Psychology Switch? The Financials May Never Be The Same

I want to talk a little about the market today before I get into a great piece I read from Satyajit Das.

I found the trading today to be strange. I have been waiting for a bit of a bounce the last couple of days because we are so oversold short term. In fact, CNBC reported that yesterday the oversold indicators were the highest they have been since 2002 which was the start the start of the housing bubble bull market.

So technically we are very oversold. You then follow this up with better than expected news and upgrades described below:

From Bloomberg

"GM, the largest U.S. automaker, jumped the most in more than two weeks and led the Dow Jones Industrial Average's rebound from an almost 167-point drop earlier in the day.

American Express Co. posted its best gain since May on UBS AG's upgrade of the biggest U.S. credit-card company.

CIT Group Inc. jumped the most since March after selling its mortgage businesses to Lone Star Funds and Berkshire Hathaway Inc.

Lehman Brothers Holdings Inc. advanced $1.15, or 5.8 percent, to $20.96. Morgan Stanley said the fourth-largest U.S. securities firm has sufficient cash and rated the stock ``overweight'' in new coverage

ISM Surprise
Stocks climbed briefly in the morning after the Institute for Supply Management's factory index rose to 50.2 from 49.6 in May, topping economists' forecasts. A reading of 50 is the dividing line between expansion and contraction."

Quick Take:

So as these stories came out throughout the day, you got to be feeling pretty damn good if your a bull. Better than expected news in manufacturing, upgrades in financials, GM suprises to the upside, and we are extremely oversold. You put this all together and they have to be thinking I need to put money to work because this should be a 300 point day for the bulls.

So what did we end up with? Up 32 points on the DOW. Thats got to be pretty discouraging for the cheerleaders. If this is the best they can do on a positive news day, whats going to happen when the next shoe drops from this financial crisis?

I wouldn't be surprised if many bulls lost hope today. Its not gonna get any better than this from a news perspective over the next year. 3 years ago I guarantee you that stocks would have soared on a day like today.

Its obvious the bears are in charge of this market. The psychology in today's stock market is to now sell the crap out of stocks on bad news and ignore the good news. This is a 180 degree switch in psychology boys and girls. Take note of it.

U or V shaped Recovery for Financials? How about an L shaped recovery?

This is what Satyajit Das is proposing. For those who don't know Mr. Das, he is a derivatives expert and very well known. He has been tough on the banks for what he calls "shadow banking" practices. I recommend everyone reads this whole piece.

Take a look at the IB's Level 3 assets verus capital. These numbers are staggering. Some of Mr. Das's conclusions:

"Structured finance has contributed strongly to earnings in recent years. Securitisation, including CDO activity, has been a major growth area. Volumes have collapsed. As at end June 2008, US ABS issuance (US$106 billion) is 73% lower than that in 2007. Home Equity ABS issuance (US$303 million) is 99.8% lower than 2007 (US$198 billion). Year-to-date CDO issuance (US$14 billion) is down 93.8% from 2007 (US$225 billion).

Higher costs will also increase limiting earning recovery. Bank funding costs have increased. Most firms have been forced to issue substantial amounts of term debt to fund assets returning to balance sheet and protect against liquidity risk. To the extent, that these costs cannot be passed through to borrowers, the higher funding costs will affect future funding.
Banks have issued high cost equity to re-capitalise their balance sheets. Hybrid capital issues paying between 7.00% and 11.00 % pa will be drag on future earnings. Highly dilutionary equity issues (often at a discount to a share price that had fallen significantly) will impede earnings per share growth and return on capital.

Investors are looking for a rapid recovery in bank earnings. Earnings may recover but the “gilded age” of bank profits may be difficult to recapture.
Glamorous banks reliant on “voodoo banking” may find it difficult to achieve the high performance of the “go-go” years.

Will the recovery in bank stocks take the form of “V” or “U”? It may be a “L”. With the Northern Rock and Bear Stearns bailouts, central banks and governments have signaled that major banks are “too big to fail”. This is a necessary but not sufficient condition for recovery of bank earnings and stock prices. The recovery might take the form of a “L” (Kirsten ITC font) – note the small upturn at the far right of the flat bottom."

Quick Take:

You must read the whole article to appreciate it. I now realize why Morgan Stanley's debt may be downgraded by Moody's. Things are not good when Morgans level 3 assets are $73 billion and their capital base is $31 billion. That's means there Level 3 assets are 231% of capital. This is worse than Lehman whose level 3 assets were 187% of their actual capital(not that this is impressive).

If These level 3 assets shift down in value to any large extent, many of these IB's are insolvent. This article is frightening to say the least. According to Mr. Das, the numbers are only getting worse as the credit crunch deepens.

The boom days of the pigmen are over. Post regulation they will be taking $100 checks and opening new deposit accounts for elderly hoping to grow their earnings a little each year. Its going to take a long time for the pigmen to get their mojo back.

The financials may never be the same.