For the next 6 to 12 months, assuming that GDP growth is slightly negative for the next 3 or 4 quarters but the credit markets begin to function again, the following is our outlook on banks, financial services companies and insurance companies.

Not much has been/can be done about the fundamental cause of the crisis -- the steep decline in the housing prices (we may only be halfway through the decline), which will continue to hurt the profitability of all financial institutions that hold mortgages and mortgage-backed securities.

Banks & Financial Services

* Banks still do not have trust in each other, and the moves by the Treasury and Fed to get the banks to start lending to each other have failed so far. The U.K. government took the big step of providing guarantees on interbank loans. It is expected that the U.S. regulators will also follow suit in guaranteeing the interbank loans as also temporarily insuring all U.S. bank deposits.
* We expect that the regulators will allow the weaker companies to fail and support the stronger firms to take over their assets. There will be a lot less competition in the industry.
* On the positive side, once the bailout program is in place, the capital infusion will strengthen the balance sheets, bad assets will be removed from balance sheets and credit will begin to again flow. Also, the Fed is expected to lower the interest rate further which will help the banks with a liability-sensitive balance sheet.
* On the negative side, forced dilution resulting from the Government's action and continued credit losses will hurt the shareholders.
* Among the banks, we prefer those with low exposure to housing/real estate loans and/or derive a significant portion of their earnings from fee based sources. Those with higher exposure to housing/residential construction loans like KeyCorp (KEY), National City (NCC), Zions Bancorp (ZION), Comerica (CMA) and Wilmington Trust (WL) will continue to be under pressure.
* With most banks winding up their riskier mortgage loans business (subprime and no documentation loans), the profitability of mortgage business will be significantly lower.? Further, as the housing turmoil is affecting the consumers in general, we now see higher losses in other asset classes as well.? Tighter lending and underwriting norms will limit the lending activity of the banks and further hurt profitability.
* Student lenders like Sallie Mae (SLM) face increased higher funding and credit costs, which will continue impacting the profitability of the company.

Insurance

* We are concerned about further writedowns on the investment portfolio. The industry's statutory capital levels had fallen sharply in the first half of 2008, and we expect the trend to continue.
* P&C insurers should report higher losses from Ike and Gustav. Top-line growth will be much harder to achieve in a deteriorating pricing environment.
* Life insurers face not only losses in the investment portfolio but also lower income from their variable annuity business, as the stock markets continue to be weak.
* Mortgage insurers like PMI Group (PMI) will remain exposed to further losses from decline in housing values, though the demand and new business quality have improved in recent months.
* The sellers of credit default swaps like Primus Guaranty (PRS) will face increased losses from their exposure to some of the failed/troubles institutions. ?