Wow. It has been an awful long time since I have posted here. Let's see what do we need to catch up on? First off, both Lehman and WaMu went, as I said needed to happen, although not in the way I expected. Second, in the face of unprecedented market stress, Goldman and Morgan became bank holding companies - something I didn't foresee happening. Third, Wachovia was bought by Wells Fargo. The TARP didn't pass, then it did. The TARP's mandate was changed to buying stakes in banks with the first $150B or so (a move I fully support). We had the 17th worst month ever for the Dow and the 9th worst for the S&P. Within that month was the worst week ever, and the best week in 34 years for the Dow. The volatility index (VIX) was also at historic highs, reflecting panic in the markets. Oh and oil dropped from $110 to $64 at last check. Finally, we saw enormous coordinated moves by a number of Central Banks to address the freeze up in credit markets following the G7 meeting.

If you want some comedy amongst all this bad news, we also had some moron at seekingalpha.com blaming Cramer for that awful week. Don't even get me started on that tool.

What else? It's looking like Chrysler and GM are going to merge, eliminating thousands of jobs (the UAW is clearly unhappy and trying to block the deal). Wachovia also exposed a massive hole in its balance sheet that Wells Fargo needed it to write of before the merger was complete.

Okay, that wasn't in chronological order, but I think that about does it. Where are we now? Well the credit markets are starting to thaw, as evidenced by the steady falling of the TED Spread and LIBOR over the last few weeks. As this occurs, it seems that some confidence is returning to the market. By no means are things good, but it doesn't seem like the whole system is going to collapse - at least not immediately. Therefore, some investors are starting to pick up bargain stocks. There are so many good companies which have been thrown out with the bad. Some real fortunes can be made in the market right now for people who have strong stomachs and a long term outlook. I read one interview with an institutional investor who said he has never seen opportunities like those that prevail in the current market.

It seems that earnings are going to be bad for a couple quarters - especially in financials, but I feel that has already been priced in. I guess I am throwing my lot in with the others who say that buy the good companies now. Good companies include those that won't need to go to the credit markets anytime soon, are well diversified internationally, have a consistent long term track record, pay a safe dividend and ideally have relatively recession-proof products (consumer staples and pharmaceuticals to name a few).

I would stay away from credit card companies for sure though. I remember back in July I opened my Mastercard bill and read that my minimum payment was optional this month, and took that as an indication that they were trying to lowball writeoffs due to delinquint customers. Shorting Mastercard would have returned ~50% since then. It seems to me that the consumer credit bubble will be the next to burst. I also watched a really interesting movie called In Debt We Trust that reaffirmed my opinions. That means stay away from credit card companies and discretionary consumer products.

Finally, it looks like Obama will win tomorrow night (I was ambivalent until that hack Sarah Palin was nominated for Vice). It will be interesting what the market's reaction will be either way...

Today I received a message from my discount broker Tradefreedom Securities (owned by Scotia Bank) saying that they have removed trading on margin for Washington Mutual and reduced the margin from 70% to 50% for Lehman Brothers. It seems that they think they are going to go under and don't want to see anyone with long positions on margin do down with these firms. I can't fathom who would be long these companies on margin, but apparently someone, somewhere is.

In my opinion, Lehman and WaMu need to go before the market can stage a recovery. I am not sure why I think this (I usually want a more justifiable opinion), but I feel that the market needs to see at least one, if not both, of these firms to be bought out in order for people to feel good enough about the strength of financials for anyone to place a bid. I heard a rumour that Goldman bid for Lehman at $11.50 per share on Tuesday. I for one would feel a lot better if Goldman stepped in here. Perhaps they will wait for their traders to short the stock to $2 before launching a hostile takeover this weekend. All here say though, only time tell.

It also seems that Merrill is the target of vicious shorting. It is down as much as 18% today and has set a new 52 week low around $19 (previous $22). I have some put positions on this stock and noticed that volume exploded today on the $15 January put, which traded 17,000 contracts today. Almost 15,000 of this volume came from two purchases, where the ask price of $3.00-$3.05 was paid. This tells me that someone is willing to bet big money that Merrill's stock price has a long way to go down before it recovers. Good news for me :)

Also, Petrobas (PBR) released details of another big oil field off the coast of Brazil. With the price of oil plummeting, PBR is on sale and I plan to buy for the long term as soon as oil starts to show sings of recovery. This is also bullish for Transocean (RIG) who supplies Petrobas with the deep water, harsh drilling environment rigs that Petrobas needs to extract this oil. The supply for such rigs is far outstripping demand (including future production), which will allow Transocean to raise rates. Both are long term buys for me.

This morning Lehman preannounced it's quarterly results: a loss of $2.8 billion, or $5.92 a share. Lehman was forced to say something to Wall Street after it's share price nosedived 45% yesterday. Unfortunately all they could say was that they are in "advanced talks" to sell 55% of Neuberger Berman and discussions with Black Rock to sell some of it's UK mortgage portfolio. In my opinion, the failure to pull any deals off reflects very poorly on Lehman. Additionally, the fact that the Korean Development Bank and Lehman broke off talks due to differences on valuations makes me question Lehman's capability to properly mark assets to market. All told, I really think they are going to have a tough time staying independent. I foresee a buyout of the firm in the next week or two.

What is different about this capitulation in Lehman's stock price is that is wasn't driven by rumours. After the SEC began investigating firms and hedge funds for spreading what were supposedly false rumours in order to make their short sales more profitable, I have noticed a marked decrease in these rumours flying around the airwaves. In fact, according to Reuters:

"Goldman is a willing counterparty to Lehman across all our businesses," spokesman Michael DuVally told Reuters.

"Morgan Stanley continues to trade as usual with Lehman Brothers," spokesman Mark Lake said.

Spokesman at Credit Suisse AG and Citigroup Inc also said they continued to trade with Lehman across all their businesses.

This is a full 180 from what we were hearing a few months ago.

Finally, I read that the price of insuring Lehman and Wamu debt skyrocketed yesterday. With AIG shedding 20% yesterday as well, it makes me think that they were writing a whole lot of CDS's on these firms last quarter (remember that AIG took a $5.57B loss on their CDS portfolio last quarter). That doesn't bode well for AIG's upcoming results.

One thing that I liked about the FNM and FRE bailouts is that the Fed set the precedent that in the inevitable future bailouts, equity holders will be wiped out. That is why while the broader financial industry rallied, in some cases very strongly, certain stocks (think Lehman and WaMu) took big hits. These firms are pegged to be the next to go and investors realized that the Fed is going to do nothing for those foolhardy enough to hold their common stock. I was surprised Merrill ended the day up though, as I would have liked to see it come down hard (I wouldn't be surprised if MER took a hit as big as 10% tomorrow, in what I foresee as a diving market). I wish I had some access to CDS quotes so that I could see what the derivative market is thinking of these firms' future.

Another thing I read on Marketwatch.com was that someone at a rating agency said a few months back that the U.S. assuming responsibility for FRE and FNM's debt may result in the U.S. debt rating being cut. Somehow I feel that political pressure will prevent that from happening...

This move will definitely help revitalize the MBS market, and I have read that the government will be refinancing mortgages with borrowers in order to reduce defaults (I am unsure whether the latter was speculation or explicit policy). Either way, I'd say homebuilders and strong financial stocks will benefit from the move. Despite this, be on the lookout for rumours having even larger effects on weaker financials than they did during the July panic selling...

My favorite financial stock has been Goldman Sachs for the last year. I find many of their calls to be incredibly accurate and their analysts to possess foresight unparalleled in the industry. Let's not forget to mention their excellent risk management, the fact that they were short subprime mortgages, and that they continue to earn billions while most of their competitors are losing them.

This firm is reporting earnings on the 16th and the stock has been suffering the ill effects of multiple earnings estimate cuts in recent weeks. This is not surprising. It should be noted that Goldman likes to manage expectations, as the market has grown used to them blowing estimates out of the water, so they feel the need to continue to do so. I remember in December, they beat earnings by 10% and the stock dove because that "was not enough" as one professional I spoke with put it. So looking forward to this quarter's earnings, when the recent cuts in expectations are taken into consideration, I would like to see Goldman beat by at least 20%. If they fail to do this, I will consider it as bad news for the financial sector in the medium term. If Goldman manages to post huge numbers, I do not necessarily feel that it will invigorate the financial sector, although I don't deny that it may cause a short term pop. Either way I will still endorse Goldman as a buy for the next 3-5 years.

In my last post I mentioned the huge buybacks of the Auction-Rate Securities (ARSs) by major banks and brokerages. The story here is that that these banks and brokers sold what were liquid securities to retail investors with the promise that the market would remain liquid. As was the case with many financial instruments, when the credit crunch hit, the market for ARSs dried up completely, leaving investors with securities they could not sell.

It is suspected that the financial institutions knew that the markets for these securities could seize up, but that they sold them despite this. Most institutions have neither admitted nor denied any wrongdoing (usually a pretty strong indication that something is amiss), but Merrill has an especially weak case. It has come to light that at Merrill Lynch, a research analyst put together a report which concluded that the market for ARSs would freeze if credit conditions deteriorated, but a fixed income saleswoman got her hands on the report and pressured management to blackball it. Ultimately the saleswoman won the argument and the report was never released. So much for Chinese Walls at Merrill. Everyone knew they didn't exist and this is proof.

Subsequent to the market drying up, the retail investors filed a lawsuit and New York State Prosecutor Mario Cuomo strong armed the banks into a settlement where they would buy back the securities from the investors at par and pay a relatively small fine. Financial institutions (including Citi, JPMorgan, Wachovia and Merrill I believe) have thus far agreed to buy back $50B worth of these securities, with expected realized losses totaling a few billion.

A lot of media attention has been given to this case, focusing on the expected losses and fines to be paid. While these are important issues, there has been little discussion on the adverse effect that this will have on the banks' balance sheets. The banks in question will have to use billions in cash to buy back these securities, which they will probably have to classify as Tier III assets (I am assuming the market does not recover, because who among the banks would be buying these illiquid assets?). This will lower banks' capital adequacy ratios and will have the effect of removing at least $50B in liquidity from already extremely stressed credit markets, which is not good news for the financial institutions.

Something I can't recall having seen in the two years of following the markets happened yesterday. JPMorgan reported a $1.5B writedown to the SEC based on their valuations of their MBS portfolio. Apparently when Merrill Lynch completed sale of their mortgage securities to Lone Star Capital at 22 cents on the dollar (it was essentially a call option sold to Lone Star for 7 cents on the dollar when the details are considered), the rest of the MBSs were marked down to similar levels. I would like to say that I think that the Merrill was quite foolish for the brokerage. But the real story here is JPMorgan's mid-quarter write down. I think that the bank is using the relative strength in the market to get away with this writedown, so at the end of the quarter (when I am assuming they think financial stocks will be much weaker), this writedown will be no surprise to the market. Sneaky, but my interpretation does not bode well for financials. But when you are a bear, you see bearish explanations for such moves.

Also, Wachovia joined Citi and Merrill in taking losses on sales in the auction-rate securities markets. The writedowns just do not stop. Not to mention the implications of the business practices for these institutions. I should wouldn't be bringing my business back to a firm who told me that the securities I am buying would always be liquid, then having to file a lawsuit in order to resell my securities because the market completely dried up. The whole system needs some work. Even my sector favorite Goldman Sachs was selling MBSs to their clients while quietly shorting the MBS market. At least Goldman had the foresight not to be holding that garbage...

Let's see, where do we start? The Fed didn't cut rates. No surprise there. They are handcuffed between spiraling inflation (headline inflation is at a 27 year high and core inflation is well outside of their 2% upside target), and a very weak economic outlook. Unemployment is approaching 6% and the housing market shows no sign of an upturn. If anything, I could see them cutting if the outlook gets much worse. It is worth pointing out that according to academic economics (which most of the Fed governors are devout followers of), inflation which is derived from rising commodity prices is outside of the control of monetary policy and should be treated as a one-time shock. This means that (according to academia) they should not adjust monetary policy to address the inflation the U.S. is experiencing. While I am not here to argue whether or not academia is correct in this thinking, it is an interesting thought to consider. I don't really see any action any time soon, because I feel the Fed wants to keep some "dry powder" if things really start weakening. I forecast 2% being the Fed Funds target rate into 2009. It should be pointed out that the Fed Fund futures do not agree with my analysis, as they are anticipating a probable hike in one of the next two months.

Freddie Mac and AIG brought more bad news to the financial sector this week, posting losses well in excess of forecasts, with FRE losing over $800M and AIG losing in the range of $5.4B. I was in no way surprised by FRE's results, actually part of me was surprised they weren't worse, but I must admit I didn't see AIG coming. They had unrealized losses of $5.57B on their "super senior credit default swap portfolio". I don't like this at all. First off, what is an insurance company doing in the credit default swap market? Second, why were they on the wrong side? I must admit, long term, they will probably be able to write this portfolio back up once the value of the swaps decline, but they may have to take another big writedown next quarter. Makes me wonder how the are going to be able to meet obligations from any big disaster in the short term...

I think I see some pessimism creeping back into financials. But I am bearish, so perhaps I am just seeing want I want to see here. But I can't see the price of oil falling much below $115, so I see the crude-driven rally fading here.

The inevitable appears to be happening. Today financial stocks led the broader market down. It was not as ugly as it could have been thanks to a large sell-off in oil which sparked a hundred point rally in the Dow. Regardless, the Dow ended down 42 points, while the S&P 500 and the Nasdaq were both down around 1%. There were two notable occurrences in the market today. First, as mentioned above, the financial stocks led the market down. This has not happened since the huge rally in mid-July began. Also, sliding oil prices could not lift the indexes out of the red. Over the last month or so, any day oil slid, the market popped. Today oil was down 3% and the market could not muster a rally. This does not bode well for the immediate future of the market. There are too many drags for it to go anywhere but down for a while (consider headline inflation, housing prices, unemployment, looming writedowns at the banks, credit card companies looking shaky...).

It will be interesting to see what the Fed has to say tomorrow, as well as Freddie Mac's earnings, which are sure not to be good. I, along with pretty much everyone else don't think the Fed is going to cut or raise rates, but every word of their release will be scoured for a hint of what is to come. I don't want to make a call for tomorrow because the market's reactions on rate decisions days never really make sense to me, but if I was a betting man I would place my chips on red...

Well today the market lost big. The Dow was down 286 points, the Nasdaq was down 46 and the S&P 500 ended down 3o points. In my opinion it was long overdue. As I predicted this morning, financials and airlines got it really bad. Big financial names were down as much as 15% on news that institutional depositors had withdrawn almost all of their deposits from WaMu. I read today that there were only $100M of such deposits left, down from $2.5B last quarter and $11B a year ago. Additionally, credit default swaps have priced in a 24% chance of default at WaMu this year and 50% over the next five years. This is certainly not good news. It appears my idea to short WaMu into earnings would have been a profitable trade, but I did not have the nerve due to the hot money pouring into financials at the time. Wow do things change fast. It looks like select financials may be testing their lows of last week during trading next week. Add the $2B loss at National City to round out financial earnings and the euphoria surrounding financials seems like ages ago. I foresee a long, slow downtrend in the financials until the next crop of good news.

Other points for the financials I found funny: the new CEO of Wachovia bought 1 million shares at an average price of $16.24 Tuesday. Unless he dumped them in a hurry, you would think he could have timed the market a little better. Also, the shorts that fled financials after the new SEC rule proposals have returned en masse, with net short positions increasing 10% or more at Wachovia, WaMu, and Banc of America. There was a similar trend in the automakers after Ford and Diamler's big losses. I read a JPMorgan report today that said that at the end Q2, financials were the second most heavily shorted industry in the history of Wall Street records. The first? Automakers. Such high levels of pessimism do not inspire faith in the markets moving forward...

I must once again highlight the point of this blog. It is to try to distill my thoughts on happenings in the financial markets in order to gain a greater understanding. Right now, it seems that hot money may be flowing from commodities (read oil) into financial stocks. Granted, the financials were well overdue for a rally, having fallen pretty much daily for the last few months. Right now there is no point arguing with the bulls. They are in full control of this sector and will be for a while, although I feel the overall trend is still down.

I would never argue that I know more than the analysts or that I alone am aware of the intrinsic value of the banking stocks. That would be downright arrogant of me, but there is one aspect of this rally which leads me to believe that it is not based on fundamentals. Have a look at the monoline insurers. For those who are unaware of what these firms do, they essentially sell insurance to the purchasers of all types of debt. Up until a few months ago, these firms all had AAA ratings and the debt they insured was given the same rating (as the insurers would pay the purchaser of the insurance for any degradation in the value of the debt). Unfortunately the monolines got involved in insuring subprime mortgages backed securities) for premiums that were way too low (as they, as well as many others involved with these instruments did not fully understand them). As the defaults on subprime assets rose, the insurers faced increasing payments to the buyers of their insurance. Overinvolvement in subprime assets has essentially spelled the end for Ambac (ABK) and MBIA (MBI).

With regionals taking larger than expected writedowns in their prime mortgages, and Amex saying that the current crisis is affecting even those with good credit, reasonable logic concludes that it is worse than expected for the monoline insurers. However, they are rallying to highs not seen in a month, with MBIA up 18% and ABK up 11% today alone, building on previous gains. This prime example of irrational exuberance is what indicates to me that this rally, for most financial stocks will be relatively short-lived.

I will admit that I do like JPMorgan and potentially Banc of America on the back of their strong earnings. But would only buy them on the weakness that I anticipate will follow this rally.

Wow. As I indicated in my last post, I though WaMu was going to miss earnings. I had no idea that it was going to be this bad. They lost $3.33B, or $6.58 per share! That is more than the entire value of their current market cap. Compare this to the $1.05 expected loss and you see how out of the blue this was. The market initially dumped after hours, then was up as much as 16% from the close and now is down about 5% from the close. I think it is fair to say that this reaction effectively throws the efficient market theory out the window! I can't imagine how the stock can only lose 5% on this news, I guess we'll see what happens tomorrow. Bulls might say that they would have made $3.34 per share had it not been for the write downs and that they cut their dividend. SO WHAT? They had $10 per share in write downs, with only $7 of it anticipated. This stock is toxic and in a market where reactions were a little more rational I would short it and ride it right to 0.

To follow up on my negative comments on Wachovia, I would like to point out that Wachovia is still carrying $15B in goodwill on their balance sheet stemming from the buyout of Golden West, a mortgage dealer with a large proportion of their loans concentrated in California. Now as I have yet to sift through their report and conference call transcript, I have read that none of this was written off this quarter. I wonder how they are going to justify not writing that down next quarter... If they do, that potential write-down represents almost 250% of this quarter's $6.1B writedown.

Another interesting tidbit I came across relates to Wells-Fargo, a widely touted bank who beat expectations. Apparently they extended the days a mortgage can be delinquent before it is internally considered non-performing from 120 to 180. That represents a 50% increase and 2/3 of the most recent quarter. A move that definitely masked the true volume of the writedowns they should have taken. How much they will ultimately have to write down is a figure we will eventually find out. Hmm I just finished a class on Financial Statement Analysis and I think that this move would certainly fall under the classification of "creative accounting" to improve financial results.