I'm Looking Through You

Someone asked me today: "Why doesn't the government know what banks are holding on their balance sheets, specifically the Office of the Comptroller of the Currency"?

The answer is: "It does". The Office of the Comptroller of the currency does monitor banks' asset quality. The problem is that some of the distressed assets were, until a short while ago, AAA-rated. Some cannot be accurately gauged. Few of the troubled assets are performing even moderately well. Should there have been better oversight? Absolutely, but I question whether regulators would have understood what they were looking at. Even banks who structured these deals thought these assets were fine. Ratings agency personnel thought otherwise, but that is another story.

Here is the deal. At best, banks won't have to take many more markdowns. Long-tern rates will rise and, although credit spreads will probably narrow during a recovery, they will stay significantly wider than in the past. Also, look for a weaker dollar to keep commodities prices high in spite of slackening demand.

What about Morgan Stanley and Goldman as banks. Ha! I don't see them attracting many depositors. It is very unlikely they could report earnings at levels which investors have become accustomed with 10 times leverage (versus 20 to 30 times as in the past).

Still there are some values in the fixed income market in the financial sector. Buy the highest quality institutions. Do not move out past 10 years. Preferred buyers should be prepared to experience volatility, but CprM in the 12% areas is ridiculous. Heck BACprH in the high 8.00% are is attractive.

Note: I do not think that inflation will go through the moon, nor to I think long-term interest rates will spiral out of control. Slackening demand will temper inflation and, at some point, long-term rates will attract investors and support the dollar. At what level might that be? My guess is that a 5.50%+ 10-year note may be sufficient. Not too bad on a historical perspective.

My bigger fear is that Congress will make this rescue bill a forum for social change and the financial system will approach a collapse. Unless fraud can be proven, homeowners should not be bailed out for buying homes which they could not afford using loans they could not pay back.