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Good news on banks?
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Written by Hugh McManus   

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Wednesday, 30 July 2008 17:48

So, banks are in a world of hurt right now, following the closure of IndyMac Bank on Friday (July 11, 2008).  But, there could be opportunties.  It may be the time to consider actually purchasing a bank or two!

I am getting more confident about banks.  I believe it was at the Money Show in Las Vegas in 2007 when we talked about the issue.  At that time, I was guessing that the economy was in the hole for between $500 billion and $1 trillion.  It now looks like it's closer to a trillion.  It's not a big deal.  The economy will fix itself.

The calculation was pretty easy to do.  Two years ago, I got figures on the increase in mortgage lending--it had jumped significantly.  Even if default rates stayed the same, someone was going to have to pony up between $50 billion to $100 billion to cover the additional loses.  Of course, thanks to the subprime mess, the default rate is much higher.

Since I was thinking of buying a house, the other ratios that intrigued me were the monthly cost of ownership compared to the rental rate and the average housing price to average income.  Both of these ratios went out of whack, which was a clear sign to me that we were in a housing bubble.  The ratio of housing price to income indicated that the problem was going to be at least $500 billion.

On July 14, 2007, the Wall Street Journal had a nice piece where it discussed the housing mortgage mess and showed a plot of the housing price/household income ratio since 1985.  Historically, this ratio nestled around 1.9: it took a dip to as low as 1.8 in late 1990; the ratio got as high as 1.92 in early 1986.  Starting in late 2001, the ratio started to climb and climb dramatically.  It hit 2.4 in 2005, which represented a huge deviation from historical norms.  From the proverbial 33,000 ft. vantage point, there was a clear, unambiguous housing bubble.  (Interestingly, oil prices are behaving the same way.)  Someone was going to have to pay for the excess; not surprisingly, it looks like it's going to be the banks.

Now the good news is that the ratio of housing price to household income has now come back down to 1.9--it dropped pretty quickly.  So right now we're apparently not seeing the excesses that characterized the housing market over the past seven or so years.  I don't know what's happening in commercial real estate--I suspected it's equally bad, if not worse, at least, about four or five months ago, I read about IndyMac's (IMB) problems with commercial paper.

Even if the housing market is somewhat rational right now--and there's no guarantee it will stay rational: chances are it will undershoot the historical average (housing price to household income) and we'll see the ratio venture back down to 1.8 or so again--there is the inventory of bad loans out there.  It's not only bad loans, but it's the way these documents were packaged: packaged into complex obligations in tranches that sought to segregate risk and reward.  There are two beasts out there: collateralized debt obligations (CDOs) that are tied to actual hard assets (assets that have fallen in value) and synthetic CDOs that are tied to the chance of a default; that is, they're not tied to a hard asset, but if there is a default, someone has to make good on those funds.  In return the person taking this risk in these synthetic instruments gets a stream of income.  Those instruments are all over the place and I think it important to dig into the footnotes of banks to find out to what extent they have exposure to CDOs, synthetic CDOs and if the company has some structured investment vehicles with exposure to high risk paper.

So, the good news is that while the housing market behavior is back to normal, banks are stuck with a bill for the party we just had.  No one still knows how large that bill will be (I am still betting for $1 trillion) or who will pay the lion's share.  Right now, IndyMac is on the hook for some.  The number of homes in foreclosure is significantly higher than the historical average--the number of houses in danger of foreclosure is high too.  So, I expect housing prices will continue to drop.  I also expect that during this coming fourth quarter--the quarter that is typically audited--banks will start writing down bad loans.  My suspicion is that they'll start signaling all kinds of earnings warnings for Q4 and try to dump as much bad news into that quarter as is reasonable.   We're going to start to see second quarter earnings in a few days; I will be particularly interested to see how CitiGroup (C) and Merrill Lynch (ML) perform.  I have both those companies on my pounce list.  I am also following Wamu (WM) closely. In fact, I just bought some of this company.  It's a pure speculative purchase.  If it bounces back up 50%, which it might, I will sell it again.  My other banks are US Bancorp (USB), JP Morgan Chase (JPM) and Wells Fargo (WFC).  American Express (AXP) is suffering too, which--since I don't own the company yet--I like.  I am really intrigued by Freddie (FRE) and Fannie (FNM).  I think we need to take seriously the possibility that we are staring at a once-in-a-lifetime chance to buy banks on the cheap.