Banking Crisis Not Over, More Writedowns and Bank Failures Despite Short-covering Rallies

By: Hans_Wagner

Are the financial woes of the banks over? To beat the market by investing in the stock market, you should have a good understanding of the factors that are driving the trends in the financial sector. For example, are we close to the end of the loan write-offs? If you are learning to invest, it is important to have well ground perspective on state of the financial sector before making any long-term commitments. Expect the financial woes of the banks to continue and be careful when the market make volatile moves in either direction.

Bank Failures

On Friday July 11, 2008, after the market closed, the Federal Deposit Insurance Corporation (FDIC) took over IndyMac Bancorp (IMB) in California. This was the second largest bank failure ever in the US. About a year ago, the share price was $29. It closed on Friday at $0.28. According to the FDIC, there have been 12 bank failures so far in 2008. The concern among investors is that there will be many more failures in the months to come as loan write-offs over whelm banks without sufficient capital.

Earlier on the same day, there was much consternation about the fate of the quasi-government mortgage banks Freddie Mac and Fannie Mae. An article in the Wall Street Journal and comments from a former Fed Governor indicated that these organizations were insolvent. Management at both companies claimed that this was not true and that they were fully capitalized and accepting mortgages.

Quoting "Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-value accounting rules. The fair value of Fannie Mae [down 78%] assets fell 66 percent to $12.2 billion, data provided by the Washington-based company show, and may be negative next quarter, former St. Louis Federal Reserve President William Poole said." (Bloomberg). Also, Senators Schumer and McCain both said Freddie and Fannie would not be allowed to fail, in the same story.

Freddie and Fannie are essential to the U.S. mortgage market. According to various reports, they are currently buying up to 80% of the mortgages now created in the US. Without them, the mortgage market would dry up and the price of homes would fall much further as very few could afford to buy a house. If this were to happen, the US would face a housing meltdown of unprecedented form.

So where do Freddie and Fannie get additional capital? As mentioned above, the price of their stock has fallen significantly. Not many investors want to place new capital in an organization that still does not know how bad it can get. Free marketers believe they need to fail to help restructure the system and make the market work properly. Others believe the government must step in at taxpayer's expense. Most likely, we will see the government step contributing a large amount of money receiving preferred shares in return. If this happens, expect the common stock holders to be wiped out. The hope is eventually the Treasury will be able to sell the preferred shares to recoup their investment once the market stabilizes in several years. This makes one think how bad can it get.

Testifying before Congress Ben Bernanke said that Freddie and Fannie were adequately capitalized and that the problem was one of confidence. The Securities and Exchange Commission said it will curb short selling in the primary dealers as well as Fannie Mae.

Potential Loan Losses

About a year ago, the “analysts” estimated that the total write down of bad loans would be about $400 billion. Then by December 2007, the estimate doubled to about $800 billion. Then along comes a report from Bridgewater Associates that expects the number to double again to $1.6 trillion. Bridgewater is a very large hedge fund who is also one of the top analytical firms. Up to now, the banks have been using a ‘mark-to'model' method of valuing the structured debt. According to Bridgewater, the modes used have grossly underestimated the actual losses. They doubt the financial institutions will be able to generate enough capital to cover the losses.

According to the report, “Lenders would have to curtail loans by roughly 10-to-one to preserve their capital ratios. This would imply a further contraction of credit by up to $12,000bn [$12 trillion] worldwide unless banks could raise fresh capital."

Not all of these losses are in the sub prime market. According to the report, more than 90% of the losses from sub prime loans have already been written off. Unfortunately, the losses form the prime and Alt-A loans could be much larger than we have already seen. The size of these loan portfolios are much larger than the sub prime portfolios. Further, Bridgewater expects about $500 billion in corporate losses that must be written off. This leads to the current estimate of more than $1 trillion in losses yet to be written off. That is a scary thought.

On Sunday evening July 13, 2008, the government stepped in to start the bail out process of Freddie and Fannie. The following is from MarketWatch:

WASHINGTON (MarketWatch) -- The White House and the Federal Reserve moved Sunday to prevent Fannie Mae and Freddie Mac from failing. In a statement, Treasury Secretary Henry Paulson said the global reach of Fannie and Freddie necessitated unprecedented action. The Treasury has asked Congress to increase the existing line of credit to Fannie and Freddie. In addition, Treasury asked Congress for the power to buy the two companies stock. In a separate vote, the Fed board of governors voted to open its discount window lending facility to Fannie and Freddie. In return, Paulson asked Congress to give the Fed a formal role to work with the new GSE regulator on capital standards for Fannie and Freddie.

So the bail out has begun. So far, Freddie and Fannie have not taken advantage of the Fed's discount window. It looks like just making it available helped to increase the confidence in the financials. Then on Wednesday, July 16, 2008 Wells Fargo increased its dividend by 10 percent, which was a surprise. This news has helped to push up the financial sector more than 10% on the day.

The Bottom Line

So what is an investor to do? The financials benefited from these moves as short covering on Wednesday helped push up the prices of the banks across the board. The transportation and consumer discretionary sectors also did well. One characteristic of bear markets is sudden moves up that can last for several weeks. However, then reality sets in and the market turns back down. We could be on the cusp of this type of move if it can sustain itself through the heart of earnings season. For investors willing to make trades that might last only two to four weeks, there is a good chance we are near an interim bottom. Before committing capital, we need to see if the rally on Wednesday can continue. Stay tuned.

If you wish to learn more on evaluating the market cycles, I suggest you read:

Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles by Joe Ellis is an excellent book on how to predict macro moves of the market.

Unexpected Returns: Understanding Secular Stock Market Cycles by Ed Easterling.  One of the best, easy-to-read, study of stock market cycles of which I know.

The Disciplined Trader: Developing Winning Attitudes by Mark Douglas.  Controlling ones attitudes and emotions are crucial if you are to be a successful trader.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

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