Why Shorting Financials Is a Logical Response
Washington lawmakers who keep blaming credit default swaps for all the problems they are confronting are perhaps, to a large degree, simply ignorant. But regulators, in contrast, are engaging in willful blindness; the crisis in housing, in rising credit card delinquencies, in the Detroit auto sector and in a host of other industrial segments has nothing whatsoever to do with any derivatives product.
In fact, the core issue governing the sorry state of Wall Street balance sheets has got everything to do with the manner in which financial statements have been prepared, specifically the methodology which enabled banks, insurers and investment houses to effectively hide the quantum of inherent leverage, not in the practice of leverage itself. And decision-makers at the SEC, the Fed and the Treasury must publicly acknowledge this fine distinction. These bailouts are destined to be classic counter-productive exercises if disclosure in financial statements cannot capture, in credible form, leverage ratios, contingent losses, consumer-default benchmarks, and currency and political risks in the case of institutions operating in the emerging markets.
In the interim, the safer assumption to make is that a deleverage-induced shakeout in finance and insurance is still pending and overdue, and that an inevitable shakeout will, at some point in 2009, start forcing a dramatic adjustment (downward) in the value of corporations like General Electric (GE), Citigroup (C), Bank of America (BAC), American International Group (AIG), and JP Morgan (JPM). The negativity on financials like Goldman Sachs (GS), on the other hand, is founded in the collapse of the traditional Wall Street investment banking model and the pressing need to figure out a thoroughly revised corporate strategy.
Short positions in broad-financial ETFs (XLF, VFH, IYG and IYF) remain attractive, with solid potential to generate above-average returns through the course of the next 12-18 months, despite the price declines witnessed thus far this year. Given that the current malaise damaging asset valuations is not restricted to Wall Street, shorts on non-US ETFs (IXG and DRF) must also rank as portfolio imperatives. ETFs allow matrix-type positions which eliminate the time-consuming task of tracking individual stocks.
The Financial Accounting Standards Board (FASB) has been issuing circular after circular with the objective of providing fresh guidance on how derivatives (e.g. credit default swaps, collateralized debt obligations, and far forward currency and commodity contracts) should be recorded by chartered accountants. That’s a bit like asking a drunk to mind the bar. These chartered accountants, all members of long-established self-regulatory bodies, have been (for years) preparing the same balance sheets which have now proven to be illusory and misleading. So, rather than worrying about fresh direction from the FASB, chartered accountants need to adhere, even at this late juncture, to a time-tested accounting principle: don’t sign off on a financial statement unless inherent corporate risks are fully exposed, and be accountable (even for criminal neglect) for what you formally approve.
No derivative is complicated to the extent that it defies logical accounting treatment. In this regard, ignorance is no substitute for an understanding of the solution, or speculative window, a financial product provides. In any event, as far as the guardians of the financial system are concerned, it is extremely difficult to believe that the daily calls for greater oversight are rooted in ignorance.
Therefore, the only inference which can be drawn from willful blindness is that a comprehensive disclosure of the contents of finance and insurance balance sheets will reveal a totally unpalatable reality, and a political no-no. It is that reality which must unfold over the forthcoming two or three quarters. Encouraging a sell-financials approach is another important dynamic: as more jobs are lost and as family incomes continue to decline, the leverage component in those balance sheets will rise far beyond today’s levels. In that event, bankruptcies may well become compelling options.
Disclosure: Author holds short positions in GE, GS, XLF
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This article has 8 comments:
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Kingsley Anderson
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36 Comments
My Website
Nov 18 08:24 AM-
Disciple of Cashin
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1 Comment
Nov 18 10:58 AM-
bobbobwhite
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118 Comments
Nov 18 02:58 PMAnd, will that be what historians write about our capitalistic system failure in future history blogs, chats and boards?(I say those because there probably won't be written books then.)
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Jake2
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248 Comments
My Website
Nov 18 06:00 PM-
Dr A J
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9 Comments
Nov 18 07:21 PM-
cpatwork
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5 Comments
Nov 18 11:13 PM-
MichaelZZ
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34 Comments
Nov 19 03:32 PMOne cannot resolve a problem unless one understands the problem.
PROBLEM: Financial institutions have reduced their lending.
The problem results from the impaired equity portion of the balance sheets of these institutions, with the impairment caused by write-downs of their assets (loans).
Due to the losses they have taken, these institutions, by law, have had their maximum potential lending amounts reduced.
The amount they are able to lend is contingent upon the amount of their equity capital (EC), e.g., if an institution has an equity capital of one billion dollars and is able to lend up to 20 times its equity capital, it could lend up to 20 billion dollars.
After taking loan write-downs (losses) of two hundred million dollars, its EC would now be 800 million dollars, thus it would have its maximum lending authority limited to 16 billion dollars, i.e., a constriction of its legal authorization to lend.
This is the crux of the problem.
The institutions have funds, i.e., liquidity. But, without the legal authority to increase lending, they are sitting in stagnant water.
Those who say that one going to one’s ATM for a withdrawal may find a closed sign are, absolutely, lying or ignorant.
If one is a Representative or Senator and is lying, he or she should be Impeached and removed from Office.
Likewise, if that Representative or Senator is ignorant, he or she, apparently, is not, adequately, accepting his or her fiduciary responsibility of understanding a subject prior to advocating or voting for it, thus he or she should also be Impeached and removed from Office.
PAULSON PLAN: Purchase impaired mortgages from financial institutions with taxpayer funds.
Indeed, this would positively affect an institution’s EC, because the impairment (loss) would have been transferred to the taxpayers. This reversal of loss would be achieved by paying face price rather than market price, since if the market price were paid, there would be no effect upon EC.
This contemplated action is anti-capitalistic, immoral, and a method of stealing from taxpayers.
The taxpayers did not cause the capital impairment (this IS the problem, i.e., “It’s the balance sheet, stupid”).
Anyone involved with designing this scheme and voting for it should be incarcerated as co-conspirators to steal from the citizenry.
The scheme’s authors and those who advocate for it would be precipitating an admission that capitalism doesn't work, which is a lie.
Capitalism is the best economic tool ever devised, but as with any tool, it can be and has been abused.
Congress should accept most of the responsibility for creating the economic atmospheric conditions that enabled the abuse.
Further, any resolution of this financial phenomenon will not abate the underlying problems of the economy.
It is not the lack of lending that has damaged the economy. It is the economy, affected by greed, that has damaged the lending, but, of course, if appropriate corrective actions are not taken in regards to this financial phenomenon, our weak economics will be adversely affected.
If the Paulson plan were adopted, it would be the most massive SPE by multiples, the dollar would weaken, interest rates would go up, thus the decline in home prices would be exacerbated, and the EC would require further resuscitations.
BEST PLAN (Recapitalization):
1) Allow some institutions to go the route of Countrywide, Bear Stearns, IndyMac, and Washington Mutual. I, also, like the AIG model.
2) Most rational institutions will do what UBS, Merrill Lynch, Goldman Sachs (just recently with Warren Buffett) have done, i.e., they have raised additional EC, usually by selling preferred stocks.
Months ago, when Merrill sold 6 billion (as I recall the amount) dollars of preferreds paying 9%, I knew they were desperate, and that this was just an early domino.
Goldman Sachs, from what I have heard, is paying Buffett 10% for the preferreds. Keep in mind; this is after-tax money. The only reason for Goldman Sachs to take a desperate (GS also gave Mr. Buffett 43,000,000 warrants to purchases GS common @ $115 per share) action was because it knew it was experiencing an EC impairment and needed to raise additional EC.
Please keep in mind that pain is not all bad. It is a signal that something is wrong and indicates that the source of the pain (problem) must be determined, analyzed, understood, and finally the best alternative action must be taken.
We are experiencing pain regarding this financial phenomenon.
3) As a last resort, it would be appropriate for the government to establish a fund (call it the RTC 2.0 AKA Peoples' Financial Fund) and use those funds to purchase (just as have Mr. Buffett and others) preferred stock from institutions. The fund should follow Mr. Buffett’s lead and demand additional potential remuneration in the form of long-term warrants.
The stock would receive dividends and would have a convertible feature to convert to common stock, at the option of the fund.
Further, until certain parameters were met, the preferred ownership would assume voting control, thus the matter of executive compensation would be moot.
We either believe in capitalism or we don’t.
We will have displayed a pragmatic solution well within the parameters of capitalism.
The U.S. dollar will strengthen.
The next step would be to address the underlying economics with the basic problem being unbridled greed.
We should not have a "shot" stimulant as we did earlier.
We need to eliminate the largess given to the very wealthy, in error, by the Bush tax cuts, and to reduce taxes on the middle-class on a permanent basis.
This will have an immediate positive effect upon our economics and we will be on the path to a rational economy.
Michael Zitterman
Sherman Oaks, Ca.
dmzfinancl@aol.com
mikiesmoky@aol.com
818-988-2792
Concept: These institutions should have gone out and should be going out raising equity capital via common and preferred stock.
Taxpayers' Role: The taxpayers (a taxpayers' mutual fund) should offer funds by offering to purchase preferred stock with favorable conversation features, but with a reasonable buy-back, and substantial warrants to purchase common. These parameters should be more costly to the institutions than the "marketplace"... to entice the institutions to raise the requisite funds from private sources, rather than the taxpayers, but the taxpayers would be there as a backstop.
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lytle
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14 Comments
Nov 19 04:10 PMExcellent anaysis. However, it is naiive to expect our govenment to implement any such measures because it would undercut the ignorant and greedy position of too many office holders feeding at the trough.
i am, like so many citizens, absolutely dismayed and disappointed in our existing government and the disregard for the welfare of our country.
It is a scenario of our officials of "what's best for me" and the hell with anything else.
And I have no idea of what can be done to change things.