Think, Don't Trade!

From the Desk of Joe Rollins

It seems like the financial stocks have taken a beating every trading day so far during 2008. Even though most of these stocks are currently selling at much less than the banks’ book values, they continue to be violently traded down by the markets on a daily basis. One expert after another on the morning financial news programs seems to say that no one should be in the financial sector right now, and they suggest that if you are, then it’s time to cut your losses and get out.

I often find myself wondering if these financial “experts” have actually given any serious thought to their recommendations. I understand trading on momentum, and that “the trend is your friend,” as the saying goes. But at some point, common sense and economic reality must have some input on trading decisions.

For the last three weeks, the financial press has been pounding investors with talk regarding the bear market, and all of the major market indices now seem to be trading down 20% from their highs in October of 2007. I often find myself telling clients that investing in a bear market is really not that different than coming face-to-face with a bear in the wild. If you’re ever in that frightening predicament, it’s not wise to make any sudden moves. Rather, it’s best to lay low, move smoothly and think before reacting. Investors should take those same steps during a bear market.

Understanding how banks make their money is fundamental to investors investing money in financials. The central component of a bank’s earning stream is its ability to borrow at low interest rates and lend high. Banks make money on the spread of interest rates between what they can borrow from the public and how much they make by loaning money to the public.

 
Please review the chart I have provided titled, “U.S. Government Bonds – Yield Curve.” The top line represents bank interest rates from exactly one year ago today, while the bottom line represents bank interest rates today, based on U.S. Treasury bond rates. Any financial analyst who asserts that banks are in a worse financial position today than they were one year ago clearly does not have a handle on the income potential of banks and financial institutions.

In 2007, banks were borrowing and lending money essentially at 5%. Please note that virtually every focal point on the chart for 2007 is at or near the 5% level. It was impossible at that time for banks to make any serious money without taking inordinate risks since they were borrowing at exactly the same rate they were able extend loans. As evidenced by 2008’s results in the chart, all of that has now changed.

To put the bank interest rate spread into simpler terms, if you have money at your local bank in a money market account, you are likely receiving the three-month Treasury bond rate or lower. Basically, the bank borrows money from you, paying you money market interest rates, which are currently significantly below 2%.

With the money the bank borrows from you, they extend mortgages and other long-term loans to the general public. As you can see by the chart, the 30-year Treasury rate is now approaching 5% on the Treasury bond rate. Today, 30-year mortgages are at 6.25% to 6.5%.

If banks borrow money from its customers at less than 2% and subsequently loan that same money to the public at 6.5%, then the spread between the spread between the two is a staggering 4.5%. Believe me; rarely in the history of banking has there been this big of a spread on their borrowed capital.

The recent increase in interest rates by the European banks was also confusing. They increased interest rates by a quarter of a point under the assumption that it would help slow down inflation (inflation is basically the only mandate Europe has to work with within its economy). The Europeans have little or no control over energy, and therefore, their increasing of interest rates will have very little effect, if any at all, on the cost of energy.

Presumably, the Europeans intended to slow down their economy by increasing interest rates while their economy is basically already at break-even. I’m having a hard time understanding why any government would intentionally throw its economy into recession in an effort to slow the rise of a commodity for which they have no control. Am I alone is seeing the absurdity of this interest rate increase?

The “experts” also talk incessantly about the rising commodity prices and the potential fear of future inflation. Please review the chart titled, “Commodity Prices – 1 Year Percent Change,” representing the four basic commodities: oil, corn, wheat and rice. As you can see, wheat, which is the poorest performing of these commodities, is up approximately 50% over the last 12 months. One might assume that these out-of-control increases in these commodities must be leading to skyrocketing inflation. Each of these commodity’s prices will most likely work its way through the economy, as the supply of each commodity must increase to make up for the increase in price.

The rate of inflation is now approaching 4% annualized, and it is assumed it is only going higher due to these escalating commodity prices. However, please note on the chart concerning bond yields that the 30-year Treasury bond is currently yielding only 4.5%. Investors obviously have no long-term fear of inflation or they wouldn’t be willing to tie-up their money for 30 years only to receive a rate almost exactly equal to the rate of inflation. It is absolutely clear that the most sophisticated investors do not believe inflation is a long-term risk to the economy or they would demand a higher rate of interest.

As I watch the financials being traded down to almost ridiculous levels on the New York Stock Exchange, I think of the inconsistencies of the positions outlined above. A lot of investors are apparently trading before they’re thinking. If an investor properly evaluates the facts, it should be obvious that banks and financial institutions are currently in a position to make substantial sums of profits over the coming year.

There are two ways for the Federal government to bail out a financial institution: by “bailing out” the financial institution (similar to what happened with Bear Stearns), or; without government intervention, which is much more effective, by allowing the financial institution to make more profits.

By reducing the short-term interest rates, the Federal Reserve has made the yield curve very steep. The precipitous nature of this yield curve allows the banks to borrow from individuals at nearly zero interest rates, and then loan out the same money to the public with an almost 5 point interest rate spread. This spread on interest rates almost guarantees higher bank profits in the coming years. For the foregoing reasons, the next 30 days may be the best buying opportunity we will see in our lifetimes to purchase the stocks of the great U.S. banking institutions.