Wednesday, January 16, 2008

No Place to Hide

It is only Wednesday, but enough activity has already occurred this week to summarize it. This week has been all about the banks and probability that the churn seen in this sector will drive the economy into recession. The choke hold of tightening credit, inflationary prices for necessities, housing issues, increasing unemployment, and flagging confidence will shortly squeeze the consumer out of the game. The fallout from the wobbling bank sector will only add to the downside economic momentum.

The staggering Citigroup loss announced Tuesday raised the anxiety over the economy while clearly underlining the unresolved crisis in the financial sector. Stocks sold off sharply in reaction to the expected-but-disturbing Citi news. The only time in the past where the financial sector was seen moving from good profits to negative profits in a short period of time was the Great Depression.

The credit card sector is also rapidly diving. Capital One (COF) and American Express (AXP) recently issued profit warnings tied to rising consumer delinquencies. A recent Motley Fool article included Capital One as a Deathbed stock.

Commentary from the Fed chairman and governors was even less promising. Economists stated that the probability of recession has increased to 50-50 from 1/3, while the Ben Bernanke glumly agreed the economy is obviously slowing. The San Francisco Federal Reserve Bank came out and directly stated that 2008 growth will be at near recession levels in the “FedViews” newsletter. All the economic leading figures including the reduction in manufacturing over-time hours – point to a recession.

Some banks are taking proactive steps to exit risky business segments. Bank of America should be applauded this week for moving to re-focus on its core banking business. The firm took steps this week to exit the stock brokerage, investment banking, CDOs, and other risky segments. This demonstrates some common sense amid the carnage in the sector.

The easing of the Glass-Steagall Banking Act of 1933 over the last decade has allowed commercial banks to enter investing banking and other risky business segments. Clearly it is time to roll-back the inappropriate Gramm-Leach-Bliley Act enacted in 1999 to “open up competition”. Legislation must be put back in place to require commercial banks to strictly focus on standard banking activities for the safety of depositors. The Great Depression taught significant lessons on why commercial and investment banking activities should be separated, and the bank lobby should have never been allowed to roll-back these earlier protections. The risk of a complete financial meltdown due to the banks’ derivative speculation with a focus on fees remains high. Only the continued Federal lending at mechanisms such as the discount window and foreign capital investment are keeping many of the banks liquid.

This leads to the question – Is there any place to hide during a complete market meltdown? Even cash in the bank may be at risk – several money market funds with CDO exposure had to be propped up over the past months. Even investments normally considered safe have risks in an environment where existing credit ratings have no real meaning. Your money market fund backed by “AAA” fixed income investments may be downgraded to “C” junk overnight … with the probability of default within two weeks.

Unstable market environments offer plenty of risks, but can provide significant rewards for investors willing to effectively sell short. The question remains if the downside action is near a trough or should investors start to bottom pick. The most immediate sector of interest will be the financial industry once the fourth quarter earning cycle is completed.