Thursday, February 21, 2008

more about why i'm buying banks

jefferson once said that banks are more dangerous than standing armies. certainly with greenspan at the helm of the fed this was the case. under his leadership the fed was instrumental in creating two bubbles - the dot-com bubble of 1995--99 was followed by a grand loosening of credit that resulted in a second bubble, the housing mania of 2001--05. still, when a bubble implodes there are always good opportunities for folks who have the courage to take risks.

this particular credit crisis has been devastating to financial stocks. banks, hedge funds and real estate investment trusts have incurred at least 800 publicly revealed writedowns of debt securities in the past year or so. investors are running in fear from securities backed by, or in any way related to, mortgages or high-yield bonds. both stocks and fixed-income securities have been knocked down to levels that are cheap even with worst-case assumptions about future defaults.

you have to choose carefully here because many finance stocks will not come back for a long time, if ever. Avoid highly leveraged REITs or subprime-heavy institutions. stay away from smaller banks, too: their disclosure of problem assets is likely to be slower than that of their larger brethren. also large brokerage houses should be looked at with a very skeptical eye - they likely have more writeoffs ahead, given their commitments to private equity firms. however, i believe the exception here is gs, which i do own.

the safest plays are among the big banks, as most of this group have taken large reserves against their losses in the various mortgage areas, hoping that the market would reward them for their candor. the market's response, however, has usually been to punish the reserve-takers with further cuts in their stock prices.

perhaps investors are spooked by memories of the 1990--91 crisis in the financial sector, when real estate losses were so huge that investors questioned the ability of some commercial banks to survive without additions to their capital bases. at the same time, scores of savings and loans were collapsing from ill-considered forays into junk bond buying and construction lending.

i believe the story is quite different today; yes, the losses are towering, yet tier-one capital--the core measure of a bank's financial strength, chiefly shareholders' equity (including that from preferred shares)--is not threatened, as was true 17 years ago. while most large banks had lousy third and fourth quarters, the worst may well be over. bac - which i own, wb - which i want to own, c - which i own and jpm - which i also own are some that should show good appreciation with time.

fre, which i also want to own very soon, has also been badly hit, dropping to multi-year lows. in the current housing debacle, which may well turn out to be the worst since the great depression, investors are frightened that the mortgage giant may be understating losses. many skeptics question its accounting, given its past bookkeeping scandal, and fear that default rates will rise significantly. not helping is fre's 3rd and 4th quarter losses and its decision to cut the dividend. federal regulators are making the company raise more capital, an expensive proposition.

a panic puts a magnifying lens on risks, making them look much bigger than they are. prime examples: fre and its sister agency, fnm, which i also want to own asap.

for all my recommendations in this column, i strongly advise acquiring positions gradually. who knows how close we are to the bottom of this very jumpy market? still, those who buy bank stocks should be well rewarded over the next couple of years (but OF COURSE DO YOUR OWN DARN DD!).

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