Keith Davis is one of the best financial sector analysts and economists in the country today, and he works for clients at Farr, Miller and Washington. Keith’s calls on the economy have been amazingly prescient. His work on the financials, including the banks, pushed us out of that industry in spring and early summer 2007 and has saved our clients huge amounts of money. I think you will find his current thoughts both insightful and helpful.
There are a number of reasons why I do not believe that the government’s proposals yesterday will lead to a HUGE rally in bank stocks.
According to Morgan Stanley, the conversion price set by the government (90% of the average closing price for the common stock for the 20 trading day period ending February 9, 2009) is a median of 18% above current market price. I would have trouble believing that the stocks rally above these conversion prices given all the other remaining concerns discussed in the following points.
The government has not yet made public what minimum capital ratios the banks will be required to hold. As long as this question remains, investors will not gain comfort about the ultimate dilution that will occur to holders of individual bank stocks. In other words, we only received half of the formula yesterday. Without knowing the capital standards the banks will be held to, there is no way to know the potential dilution that may result from government capital injections.
The assumptions the government is using in the stress test do not appear to be “worst case”, in my opinion. In the “adverse” scenario, the government is assuming the following:
1) GDP is down 3.3% in 2009 and up 0.5% in 2010;
2) Unemployment of 8.9% in 2009 and 10.3% in 2010;
3) House price declining a further 22% in 2009 and 7% in 2010
According to a New York Times article published this morning, the consensus estimates among economists have GDP falling 2% this year and unemployment peaking at close to 9% in 2010. The consensus estimate for housing prices is a decline of 14% this year and an additional 4% next year. Many people are thinking these metrics could come in much worse than the consensus believes, and I’m not sure the government’s assumptions reflect a “worst-case” scenario. If these metrics indeed do come in worse than expected, loss rates at the banks will soar, further depleting capital and requiring a reassessment of the “worst-case” scenarios outlined by the government.
The “cram-down” legislation currently in Congress will likely permit bankruptcy courts to amend mortgage contracts, which could lead to even higher loss rates at the banks. This may require banks to reevaluate projected loss rates and the government to require more capital.
Investors will continue to look at what happened to AIG, FNM and FRE, providing evidence that the government’s initiatives to support these companies can be unsuccessful
Having said all this, I do believe yesterday’s announcements will provide near-term support for financials. It appears that the banks will remain ongoing concerns, which alleviates investors’ biggest fear (complete nationalization).
I am encouraged that the daily market drops are taking a pause and that the November low on the S&P 500 continues to hold. As we’ve said before, this market will likely rally and fall several more times before it ultimately turns higher. It feels like it is ready for an upward leg. Cross your fingers! Hang in there!