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Week Ahead 4-26-2010

admin on 04 27, 2010

Last week I went on a bit of a rant in the weekly webinar on the accounting tricks our government has allowed our banks to get away with.  We are hearing the rumblings of financial reform but none of it really hits at the heart of the problems.  We have created a great backer in the Federal Deposit Insurance Corporation for the individual investors with less than $250,000 in deposits.  The FDIC also covers the losses associated with the banks so the assets can be moved to another bank.  Banks pay into the deposit insurance and have been asked to prepay the next three years of premiums to cover the lousy year we just had and the bleak future we are looking at.  In total last week the FDIC shut down 7 banks with assets totaling 6,330,200,000. (That is 6.3 Billion!).  These 7 failed banks will cost the FDIC an estimated $973,900,000 or over 15% of their assets.  This 15% number is deceiving because the largest bank only had a 5% loss to assets ratio.  The average loss per bank was over 25%.

Who has to cover this…ideally the healthy banks are responsible for their failed competitors, but the US government is the ultimate backer.  The FDIC has already closed 57 banks this year and that is after 140 closings last year. As of February there were over 700 reported problem banks.  Rumors have it that this number is under reported by 3-4 times.

The core of this problem is that if there was proper legislation and proper enforcement the FDIC should never have to get involved.  There would be enough capital to cover losses of loans.  In fact, after we have seen some of the earnings from the big banks this past week, we have seen that their loan loss provisions are being reduced even though these banks are continuing to fail.

Banks have been able to take advantage of the yield curve, where there is low borrowing cost in near term and invest it for higher returns further in time.  This has helped stabilize their books.  The loan loss provision reduction has also helped.  Have their residential and commercial mortgage loans improved?  Common sense would tell us that since foreclosures and unemployment are still high, that these loans should only be getting worse.  The accounting trick that we have come to see is through FASB 157.  Banks do not have to mark to market their Level 3 assets.  This is where they hide their losses on these hard to quantify mortgage backed securities.  If the sampling size of these recently shut down banks held true then our financial system as we know it would collapse.  Roughly 25% of the assets were already bad.  This does not include what will go bad.  It is like the vegetable merchant. They get their vegetables in bulk and there is no telling how many of each veggie is already bad, going to go bad quickly or stay fresh long enough to sell it.

The idea behind the government letting banks off the hooks is that it stops the bleeding immediately.  The main issue now is that they are not forcing a formula on them on how to value those assets.  They can mark them however they want.  They are also not forcing them to keep a certain level of loan provisions for those assets, as seen by the reduction of the banks in their earnings statements.

The FDIC is doing what it was created to do.  Our government and the SEC are not.  Transparency is critical when investing in a company like a bank.  How can the average investor put their money into a bank knowing their level 3 assets are not marked fairly?

It is true that our market needed the financial institutions to get healthy, but we have not done that in a way that has helped them for the long term.  If they are too big then break them up.  Re-institute the Glass-Steagall act.  In bust cycles the banks will do poorly and in boom cycles they will do great.  We are in a bust cycle and our government is trying to act like we are in a boom.  Get the bad companies with poor business practices out of the way and let stronger smaller companies fill the void.  We have been playing to the corporate cartels long enough.    We should not let financial reform pass that allows for more bailouts.

For those of you who were in the weekly webinar on April 8^th, we talked about the Oil breakout and how to play it.  Some of those plays especially the one we liked the most, COP (ConocoPhillips) are doing well despite the fact that the Oil futures have been sideways.  In COP we gave a quick target of getting to resistance which it did on Friday.  With futures trading sideways to off, this little pop may be time to look to hedge or roll.

On April 8^th the ATM May call was $1.1 and is now trading for $3.7.  If you want to roll out to give yourself more time for our longer term projections to happen and protect your profit then you can roll to the Jun 60s for $1.13 (the same price as the initial investment).  This is a little aggressive, but you could take $2.57 off the table and still be able to profit to the upside and give yourself more time if oil breaks out of this consolidation.