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April 27, 2009

Will Failed Banks Sink the Stock Market?
by Mark McMillan

4/27/2009 6:20:16 PM

Introduction

This week's we are going to explore failed banks and the stress test the government recently completed on some of the banks. As always, we off our outlook for U.S. equities markets. This week's outlook includes both fundamental and technical information and analysis. We hope you enjoy it.

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Twenty-nine Bank failures in 2009

In general, banks fail when they get stressed. Individual banks may get stressed due to specific investment choices, capitalization levels, etc. We are more concerned with widespread economic events that affect many financials institutions. Historically, these effects are related to the failure of loan categories that banks are most heavily involved.

Most often, we see a slowing in the economy causes employment to drop with a corresponding reduction in income, causing individuals to miss mortgage payments, credit card payments, etc. There are also commercial loans that businesses may default on, in particular when the economy slows and the businesses encounter cash flow problems. There are specific types of loans related to both residential and commercial property development. As long as property values are stable or rising, these property development loans tend to get paid or the banks can foreclose on the property and get repaid by selling the property. It is when property values fall that developers see development projects providing little or negative returns and bank loans are defaulted on. The banks who foreclose on the property find a wide gap between the value of the property and the amount that was loaned causing banks to take significant losses.

For a perspective, recall that thousands of financial institutions failed during the Savings and Loan Crisis. That is the period of time when the Resolution Trust Corporation (RTC) was created and headed up by the then current FDIC chairman, Bill Seidman. Assets were sold off after the institutions became insolvent. This was a reactive approach.

Only six banks failed in the period following the stock market low in March 2003 through mid-2004. There were no more failures until 2007.

In calendar year 2007, only three banks failed. Recall that housing prices had peaked in 2006 but the stock market kept rising into fall 2007.

In calendar year 2008, the effects of the housing bubble bursting and the resulting credit and financial crisis caused the failure of 25 banks.

In calendar year 2009, we have seen 29 failures reported by the FDIC.

To understand the prognosis for the economy and the stock market, not that the two are completely correlated, we need to understand what is likely in store for financial institutions going forward. We have already delved into aspects of this in past letters, but let's focus on a few things in light of the current environment and actions taken by the U.S. Treasury and the Fed.

The Stress Testing of Banks

Treasury Secretary Geithner announced that the Treasury would stress test the nations nineteen largest banks. They didn't fully define stress testing at the time but it is a term that is used to model financials for banks under various conditions. They will release the results of the specific stress tests on May 4th.

On Friday, the government released a report that stated that most U.S. banking organizations have capital levels well in excess of the amounts required to be considered well capitalized. Fed regulators continue to assert that banks should be prepared for the worst.

What will the stress tests specifics tell us? We have to guess at what the government will include but we would have to suggest that the government ran scenarios with models of unemployment at different levels driving credit card and mortgage defaults to certain levels, etc. It may be that the government sets the worst case unemployment rate at 10% or so. In that case, most, if not all, of the large banks will likely be able to achieve a passing grade. If the worst case scenario sees unemployment spike above 10%, a number of the largest banks would see default rates that could cause their reserves to be inadequate to be consider "well capitalized".

Well capitalized means that a bank has a total risk-based capital ratio of 10.0 percent or creater, has a tier 1 risk-based capital ratio of 6.0 percent or greater, and has a leverage ratio of 5.0 percent or greater.

Adequately capitalized means that a bank has a total risk-based capital ratio of 8.0 percent or creater, has a tier 1 risk-based capital ratio of 4.0 percent or greater, and has a leverage ratio of 4.0 percent or greater.*

* There are some criteria that allow the leverage ratio to be even lower.

So, what we know from the government's stress testing is. No more than we knew before they released their report. There are many sources of information to show that most U.S. banks are currently well capitalized. What is important is what capitalization levels will the banks be at in the event of the likely and worst case scenarios. The government will have to decide what the worst case scenarios are and the decision may be politically motivated, i.e. they may choose a 10% level for unemployment if that preserves most/all of the nineteen largest banks well capitalized ratings.

Why is the government stress testing the nations nineteen largest banks? Those banks hold 70-80% of all the nations bank deposits, so they are largely representative of the banking system. A failure of any one of them could wipe out the funding of the FDIC to insure depositor accounts, so this is something the government will not allow to happen. This is where the expression, "too big to fail" comes in.

The talk of nationalization comes from the possibility that the government would take over an institution rather than let one fail. With AIG, they have injected so much capital into it, they have prevented it from failing but it is now largely owned by the U.S. government. That was done due to all the Credit Default Swaps (CDS) that were written by AIG. If AIG were to fail, then the insurance represented by the CDS written by AIG would have disappeared and many more financial institutions would have fallen from well-capitalized status and perhaps yet more would have already failed.

The U.S. government has, thus far, been reticent to nationalize banks preferring instead to make capital available at very attractive rates and to expand the sort of collateral they are willing to accept.

When the music stops, who will have a chair to sit in? While this analogy is taken from a children's game known as musical chairs, it is apropos to the financial markets at this time. All of the banks must put on a brave face and state to the world that they are well capitalized and don't need more government funds and even talk about early repayment of funds they have taken.

In point of fact, if the recession is longer or deeper than expected, causing unemployment to climb and along with it, defaults on loans, the banks could be in a world of hurt. At this time, there are plenty of investors who believe that large banks will make it (perhaps with the government's help) and there is also a large bearish camp.

From our perspective, the May 4th release of the actual stress test results represents a high degree of uncertainty and we don't intend on holding banking stocks on that day. While the government may set the "worst case" conditions to be somewhat benign to banks, there could easily be a large sell-off due to concerns of "sugar coating" the results. It isn't that we believe the large banks will fail nor that most of them will need more government assistance. We do believe that the markets could easily see a "sell the news" effect.

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Market Outlook and Conclusion

This week's market outlook includes the charts for the major index ETFs along with some auxiliary charts which help to illustrate market sentiment. We thought it would be particularly useful to understand what technical analysts are looking at when they weigh in on whether the market has indeed bottomed, or whether this was merely a "dead cat" bounce.

Before we cover the charts, it is worthwhile to look at the TED Spread. The TED Spread is currently hovering just below 1.00. Recall that the TED Spread is the difference in interest rates between 3-month (T)reasuries and 3-month LIBOR rates. LIBOR is the London InterBank Offered Rate denominated in (E)uro (D)ollars. Note the T in TED comes from Treasuries and the ED comes from Euro Dollars.

The largest U.S. banks have reported significant improvements in profits and handily beaten analyst expectations. Of course, there was a little bit of financial shenanigans as some of the profits were the results of two factors. First, Bank of America (BAC) and Wells Fargo Corp (WFC) acquired other institutions in the current quarter which allowed them to increase their revenue and earnings power. In addition, all banks were allowed to modify values for secuirities due to rules changes for mark-to-market accounting. This was a non-recurring adjustment and allowed the banks to handily beat expectations.

The looming write-offs and the need to increase reserves against them caused banks to sell-off when Bank of America reported results on Monday, April 20th. Since then, much of the panic selling has abated and value investors have stepped in to buy the banks at discounted prices and some banks, such as Wells Fargo had achieved new local highs by the end of the week.

Near month crude oil futures have moved up to $51.55.

Now let's turn our attention to the charts. If you watch the financial stations on your television, you can't help but notice that they regularly trot out chartists. One financial host recently stated that you can't trade on fundamentals at this time, you have to trade by the charts. This is quite a turnaround for many market observers. We thought it would be appropriate to take a look at what all the fuss is about.

Let's first take a look at a representative weekly chart then we will look at the dailies for the major indexes.

You will note that the chart pattern is a "W" shape where the right side is now essentially at the same height as the left side dating to November 4th, 2008. The horizontal resistance actually aligns with the 40-week moving average which is the often quote 200-day moving average which lies just over head at around $34.25 or so and comes down a bit every day. Price is also at the top of the Bollinger Band (the blue shaded area defines the area between the upper and lower Bollinger Bands). This results in either a reversal or in "walking the band" which means that price continues to move in the direction of the band along the outside of the band. In this case, it means the QQQQs will either reverse here or will move to a more significant uptrend where price will march along the upper Bollinger Band. A reversal generally pulls back to the center of the bands (20-week moving average) or to the other band.

With the perspective of the Weekly Chart for the QQQQs in mind, let's take a look at the daily charts, starting with the QQQQs.

The daily chart shows the QQQQs moving up within a steep uptrend as they flew past the December highs and are set to reach the horizontal resistance of the November highs and coincident 200-day moving average lying just above. We would be hesitant to believe the QQQQs will break above the 200-day moving average on the first attempt and believe this may provide a good short-term short opportunity. Note: See the discussion after we also review the other major indexes.

Next, we will look at the Russell-2000 index (IWM).

The Russell-2000 represents 2000 small-cap stocks. The chart shows it continues to move in an uptrend and has recently broken just above the horizontal resistance, dating back to January. The MACD continues to show an uptrend and RSI hasn't yet reached oversold levels.

The SPYders are clearly struggling to move up to horizontal resistance which is around $88. While price is maintained in an upward sloping channel, a failure to reach that level and then to break through it would likely lead to another move lower for the markets. At the same time, a break up through that level could see the SPYders move all the way up to challenge their 200-day moving average.

The DIAmonds are clearly struggling. Unlike all the other indexes, they haven't even moved up to challenge the recent high seen a week earlier. Horizontal resistance exists overhead at around $84 with another layer just above $83. While price is maintained in an upward sloping channel, it is a lesser slope than seen for the other major indexes. Theoretically, it should be easier for the DIAmonds to maintain price within their channel than for the other indexes to do likewise.

The markets are now following the lead of the NASDAQ-100 (QQQQs). If the QQQQs are able to move above their 200-day moving average, it is possible for that resistance to become support, and when the other major indexes move up to challenge their 200-day moving averages and are rebuffed, the QQQQs might only move back to their 200-day moving average and provide a cushion for the other major indexes.

We are going to use some sentiment indicators tied to price premiums for option contracts. When price premiums are high, volatility expected is high. Conversely, when price premiums for options contracts are relatively low, this signals the market is pricing in low volatility. This relates to a belief that bear markets are risky and bullish ones hold less risk. In particular, when puts (bearish bets) are going for a premium, implied volatility is high. When puts are selling at a discount, then implied volatility is low.

With that backgrounder, let's take a look at a couple of auxiliary charts to try to understand where sentiment lies.

The VXN represents implied volatility for the NASDAQ-100. It shows that the VXN had a bearish cross a bit more than a week ago suggesting the VXN will continue to move lower in the intermediate/long term. This implies the QQQQs will move higher during the same time frame as the VXN and the QQQQs are inversely correlated.

The VIX represents implied volatility for the S&P-500. It shows that the VIX 50-day moving average is coincident with the 200-day moving average and ready to complete a bearish cross any day. This implies a continued move lower in the intermediate term and a continued move higher for the S&P-500 (inverse correlation to the VIX) in the intermediate term as well.

Summing it all up, we have daily charts for all the major indexes which show they are currently near and ready to test resistance. A break up through this resistance could see a continuation of the uptrend. A retreat from resistance is likely to be met with another upward thrust in short order due to the inverse correlation of the VIX and VXN as they would move up to test the resistance of their 200-day moving averages.

Our call then, is that the markets are all still in a long term downtrend, but they are also in a short and intermediate term uptrend. We believe the bottom has been set in March. We also believe that bottom will be retested later this year. In the short term, we would look for a pull back, either somewhat immediately or delayed a week or two at most, depending on short term action.

I hope you have enjoyed this weekly article. You may send comments to mark@stockbarometer.com. Please don't be shy in expressing your opinions of what you would like to see covered.

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Mark McMillan
The McMillan Letter

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