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by Martin Chapman

Created on: June 28, 2008   Last Updated: June 29, 2008

NEVER CATCH A FALLING KNIFE!

This old stock market adage is as apt today as it ever was. World Banking stocks are already down over 22% this year and we have returned to level we were at in March 2008, when the Federal Reserve had to the rescue Bear Stearns to avoid a financial meltdown.

So Bank share prices are now lower than they were a year ago. Is that a good reason to buy Bank shares? ABSOLUTELY NOT! The knife is falling and if you try to catch it you will cut your hand.

A VERY NASTY PERIOD IS TO COME

Bob Janjuah, the Credit Strategist at The Royal Bank of Scotland, who predicted the Sub-Prime Crisis last year, recently stated that "a very nasty period is soon to be upon us!" and the bank has advised clients to brace for a full-fledged crash in global stock and credit markets.

All this might lead a contrarian to buy now, but the right time to buy bank stocks will come when all sub-prime exposure has been disclosed, trust increases in bank earnings again and the banks start to write-back their provisions.

The amount of worthless Sub-Prime Paper held by financial institutions is estimated at somewhere between $300 billion and $1 trillion, but nobody knows for sure how much it is and who exactly holds this exposure. Therefore as long as this uncertainty remains, it is advisable to wait for clarity.

NEGATIVE DIVIDEND YIELDS

World Bank Indices show Dividend Yields of 5.5%, which looks more attractive than it has for some time. But US or German 10 year government bonds will give you a yield of 4.1 to 4.6% risk free and Global Investment Grade Corporate Bonds offer a further spread of 2% over government bonds, so why bother risking your money in the Banks.

Moreover, it can be argued that dividend yields for many banks are not even positive. Why? Because Banks are having rights issues worldwide, as they repair their Capital Adequacy Ratios. But if we deduct the capital raised from the dividends paid, we see that many Banking Stocks have NEGATIVE DIVIDEND YIELDS.

Furthermore, it would be preferable if banks were at their more traditional Price/Book ratios of 1 or less, instead of 1.3 times at the moment. This is all the more important as the quality of bank earnings are currently being regarded with scepticism by investors.

CREDIT MARKETS SAY BANKS ARE NOT LENDING TO ANYBODY

LIBOR rates remains stubbornly high and it is clear that banks are currently unwilling to lend to each other. The securitization markets, an important source of financing for many banks, have simply dried up. Also the success of interest rate reductions by the Fed will only become clearer later this year, as there is usually a time lag. However, if the banks do not lend to customers, then the transmission mechanism fails and then we will go into a depression, similar to Japan.

HOUSING FORECLOSURES - A REMINDER OF THE 1930s DEPRESSION!

Stability will need to be seen in the housing markets. Some 40% of US subprime loans will default over the next two years. Many people will enter the negative equity trap and will return their housekeys to the bank. Over the next two years, foreclosures will be double the amount of home sales. This would be a 1930s type scenario and does not favor investment in mortgage related financial stocks.

CREDIT DEFAULT SWAPS - THE SWORD OF DAMOCLES

Credit defaults are rising at a time of rising prices, deteriorating sub-prime and housing markets and a weakening economy. The notional amount of the CDS contracts outstanding is an enormous $45 trillion. George Soros says that when defaults occur, the prospect of a financial institution not being able to fulfill his obligation "hangs over the financial markets like a sword of Damocles". For this reason the Fed saved Bear Stearns. Maybe the "monoline" insurers like Ambac could be the type of defaulters George Soros is worried about.

INFLATION - A LENDER'S NIGHTMARE

If you are a bank lender then inflation is good for your clients, but not for you. Also if you have some of your portfolio in bonds, securitised bonds or whatever, these will also fare badly in inflationary times. Therefore a critical element in deciding when to invest in banking stocks again is an easing of inflationary pressures.

ONLY DISTRESS LENDERS ARE BOOMING

Some banks are benefitting from the crisis. For example, Goldman Sachs is currently doing very well out of underwriting fees from primary issues, especially equity for companies in distress. Some credit card companies are also reporting booming business and have seen their share prices rising quite rapidly. However, if this seems too good to be true then it probably is and we can expect an increase in credit card defaults in the coming year.

CONCLUSION

The knife is falling and negative sentiment alone is not a convincing enough argument to buy. So long as Banks continue to raise cash, better value can be found elsewhere. It is vital to have clarity on the credit cycle before buying bank shares. Economically things are getting worse and time is needed to see if lower interest rates are helping. Furthermore, it is vital that banks start lending again and with inflation still high and massive house foreclosures to come it may be better to avoid Banks for now.

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