What’s next for the banking sector?

What’s made the stock market so jittery lately? Was it oil prices or commodity run-ups? I don’t think so. I think what’s bugging investors is: will something bad happen in the banking sector?

So far, the banking sector has suffered from defaults on higher risk mortgage investments. Some of these were subprime, some were Alt A (a step up from subprime, but not prime), and some have been home equity loans. All were bad loans and bad investments to begin with.

Because many market participants were buying mortgage investments with other people’s money (read: borrowed money), this part of the market really suffered when it became clear that almost no one knew what the mortgage investments they bought were worth.

But, so far, the banking sector hasn’t really suffered from major defaults on business loans, credit card loans, auto loans, prime mortgages, etc. In other words, the banking problems that started in March of 2007 have almost entirely been an investment phenomenon, not a broader bank lending problem, per se.

The question now is: could that change? Could the problems seen so far be the tip of a broader loan default problem? Could the economy be rolling over into recession and signaling that loan defaults will increase across the board?

If the answers to these questions are yes, the the problems in the banking sector, and the rest of the economy for that matter, may only be getting started.

Can the Federal Reserve fix these problems? Many people believe they can, but some strong dissenting opinions, even from within the Fed, are starting to question the validity of this premise.

The Fed may control interest rates and be able to bail out banks, but not without cost. The cost, in most cases, is higher inflation. With soaring energy and food prices, this will not be welcome news.

The other problem is that Fed actions are creating moral hazard. When you bail out stupid risk takers, they learn a bad lesson: they either make a ton of money making risky bets or they get bailed out. “Heads I win, tails you lose.” This may be leading to even more bad lending and highly levered investing.

What’s next for the banking sector?

It all depends on fundamentals at this point. Either banks have made good loans and have enough reserves to weather tougher times, or they don’t.

If they don’t, then expect the banking sector to hit new lows as more and more news comes out that broader loans–like credit card, auto, business, commercial real estate, prime mortgages–are hitting higher default levels.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Catching falling knives

One of the most difficult tasks in investing is to buy things as they go down. Psychologically, its no fun.

Hence, some investors refer to this as catching falling knives: you may do it right, but you may also get cut.

The payoff in investing can be huge. Buying companies that most people think will go bankrupt can be very profitable–if they don’t go bankrupt. There’s the rub, as Shakespeare put it.

How do you know the company in question won’t go bankrupt? There are very smart people out there who know enough about certain businesses, bankruptcy, etc., who can pull this off. But it’s not for the faint of heart any more than catching literal falling knives.

This question occured to me because a lot of very smart value investors are looking hard at mortgage and bond insurance companies (which I wrote about here and here).

Mortgage guarantee companies like Triad and Radian and bond insurers like Ambac and MBIA have been taken out to the woodshed recently, in terms of their stock prices. This seems justified considering they seem to insure a lot more than they could pay out.

Such investments were great as long as you assumed a housing recession or deep economic recession never hit. That doesn’t seem like a very wise bet, now, nor did it beforehand.

The question is how will these investments do going forward? It seems hard to imagine the government will let the rating agencies downgrade their insurance ratings, for this would surely put them out of business and leave the financial markets in one heck of a mess (tons of investors have their money insured by these entities and would lead to a major dislocation).

But, do you want bet on that? That’s the question. Will the government save these entities? Should their shareholders get off scott-free instead of bearing the risk they took? Will this encourage moral hazard (I can answer that last one–YES)?

Although I believe a ton of money could be made by investing in bond and mortgage insurers at these prices, I’m not expert enough to catch these falling knives. Do I know enough about the risks they’ve assumed and the capital they can use to support claims and the cozy relationship between rating agencies/the government/such insurers?

I don’t. And not many do.

Perhaps that’s why it might be best to leave catching falling knives to the experts.

As Warren Buffett put it, I don’t try to find 7 foot fences to jump, I look for 1 foot fences to step over. Bond and mortgage insurers look like a 7 foot fence to me.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Moral Hazard

Today, the Federal Reserve and President of the United States offered a life raft to the mortgage market.

It sounds like this will come in the form of additional liquidity for lenders from the Federal Reserve, and loan guarantees and loan restructuring for borrowers through various government departments.

Although this may seem like much needed help for “victims” of the market, to me it looks like a dangerous incentive to take more risk–also known as moral hazard.

You see, borrowers who shouldn’t have gotten money were lent money. Many were speculators hoping home prices would keep going up. Others were ignorant of the loans they signed because they didn’t bother to read the paperwork.

Should borrowers be bailed out who shouldn’t have borrowed? Suppose I go out and buy a large screen TV with my credit card. Suppose I can’t make the payments because I didn’t realize the interest rate I would pay. Should taxpayers bail me out because I’m ignorant of the contract I signed? If they do, what would I learn? Not to take the risk?

Even worse, lenders knew about their borrower’s credit histories and ability to pay. Lenders also knew they would pass such loans off to Wall Street investment banks who would sell such bad loans to ignorant investors.

Should the mortgage originators, Wall Street banks and lazy investors be bailed out for making bad loans? Suppose I lend someone money at a 20% rate because they can’t get a loan elsewhere. Suppose they can’t make payments at some point. Should the taxpayer bail me out for making a bad loan? What would I learn? Not to make loans to people who can’t pay?

The Fed and President are offering to bail out borrowers and lenders with other people’s money. Those other people are U.S. taxpayers. You will pay in the form of inflation due to the Fed printing money and higher tax rates or higher government debt due to the executive branch bailing out “victims” of bad lending.

The real problem with this scheme, as any study of history will tell you, is moral hazard. If someone learns they can take risk at another’s expense, then they’re incentivized to take that risk over and over again.

If you let a teenager borrow your car and they get in an accident, what do they learn if you prevent them from living with the consequences? Why would that be any different with adult borrowers and lenders in the U.S. economy?

Just look at the people rebuilding their huge houses in Alabama that were wiped out by hurricane Katrina. They know they don’t have to pay for insurance because the government will bail them out, so they are quite happy to rebuild because they know they won’t bear the expense of the risk they’re taking.

So, when you see spiking inflation over the next several years and higher tax rates or increased federal debt to pay for all the bailouts the government is offering, keep in mind that you’re getting to bail out speculators in real estate, people with bad credit histories, banks who pass their loans off to Wall Street, Wall Street investment banks that don’t need the help, and investors who don’t bother researching what exactly they are buying.

And, when such teenagers take this risk over and over again, and you get to bail them out each time, remember that there is a name for this phenomenon–moral hazard.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.