Financial Companies Face $1.2 Trillion Risk

David Callaway, the editor-in-chief of Marketwatch posted an article that seemed to indicate that it was a good time to do some bargain hunting in financial services stocks. Companies like Merrill Lynch, Bear Stearns, Morgan Stanley, and Washington Mutual have been beaten up are down more than 20% this year.

The problem is, they may have further to go. There is no sign that the problems that have led to their decline is going away anytime soon. In particular, the credit bubble is still unwinding, and according to derivatives expert Satyajit Das we are still in the very early phases of this process. Just today, MSN reported that home foreclosures were up 100% and this number is expected to increase into next year. We are not even close to seeing the true scope of the CDO and mortgage backed security meltdown.

This will hit banks and financial institutions in several ways:

1. They will have to continue to write off assets that are tied to or backed by these assets. Das estimates that every $1 in real assets backs $20 in derivatives and borrowed money. That means that every time a house forecloses there is a 20X multiplier effect. Multiply that by the more than 500,000 houses that the US Department of Housing and Urban development expects to face foreclosure next year and then multiply that by the 50% of house value that is typically lost when a house forecloses (according to Ron Morgan, a managing director at ISGN Technology's third-party servicing company, MortgageHub). So if you multiply 500,000 * $125,000 * 20 you get $1.2 trillion dollars. That's how much is in play. Now, let's be generous and say that only 10% of the houses that could foreclose do, that still leaves $120 billion dollars of financial damage hanging out there. Bank stocks have been getting killed for writing off a couple billions dollars in assets. What happens when we start talking tens of billions?

2. The banks money-making machines are over. Banks, hedge funds, and private equity shops have grown fat on the cheap money and liquidity provided by the CDOs and mortgage backed securities. They have been able to use the money to do every bigger deals and to arbitrage currencies (see my article on the Carry Trade for some insight into this). But that cheap money is gone. The credit markets are shut, wiping out cheap, easy access to the funds needed to do leveraged buyouts. In addition, currency markets have responded by sinking the dollar, making the kind of arbitrage that has padded the bottom lines of banks increasingly difficult.

The Fed is trying to help by shifting the yield curve and lowering short term rates. This allows banks to borrow money cheap and make money off longer-term instruments that pay more. But it will not be enough. The economic engine that has nourished these banks for so long has come to a stop.

There will be good buys to be had. But it took ten years to get to this point, and it may take ten years to get back, Remember, the Nasdaq which at the height of the Internet bubble in 2000 was above 5,000 is today only back to barely above 2,500.

When someone says things will bounce back quickly, it's wise to take a reality check and realize the higher the bubble, the steeper the fall.