It Begins and Ends With Financials The banking system in the United States, to put it mildly, is
still weak. Much has been made of Citigroup (NYSE: C
- News)
and Bank of America (NYSE: BAC - News) proclaiming operating profits for the
first quarter of 2009. While slightly encouraging, it is hardly satisfying as
it fails to account for balance sheets, the heart of the problem since the
beginning of this crisis. The Federal Reserve and Treasury have gone to extraordinary and
unprecedented lengths to create an environment in which banks can earn
operating profits; borrow at the short end of the curve for practically nothing
and lend out at a higher rate. Frankly, if you cannot earn a profit in this
environment, you should close your doors for good. There is still pain ahead
for the bank's balance sheets. As home prices continue to fall and job losses
keep mounting, the bank's bad loans will continue to deteriorate. Bloomberg reported on Friday, April 3rd that federal regulators
may force at least a dozen of the nation's biggest financial institutions to
write down as much as $1 trillion in loans, twice the amount already recorded.
Treasury Secretary Geithner is pushing for fast-tracked Congressional approval
of a law that will allow the takeover of important institutions and bank
holding companies, which should signal that risk to the system is still great.
Additionally, there is a great deal of speculation as to whether PPIP will be a
benefit to ailing banks. Selling troubled assets will likely mean realizing a
large amount of previously unrecognized losses. We see the recent rally in the
Financials (NYSEArca: XLF - News) as an opportunity to sell this
overconfidence in the banking system. Taking Cues from Credit and Commercial Real Estate As we have witnessed in previous bear rallies, the credit and
equity markets are telling us two different stories. Corporate debt is still
pricing for disaster, as investment-grade corporate bonds are pricing in a
five-year default rate of 40%, according to Deutsche Bank. Moody's recently
downgraded $1.76 trillion in Corporate debt, signaling the approach of the
worst defaults rates since the Great Depression. But wait, there's more. Moody's chief economist John Lonski adds that 'the most
prominent new driving force behind credit rating reductions would be
deterioration of commercial real estate.' Commercial real estate values are
still in the midst of a free fall, defaults and delinquencies are mounting,
rents are falling, vacancy rates accelerating, and refinancing is tight at best
and at worst non-existent. As evidenced by the CMBX index, CMBS spreads are still at highly
distressed levels. All but AAA spreads remain at or near all-time highs. While
there has been some spread tightening in CMBS/RMBS AAAs since Geithner's PPIP
announcement, take that with a grain of salt, AAA spreads are compressing from
previously unimaginable levels. A recent article from Bloomberg notes that the
country's 10 largest banks have $327.6 billion in exposure to commercial real
estate, half of which are owned by Wells Fargo and Bank of America. As the
economy is still shedding jobs at an alarming rate, commercial real estate will
continue to deteriorate. There is still another shoe to drop. The United States is Not an Island unto Itself It is also important to remember that the United States is not
alone in this crisis, and it cannot fully recover without the rest of the world
following suit. Although it seems we are going by the FIFO method of economic
recessions, First In First Out, it seems highly unlikely that a recovery can
take hold without some signs from the rest of the world. From a global
perspective, the world economy is very much still in the throes of a very
serious and deep recession. The Eurozone, and especially Japan, are showing no signs of
relief. In fact, Japan's economic situation seems to be continually
deteriorating, with Prime Minister Aso calling for another large economic
stimulus package to be compiled this month. The United States' third largest
trading partner and southern neighbor asked for a $40 billion loan from the IMF
just this week. Given its shaky economy and the increasingly difficult task of
saving itself from narco-statehood, Mexico seems volatile. Additionally, the
recent announcement out of the G-20 to raise the IMF's reserves to $1 trillion,
raises some serious issues with us. The need for additional funds at the IMF
signals that there are crises looming for many weak and battered countries. Although, it should not come as a surprise in this climate that
the IMF will have to step in and help weak economies, what are the chances that
the IMF can execute flawlessly on all of them? If their past performance is any
indicator, it would seem highly unlikely. Due to our expectations of continued weakness in the financial
sector, the looming deterioration of commercial real estate, the credit markets
tepid backing of the equity rally, and the still very shaky and highly volatile
global economy, it's our view at ETFdesk.com the recent run-up in stocks is
unwarranted and presents an overly optimistic view of the months ahead. We believe investors should consider taking short term profits
or use the recent run to reduce equity exposure they are weary of. We also
believe investment grade debt (NYSEArca: LQD
- News) represents an opportunity for investors
seeking beaten down prices without the downside volatility of equities. Thomas Schumacher is the Chief Strategy Officer at ETFdesk.com.
His views do not necessarily represent that of ETFguide or Yahoo Finance.