Banking crisis continues

Posted September 6, 2008

Andrew Gordon of Red Flag Insider does not see a quick end to the banking crisis. What is the best action for retail investors to take in this situation? Tune in to see…

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Baltimore (TFN): J.P. Morgan, Chase, UBS and Lehman Brothers have announced combined losses of over $4 billion. How long can the bank sustain these kinds of losses and what should individual investors do?

I’ve invited Andrew Gordon of Red Flag Investor to help us answer these questions. Welcome back to the show, Andy.

So given the small percentage that high risk loans actually represent in the U.S. mortgage industry, what is at the core of all this trouble with the financial institutions?

Andrew Gordon: Well, you’re right. Sub-prime loans are only $650 billion out of a $12 trillion mortgage market. That’s not a big amount, is it? Well the fact is banks have written a lot of paper on the basis of sub-primes and other mortgages and they’ve written derivatives of these sub-prime mortgages and then derivatives of derivatives. That’s a lot.

So it’s become in tens of trillions of dollars of securities and derivatives include these sub-prime and high risk mortgages. It’s like suppose you’re in the market for a 1,000-room hotel and I told you this is a top rated hotel. You have to pay top dollar. You find out ten rooms have completely been trashed, but you can’t find which rooms they are so you can’t fix it. Are you willing to pay top dollar? No, of course not.

Investors are willing to pay top dollar on what used to be Triple-A rated securities and derivatives. So the market has completely dried up. The price has gone way down and banks have been forced to write down by substantial amount the money that they thought they had tied up in these securities, but it’s much less. So its really driven the assets and the value of banks down.

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Laura Cadden: How bad do you think this crisis could get?

Andrew Gordon: It can get much worse than it is now and I’ll tell you why. There are stricter lending rules that banks have now. Prices have been falling. Foreclosures have been going up. The cost of borrowing has been going up. Is anything going right in the housing industry?

Maybe if new building has slowed down, which it has and I think that will allow inventory to fall. You need that. But everything has been going around in the housing industry. We don’t see a bottom. There’s about $500 billion that have been written off right now. That’s going to double.

How much does this cost? Well, Merrill Lynch just sold a chunk of their securities, like their bad loans are underwater. Loans let’s say for 22 cents on the dollar. That’s nothing.

They had to guarantee in effect 75 percent of that. You know what that comes out to? A nickel. They sold their underwater loans at a nickel on the dollar. Banks have to do that going into the future. You’re going to see a lot of banks are failed. Maybe as much as 100, perhaps 200 banks.

Laura Cadden: So you think so. Just like Indy Mac, the federal regulators coming in –

Andrew Gordon: Sure; Indy Mac is the beginning of what could be a deluge. There are eight banks that have failed so far this year. That’s a trickle. We’re going to see a lot more. What do these banks have to fall back on? Not the housing bill. It’s going to allow those borrowers who can afford to pay slightly lower mortgages to renegotiate with their banks. That’s not going to save them.

I’m not sure if the Treasury or the government is interested in saving these banks. I don’t think they should be saved. I’m not sure if Fannie or Freddie should be saved. They will. They’re too big to fail.

But no, we’re going to see dozens if not hundreds of banks go under over the next couple years.

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Laura Cadden: So what do you think a retail investor should do? I mean do you think there are plays out there?

Andrew Gordon: Well, what you’re asking is is there any way to play a falling sector where you see banks going under, the shares of banks falling on the basis of continued write downs, of talk of bankruptcies of going into receivership.

I would say that it’s difficult, but there’s one signal that perhaps the retail investor could use in investing in banks and that is wait to see these banks announce dividend cuts, especially if they’re doing it the first time. It’s a signal that their shares will go down. You can shore them or you can play puts off them and make decent money. That would be my way of leveraging this falling sector.

Laura Cadden: Great ideas. Thank you so much for the information.

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