Wednesday, April 1, 2009

Too Big To Fail? M2M Easing May Decide

I want to talk about the banks tonight. I have a theory that I want to share. I am sure this theory is not unique but I will claim it is mine only because I have not heard it or seen it but I have not had a lot of time to read WSJ, Reuters or Bloomberg lately. But, if you want to skip to my thoughts on the market today and the rest of the week, jump to the "BACK TO THE MARKET" section lower.

Tomorrow may be a pivotal day for the market. When I say market, I am focused on financials. Financials will either lead the market significantly up, or significantly down. If financials lead the market significantly down, we are probably in a situation that many of the major banks are nationalized to some degree. Insolvent. Not all of them, but many of them. If this happens, then another sector, perhaps energy or tech will lead the market slowly back up over the next few years. Financials will never be what they once were. They will not be a leader. Here's why.

Lets say tomorrow M2M accounting rules are relaxed such that some assets can be valued at prices other than mark due to whatever circumstances the gov't or banks want to make up. Does this mean all banks are solvent? Does this mean all banks are out of trouble? Of course not. It may certainly help the banks that played closer to the rules and did not get heavily leveraged. It can allow them to reduce write downs and claim higher capital, thus allowing them to get back into more normal business activities. But it does not cure all. Even the good banks are going to have difficulty determining proper values of assets. It will be hard to really determine how much value any given bank has at any point in time. And if real estate prices continue to drop, it still presents risk that these banks can still fail and have further huge write downs.

For these banks, they are still too big to fail. We can no longer move forward with financial entities that are too big to fail. I see these major banks who pass the stress test and are determined to be solvent, to still have to raise capital in order to free up credit markets. These all-purpose banks will eventually be forced into downsizing by selling off divisions. No more all purposes banks. No more, "Too large to fail". What is interesting about this is, either the gov't can force this early on, or it will happen naturally over the next 2 years. Banks will have to raise capital as residential and commercial real estate prices continue to slide. Regulations around bank capitalization will force it. From this will be created smaller entities that will be separately run, and separately traded on the stock markets.

For many banks, even the major banks, they will not pass the stress tests even with the M2M easing. These banks will be broken up into smaller entities and their bad assets will be forced to be sold off via auction or via free market selling at rock bottom prices. It will create a micro-burst of real estate price drops of probably 30-40% more than they are now. This will hurt initially but it will be the bottom and real estate will quickly regain traction within 1-2 years and head back up. It is the natural progression that needs to happen.

These less fortunate banks will either be wholly nationalized or partially nationalized like Citi and AIG are today. They will be broken up into smaller entities and then re-enter the private market as these smaller entities.

For smaller banks such as regionals, the healthy ones will scoop up some of the insolvent competitors or the smaller local banks which are insolvent. This will result in some of the healthier regional banks to be about the size of some of the trimmed down major banks.

For the small banks, there will be consolidation among themselves or they will be scooped up by the regionals.

What you hear a lot of is consolidation of the major banks. I disagree. I don't see consolidation of major banks. What that creates is banks that are even bigger than too big to fail. I believe the major banks will become smaller. It is the new era of banking. Smaller and more lean so that gov't can regulate them easier and the banks start playing the free market capitalism game where they are no longer too big to fail and gov't can allow banks that are insolvent to fail.

We will never get back to banks the size of Goldman, JP Morgan, Lehman, B of A, etc. Gov't will not allow it for the benefit of the future for the U.S. economy. Our gov't made the mistake of doing the opposite in 2008. Forcing banks to consolidate. Now the banks that are too big to fail are bigger than they were before. Bank reduction will result in a better financial foundation for the world economy.


All right, the market is behaving as planned and almost on cue. The target for today was a VIX at 42 and a market up 2%. This was actually a pretty easy call given the FASB meetings this week and the anticipation of the news. The hard part was ignoring TA and the futures which clearly showed today should have been a down day.

Tomorrow is a different story. While I have been very confident this week, I am not as confident for tomorrow due to news driven events. I feel we are at a crossroads right now. The VIX is near its lower trend line. The S&P is teetering on a support line. Big news is coming out. But this news may be the last bullet the gov't has to turn financials around. Is it the magic bullet? Or is it a blank.

Given what the VIX is telling us, I believe tomorrow the market will gap up and run a bit in the morning. That will bring the VIX to about 41 and at a key resistance. The S&P may get to about 825-830, another key resistance. News should hit about then or even leak a bit pre-market. Ignoring the news, it sets up a key trigger for the market to reverse and reverse hard to the down side. If the FASB was not meeting tomorrow, I believe the market would bounce off of 825 and head straight down to 750. So, lets factor in the news...

If M2M easing is announced and one of two proposals is accepted, The market could very well take off on the back of financials. There is certainly uncertainty on what the new rules will do, but the market will still take off. Perhaps 850-875. But then stall. From there I would expect a gradual move down over the next few weeks to the 750 or lower range as stress test results are announced and the gov't has to nationalize or semi-nationalize some of the banks. We will see sub 700 before end of June.

If M2M easing is not decided upon or voted down, this will be a severe blow to the financials and to the market. With bad news coming in the form of earnings and stress tests and higher unemployment and lower RE prices, we could see a huge market move down. But no lower than 750, and eventually slowly go down to sub 700.

So with either result, we go to sub 700. One takes a longer road to get there.

For me, I see an opposite of today. I think we gap up and run a bit then move down in the red by 10:30 or 11:00. I think at that point, assuming no major news, cash is king. Take any long profits while you can. Play financial straddles and wait for the news. When it hits, jump in quickly to whatever side but be sure what the news is. I am hoping at the time of the news, the VIX will be at 41 and PCR data will show heavy call volume. If that is the case, I will lean heavy to the short side with SRS and FAZ and call options on FAS and/or SPY.

Again, tomorrow is a pivotal day and could be a fulcrum for the near term direction of the market.


  1. thanks for the good article. totally agree.. and pardon me.. what is PCR data?