The Stimulus Won't Work Without Fixing the Banks

According to two recent public opinion polls, "large majorities of Americans" support President Obama's plans to revive the economy. There's a lot of hope that the fiscal stimulus can take the U.S. economy out of the current mess, so that we can get back to doing business as usual in 2010.

If history is any guide, though, a fiscal stimulus will do little if the banking system is in disarray. In recent memory, Japan is the best example of a major industrialized country with a busted banking system. In Japan, government spending did little in the past 20 years as the banks curbed lending while operating in survival mode.

We should not expect a perfect repetition of the Japanese experience, but as Mark Twain correctly observed, "History does not repeat itself. But it does rhyme." Simply put, the banks are more important than the stimulus plan.

This is why financials led the market fall a few weeks back when Treasury Secretary Timothy Geithner was all talk and no detail in announcing his "plans" for the public-private partnership to fix the banks. Geithner is surely aware of the Japanese experience, and he has precious little time to act.

U.S. banks have reported more losses -- and in a much faster fashion -- than the banks in Japan after the Nikkei topped out in 1989. Total write-offs by global financials have already topped $1 trillion, a result of the higher degrees of leverage embedded in the U.S. and other Western financial systems (thanks to derivatives and structured finance products).

Warren Buffett referred to derivatives as "financial weapons of mass destruction" -- in 2003! If Warren had the chance to elaborate, securitization would probably be included in his statement.

And one of the few strategists who called the bust in U.S. banks -- Christopher Wood of CLSA -- recently stated at a Tokyo conference that he believes the U.S. situation will have worse deflationary effects than Japan because of the collapse in securitization. While Japanese banks made many dumb loans against overpriced collateral in the late 1980s, the securitization market was not well developed in Japan, thus, this imprudent lending behavior did not spread like cancer in the financial system.

As I have written before, you cannot make the banks lend more money in a slowing economy … when they just got burned by having lax lending rules. It makes no sense. This is especially true if they don't know what the toxic assets on their balance sheets are worth. Clearing the overhang of toxic paper in the U.S. financial system should be the government's top priority -- not deficit spending.

Broker winners
Crises separate the wheat from the chaff. In the brokerage space, the two clear winners are Goldman Sachs (NYSE: GS  ) and Morgan Stanley (NYSE: MS  ) . Brokers that have been taken over by large banks tend to fade. Salomon Brothers got lost in the mess that is now Citigroup (NYSE: C  ) , so will Merrill Lynch as part of Bank of America (NYSE: BAC  ) . Goldman and Morgan will have less competition when the banking system stabilizes, so they are clear winners.

Goldman trades at 0.81 times book value, while Morgan Stanley trades at 0.72 times book value, both at a discount. The firms are unlikely to be as profitable as they were in the last credit cycle due to the decline in the use of balance sheet leverage, but they will also have less competition to deal with.

Bank winners
I am puzzled by the precipitous decline in Wells Fargo (NYSE: WFC  ) , given that it has done everything right in this financial mess. The market just does not seem to be impressed with its Wachovia acquisition. I'm equally puzzled by the decline in U.S. Bancorp (NYSE: USB  ) and Bank of New York Mellon (NYSE: BK  ) , two banks with very little exposure to toxic assets. It seems as if the market decided that any large bank is at risk, regardless of operational performance.

If the major indexes keep falling in 2009 and mutual fund and hedge fund outflows continue, even good banks will decline as their valuations contract. But it is in these messy times that you get to pick up good stocks on the cheap.

Brokers have done better than banks thus far in 2009, so Goldman and Morgan are worth a look on pullbacks, but if you look for bottom-fishing candidates in the financial sector, the three banks above still make sense to consider.

More on financials:

Fool contributor Ivan Martchev does not own shares in any of the companies in this story. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


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  • Report this Comment On February 28, 2009, at 2:19 AM, nicko168 wrote:

    Based on the past weeks, the stock market has been a place for the guys to rally & show their frustration towards "Robin Hood".So, no matter what stocks u thinking of..forget it....

    Ultimately, do you know who's the real fools? Ha..Ha..

    Real fools are the one who plunge their own economy to zero together with the $787 billion stimulus plan. Why?

    They'll be slapping their own face caused it opens up the opportunities & competition to the "third" world to buy all the "CHEAP" US Companies..Arabi, China, Kuwait & maybe Iran, Iraq etc...

    Based on the recent news, US companies are selling off thier valuable assets (technologies, bank etc) in order to pull through the crisis & who are they selling to? Make a guess....AIG went to China, Singapore etc selling off their stakes..Another is selling their US technologies or commodities caused they're ridden by billions of dollars debt....At the end of the crisis, what will the US companies who once holds the supremacy in technologies, banking etc become? "Zero" is my answer...

    Who the losers? The real losers are the next generation facing the real US....

    There's a old chinese teaching:

    "To break one chopstick is easy..

    To break a bunch of chopstick, is difficult"

    To the real fools, WATCH OUT!!! Ha..Ha...

  • Report this Comment On February 28, 2009, at 8:24 AM, orofnap wrote:

    to nicko168

    in 1939, japan was defeating china. japan's planes, like the zero, were dominating. five years later, the japanese planes were worthless. presently, the u.s. commands the sky with a plane that has never lost. that is impressive. if the chinese adopt a government like ours they might compete with us. that would create more cooperation and greater prosperity for all not losers. if they dont adopt a government like ours, like the japanese of ww2, they will find themselves worried about breaking a few chopsticks rather than getting a chainsaw and doing it in a couple of seconds.

  • Report this Comment On February 28, 2009, at 8:40 AM, orofnap wrote:

    to all the other fools

    the government is going to reveal a new talf or tarp program. people with a lot of money, the private part of the plan, will cooperate with the government to purchase toxic assets. i have heard wilbur ross, a person with a lot of money, talk about how valuable the assets could be after incentivized by the government. so, i believe that they will be sold. if the toxic assets are removed from the banks, will the banks be worth less or more? couple that with the present increase in outstanding stock from past government investment and what do you get for a value of the stock?

  • Report this Comment On February 28, 2009, at 8:57 AM, dmjst11 wrote:

    Now if new cap and trade policies cause the costs of good and services to increase companies will be forced to move west, but we will have renewable green energy.

    All the good manufacturing jobs will be gone

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