12/14                                                                                          

BANK ON IT ?

Bank On It?...We're not seasoned bank analysts/specialists by any stretch of the imagination and we will never pretend to be such.  We hope we know enough to ask the right macro questions when looking at the broader financial groups and specific companies within the various financial industries.  Now that we appear to be on the cusp of a monetary easing period in response to a fairly rapidly deteriorating domestic and global economy, we expect the knee-jerk chant of Street strategists to be "buy the financials because interest rates will be coming down".  For us, the real question in looking at the financials here is whether these issues reflect potential severity of credit quality deterioration ahead.  Forget what may be temporary interest spread enhancement as rates initially drop.  As you would imagine, there is really no way to answer the credit quality question without having perfect foresight of future domestic and global economic experience.

Nonetheless, we can make a few observations regarding credit quality trends and circumstances.  At the moment, non-performing loans are increasing enough to warrant our attention.  For the bigger institutions, non-performers are near or above levels last seen in 1994.  Here is the data directly from the Fed:

The alarm bells are starting to ring, but by no means are the air-raid sirens blaring...yet.  In the banking crisis period of the early 1990's, levels of non-performers were much higher than today in every bank asset size category.  What is very interesting this go around is that it is the big banks that are experiencing the most difficulty.  Admittedly there may be a bit of natural selection skewing the meaning of the numbers as many of the smaller and less well run banks were acquired over the last ten years, but the current facts are that non-performers are ticking up among the big players.

As you know, it has really been the big boys that have been able to play in the new era lending sandbox over the past half decade or so.  Participating in loan syndication activities and lending to tech and telecom names based on enterprise or franchise value.  The importance of the trends at the big banks is that banks with over $10 billion in total assets account for three quarters of  bank wide commercial and industrial lending.  Naturally they will be the first to reflect credit deterioration in both the new and the old economy companies.  According to the consensus, up until a few months ago, the longest economic expansion on record was humming.  Why then have non-performing loans at the biggest institutions almost doubled in a consistently deteriorating fashion over the last four years?  This clearly begs the question of how bad will be bad as we move toward a potential 1-2% quarterly annualized GDP growth rate ahead.  Heaven forbid we enter a multi quarter recession.

Pictures Of The Smiles We're Leaving Behind...The chart of the Philly bank index is quite telling.  The banks in aggregate have been bumping up against resistance for almost three years now:

A few weeks back we discussed with you the condition of the junk bond market in a piece called Junk Yard Dogs.  The parallel we draw with the banks is that the junk bond market is clearly reflecting credit distress as witnessed by bond prices and yield spreads.  The damage is out in the open and easily seen.  Fully discounted in price?  Maybe not, but well along in the process.  We seriously doubt that the potential or ultimate credit damage in bank balance sheets is fully being discounted at the moment.  In fact, with a potentially impending monetary loosening, investors may temporarily lose sight of the fact that credit problems are growing as excesses and malinvestments of the former new era are being reconciled on an ongoing basis.  

In the last few years, about 40% of issuance in the junk bond market has been from telecom related issuers.  Just last week, British telecom brought a $9 billion piece to a marketplace only too happy to oversubscribe the issue.  During 2000 alone, the foreign telecom companies have completed the following:

Many of the foreign issuers have paid an increasing price recently to get these deals done.  The Duetsche bonds of a month or so back have a coupon reset upward in the event of a rating downgrade.  The BT issue of last week has a 25 basis point upward coupon reset per rating downgrade, per agency.  Likewise it has an optional put back to the company should the rating fall to BB.  The game is changing, even for what have formerly been perceived as quality issuers.

A "Bridge" To Tomorrow...What is little discussed in the current market are the bridge loans the banks and the brokers have made to telecom and tech companies over the past year or so.  Initially intended as something temporary, these bridge loans may end up reeking havoc for the banks and brokers before it is over.  Since the junk bond market is essentially shut down and these telecom and tech companies do not have a prayer of raising equity money, the banks and brokers are forced to cross their fingers and pray this theoretically temporary funding can be replaced with more permanent financing.  At the moment, this seems more a wish than an eventuality.  A non-performing loan is characterized as a loan 90 days or more past due.  We expect this phenomenon to be the next shoe to drop for these lenders.  

The brokerage stocks have been on a tear since the bottom during the LTCM period.  See what we mean?

Undoubtedly consolidation has been a major driver of stock prices over the last few years, in addition to tremendous investment banking fees and substantial trading and brokerage income.  The brokers are also a very highly levered group and major conduits for credit creation in the system at large.  With respect to the tech and telecom lending practice, Merrill alone reported that bridge loans increased from $190 million in 2Q to $568 million in 3Q of this year.  Surely they were being good Samaritans in trying to accommodate potentially lucrative fee paying banking clients.  Now, given that the financial markets have turned their back on this paper, what's next?.  We do not have numbers of what has been going on at other brokerage firms, but what we do know is the following:

Highly levered firms stuck with potentially volatile paper does not make for good reading in Wall Street research reports.

Has The Well Run Dry?...Lastly, a number of banks involved in the VC game also face another little vexing problem at the moment that may not yet have played out in full.  Chase is suspect numero uno here.  The drop in the values of VC portfolios decreases the earnings reporting flexibility for those whom portfolio profits have been a former benefit.  As you know, the fourth quarter has been particularly devastating for many a dotcom, small telecom, etc. type of new era company.  Not only have unrealized gains in VC investment portfolios shrunken considerably, but where are the write-offs for companies that have now gone to "new era heaven"  (translation: zero)?  When the gains are potentially used up, only the write offs will remain, now won't they?  (Just today, Chase and JPM warned.  Chase specifically cited losses in the VC Investment portfolio and drop in overall portfolio value.)

Greenspan imploring bankers to refrain from restricting credit to worthy borrowers seems wrought with irony.  This statement from a man proclaiming the virtues of the new era as short a time ago as the summer.  We're convinced Greenspan is fearful of a recession induced by restrictive credit.  Let's face it, he has very good reason to be scared.  You may remember that when Greenspan "saved the banking system" in the early 1990's by dropping short term interest rates significantly, banks initially sat back and reaped the benefits of a positive yield curve while licking their wounds from credit losses generated by speculative lending in the late 1980's and early 1990's.  Will something along these lines again be the same response of the banks currently if the Greenspan liquidity band again strikes up a familiar tune?  Quite possibly.  We would be very skeptical, but not surprised, of a move in the financial stocks based on a monetary easing path ahead.  Knee-jerk, blind reaction.  Just remember that there are two sides to every balance sheet.  We would conjecture that credit problems in the banks and brokers have just begun for this cycle.  As you may have noticed in our managed account activity page, our exposure to the financial sector is zero from an equity standpoint.        

Rearranging The Deck Chairs?...You may or may not be aware that the NASDAQ 100 will be conducting a little "housecleaning" this weekend.  Translation?  Cleaning out the under performers.  As of the open on Monday, 12 new and improved members will be joining the prestigious club and twelve deadbeats will be shown the door.  Given our continually morbid curiosity with all things financial, we can't help but look at the numbers.  Incoming:

As you can see, this little group has had a minor performance edge on the NDX as a whole this year.  A lot of doubles and near doubles.  This should also go a ways in raising the aggregate P/E multiple on the NDX 100 also.  

The deadbeats being given the bum's rush (and don't come back !):

It's just comforting to know that these above mentioned outcasts have inflicted maximum damage on the performance of the NDX this year before departing quietly.  Actually, the adjustments are really based on nothing more than size or market cap.  The NDX, as you know, are the top 100 non-financial market cap issues on the NASDAQ.  In a bull market, this rebalancing really gives an upward bias to the index over time.  The top performers are continually moving up in rank and become more meaningful as a singular weight in the index.  This has also been true for the S&P.  Over time the laggards are weeded out and the best of the best take their place.  Again, this is wonderful in a longer term, upward trending bull market.  We're just not so sure this works like a charm in a bear market.  Most clearly, the incoming in the NDX have potential forward valuation risk that far outweighs those being booted out.  But, as you know, because of the actions of investors in pushing these favored issues higher, the tribe has spoken...for now.

Icarus Falling From The Sky...As you may know, Janus is the Roman God of "beginnings".  (January)  The name of Janus is invoked when sowing grain.  Janus is also known as the god of entrances, of going in and coming out.  The god of doorways and boundaries.  For this Janus, is the following representative of the beginning of the end, or the end of the beginning?

We have the feeling that current Janus family fund investors are invoking the name of Janus allright.  But, possibly not in the manner the fund would prefer.  If you live by the tech sword, so to do you die by that same sword.

Channel Surfing...Don't touch that dial until you take a peek at the following chart from Tim.  Will continued preannouncements weigh on the averages ahead?  Will Greenspan snip a few basis points off the Fed Funds rate next week?  What about the supposed year end rally as time is running thin?  Watch the channels for clarification if the current market picture seems a bit fuzzy to you: