.

And while the fundamentals for a strong housing market (low interest rates, low jobless rates and population increases), the lack of confidence that housing prices will stop falling are keep potential buyers on the fence.

As long as there’s more glut on the market, prices will fall further. Housing developers in Southern California are so desperate, for example, that one is offering a "buy one, get one free" deal.

Foreclosures aren’t helping either.

Foreclosures soared 0.99% in Q1 2008, bettering previous highs of 0.83% year over year, as the delinquency rate jumped to 6.35% from 5.82% year over year.


Option ARM Resets

Once the subprime carnage has stopped, the market is faced with Option ARM and Alt-A resets.


Option ARM resets June 2008


It shouldn’t come as a shock when mountainous Option ARM and Alt-A loans begin resetting and the second leg of the credit crisis begins.

Alt-A loans were given to borrowers with credit scores of between 620 and 700, and included the option of interest-only loans, option ARMs, and no documentation loans that required little if any documentation for loan approval. Ninety percent of those that got an Option ARM in 2006 provided little or no documentation.

Ninety percent!

And it’s estimated that only 60% of Option ARM borrowers make only minimum monthly payments. Others estimate that up to 80%.

Say a borrower makes minimum payments on a $600,000 loan. That loan could easily be a $750,000 loan within two years.

And we’re supposed to be shocked when this problem ends in the second credit crisis?

MBIA and Lehman… Countdown to Extinction?

Another fear, mortgages that support securities that MBIA insures, for example, could default in higher numbers. That, and fears of a Moody’s downgrade of MBIA could wreak substantial financial havoc.

And Lehman, whose supporters say that LEH is being unfairly driven lower by short-selling funds, is over-leveraged with mortgage liabilities. If these guys go under, mortgage backed securities would sell for fire-sale prices and we have a Bear Stearns situation…. Only to be followed by multi-billion dollar financial write downs.

Yep, that makes financials a great buy.

Financial Companies Suffer as Consumers Turn to Plastic

As consumers lose disposable income to hyper-inflated food and energy cost, an easy way to stretch your credit is to use credit. And it’s becoming a problem.

Last week, the Federal Reserve reported that credit card delinquencies rocketed to 4.86% in Q1 2008 as revolving debt surged 7.9% to $957.2 billion. That means potential problems for companies that underwrite that debt, including Lehman, Citigroup, Bank of America, Capital One, Discover, American Express, and UBS, for example.

Fortunately, Visa and MasterCard have low risk of default. They get paid a fee every time a consumer uses their cards, while the banks that issue credit for those cards assume debt responsibility. Credit card companies like Visa will continue to be the safe stocks in the credit market. That’s because they’re smart enough not to lend credit to cash-strapped consumers and aren’t open to delinquency issues.

Trust Issues Abound

Lehman Brothers’ CEO Richard Fuld, Goldman Sachs CEO Blankfein, JPMorgan CEO Jamie Dimon, and Merrill Lynch’s CEO (who said the "worst is over" a month before writing down another $6 billion), all attempted to convince us that the "worst was over."

Citigroup’s recent sale of an additional $4.5 billion worth of shares (its fifth attempt to raise capital in five months) came with the promise that each would be the last. Citigroup has now raised $40 billion by diluting shares, as they tell us everything is okay.

And as we said back in March 2008:

"If the Bear Stearns situation sounds familiar, it’s because a similar incident happened with Countrywide.

It was 2007 when Countrywide Financial (CFC) had us believing that it had ample capital and liquidity to stay in business. They disclosed $35.4 billion in reliable liquidity. And they disclosed "sufficient liquidity available to meet projected operating and growth needs and significant accumulated contingent liquidity in response to evolving market conditions."

But who were they fooling? They burned through the $2 billion Bank of America cash infusion, burned through the $11.5 billion credit line used to ease liquidity issues. They burned through Fed cash infusions. And they burned through that $50 billion cushion they said they had.

They said they had ample capital and liquidity in August 2007 when they stated, "Our mortgage company has significant short-term funding liquidity cushions and is supplemented by the ample liquidity sources of our bank. In fact, we have almost $50 billion of highly reliable short-term funding liquidity available as a cushion today. It is important to note that the company has experienced no disruption in financing its ongoing daily operations, including placement of commercial paper."

Seven days later, the company announced that it faced "unprecedented disruptions" in debt and mortgage markets.

Now, take a look at what Bear Stearns did.

On March 12, Bear Stearns’ CEO appeared on CNBC and said (per their "liquidity position has not changed and their balance sheet has not weakened at all. Says their liquidity cushion has not changed. Don’t see any pressure on their liquidity, let alone a liquidity crisis. As they close the books, they are comfortable with the range estimates that are out there currently."

He even denied threats to liquidity and said the company had a $17 billion cushion. Investors actually cheered the news and sent BSC up days before the stock landed at $2."

And now Lehman is falling on speculation that it faces Bear Stearns-like problems, as management tries to assure the Street that everything is okay.

When the housing market bottoms, then we can talk about a housing bottom. Calling a bottom ahead of Option ARM resets on the part of economists and CEOs is premature at best.

Trust in financial stock CEOs hasn’t bottomed either.

Oh, and coming bank failures are no secret.

Says FDIC Chairperson Sheila Baird, future U.S. bank failures "linked to the downturn in the real estate market may include ‘institutions of greater size’ than in the recent past."

Yep, its quotes like that that makes financials even more appealing.

Again, stay away from investing in financial companies. But do buy stocks with little exposure to credit decay, including the likes of MasterCard and Visa.

Good Investing,

Ian L. Cooper


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