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"A" Bottom or "The" Bottom?


History foretells more pain for banks.

All of a sudden financials are now the place to be for the bulls. With Dick Bove's pronouncement of the bottom last week and Barron's positive article over the weekend the "all clear" signal has clearly been sounded.

And on the surface there is plenty of good reason: a crisis averted with the successful "coordinated" rescue of Bear Stearns (BSC) (and with an unprecedented upward re-pricing of the deal, no less), an additional 75 basis point cut from the Federal Reserve, an additional $200 billion from the Fed available to investment banks (in addition to commercial banks), looser capital requirements for Freddie Mac (FRE) and Fannie Mae (FNM), additional mortgage capacity by the Federal Home Loan Bank System and even lower commodity prices. All these are positives for the financial services sector.

But after looking at the bounce for many financial services stocks since last week, I also find myself hard pressed to get excited as a bull. Fannie and Freddie are both up over 50% and most other "distressed" names are up at least 20% from Tuesday.

So I'm left with the proverbial $64,000 question of "Was last week 'A' bottom or 'The' bottom for financials?"

At the risk of being viewed as a perma-bear, and recognizing that financials are likely to continue to move higher this week, let me offer a couple of cautious reminders on the sector.

First, if this were the bottom, other than "events" like Long Term Capital Management, it would be the fastest bottom to occur in modern economic history. Heck, the last time I checked, economists hadn't even agreed that we are in a recession. And now, we're declaring "the bottom"?!

Second, at the worst last week, the S&P 500 financials had a valuation of about 1.3 times book. While well below last year's highs, history suggests that financials bottom below book value.

Third, history also suggests that bottoms don't happen when the first bank fails. True, the easy money has been made for the bears at this point, but a review of the past reveals that there is still plenty of opportunity. As Merrill Lynch's banking analysts recently pointed out, during the 1989-1991 recession approximately 25% of their universe disappeared, and the tally for this recession is still less than 7%.

Fourth, the losses that have been recognized so far have been largely concentrated in the sub-prime mortgage sector (and almost exclusively by those financial institutions with mark- to-market accounting). Few classic banks have incurred the kind of provisioning charges that go along with a mild recession, let alone a full-blown credit crisis.

Fifth, liquidity, while helpful and of late plentiful, is no substitute for the painful shrinkage that must occur for "the bottom." And looking at last week's investment banking earnings releases one sees significant quarter on quarter balance sheet growth, not decline. Growth does not happen at the bottom. At the bottom, firms shrink because they no longer have adequate capital to support their asset base.

Sixth, and related: At the bottom you move beyond "mark-to-market" accounting (used in normal times) and even "mark-to-mayhem" (used during an "event") to full-blown "mark-to-move'm out." Because of all of the liquidity provided by the Federal Reserve, the largest firms are still growing and, as a result, risk is being increasingly concentrated into fewer and fewer hands. At the bottom, firms shrink as risk is dispersed to new participants because assets are finally priced to move - whether voluntarily or involuntarily by the regulators. And again, I would suggest this process is just beginning - the transfer of $30 billion of bad assets from Bear Stearns to the Fed barely scratches the surface.

To be clear, although I don't believe a bottom has been reached, I neither wish for nor foresee a systemic crisis. In fact, I give the Federal Reserve and U.S. Treasury high marks for their crisis management. And importantly, I believe their aggressive actions will avert the kind of global failure that some outside of Minyanville espouse.

At the same time, though, I believe there are significant further declines ahead as the weakest firms fail and the stronger are buttressed through coordinated government intervention and even nationalization. But to those who believe this can occur without further significant common shareholder dilution, I would offer modern banking history as caution.

A bottom? Yes. The bottom? Not close.
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Position in SKF and JPM debt obligations
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