Playing Mousetrap

The cheese in a mousetrap is real cheese. That’s not the whole story, of course. But that’s the END of the story for every impatient and over-confident mouse. Ten American banks profess no further need for their TARP borrowings. This event is “real cheese,” but it is not the whole story. So why not let some other investor- mouse take the first bite?

Many professional investors – usually bad professional investors – like to say that the stock market “looks ahead,” as if the stock market can peer into the future and adjust today’s stock prices accordingly. Therefore, the fact that bank stocks have doubled during the last 90 days has led some folks to declare, “Aha! The finance sector is recovering!” The higher bank stocks go, the more these folks believe “the worst is over”…and the more they believe they should continue to bid bank stocks higher still.

But the truth of the matter is that the stock market has a hard enough time trying to see the present, without also trying to squint into the future. The nearby chart tells the tale. On ten separate occasions during the last twenty years, Japan’s Nikkei 225 Index rallied more than 30%. On four of those occasions, the Nikkei soared more than 50%! And yet, the Nikkei still sits 50% percent below where the first of these 10 rallies began, way back in 1990. During each of these bear market rallies, investors invariably believed that the worst was over and that recovery lay just ahead. One of these days, the worst actually will be over in Japan, and recovery will in fact lie just ahead. But that hasn’t happened yet.


Returning to the U.S. of A, the current stock market rally has produced a gain of 40 percent. No Absolute Law of Financial Markets would require this rally to end soon, or would condemn the S&P 500 to following the pathetic precedent of the Nikkei 225. Nevertheless, recent intelligence from the U.S. financial sector suggests that the worst might NOT be over.

“The losses in the US banking system will likely exceed the entire tangible capital in the system,” warned hedge fund manager, Igor Lotsvin, at last month’s Value Investing Congress in Pasadena, California. “Certainly that’s not going to happen for every bank. But the remaining $1 trillion of tangible equity [in the banking sector] is not sufficient. The losses will happen across almost every asset class… and certainly commercial [real estate lending] will be the next shoe to drop. We see the same types of issues with credit cards…This banking crisis is unlike anything we’ve seen before.”

“And remember,” Lotsvin continued, “the bulk of this crisis happened before people started losing their jobs. Historically, employment levels are a primary driver of credit quality. People default on their mortgages for three primary reasons: either interest rates spike up, you lose your job, or you’re so upside down on your mortgage there’s no reason to pay it, even if I have the money. What we are seeing so far is the increase in interest rates that drove so many people into default. We haven’t even seen the play out of unemployment and the fact that home prices are going down at a very rapid clip, which is putting a lot of people upside down in their mortgages.”

But home loans are just one small part of the reason that Lotsvin is worried. Signs of distress are beginning to appear in almost every category of bank lending – including those categories that had been holding up well until very recently.


All together, these other loan categories dwarf the size of the subprime mortgage market. So if the relatively small subprime market was large enough to create the biggest credit crisis since the Great Depression, what happens when the larger loan categories start to have serious problems?


“You can con investors,” Lotsvin concluded, “you can con taxpayers, you can con mutual fund managers many times over…but the laws of supply and demand cannot be conned. The supply of distressed inventory is so large that there is not enough of a balance sheet to take it all on…The supply of distressed assets is astronomical.”

Hedge fund manager, Jason Stock, who also appeared at the Value Investing Congress, sympathized with Lotsvin’s cautionary outlook. “We think the banking sector is definitely undercapitalized,” Stock warned. “We’re expecting commercial loans to eat through a good portion of the capital. We think the common stockholders could be either massively diluted or wiped out in a number of the banks.”

“When we look at where we’re headed,” Stock continued, “and we looked at what the delinquency rates are in the various categories – commercial real estate, business loans and consumer loans – those pieces of the pie have yet to see meaningful deterioration.”

Stock is particularly concerned about commercial real estate loans, which represent about one third of all loans in the banking sector. “A lot of these loans were originated by [banks] that were willing to lend anybody and everybody at 90% to 95% to 100% loan to values,” Stock explains, “and were giving borrowers five-year interest-only real estate loans, which was really unheard of if you went back into more traditional banking periods.

“So as these loans come due, and there’s no financing available to refinance them, it’s definitely a big problem…A lot of the banks that we speak to are extending these loans. So if the loans come due, instead of declaring it ‘nonperforming,’ everyone says, ‘You know what, we’re better off giving the borrower another year or two,’ hoping that the cash flow can continue to make payments on the loan. But at some point these loans have to be refinanced… and we think there’s a fairly limited amount of capital available that’s going to lend against these vacant, distressed properties.”

In other words, dear investor, expect the loans losses and writedowns to continue for a while longer. In the meantime, be wary of cheese.