I was recently perusing some investing blogs and ran across an article I feel adequately captures my concerns (and belief)
that financial mass destruction is probable in 2009. Rakesh Saxena, the
article’s author, does a good job explaining the unbelievable amount of
financial engineering by the likes of Citigroup (NYSE: C), JP Morgan (NYSE: JPM), Bank of America
(NYSE: BAC), Lehman
Brothers, Bear Stearns, and many others. Reading this article, as well as the
insightful comments, reminded me of two specific reasons why I urge everyone I
know to stay away from financial stocks - even shorting them.
What Do Banks Do?
In the aforementioned article, one part I found particularly amusing was
Vikram Pandit’s response to a question posed at a Town Hall meeting:
Responding to a rhetorical “What does a bank do?”
question at a Town Hall meeting last November, Citigroup (C) CEO Vikram Pandit explained that “a bank
takes deposits and puts them to work by investing and making loans.”
Unfortunately, Mr. Pandit, that’s not entirely true. The truth is that large
banks in their current form, especially Citigroup, deal in some of the most
complex derivatives the financial world has ever seen.
Famed investor Warren Buffett has always maintained that he only invests in
businesses he understands very well. I do the same. While I certainly understand
a (very small) portion of the large and complex derivatives market, there’s
little chance of me explaining it adequately to a novice. In fact, the vast
majority of people on this planet probably could not do so, besides (maybe?) the
individuals who designed them. Honestly, I doubt Mr. Pandit could even explain
them.
So there’s strike 1 against investing in financial stocks; they’re nearly
impossible for even Wall Street veterans to understand.
It’s the Government, Stupid
If the free market forces had their way, Citigroup and a large majority of
banking institutions would be gone within the year, or at least reduced to a
shadow of their former selves. So theoretically, shorting these stocks might be
a very good idea. In fact, I believed shorting financial stocks was a great idea
back in November, 2007. I was quoted in Business Week here, for my article: Profiting from the Housing Bubble. In the article, I
recommended purchasing shares of Ultra Short Financials Proshares (AMEX: SKF) exchange traded fund (ETF), which shorts financial
stocks.
Do I still recommend SKF? Theoretically, yes, but practically, probably not.
The issue now is summed up quite nicely in a response to Mr. Saxena’s article,
courtesy of Crocodillian:
“At this point, though, while all of these firms
deserve to go broke, going short is risky– their fortunes now rest in the
political arena, not business logic. On what terms will Citi be bailed out? Who
can say? It is as much in Washington as on Wall Street that this will be
decided.”
Bingo. There are two forces at work here. One is the free market, which
dictates that these financial institutions are technically bankrupt (they have
insufficient assets to cover their liabilities), and the other is the
government, which is keeping them afloat with bailouts. Which one will win? I
don’t have the faintest idea.
The Bottom Line
It seems to me that the government will be unable to prevent a wave of
financial institution bankruptcies from happening in 2009, which is why I favor
shorting over going long. But I’m hesitant to even short; there are just too
many unknowns and what ifs.
