Who’s right? Investors who’ve driven down the shares of Citigroup, Bear Stearns, Morgan Stanley, and Merrill Lynch by 50-58 percent? Or the sovereign funds from the Middle East and Singapore that have poured $69 billion into big investment banks?
We all know the rationale behind these big infusions of money. They’re supposedly buying top-flight global financial institutions at fire-sale prices.
It involves two bets. One is that the U.S. economy will eventually bounce back. And the other is that the big banks will bounce back with it.
That sounds like a sure thing, doesn’t it, especially when it follows two of the basic rules of safe investing. Buy out-of-fashion companies. And buy the best of the best.
Sovereign funds don’t like to take risks. But that doesn’t make them immune to mistakes.
They were started by the cash-rich countries of the Middle East, China, and a few others (like Norway and Singapore) to get a better return on the trillions of dollars that would otherwise be invested in boring government bonds.
These aren’t hedge funds. It’s not always about profit. Some have strategic objectives as well. And they’re not run commercially. They’re government operations run by government bureaucrats. And they typically eschew high-risk investments. Of course, that didn’t prevent China’s sovereign fund – the China Investment Corporation – from losing almost one-third of their recent $3 billion investment into Blackstone.
Making investments into iconic brands while they’re down and out sounds like “Smart Investing 101.” But while these funds have helped to keep the sector from falling harder than it has, the shares of big banks are still heading down.
And more infusions are expected.
Smart Investing 101 doesn’t work all the time. And when it doesn’t, it’s usually because investors are looking backward. They dwell on the past glories of the company or sector rather than acknowledging what is usually a fundamental shift in the industry.
Exhibit #1 - Old media
What could be more iconic than The New York Times (in blue) or The Washington Post (in green)? Even the relatively new USA Today (Gannett, red) has become an American institution.
But such status hasn’t prevented their stocks from falling. The one thing that has saved The Washington Post from such a fate is their fast-growing educational subsidiary, Kaplan.
INTERNAL ENDORSEMENT
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These media giants had cheap shares two years ago. But the emergence of such sites as Google and the resulting surge of online advertising killed their business model. Sure, their prices may have been cheap two years ago. But the market didn’t think they were cheap enough.
Exhibit #2 - Sears
How the mighty have fallen. The 121-year old retailer is undergoing yet another reorganization. Its shares have lost half their value over the last year. Mega-stores like Target and home-supply stores like Lowe's and clothing stores like Kohl's have chipped away at Sears' customer base.
In trying to be too many things, Sears lost its identity to retailers with a better handle on what their core customers want. They may regain their magic, but their days as a widely respected “solid as Sears” brand seem like eons ago.
Exhibit #3 - Big banks
Leave it to these banks to turn “financial engineering” into a dirty term. Their write-downs of bad debt have risen to $108 billion. And now that the monoline insurers – ACA Capital (ACAH), AMBAC (ABK), MBIA (MBI), and FGIC (a GE/Blackrock company) – are getting downgraded, the insurance on the massive amount of collaterized debt swaps they covered will be no good.
How much money is at risk? AMBAC was downgraded from AAA to AA by Fitch last Friday. Their AAA ratings had provided insurance coverage on $556 billion in municipal and structured finance debt.
MBIA’s exposure to bonds backed by mortgages and CDOs is $30.6 billion. MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week. Its stock has since gone down more.
ACA also has junk status. It has insured $69 billion in mortgage and corporate bonds. Along with MBIA, it’s as good as out of business. Nobody will pay for junk-rated insurance.
Banks that assumed they were hedged by this insurance have been left in the lurch. As a result, estimates for how much write-downs will occur down the road have spiked. The new numbers start at $450 billion and go up from there.
Now, we all know that the champion of buying out-of-fashion companies is Warren Buffet. But I doubt if he thinks that these big banks are such a great investment opportunity.
Consider what he did when he bought insurer Gen Re five years ago. Gen Re was in the credit default swap business. Buffet decided to get out of it. He gradually pared down exposure to almost nothing.
But he had four years to do it. So the markets barely noticed. It’ll be a little different this time around. Getting rid of such contracts today will be a bloody and huge money-losing affair. The banks are going to get walloped. Again.
And, once again, sovereign funds most likely will be there to help bail them out. But will they do it even with share prices in a free fall? Yep, they’ll have to, if only to protect previous infusions.
It’s a bet that sovereign funds are apparently willing to take. But, in that case, smart investing will have morphed into desperate investing.
Make no mistake about it. They’re taking a huge risk. Once upon a time, these big banks were top-flight financial institutions. Now they’re anything but.
Good Investing,
Andrew Gordon
P.S. To let me know what you thought of today's article, send an e-mail to: feedback@investorsdailyedge.com.
[Ed. Note: With a bear market looming, it’s more important than ever to select safe investments that produce monthly dividend income. Click here to learn about Andy Gordon's INCOME service that selects the best dividend-paying stocks available.]
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