Agora Financial’s Rude Awakening

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Laguna Beach, California

• Financial stocks: Out of the woods…and into the forest?
• $200 billion times ten…equals one big subprime fiasco,
• Keeping an eye on your oysters and plenty more…

Eric Fry, reporting from Laguna Beach, California…

“Financial stocks are oversold, and may be due for a bounce,” declares Dan
Amoss, editor of Strategic Investment. “But they are not out of the woods
yet.”

Hmmm….

Dan’s assessment seems balanced and reasonable, but we’re not sure WHICH part
of Dan’s message deserves greater weight: the “due for a bounce” part or the
“not out of the woods” part.

Financial stocks certainly seem to be due for a bounce. Most technical
indicators for the financial sector portray a “deeply oversold” condition.
And most gauges of investor sentiment tell a similar tale. To top it all off,
most anecdotal evidence seems to be screaming “Buy!”

Grim tales from the front lines of the American credit crisis appear
incessantly on CNBC, and on the front page of the Wall Street Journal and
inside every single issue of the world’s leading finance magazines. The
credit crisis is not a secret anymore. So now that the foundering financial
sector has become the leading worry of the day, financial stocks may have
become less of a “Sell”…at least for a while.

A rally of some significance and duration seems likely. But your California
editor is too lazy to bother buying financial stocks just because they are
“due for a bounce” (and he would not recommend this trade to anyone who
enjoys sound sleep). On the other hand, he is too fearful of a bounce to
bother trying to sell short financial stocks at current levels.

So no position seems like the best position.

Timing is everything, of course…or almost everything. Consuming a
flawlessly fresh “Fine de Claire #3″ oyster is a delectable earthly delight.
But if you wait a week to consume that very same oyster, you’d be hating life
within an hour or two.

Buying stocks that have been falling for weeks, just because they might
bounce for a few days is a lot like eating raw oysters, except that you never
know what’s fresh and what’s toxic until after the fact. Since you don’t
know, why bother? Better to stick with safer fare.

The finance sector “oysters” might provide appetizing investment returns to
daring investors over the next few days or weeks. But they will probably
become very toxic very quickly thereafter…as Dan Amoss explains below…

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————————————————–

Less Bearish…For Now
By Dan Amoss

Banks and other financial companies operate with lots of leverage. This is
good for bank shareholders when times are good, but very bad when loan losses
start impairing assets.

Banks invest shareholder capital in a way that multiplies returns and risk by
15- or 20-fold. A bank can expand the size of its balance sheet when it
borrows money from depositors. Banks shareholders use depositors’ money to
buy new assets, which generate the cash that pays depositors back a fixed
return. Then, the banks keep any returns over and above the returns paid to
depositors. The greater the leverage, the greater the return, especially if a
bank’s management invests assets in a wise (or lucky) manner.

Unfortunately, many large American banks have behaved unwisely (or
unluckily). Hence the endless stream of recent news about write-offs, and
about billion-dollar losses from SIVs, CDOs, and other mortgage-infected
instruments. To understand what’s going on, imagine dumping these exotic,
impaired instruments into the asset side of a bank’s accounting ledger,
sprinkle in a heaping tablespoon of leverage and voila: “Balance-sheet-
upside-down cake.”

Among bank assets, mortgage-backed securities now play as big a role as plain
vanilla mortgages. As these assets go bad, or lose value, the bank’s equity,
or capital, can vanish in a hurry.

An article in The Economist explains:

“All this turmoil is focusing attention on banks’ capital ratios, the amount
of money they set aside as a percentage of assets to cover unexpected losses.
This cushion is being squashed in a number of ways. First, net losses eat
directly into capital. Second, since capital ratios are typically calculated
on the basis of how risky a bank’s balance sheet is, the ratings downgrades
add to the amount of rainy-day money banks need to set aside. Third, assets
are growing as banks take on the financing of more off-balance sheet
vehicles, which again adds to the capital they need.”

Banks and other financial companies that find themselves on the wrong side of
this financial crisis must rebuild capital. There are a number of ways they
can accomplish this, but all are unpleasant.

First, the companies could issue new shares. This hurts because it dilutes
existing shareholders when stocks prices are already depressed. It’s
especially embarrassing for companies like MGIC Investment Corp. and MBIA
Inc. These mortgage insurers were buying back gobs of stock at much higher
prices. Now they’ll probably have to sell this stock back to the public at
low prices, resulting in hundreds of millions in economic losses for
shareholders. This is a painful move for these companies, but they must cover
their liabilities, which include paying for the impending wave of insured
losses in structured credit and mortgages.

Second, the companies could cut dividends. When a bank pays a dividend, this
transaction reduces both assets and equity, resulting in a slightly
diminished ratio of equity to assets. When this ratio falls below a certain
level, a bank can count on receiving more regulatory scrutiny. Cutting the
dividend may be painful for shareholders, but it’s often the least painful
way to rebuild capital.

Third, the companies could sell “non-core” assets. Financial conglomerates
like Merrill Lynch have the option of selling their interests in a wide range
of businesses to raise cash. Merrill owns almost half of publicly traded
money manager BlackRock. Merrill could sell this interest in order to rebuild
capital in its division that’s getting pounded by CDO losses.

Finally, this hypothetical financial company could slow the growth of its
loan portfolio. This would allow the cash that normally flows in from older
loans to remain on the balance sheet, instead of funding new loans. On a
company level, this may be a good thing, but on an economy-wide level, it’s
not. When banks slow down lending, it makes credit harder to get, even for
those with good credit. Citing Goldman Sachs estimates, The Economist article
notes, “If banks suffer a $200 billion loss on subprime mortgages but want to
keep their capital ratios at an average level of 10%, that would stifle
lending by a whopping $2 trillion.”

Government-sponsored entity Freddie Mac spooked the markets last week when it
announced it must raise capital amid rising losses. This process will involve
some combination of the unpleasant choices listed above. It’s not good news
for housing market finance because it means Freddie will be less aggressive
in buying mortgages from banks – just at the time when Congress has been
pushing to allow Freddie to become more aggressive.

Washington, D.C., politicians will eventually concoct some type of tax- and
inflation-financed housing bailout, but after last week’s news from Freddie
Mac, it will take longer than expected. Financial stocks are oversold, and
may be due for a bounce, but they are not out of the woods yet.

[Joel's Note: To learn how to survive the scams, schemes and swindles
concocted by D.C. and Wall Street, check out Dan’s Strategic Investment
report.

———————————————

Did You Notice? – Freddie Falters and Countrywide Cringes
By Brian McAuley and Mike Shedlock

What happens when Freddie Mac tries to repair its crippled balance sheet?
Well, for one thing, the government-sponsored basket-case buys fewer
mortgages from folks like Countrywide Financial. And if Freddie stops buying,
Countrywide stops lending. That’s how a crisis becomes a contagion and a
contagion becomes a disaster.

Last week’s earnings news from Freddie Mac was nothing short of terrifying.
The giant lender posted a $2 billion loss, which was three times what
analysts had expected, and also disclosed that it needed to raise more
capital to meet regulatory requirements. In order to raise that capital,
Freddie proposed cutting its dividend by 50%. That news sent Freddie’s stock
down almost 30%.

But while the market seemed fixated on the dividend news, the far more
important news went largely unnoticed. If market conditions continue to
deteriorate and the dividend cut fails to raise enough capital to meet
regulatory requirements, Freddie says it will consider slowing purchases in
its mortgage portfolio .

Whoa! That is a very big deal for the housing market. Ever since the
secondary market for mortgage-backed securities dried up over the summer,
Freddie Mac and Fannie Mae have been the reliable and counter-cyclical
sources of liquidity that have kept a pulse going in the mortgage market. Now
Freddie is telling us that if conditions continue to deteriorate, it may have
to purchase fewer mortgages, effectively making fewer mortgages available to
the largest segment of the mortgage market.

This is earthshaking news, because up to this point, even as the availability
of nonconforming mortgages (jumbo loans, no-doc loans, interest-only loans,
and various adjustable-rate products) became scarce, there was some comfort
in knowing that Freddie and Fannie would always be there to buy standard,
full-documentation loans for amounts less that $417,000.

However, if Freddie and Fannie were forced to curtail their purchasing of
mortgages, this would take even more homebuyers out of the market by
restricting the availability of even standard conforming mortgages.

It’s no surprise, therefore, that Countrywide shares also declined on the
news and still remain close to their lows for the year. In fact, bankruptcy
rumors continue to dog Countrywide. (However, the giant mortgage lender
continues to insist that it possesses “ample liquidity and capital and will
be a beneficiary of ongoing mortgage market consolidation.”)

Whatever the actual case may be, Countrywide can no longer sell mortgage-
backed bonds to the secondary market. No one will buy them. So that means
that Countrywide depends greatly on Freddie and Fannie to purchase its
mortgages. But if Freddie and Fannie cut back on their mortgage-purchasing
activities and that access becomes restricted, it may prove too much for
Countrywide to bear.

The potential for reduced access to funding from Freddie and Fannie is
certainly a hard place to be in, but the rock for Countrywide is likely to be
a downgrade of its debt rating to “junk” status. In a recent filing, the
company said such a downgrade would have a severe impact on its ability to do
business – meaning it would likely be unable to continue as a going entity.

So from just about every angle you look, it appears the mortgage market is
going to continue getting worse and that conditions for companies like
Countrywide will become critical – either they start to improve right away or
too many doors will have closed. And needless to say, this is not a positive
development for the housing market. No matter how you slice it, fewer
mortgages mean fewer homebuyers, and that means lower home prices.

[Joel's Note: Brian and Mish are the pair behind the “Housing Tsunami” report
that came out a few months before the epic Countrywide Financial sell off a
few months back. In fact, readers of the report were perfectly positioned to
take triple-digit gains thanks to the pair’s recommended play on the lending
giant. If you’re interested in seeing what’s around the corner for this
housing story, can check out: The Time Bomb Ticking Under Wall Street

———————————————————–

Rude Endnote: In yesterday’s Rude, Eric posed the question: Are American’s
shifting their assets overseas to be considered “early adopters” showing the
way to the rest of us, or are they just “traitors” and “quacks?”

Open the reader mail floodgates…

“I emigrated from the US just a few months after 911,” writes one charged
Rude reader. “The move was planned a number on months prior but 911 sealed
the deal.

“Australia was the place to go. I got almost 200% on my US dollars and, for
me, the writing was on the wall back then.

“Its been quite a show watching how slow the Wall Streeters are to recognize
the building is burning.

“Just last week there was a report on the radio interviewing Wall Street
stock brokers and they were 100% oblivious to any pending problems!
For the average Joe on the street, they will be hit so hard and fast, they
may go a bit mad.

“Good night and Good Luck!”

If you would like to chime in, send your “traitor vs. adoptee” emails to the
address below. We’ll publish a selection of the Rudest comments in upcoming
editions.

Cheers,

Joel Bowman
Rude Awakening