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.
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