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XMFSinchiruna (26.59)

Wave 2 of the credit collapse approaches



July 27, 2009 – Comments (35)

On June 1, I asked you if you were ready for Round II of the Mortgage Meltdown after data on renegotiated residential mortgages showed that 65% to 75% of subprime loans renegotiated by creditors to avoid default were headed toward default despite those efforts.


That data flew squarely in the fact of the (incredibly) still ongoing rally in related equities (financials as well as real estate), and became one of several reasons for my high degree of un-ease with the rally at large. Blogger GMX noted parallel reverberations through the MBS market.

Throughout 2008 you'll recall one of my primary focuses was on correcting the prevalent notion that critical losses would be contained to Subprime or even Alt-A mortgages. I blogged repeatedly about the series of dominoes that unfortunately had to fall in succession as a result of the broader deleveraging event... including commercial real estate, credit card debt, auto loans, student loans, and even state and municipal debt. Commercial real estate is now preparing to fall with a resounding thud, which is both indicative of severe corporate malaise in general (reduced demand) as well as a harbinger of renewed pain for the financials. The financials have originated tons of new derivatives on new debt issued over the past year, adding fuel to the next fire.

Round 2 of the financial crisis will be more damaging than round 1, in part due to the scale of the response initiated to combat round 1. Buckle-up and hunker down, Fools.... here we go again.

I posted an article to my blog last year (april 2008) which included RBC analyst Gerard Cassidy's then-dire forecast that 150 banks would fail by the end of the financial crisis. His recommendation then to "underweight" the banking sector on the expectation of rising loan losses and capital shortfalls certainly turned out to be a solid call, which is why I urge Fools to listen this time as well.

The same analyst has issued a new warnings: he now expects up to 1,000 banks to failover the next 3-5 years as the recession (depression ... get over it already) intensifies.

SAN FRANCISCO (MarketWatch) -- More than 1,000 banks may fail during the next three to five years as the recession intensifies and loan losses climb, an analyst at RBC Capital Markets estimated on Monday.

In 2008, analyst Gerard Cassidy forecast 200 to 300 bank failures, but now he says the environment has deteriorated since then. See 2008 story on bank failures.

"Residential mortgage delinquencies remain at record levels, home-equity loan defaults are steadily rising and residential construction and land loan non-performing assets are skyrocketing for lenders with excess exposure to the weakest housing markets in the U.S.," Cassidy wrote in a note to clients.

"In conjunction with the slowdown in the economy, credit deterioration has accelerated in the commercial and industrial and commercial real estate loan areas," he said.

Since the mortgage-fueled credit crunch erupted in 2007, 34 banks have failed in the U.S. While Washington Mutual /quotes/comstock/11i!wamuq (WAMUQ 0.08, +0.00, +2.44%) became the biggest bank failure in history last year, Cassidy expects most of the banks that collapse will be relatively small, with less than $2 billion in assets. See story on latest banks to fail.

Cassidy and his colleagues have developed an early-warning system for spotting future trouble at banks using a calculation known as the Texas Ratio. It measures credit problems as a percentage of the capital a lender has available to deal with them.

The formula divides the number of a bank's non-performing loans, including those 90 days delinquent, by its tangible equity capital plus money set aside for future loan losses.

Cassidy came up with the ratio after covering Texas banks in the 1980s. He noticed that when problem assets grew to more than 100% of capital, most of the Texas banks in that precarious position ended up failing.

Among the 50 largest U.S. commercial banks by assets, Sterling Financial /quotes/comstock/15*!stsa/quotes/nls/stsa (STSA 2.29, -0.10, -4.18%) of Spokane, Wash., had the highest Texas Ratio at the end of the fourth quarter. The ratio of 54% was up from 45.4% in the third quarter and 15.6% at the end of 2007, according to RBC data.

Colonial BancGroup /quotes/comstock/13*!cnb/quotes/nls/cnb (CNB 0.72, +0.06, +9.09%) of Montgomery, Ala., had a ratio of 53.4% at the end of 2008, ranking it second among the top 50 commercial banks. That was up from 44.6% in the third quarter and 11.2% at the end of 2007.

Popular Inc. /quotes/comstock/15*!bpop/quotes/nls/bpop (BPOP 1.28, +0.19, +17.43%) was third with a ratio of 37.4%. But that was down from the 40.1% that the Puerto Rico-based bank had during the third quarter.

Huntington Bancshares /quotes/comstock/15*!hban/quotes/nls/hban (HBAN 3.67, -0.06, -1.61%) of Columbus, Ohio, was fourth with a ratio of 36.4% at the end of the fourth quarter. That was up from 21.1% in the third quarter, RBC data show.

Banks have raised a lot of capital, both from the government and private investors, so Texas Ratios remain lower than may normally be the case at this point in the credit cycle, Cassidy explained.

Wells Fargo /quotes/comstock/13*!wfc/quotes/nls/wfc (WFC 23.47, -0.79, -3.26%) saw its Texas Ratio drop to 15.5% at the end of the fourth quarter, vs. 19.3% in the third quarter.

J.P. Morgan Chase /quotes/comstock/13*!jpm/quotes/nls/jpm (JPM 37.92, -0.23, -0.60%) had a Texas Ratio of 6.5% at the end of 2008, down from a ratio of 9.7% in the third quarter, Cassidy noted.

Still, other big banks, including Citigroup /quotes/comstock/13*!c/quotes/nls/c (C 2.80, +0.07, +2.56%) , U.S. Bancorp /quotes/comstock/13*!usb/quotes/nls/usb (USB 19.77, +0.35, +1.80%) and Bank of America /quotes/comstock/13*!bac/quotes/nls/bac (BAC 12.58, +0.07, +0.56%) saw their Texas Ratios climb during the fourth quarter, RBC data show.

In his research report, Cassidy bluntly calls on investors to "avoid the bank stocks" during this precarious climate and gloomy outlook hanging over the industry.

"We are nowhere near the end of this down leg in the current credit cycle," Cassidy said. "Bank stocks will likely remain under pressure as the industry confronts its credit problems, de-leverages and raises common equity over the next 12 months."



P.S. I have done something I hardly ever do. I've acquired some exposure to select short and ultrshort ETFs in real life. Although I detest the toxic derivatives upon which they are based,I could not pass up the opportunity for near-term gains here. I will not say which ones, since I am actively trading those positions.


35 Comments – Post Your Own

#1) On July 27, 2009 at 7:56 AM, dudemonkey (55.00) wrote:

As always, great article.  Although I'm long-term fairly bullish on the global economy, I've been repeatedly surprised by the strength of the recent rally.  Still, there are some good values if you look hard, but you have to turn over some rocks to find them.

Sinch, I'm waiting for your next Ultimate Commodities Update.   I'd put that on my calendar before I'd put any earnings release or Fed statement.  

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#2) On July 27, 2009 at 8:01 AM, XMFSinchiruna (26.59) wrote:


Thanks for the request ... I'll provide an holistic update as soon as earnings cools down.

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#3) On July 27, 2009 at 8:16 AM, batkot (< 20) wrote:

Are you bearish short term TMF sinchruna .. and if yes when and how much do you think  the pull back would be in the S & P ?

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#4) On July 27, 2009 at 8:33 AM, XMFSinchiruna (26.59) wrote:


I'm not a short-term trader, but for the obvious overextension of this particular bear market rally in the face of ever-deteriorating macroeconomic headwinds I made an exception.

I don't have a ST target for the S&P in mind ... I will simply hold my short ETFs until volume indicates a maturing wave of buying interest, and then I will liquidate all but a small portion of those positions for reduced exposure to additional downside. 

Many may wonder why someone like me with 85% exposure to precious metals already would bother adding leveraged exposure to market downside. :) Simple answer: I don't equate pm exposure as equivalent to a bearish call on the equity markets. At this stage in the pm bull market, now that the full scale of the currency crisis is obvious, correlation between the metals and the indeces will tend to be reduced substantially. Indeed, within some inflationary scenarios equities on a nominal basis could increase surprisingly well, and with fabricated inflation numbers nearly universally accepted, that phenomenon is not widely understood even as it occurs.

And finally ... here's a little something to make you chuckle, hopefully counteracting the unfortunate negativity of much of the material I feel duty-bound to report.

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#5) On July 27, 2009 at 8:57 AM, SkepticalOx (98.81) wrote:

It's not as if people don't know this is second wave is coming, as most were when the first wave (subprime) hit. Question is, how much of this is the market already accounting for?

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#6) On July 27, 2009 at 9:17 AM, XMFSinchiruna (26.59) wrote:

Commercial Real Estate - The Other Real Estate Bubble



It might be obvious to Fools who have daily exposure to information outside the scope of the recovery-touting public relations blitz, but it's far from conventional wisdom. Thanks to relentless reassurances from Bernanke, Geithner, Frank et al., plus ridiculous bullishness from the likes of Kudlow and this guy, many millions of investors presently presume that the worst of the crisis is well behind us, and that we have safely entered a recovery phase in which "systemic risk" is no longer at issue. To the extent that such macroeconomic presumtions are baked into equity prices, we are overdue for a sizeable correction.

I'll remind you that when the first wave (subprime) hit, despite plenty of forewarning, many people were nonetheless financially devastated by the scale of the fallout through the financials and into all sectors of the economy. In other words, though the subprime crisis was clearly visible at Dow 13,000, that visibility clearly did not translate into appropriate equity valuations, and people were burned badly as a result. 

I believe it's about to happen all over again, only this time people have far less of a cushion with which to absorb the losses.

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#7) On July 27, 2009 at 9:18 AM, outoffocus (24.07) wrote:


I think the economy is more likely pricing in a full economic recovery by the end of 2009 than a second wave down.  That will probably cause this second wave down to be that much uglier.

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#8) On July 27, 2009 at 9:23 AM, Jimmy2008 (< 20) wrote:


Last Fall, when stocks fell, USD was up. If stocks fall this time, what could happen to USD? Up or down?

I am truely amazed that people are so stupid in seeking safety in USD. However, it could happen again. Most people are either stupid/naive or like being lied to.

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#9) On July 27, 2009 at 9:32 AM, XMFSinchiruna (26.59) wrote:


I can't claim to predict the reaction of these markets to near-term movements, since the only thing consistent about them over the past couple of years has been their apparent disconnect from the laws of logic. :)

What would happen in a rational world: If equities tumble, people would see the inevitibility of further stimulus and/or fiscal interventions to keep the entire system afloat and would therefore continue the now-incipient flight away from Treasuries as the ultimate safe haven and into gold and silver as the ultimate safe haven assets in times of currency crisis.

What will more likely happen: Some will awaken to the true nature of inflation (devaluation) risk in Treasuries, but the majority will still flock to them like lambs to the medium-term slaughter. It's conceivable that the dollar could find some counterintuitive support just like last time, but I believe it's inconceivable for that to occur to the same degree. At some stage, precious metals will climb despite such a bump to Treasury demand, and that will be the signal that a major move down in the dollar is developing.

The $2 trillion wild card:

China (and those nations emboldened by China's increasingly public push to de-dolarize the global reserve system).

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#10) On July 27, 2009 at 9:52 AM, olddog51 (< 20) wrote:

Resorts are missing their payments due to low traffic.

see Yahoo finanace  "forclosure inn"  wf and others are the note holders "THUD"


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#11) On July 27, 2009 at 10:11 AM, bothisellhigher (28.99) wrote:

Excellent blog and comment.  I too anxiously await your holistic update of commodities as I am also 85% in...AUY...with the other 15% in BP and LINE-hope I'm up against Q-7 offsuit!

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#12) On July 27, 2009 at 10:35 AM, XMFSinchiruna (26.59) wrote:


Careful ... as great a play as I think AUY is, I think 85% in any one company is inherently risky. What if Brazil nationalized gold mines?  (hopefully that won't happen, but it's conceivable).

My 85% pm exposure is realized through a basket of more than 50 mining companies spread around the world and at various stages of production.

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#13) On July 27, 2009 at 10:51 AM, jatt22 (50.41) wrote:

thanks  for  this  blog  and  comments  and  answers  r  very knwledgable .

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#14) On July 27, 2009 at 11:44 AM, ReadEmAnWeep (89.75) wrote:

So I know you said you don't have a target price for the S&P to correct to, but how bad do you think it will be for equities? Last fall all over again?

What would be a good way to get some protection from that. Would global companies be a good bet? I don't have the knowledge of pm's like you do, what do you think would be a good thing to look into? I mean its probably not a good idea for me to sell all my stocks on a guess that there will be a correction right?

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#15) On July 27, 2009 at 12:17 PM, kaskoosek (29.96) wrote:


I don't think anyone knows, but I disagree with sinch on this one.


He is trying to time the market in the short run, which will be an ultimate failure, taking into consideration inflationary pressures in the long run. 

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#16) On July 27, 2009 at 12:26 PM, ReadEmAnWeep (89.75) wrote:

Ya, thats what I was thinking. That I should try to stay away from assuming I can time at all... I am new to investing and I think I am a long term investor (growth/value?) at heart, lol. Plus, if there is a down turn: First, it would be paper loss unless I sell then. Second, it would be an opportunity to add to my holdings.

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#17) On July 27, 2009 at 12:42 PM, outoffocus (24.07) wrote:

Plus, if there is a down turn: First, it would be paper loss unless I sell then. Second, it would be an opportunity to add to my holdings.

Thats what I'm banking on.  Except this time I'm going to be a little more patient when it comes to my additions.

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#18) On July 27, 2009 at 12:52 PM, XMFSinchiruna (26.59) wrote:


By predicting that my short-term bets will fail, you too are trying to predict the short-term movements. :)

Inflationary pressures are only as significant to equity valuations as the extent to which they are perceived by market participants.


I rarely try to time the markets, but I made an exception here. Still, I am only allocating less than 1% of my assets to this tiny leveraged bet. If the rally continues substantially further into unsustainable territory, I might double down, but that would still leave me below 2% allocation for this timing-related play.

I certainly wouldn't recommend that anyone make major allocation changes within their portfolio in anticipation of market movements in either direction. Not only is that a formula I do not advocate, but the markets have been in complete disarray and this exceedingly difficult to predict since this crisis began. 

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#19) On July 27, 2009 at 1:05 PM, playfuldragon (66.40) wrote:


I agree with being patient and waiting to add to any stock.

As a new investor I have learned the hard way to wait for just a little while.


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#20) On July 27, 2009 at 1:47 PM, kaskoosek (29.96) wrote:


50/50 outcome is a failure in my book.



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#21) On July 27, 2009 at 2:29 PM, ttboydxb (28.24) wrote:

Sinchi, another awesome post bubba!  Keep up the good work! There will be a lot of cryin when the next shoe drops I think, as to when it will happen?  Who knows?  I just think that each person should come up with different scenarios (on their own) and strategies for what to do with your $ for each then, sit, watch, and act according to what happens....


P.S. I might have missed it but the explanation of your user id??

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#22) On July 27, 2009 at 2:50 PM, XMFSinchiruna (26.59) wrote:


It's only 50/50 beforehand. After I sell my tiny bets I'll let you know whether I passed or failed. Last I checked, growing one's portfolio with realized gains was always considered a positive result. If I seel those leveraged ETFs at a loss, I'll be sure to post here that you were 100% correct. 

Anyway, like I said, it's less than 1% of my holdings. It's as much for entertainment as for anything else. :)

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#23) On July 27, 2009 at 2:50 PM, GeneralDemon (26.40) wrote:

Sinch, since you have made a full disclosure that you will be buying and selling these ETF's at your discretion, why can't you state your choices? During round #1 - I bought puts on many homebuilders based on our expert FloridaBuilder's rankings. He recommended no one short a company based on his calls - but he still listed them. Why can't you?

BTW, nice post.


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#24) On July 27, 2009 at 2:50 PM, XMFSinchiruna (26.59) wrote:


Thanks for reminding me ... you didn't miss it. Stay tuned :)

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#25) On July 27, 2009 at 2:55 PM, mikecart1 (74.04) wrote:

The market will crash hard and I can't wait.  I am loaded on ETFs and ready to make some serious cash in the next 6 months.

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#26) On July 27, 2009 at 3:02 PM, XMFSinchiruna (26.59) wrote:


Please reference the Motley Fool's disclosure policy:

"Cannot write about a stock in the period from 10 days before to 10 days after purchasing or selling the stock."

Thanks for understanding.

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#27) On July 27, 2009 at 3:34 PM, GeneralDemon (26.40) wrote:

From the Motley Fool disclosure policy:

All Fool employees and contractors -- that's anyone with a TMF prefix on their screen names -- are required to publicly disclose their current individual stock holdings on their personal profile pages on the website. (We do not disclose the individual stocks that might be in a Fool's mutual funds.)

Hah - confounded by the ET(Fund) vs. individual stock wording. Oh well.

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#28) On July 27, 2009 at 4:33 PM, XMFSinchiruna (26.59) wrote:


No, that's not it, general. It's just that I can't mention them names within the stated period. My "stocks I own" section of my TMF boards profile, however, is up to date.

I was surprised myself to find just now that I have 78 different holdings. :P I thought I had simplified a bit during this recovery, but apparently only to a degree. :)

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#29) On July 27, 2009 at 6:03 PM, GeneralDemon (26.40) wrote:

O.K. now permit me some Perry Masonesque examination:

(I will only delve into the generalities)

GeneralDemon: Biggest pop equals biggest potential flop?

Sinch: Yes

GeneralDemon: Financials, homebuilders, Restruants, Autos? Come on.. out with it man!

Sinch: (fill in blank here) 

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#30) On July 27, 2009 at 8:31 PM, silverminer (29.77) wrote:


I'm enormously bearish on financials at the moment as this rally was born on accounting fantasies and extended upon illusory earnings. As the entirely underestimated second wave of the debt deleveraging event reaches deep into downward spiral #2, I agree with estimates from above that 1000 banks could fail and I find the FDIC woefully underfunded for such a scenario (necessitating additional Treasury funds).

I'm bearish on anything related to real estate at the moment... period. We have a much more sustained contraction on our hands than anyone seems willing to admit.

I'm bearish on some indices in the very short term as the above sectors lead the first portion of the next down wave, but have too healthy a respect for the plunge protection team to bet against them for long. If they can propel this countercyclical rally and asuage investors' concerns to the extent that they have, the power is immense. [It all started, remember, with the magical stress test based upon fantasy scenarios, mark-to-imagination accounting of derivative exposures, shelving of loan losses by delaying defailt actions, etc.]

The Treasury and the Fed continue to throw hail mary passes, but no receivers seem to have made it downfield.

I wouldn't touch real estate with a ten foot pole. But that's just me.

I'm bullish, and underexposed, on agriculture.

Everything else, you already know of me. :P\

Fool on! 

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#31) On July 27, 2009 at 10:23 PM, BigFatBEAR (28.46) wrote:


Good write-up here.

I also bought puts on the QQQQ today, after GMX convinced me that 10 up days on the nasdaq is unheard of, and showed me how much cheaper options have gotten now that the vix is around 52-week lows. It is my hope that this is my last options trade, and that it is handsomely profitable.

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#32) On July 28, 2009 at 12:08 AM, topsecret09 (83.41) wrote:

  You are very knowledgable Indeed,I look forward to more of your posts. You obviously have a firm grasp on how the markets react (whether logically or not) to ongoing macroeconomic trends that In my opinion seem to defy everything that I have learned over the past 30 years...  When the FED says that we do not have to worry about Inflation because the consumer IS NOT SPENDING MONEY..... That,my friend, makes me worry...  If the consumer Is not spending money,we will not get out of this recession. When the spending comes back,so will Inflation,,,,,,,, Sheesh

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#33) On July 28, 2009 at 7:46 AM, XMFSinchiruna (26.59) wrote:


Almost, my friend! Just one key point to clarify. The onset of inflation is in no way dependent upon a resumed velocity of money (spending, lending, etc). The inflation we will see is not an economic event, but a currency event. We have a crisis of confidence in the USD on a global scale, and continued fiscal interventions and/or runaway deficits are plenty powerful enough to drive inflation by themselves as they drive away willing participants in future Treasury auctions while scaring China into redeploying its existing reserves. Inflation hinges only upon the actions of the Fed, Treasury, Congress, China, Russia, Brazil, India, etc. etc.... but not the U.S. consumer.

Velocity of money could exacerbate the inflationary consequence of their actions, quite considerably in fact, but it will not be the root trigger of the inflation.

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#34) On July 28, 2009 at 3:57 PM, topsecret09 (83.41) wrote:

  Since Inflation Is actually measured through the CPI( Consumer Price Index) Its obvious that the consumer can effect the Inflation rate. The more that the consumer spends for goods and services (higher prices),and the acceleration of that spending over time, can, and does cause higher Inflation.... While I agree with you on the currency problems,and I also agree that the consumer will not be the only contributor to the Inflation problems that lurk In the future, I do believe that the consumer can  add to the Inflation fire that Is just over the horizon... Thanks for your reply,look forward to more of your posts, Jim

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#35) On July 29, 2009 at 3:12 PM, goldminingXpert (28.80) wrote:

Part 1 of the credit collapse barely counts as a warm-up drill.

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