Financials: catching a falling knife

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Back in June, I wrote about financial investors in bank shares having lost $10 billion. Then, I predicted that losses would mount and bank shares will fall. It seems that one part of that equation is true already as bank shares have fallen precipitously in the last several days on the heels of turmoil with the GSEs and with IndyMac.

However, I think it is time to revisit the chatter about why bank shares are falling and why investing in them is like catching a falling knife.

In June, FT Alphaville, a blog for the Financial Times said this about the early investors in financials:

Investors who backed the recent drive by U.S. financial companies to raise capital are sitting on nearly $10bn in paper losses amid a continued slump in the sector’s shares, an FT analysis shows. The negative returns suffered by investors are likely to make it more difficult and expensive for U.S. financial groups to tap equity markets if, as expected, they are forced to raise more capital. Investors who bought the $65bn-plus in common and convertible shares issued by large U.S. financial institutions since last October have seen their total investments fall by more than $9.7bn – a negative return of about 15% – according to an FT analysis of Dealogic data.
FT Alphaville, 16 Jun 2008

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Today, Bloomberg had an article highlighting the worsening state of losses in banking shares:

TPG Inc.’s plan to profit from Washington Mutual Inc., the biggest U.S. savings and loan, may be sinking with the housing market.The private-equity firm, led by David Bonderman, anchored a $7 billion cash injection into Washington Mutual in April by purchasing stock at a discount. The Seattle-based lender’s share price has since plummeted, wiping out two-thirds of the investment’s value.

Washington Mutual tumbled to the lowest since 1991 yesterday on the New York Stock Exchange, leading the drop in home lenders after IndyMac Bancorp Inc. was seized last week by U.S. regulators. Bonderman’s firm, which invested $2 billion in Washington Mutual for a 13 percent stake, has been stung by record foreclosures, particularly in California, home to half of the bank’s loans.

Bloomberg, 15 Jul 2008

With share price losses having mounted significantly (the S&P500 Bank Index is down below 150 from near 300 in February and almost 400 one year ago), one gets the feeling that actual losses on net income and bankruptcies are coming.

Where?

Soon after this crisis began in February 2007, U.S. Treasury Secretary Henry Paulson said the sub-prime mess is:

“going to be painful to some lenders, but it is largely contained.” “We have had a significant housing correction in the U.S.,” Paulson said in an interview on CNBC. “The correction has been significant. You can’t have a correction like that without causing some dislocation. It is too early to tell whether it has bottomed. We’ll know more in the next month or two.”
13 Mar 2008, MarketWatch

However, the mess continued on and on until $400 billion in assets had been written down. But that part is done. Bridgewater Associates, a respected hedge fund in the US, recently said that sub-prime is 90% over. So the losses are obviously not going to come from sub-prime.

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There are three obvious places to look:

  1. Other mortgage areas beyond subprime that have been ‘tainted’ by the subprime mess and that are showing signs of distress.
  2. Other credit classes that exhibited the same levels of euphoria during the upswing
  3. Other unrelated credit classes that might be affected by a negative feedback loop that credit contraction has on the real economy.

As far as Mortgage classes go, Alt-A is the class to watch now. This class between sub-prime and prime is now exhibiting many of the hallmarks of distress previously seen in sub-prime before it cratered. (See posts under the tag mortgages and home loans for more). IndyMac, now bankrupt, was a major provider of mortgages in this sector. In April, Moody’s began downgrading Alt-A Residential Mortgage-Backed Security (RMBS) bonds.

Moody’s Investors Service issued more Alt-A downgrades on Thursday morning, this time taking a heavy hand to 32 different Aaa-rated tranches from 10 different Alt-A deals. Many of the downgrades even pushed former Aaa’s into non-investment grade categories — a stunning descent for top-rated Alt-A mortgage bonds that underscores two key points.

First, defaults are obviously accelerating. Second, many Alt-A deals were issued with less in the way of overcollateralization — which, in plain English, means that these deals will start to see downgrades sooner, compared to the relative stress that a typical subprime RMBS deal can withstand before the hits start coming at the Aaa level.

The rating agency placed an additional 254 Aaa-rated Alt-A classes on negative ratings watch Wednesday.

All underlying collateral for the downgrades issued Thursday was originated by Impac Mortgage Holdings., Inc., the agency said in a press statement, making the Irvine, Calif.-based lender among the first major Alt-A lenders to see significant Aaa- downgrades to mortgages it originated.

Housing Wire, 24 Apr 2008

One shouldn’t rule out prime mortgages either.

When it comes to other asset classes that were exuberant on the upswing, my list includes:

  • CRE (Commercial Real Estate)
  • Construction Loans
  • Leveraged Loans
  • Credit Card and Auto ABSs (Asset-backed securities)
  • High Yield corporate debt
  • Emerging market sovereign debt

Now, those same classes are all ones that should suffer along with the global real economy downturn.

Conclusion
My prediction is that Alt-A RMBS losses will be the first to appear en masse followed by other asset backed securities as these have to be marked to market. This will mean significant additional losses for the money center banks in particular. But not only in the U.S. but elsewhere as many global players have exposure in these areas.

Construction and CRE loans will sour next as the regionals are forced to increase loan loss provisions in the commercial and residential real estate sectors. Real estate is the hardest hit sector to date. Therefore, I would look for losses to come there first.

Finally, we will begin to see losses in other asset classes as the real economy starts to struggle. High Yield (particularly lower grade bonds) and leveraged loans will suffer. When and how sovereign issues enters the picture is dependent on asset class contagion. Spread products like high yield sovereign debt is vulnerable to wholesale risk repricing and could fall at any point with other debt asset classes.

This scenario certainly spells bankruptcy for a few money center global players ad a raft of regional and local banks. With IndyMac as a canary in the coalmine, I suspect we will see these bankruptcies in the very near future.

All of this is reason to believe that investing in financials is going to be like catching a falling knife for some time to come.

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