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Will "Write-Ups" Bolster the Financials?


See all sides when we edge into earnings.


"Up is down, down is up, he says hello when he leaves and goodbye when he arrives."
- Jerry Seinfeld, in a Bizarro World

This past spring, when men were men and sheep were nervous, we assumed a constructive stance on the financials. It was a rapid departure from our multi-year stance that many of the world's largest financial institutions were not only extremely vulnerable, they were technically insolvent if Level III assets were properly accounted for on their balance sheets.

While the financial fabric was frazzled and frayed, a who's who in the banking industry -- from Citigroup (C) to Morgan Stanley (MS) to Bank of America (BAC) to Wachovia (WFC) to Washington Mutual (JPM) -- wrote down massive amounts of toxic assets. It became a commonplace occurrence; the question wasn't one of "if," it was simply "how much?"

In the heat of the March meat, I posed a question in the interest of "seeing both sides." It seemed so far-fetched that few folks took it seriously, and for good reason. I asked if we would see "write-ups" in the financial realm before this crisis passed, not as a precursor to recovery, but rather to litter the landscape with false hope and empty promises which are the hallmarks of true bear markets.

It's a theme we've touched on since -- Professor James Kostohryz wrote about it in one of his prescient summer scribes and I again spoke about it in August after Professor Branden "Metro" Rife commented on the constructive comments by the Radian Group (RDN). Still, despite the 165% rally in the BKX -- and please note the sector is still 60% off its all-time high in 2007 -- few folks on the Street have discussed this dynamic.

The implications, if these were to occur, are massive through the lens of psychology. On the one hand, the bulls would argue its viable post-rationalization for the massive move and the first step on the road to recovery. On the other, bears will note the market is a leading indicator and the improvement was the reason for the rally and a perfect opportunity to sell the news.

My take is that the truth will likely reside somewhere in the middle. While the knee-jerk response will most likely be higher, the bloom will fade from the rose as a function of time. Where you stand -- and how you approach this should it come to pass -- is purely a function of where you sit, how you're positioned and what your time horizon is.

My rationale -- one man's humble opinion -- is that the DNA of the marketplace (350% total debt-to-GDP) aren't seeds that secular bulls are born from and we're paving the path of maximum frustration until the next wave of this crisis arrives. There are two important points to remember in this regard. First, the Great Depression was an era rather than an event and second, Japan saw four rallies of 50% since 1990, yet the index is still 70% below where it was at the time.

As I noodled this topic early this morning, I reached out to our resident bank expert, Minyan Peter, who was the treasurer at one of the largest banks in the Midwest when that was still considered a prestigious post. I asked him, quite succinctly, "What do you think about 'mark-ups' at banks spurring a last gasp higher for the tape?" His response was as follows:

"It all depends on reaction. As you know I firmly believe that earnings are the past balance sheets of the future. Unless the economic recovery is truly "V" shaped, mark-ups create substantially more risk of future loss, akin to the extremely low levels of loan loss reserves at the top of the market in 2007.

"I expect the "trading" banks to have record/near record results for the third quarter, helped by the flywheel created by the pro-cyclical momentum of the bond and equities market. But after two quarters of this, unless you think corporate bond spreads are going to zero you have to wonder how much better than this it can get.

"At the same time the "credit" banks are going to show substantially higher delinquencies and losses, which don't bode well for the future. I know there are many out there who believe that the "trading" banks have decoupled from the "credit" banks and are now largely immune from credit risk, but I'd be very careful with this premise.

"Six months ago the world was terrified about how interconnected the financial system was. While markets have rallied since, and there has been enormous rhetoric on the topic, very little has been done to address this risk. From my perspective interconnected balance sheets remain the future, whether the market wants to believe it or not."

The market is an ever-changing, non-linear fluid assimilation and there are a number of elements that commingle to determine asset prices at any given time. As we edge into autumn, many of these will be competing for our collective attention. There's the FASB ruling, potential strife in the Middle East (watch Israel and Iran), the arrival of (swine) flu season, growing angst of performance anxiety (the buyers are higher) and, of course, the governments role in our "free market" capital construct.

While my most lucid thought is that this is a cyclical bull nestled within a very grizzly secular bear, I find myself channeling Don Henley as our capital market construct arrives at the end of its innocence. "Who know how long this will last, now we've come so far so fast." I don't profess to know all the answers, my friends, but my hope is that asking the right questions are stable steps in our collective preparedness.

Fare ye well and may peace be with you.

For more see Hoofy and Boo's always astute report.


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Minyan Peter has a position in JPM debt obligations
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