We Live In Interesting, Incompetent Times

Epics and Ongoing Busts in the Financial Sector

There may be a major hurricane battering the oil rigs and refineries in the Gulf of Mexico and Texas, but an even bigger one is crushing many of the key banking firms in America.

One is a natural disaster — you can’t blame people for Hurricane Ike unless they’re too stupid to heed storm warnings and get themselves and their families out of danger. But you can definitely blame people — specifically executives and regulators — for the man-made disaster currently engulfing investment banks and the financial sector as a whole.

Hundreds of billions of dollars in damage has been done and it’s doubtful that the storm’s full fury has yet been realized. After all, why else would the Federal Reserve Board announce that it’s expanding access to credit for financial companies? And 10 global banks aren’t co-operating to create a new $70 billion lending program because they actually like each other.

Lehman Brothers has collapsed with fellow train wreck Merrill Lynch striking a last-minute deal to avoid a similar fate via a $44 billion merger with Bank of America. Here’s a good view of Lehman’s excellence in building shareholder value and managing their firm to greatness:

All this happened when U.S. government officials declined to orchestrate a taxpayer-funded bailout for Lehman. And there are persistent rumors that the Merrill Lynch buyout occurred primarily as a PR move to convince observers that the most diseased and sickly patients had been either saved or mercifully shot like a horse with a broken leg.

All this happened only months after Bear Stearns was forced to sell out for next to nothing to JP Morgan. Bear in mind that all these brokerages weathered the Great Depression, which has become the standard barometer of financial strain. If nothing else, that should indicate the staggering level of incompetence in these companies’ management teams.

“This is as big as 1929, 1930, 1931″

… No, it’s worse than that. Otherwise a 158 year old firm such as Lehman would still be a viable company, right?

“This is an extremely, and I stress extremely, rare event,” said Mohamed El-Erian, the chief executive of Pimco, the world’s biggest bond fund.

The head of another major investment bank: “This is wild. I’ve never seen anything like it. This is totally historic.”

Yes, historic laziness and greed, indeed. A policy of excessively low interest rates that fueled an explosion in the money supply, lax regulation, an increasingly interventionist Fed, and management teams that felt that risk didn’t apply to them were all major contributors to the ongoing disaster.

Has Bank of America Committed Suicide?

There is no evidence that any of these factors have been corrected as Bank of America (BAC) bought Merrill Lynch. Bank of America (NYSE: BAC) is the largest commercial bank in the United States by deposits and market capitalization with $119.19 billion in revenue, $1.72 trillion in total assets and 210,000 employees.

Sure, analysts are saying that BAC is now strong in previously weak areas thanks to the purchase, but exactly how healthy are these new assets? All that’s happening is that one of America’s largest retail banks is now “enhanced” with one of its largest retail brokerage networks. It’s a rear-guard action meant to hold off greater damage, and it could very well fail, given that BAC is also sitting on Countrywide’s toxic loan portfolio.

In fact, this entire crisis is about cushioning the blow of poisonous derivatives going boom. The trigger was bad loans that should never have been made in the first place to people who could never afford to pay them because the jobs needed to afford them just don’t exist. However, that was just a symptom of the systemic problem where everyone lied to everyone else about the value of everything, and now the invisible hand is demanding meaty, bloody sacrifice for those sins.

The only reason that the rest of the “real” economy isn’t getting hit harder right now is because lending has been very cheap for a long time while. Many major companies locked in rates for long terms over the past five years, so they haven’t needed to borrow as heavily in the short term markets. But as this crisis continues to overhang, more and more companies will be forced into the market to issue new debt and they’ll get crucified by the interest rates they’ll have to pay. This in turn will cripple earnings going forward. The economy is truly screwed, and it will all unwind in slow motion over the next three years.

Already the wealth that has been lost for shareholders and employees is unprecedented and unfortunately will not be recovered … ever! Sure, BAC is bouncing a bit now on the short-term news of the buyout (any port in a storm!), but for how long?

Privatized Profits, Socialized Losses

Who’s going to raise money in this country with the brokerage firms in collapse? Everyone is trying to ride out a collapse in perceived values across the economy, or at least trying to stretch the crash out into something survivable, something that won’t trigger bank runs.

What’s worse is that the Federal Reserve has said they’re going to continue accepting poor quality collateral for loans. Banks can buy up the toxic stuff that killed Lehman then get a loan from the Federal Reserve using that crappy collateral — at whatever value they claim it’s worth. Does this inspire any confidence in you?

This current situation is looking more and more like a broadly diversified command economy by the minute, with the state puppeteers trying to maintain an illusion of separation from the state-backed industries … and failing. But is more regulation the solution? We still haven’t figured out what to do with “too big to fail” banks, other then saying “don’t get too big” and already it may be too late to reverse that course.

The Next Victim Begins Floating Belly-Up

With that thought in mind, who’s likely to be the next major victim?

American International Group, Inc. (NYSE: AIG) is the 18th-largest company in the world with a $31.6 billion market capitalization and $6.2 billion in net income. But in 2008, AIG’s share prices fell over 90% to less than $6 in September and the company reported over $13.2 billion in losses in the first six months of that year. Not good news at all.

Here’s a long term chart of AIG’s spectacular fall so far:

And this short-term chart should give you an idea about where to go short, if you’re so inclined. Remember how gaps are usually filled? AIG will no doubt bounce up a bit as the powers that be stave off full disaster just a little bit longer.

And so you might get a rise as high as $12.50 to close the entire gap — if you’re lucky. Then
hang on to your hats, folks, because it’s going to get worse.

Betting on management and government incompetence is a fantastic bet to make right now!

Good investing,

Nick Thomas
Analyst, Charts of the Week