A New Short Idea in the Banking Sector

"You know, you saw subprime go first, and then, on a slight lag, you saw home equity, and now in the lag, you’re seeing prime go. And it’s exactly the same loss factors. But remember, the components of where we are in the states…[are] very different. And we started doing more jumbos in ’07, so a lot of that is – part of that is ’07 vintage, which I think I told you at the time we were going to do and grow our balance sheet and gain share. And we were wrong. You know, we, obviously, wish we hadn’t done it.

"So when you adjust for all of those things – vintages, CLTV, stated income, where it’s done – that’s what we’re seeing. You know, it’s very early in the loss curves…

"Prime looks terrible, and we’re sorry."

– J.P. Morgan CEO Jamie Dimon

The recent financial stock rally has all the signs of panicked short covering, rather than typical buying. Consider how the depository institutions most likely to eventually join IndyMac in federal custody – including Washington Mutual, Downey, and Huntington Bancshares – are rallying the most. So many shares had been sold short that a violent rally was inevitable.

Eventually, though, this rally should prompt two things:

1. Mutual funds selling financial stocks into strength. We’ve finally seen a shift in psychology away from buying financials on the dips. Many managers are preparing for an extended bear market in the sector.

2. Banks with capital shortfalls will announce secondary stock offerings. This will lower the cost of new capital, because higher stock prices allow the banks to issue fewer shares to raise a fixed amount of capital.

The SEC is implementing rules that will make it a bit harder to sell short stocks that are difficult to borrow.

I think "naked" short selling (shorting a stock when your broker has not yet located shares to short) must be stopped. This practice gives legitimate short selling a bad name.

Stock should be located and borrowed before it is sold short, not the other way around. If your broker cannot locate shares to short, you should move on to another idea, or use put options.

But the hysteria about "rumors" bringing down financial companies has gone too far, I think. This is the defense of CEOs who are looking to blame someone for their own incompetence – incompetence that put their firms in a vulnerable position in the first place. Short sellers did not conspire to force Wall Street firms to enter the business of securitizing dodgy debts. Firms like Bear Stearns ruined their own companies with the poor strategic decisions they made. The free flow of opinions is vital for the health of the stock market. One should be very suspicious about executives who try to suppress any negative opinions about the value of their stock. Allied Capital comes to mind.

You can read about Allied’s crusade against David Einhorn in his excellent book, Fooling Some of the People All of the Time.

Allied is still a good short idea looking out beyond a year because it’s running out of attractive assets to sell and finding it harder and harder to issue new equity.

Short sellers need to do their own fundamental research and form their own opinions. Only fools buy or sell short stocks based solely on rumors. Legitimate short sellers are very beneficial for the market. They provide liquidity at market bottoms by buying to cover their positions, and they are often the first to discover and put an end to accounting frauds and stock promotion schemes that siphon capital away from legitimate businesses.

Timing is important in the banking business. Also, as in investing, it pays to be a smart contrarian. Ideally, banks should make as many loans as possible once the economy bottoms. In an improving economy, borrowers can more easily pay down debts.

Loans made with disciplined underwriting guidelines ahead of an economic boom can be both safe and profitable.

On the other hand, aggressively expanding a loan book at the peak of a credit cycle and an economic cycle can lead to disaster.

Once credit cycles turn, loan portfolios, or loan books, become sources of risk, rather than profit. Look at the experience of Countrywide, which just got acquired by Bank of America for a fraction of is peak value. It blew itself up by aggressively expanding its mortgage loan book at the peak of the credit cycle – which happened to coincide with the biggest housing bubble in history.


Dan Amoss, CFA
The Daily Reckoning

August 20, 2008

P.S. The best banks to sell short are the ones that got sloppy at the peak of the credit cycle. This month’s short idea got a bit sloppy, but has thus far flown under the radar screen. 

Dan Amoss, CFA runs Strategic Short Report, and is a contributing editor for Whiskey & Gunpowder. Dan joined Agora Financial from Investment Counselors of Maryland, investment advisor for one of the top small-cap value mutual funds over the past 15 years.

Dan brings with him the unique experience of an institutional background and a drive to seek out the most attractive investments within favored "big picture" trends. He develops investment ideas for his readers with a global network of geopolitical and macroeconomic analysts. Dan holds the Chartered Financial Analyst designation, a professional designation widely recognized within the investment community.

The happiest days are the saddest; the easiest times are the hardest; vacations are when the real work is done. Most of the year, we keep our heads down…working, going to school, doing what we must do. Then, on vacation, we look around us, and the world has changed. More below…

In the meantime, we remind readers that we are on vacation this week; don’t expect any serious reckoning.

The Dow fell 180 points on Monday. On Tuesday, it dropped 130 more.

Yesterday came more evidence that credit is still getting crunched. CDO defaults are increasing; CDO values are in "free fall," says the Financial Times.

Lehman Bros. is expected to announce a $4 billion write-down.

Single family housing permits are at a 26-year low; homebuilding is at a 17-year low. Naturally, suppliers – such as Home Depot – are reporting lower profits.

What is needed in the United States, says an article in the International Herald Tribune, is a "long period of frugality." No doubt about that. Thanks largely to reckless and dishonest credit cues from the Greenspan Fed, more people made more financial mistakes than at any time in history. It will take years of scrimping and saving to correct them. We don’t have to tell you what that means; less spending = less GDP growth = recession. A long, slow recession a la Japan.

Many investors are now betting that the whole world economy will fall into a soft, Japan-like nap. They’re buying the dollar…and U.S. Treasury bonds…as a protection. But we caution Daily Reckoning readers that there are big differences between the United States and Japan…between the dollar and the yen…and between today’s globalized economy of 2008 and Japan, Inc. of 1990. In a nutshell, Japan could drop into a cushy bed of savings and sleep for a decade or two. When the United States gets knocked down, on the other hand, Americans fall onto the cold concrete of debt. Rather than live off the credits they built up over the past 20 years, they’ll have to service the debt they incurred.

The U.S. is still running a trade deficit of about $2 billion per day. In order to continue financing that shortfall, it has to guarantee the rest of the world that its dollar will be at least as solid in the future as it has been in the past. But in a severe downturn, the pressure to let the dollar slip will increase.

All through the ’90s, the Japanese maintained a positive trade balance…and a strong yen, with falling consumer prices. Japan tried to stimulate the economy by running huge fiscal deficits and lending money at zero interest. The economy did not recover; but it didn’t collapse either.

But when the feds become desperate to revive the U.S. economy – if it comes to that – the results could be calamitous. More on that as the story unfolds…

*** Henry left for college yesterday. Was he ready to be on his own? Would he get distracted by campus life? Would he get up in the morning and do his work without his mother on his back? Would he lose his passport?

We spent the last 18 years preparing him; but when the day came for him to leave finally came, we weren’t ready for it.

He said goodbye to both grandmothers…to his brothers…to nieces who are staying with us this summer…to Damien, the gardener…to the cook…to friends and relatives. Then, his mother and father took him to the train station. The station was deserted. Henry bought his ticket and sat down with us outside the waiting lounge, facing the tracks.

"We’re going to miss you," said his father. "There are a lot more shutters to paint."

His mother was silent. She stroked his curly brown hair. She petted his shoulder. The sun reflected on the polished steel seats outside the station as if on a mirror. She turned her head down to avoid the glare, then looked up at him again…

After a few minutes, the moment she dreaded arrived; we saw the little blue train coming around the bend. Henry stood up, gathered up his two bags. His father hugged him. His mother kissed him on both cheeks. He got into the car and took a seat, while we waited on the dock. A young man with a long face stood at the doorway of the train, smoking a cigarette. He smoked rapidly, until the conductor blew the whistle. Then, taking one last, deep drag, he tossed the butt on the tracks and the door closed.

The train started to roll forward. The glass was tinted, so we could barely make out the people inside. Then, we saw him again…Henry waved…and the train sped up.

"He’ll be fine," we said, escorting Elizabeth to the car.

But she was in tears…not because she doubted Henry could take care of himself, but because she knew he could.

"I should have gone with him. But I wish he didn’t have to leave at all," said his mother. "Some mothers feel liberated when their children leave home. They feel as though they can finally do what they want. I don’t feel that way at all. I feel like I’ve been hit by a bus."

Until next we meet,

Bill Bonner
The Daily Reckoning