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  It's still sub-prime time for banking stocks

BENJ GALLANDER and BEN STADELMANN

Friday, February 22, 2008

It was 12 months ago that problems with sub-prime mortgages in the U.S. clearly emerged. In a sobering press release last February, global banking giant HSBC stated:

"The impact of slowing house price growth is being reflected in accelerated delinquency trends across the US sub-prime mortgage market, particularly in the more recent loans, as the absence of equity appreciation is reducing refinancing options."

That sentence neatly enunciated the crux of the issue. A mortgage in the hands of someone with poor credit is no big deal as long as the value of the house is going up. When prices top out, however, and the homeowner can no longer sell it for the value of the mortgage or refinancing, the delinquency rate snowballs as more and more homes hit the market, driving prices further down in a nasty cycle.

Economics 101, you say? Yes, the warnings a year ago really were that obvious and lucid for anybody who wanted to listen. But that's just it: many commentators steadfastly refused to admit anything was amiss. The front page of Business Week on February 19, 2007, carried the headline "Why Housing Hasn't Hit The Skids." The article started breezily with the observation, "So this is the much-feared 'housing bust'? Bust Lite is more like it."

It went on to extol the virtues of low interest rates, which keep more expensive homes affordable. As for the risk associated with bundled securitized loans, it quoted a portfolio manager who patiently explained that "Investors know more about the loans they're buying, so they will pay more for them. Credit default swaps, which let people bet for or against a bond or loan's creditworthiness, have also improved transparency."

How could a reputable publication like Business Week get it so utterly wrong?

Investors have to constantly put what they read and hear through a credibility filter. In the marketplace of ideas there is never an absolute consensus on anything, and nobody gets it right all the time.

On a topic as big as the evolving credit crisis, the sheer volume and inconsistency of interpretations is numbing. That's an intractable problem for, say, a value investor who is trying to assess whether or not the worst is over for beaten-up bank stocks.

One of the yardsticks we use is to examine the public statements made by companies that have been caught up in a sector's problems. Which brings us back to HSBC. Already, back in August 2006, the bank expressed concerns about rising rates of personal bankruptcy and it tightened lending practices while boosting loan-loss provisions.

Over the next several months there was a string of warnings describing the intensification of loan problems. Throughout, the bank was forthright about admitting its mistakes and acknowledging the necessity of pulling up their socks.

Last November, HSBC courageously restructured two troubled SIVs and moved $45 billion of assets to its balance sheet. That didn't dispel the doubts about how much the CDO components of the funds are actually worth, but the new arrangement makes the bank's potential liabilities far more transparent and did help reassure investors that the funds wouldn't be liquidated at fire-sale prices.

None of which makes HSBC a particularly worthy investment; by its own admission it got itself into this mess with its aggressive record of big acquisitions. But at least it has made a solid effort to talk about the industry's problems in a realistic fashion, while competitors mumbled about off–balance sheet concoctions as being "non-material," only to suddenly spring billions of dollars in losses on shareholders out of the blue.

At this point, HSBC continues to indicate that the current financial problems will resist any type of quick resolution. While investors contemplate the bewildering zoo of CDOs, SIVs, conduits, etc., the key thing to remember is all these financial entities are derivatives — i.e., their value is contingent on the value of underlying assets and they have the intrinsic capacity to redistribute risk from one party to another.

In theory, this makes the financial system more robust, as losses are dispersed over many market participants rather than remaining the sole responsibility of the institution making the loan. In reality, all the intermediaries want to take their piece of flesh, leaving less reward on the table for investors.

Some analysts now say that sentiment on banking stocks is too negative and those who can "see over the valley" can grab a sterling buying opportunity. When companies like HSBC claim that the coast is clear, we'll be more inclined to believe it.


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