Hedge funds increased their stakes in financial stocks during the second quarter according to the Goldman Sachs Hedge Fund Trend Monitor (WSJ). Specifically, ownership in financials increased 55% from Q1 to Q2, growing to $70 billion - representing 3.7% of the sector's market capitalization. Bank of America (BAC) and JPMorgan (JPM) were some of the more popular financial holdings within hedge funds, with Regions Financial (RF) and Citigroup (C) also becoming new long positions for some funds. While the net short position of financials also rose slightly, 8% to $63 billion, the large increase in long exposure has resulted in hedge funds being net long the financials by the end of Q2 (WSJ). Although hedge fund redemption request have decreased, reducing the need for forced selling, it is unclear if hedge funds on average will maintain their net long positions in financials after the nice run these stocks have made since the March market lows.

Meredith Whitney was recently on CNBC (the video is provided below) discussing the banks and financials. Some observations from the interview include:

• This will be a tactical quarter for the banks.
• She has a bullish call on Goldman Sachs, but a bearish call on financial stocks in general.
• A huge refinance wave will create the "Mother-of-all" mortgage quarters, boosting earnings for the quarter for many banks, even though business in general is not getting better.
• Core earnings numbers may not be very good, but below the line numbers will be good due to all the mortgage activity. This will result in huge moves in tangible book value for the banks, even with unimpressive earnings numbers. These stocks trade on multiples of tangible book.
• A move from $18 billion in incentives to $75 billion in incentives to modify mortgages, with less modification liability, could cause some banks move 15% short-term.
• Mortgage modification numbers will increase logarithmically, causing past dues to become current, and allowing the banks to receive fees for the modifications.
• As a result of the fees and less litigation due to the current legislation, banks may even seek to modify mortgages which have not yet defaulted, or are not yet past due.
• Bank of America (BAC) is the cheapest of the banks, based on tangible book value (excluding Citi).
• Bank solvency has been off the table for a few quarters now, but main street has not been helped by the financial bailouts as much. A lot of refinancing is occurring, but not a lot of new lending. The new legislation and increased risk aversion is actually providing less access to credit.
• The next couple of years will be debt market-focused due to the tsunami of debt issuance needed to pay-off current spending.
• She also mentioned in the discussion (not included in the CNBC online video) that unemployment could reach toward 13%.
  
  
  Source: CNBC Video
  

Tightening credit is hurting more than just Wall Street (see BusinessWeek article). As of September 9 of this year, 57 companies had defaulted on a total of $45.3 billion of debt, up from 22 total companies defaulting in all of 2007. For the 57 that have defaulted, 45 are not in the financial industry. Unfortunately, the trend may get worse as approximately 70 percent of non-financial companies carry a junk credit rating, with the default rate possibly rising to levels not seen since 1981. Companies that are feeling the impact of the credit crunch include automakers (in particular GM), airlines (UAL Corporation - UAUA), franchisees (such as some at McDonald's, MCD, who may not default, but are having problems getting loans for coffee bar expansions), and entertainment (Boyd Gaming - BYD, Trump Entertainment - TRMP, and Six Flags - SIX). The S&P list of "weakest links," or companies that could default in the next 12 months, is now at 162 firms and growing.

The global federal-induced short-squeeze is now going global, as countries from Australia, Taiwan, and the Netherlands join the U.S. and U.K. in prohibiting some short selling (see WSJ article). Potential problems with the short-sell ban are already becoming evident as those needing to hedge positions, or those making a market in derivative products, are finding it difficult to comply. During the last order the SEC had already considered some restrictions on market makers who need to short stock when making a market in put options. Now, the SEC is also considering allowing short-selling to be used in some cases as a hedge - it is expected that they will allow such shorting.

Of course, where do you draw the line? What about hedge funds that actually hedge their positions? Will they be excluded? What about convertible bond and arbitrage positions? What about allowing investors to hedge their investments when companies raise money in a rights offerings? What if the sale is for risk management purposes? If risk management is considered a viable reason for shorting, couldn't everything be considered risk management to some degree? Isn't shorting an overvalued company a way to take the risk of the overvalued stock out of the marketplace? Yes, this argument is a little much, but the points is that once again it is difficult to know where to draw the line when making exceptions, which only becomes more difficult as the unintended consequences start becoming worst than what the order was hoping to accomplish in the first place.

While the order did seem to stem the selling tide last week, it ultimately makes the stock market more inefficient. If now less efficient, does this mean that the market is in fact now more risky, given that prices are more artificial than before, and that any snap-backs could be worse in the long-run (if the order is removed)? These are questions that will no doubt only be clear with 20-20 hindsight. Extraordinary times do often require extraordinary measures, but eventually we are going to come to regret interfering with a market structure and mechanism that was put in place to keep us all honest, and keep prices as efficient as possible. Finally, I do find it ironic that for the last year or so we have continued to complain about how the prices of all the various credit default swaps and CDOs were difficult to price, making it even more difficult to know their current value and a company's true level of exposure for holding such securities. One can argue that we are now starting to make transparency mistakes with our equities.

During Jim Chanos's recent appearance on CNBC, the famous short seller mentioned that financial stocks have probably seen the worst and that his fund now has fewer short positions in financial stocks than it did in the recent past (see Reuters article). He also feels that most of the bad news is already known and priced into the financials. As an alternative, Chanos is now shorting companies involved in commodities, in particular "... companies that might depend on cement prices or steel prices going up." Certainly not good news for the automotive, infrastructure, and housing markets.

The news with Lehman Brothers just keeps coming. In a yesterday's post I highlighted some recent articles that discussed the value of Lehman Brothers Headquarters (article), potential private equity investment and/or purchase of Neuberger Berman (article), and plans for Lehman to cut 1,500 jobs (article). Now it appear that even as plans for reducing the work force are being put into place, Lehman Brothers is looking to hire at various B-schools (see DealBreaker article). While the move is not unprecedented (companies often hire cheap college grads to replace expensive long-timers), the timing and focus are interesting. Not only does news of the job ads come less than a week after the news of lay-offs (granted, it may have been in the works for a long-time), but Lehman is apparently looking for an "Investment Banking Full Time Associate." Of interest in the job description is the following:

"The division provides comprehensive financial advisory and capital raising services. This includes advice relating to mergers and acquisitions, privatizations, and debt and equity financings and restructuring."

No doubt that capital raising and private equity experience would certainly be useful at Lehman right now. Then again, a potential drawback is that "the program begins with four weeks of training in New York." The company could look very different in one month. As mentioned in the DealBreaker article, new hires better "act now, before they go under." Yes, I know. This is too easy to make fun of, and real people are losing real jobs. Nonetheless, given Lehman's recent moves, in particular its desire to have both a quick and sensible sale of their mortgage-related assets, at some point reality will need to step in. To see just how silly things have gotten, check out a recent Here In The City News article regarding a funny spoof email making the rounds on Wall Street. Who ever thought Lehman Brothers, the Tooth Fairy, and Tinkerbell would be in the same article. As with most good humor, there is often a little bit of truth hidden in the satire.

Of course, all of this has the contrarian in me wanting to poke around a little in the stock. I mean, how much worse can it get? Bear Stearns II cannot happen again, can it? Recent valuations certainly seem to be pricing the possibility. The moves have also been extreme enough that the technicals don't provide much help. Some support exists around $13.50, and even near the current price around $16, but both are weak. Downward trend line resistance is near $20. Investors could wait until this trend is broken, but one would have to give up four points and over 25 percent while waiting for confirmation. Traders, acting a little quicker could capture the moves, but as we saw with Bear Stearns, even nimble traders sometimes don't have enough time to act. In the mean time I will probably just sit on the sidelines and enjoy the show. There are just too many other stocks with better risk-reward ratios for investing and trading, even if they are not quite as entertaining.

As reported in a Reuters article and elsewhere, the SEC is expected to propose a new short selling rule in the next few weeks that will be broader than the original temporary order that protected 19 financial stocks (17 major Wall Street firms, along with Freddie Mac and Fannie Mae). SEC Chairman Cox is quoted as saying the proposed rule "will focus on market-wide solutions," implying not only larger breadth, but possible other restrictions or changes affecting the markets that reach beyond just widening the number of stocks and sectors affected. One possible change is to require investors to publicly disclose large short positions, similar to the current requirements for disclosing large long positions. Whether a more encompassing rule will prop-up the markets longer-term and give some non-financial stocks a boost is difficult to predict. Even with crude oil continuing to sell-off, the Financial Select Sector SPDR (XLF) has given back some of its gains and is near short-term, yet technically-weak support. With the S&P 500 having trouble getting above 1,300, and the DJIA having difficulty around the 11,750 level, another SEC-induced short covering rally that is now more inclusive may be just what the market needs short-term to break resistance, even if not the original goal of the SEC. While potentially beneficial short-term, one can only hope that any new regulation will not have any harmful or unintended consequences for the market long-term. Then again, sometimes hope is all you have to work with.

For those who read the crude oil / financials post and are interested in reading more about the current relationship between the USO (crude oil) and the XLF (financials), check out these two posts (first, second) at the VIX And More blog, or at greenfaucet. Bill Luby has created what he calls a "headwind index" that looks at the ratio between the XLF and USO. Interesting stuff.

As seen in the chart below, financials (represented here by the XLF) and crude oil (represented here by the USO) continue to diverge.

Source: BigCharts.com (1 year, daily)
Source: BigCharts.com (6 months, daily)
There have been numerous explanations for the recent move in financials (new SEC requirements generating a short squeeze, oversold stocks, reported numbers not as bad as expected for select financials, etc.), but I suspect that the recent sell-off in crude oil also has a lot to do with the short-term price action in the financials. The chart below shows the recent 10 day, 15 minute price performance of both the USO and XLF. Again, the divergence between the two, in particular the price action around sharp sell-offs in the USO, is of interest.

Source: BigCharts.com (10 day, 15 minute)

While a simply chart comparison, I suspect that until the market has confidence that recent credit problems and sell-offs in housing are corrected, the price action in crude oil will continue to affect the performance of the financials, and the market in general. The financials have had a nice move over the last week, housing is still weak, the Fed is in a box regarding rates, the crude oil supply-demand balance still remains tight, and hurricane season has begun in earnest. Each points to continued interesting times for both crude oil and the financials. The impact of crude oil on the dollar, inflation, and interest rates also can not be ignored. While crude seems to be looking for reasons to sell-off the last week, I don't expect this trend to hold for long, nor do I expect the market to quit following crude oil movements as long as we stay around these current historically high levels.

The old Chinese proverb (with English translation) of "May You Live In Interesting Times" certainly seems to be the case for financial companies and those affected by the credit crisis (which is just about all of us). Even just a quick review and read of the financial/investment news sites gives the following:

International Herald Tribune discussing problems with Citigroup and the financial industry in general. Meredith Whitney is also quoted as staying "There is no place to hide for them." It is felt that Citigroup is so big that they are exposed to nearly everything.

New York Times article continuing to discuss how gas and food prices are pushing up inflation.

London Times Online discussing how share prices fell on the London markets after news of historic drops in home prices, and inaction by the Bank of England, are striking fears that Britain is in or near a recession.

London Telegraph article on how the Bank of England is essentially sitting on the side lines with regard to interest rates while they try to determine if a potential recession or out-of-control inflation is their worst problem.

WSJ article reporting an 18% drop in Q2 net income at U.S. Bancorp as it triples it provisions for credit losses.

Chicago Tribune article on how investors are fleeing suspect banks as fear mounts regarding a more widespread crisis in the banking sector.

Reuters article about how George Soros is once again predicting that this is the worst financial crisis of our lifetimes, and that Fannie and Freddie are just the beginning. Soros goes on to say that it may not get better any time soon given that the Fed Chairman is in a box with limited options.

Financial Times article about how the credit crisis is causing Australian companies to sell assets in an effort to improve their balance sheets.

Bloomberg article regarding the dollar hitting new lows versus the Euro, just as Bernanke and Paulson discuss issues with Fannie and Freddie, and the markets in general.

MarketWatch article discussing how Lehman Brothers, while not in danger of failing, may need an alliance, need to go private, or even need to be taken-over to prosper, yet it is unclear who might actually be in a position to purchase them. European companies, such as Deutsche Bank, Barclays, and HSBC as possible candidates since most U.S. companies will not be interested.

Forbes reporting how German investor confidence is at a 16 year low.

Fortune article discussing how the SEC, if it did not already have enough to worry about, now has to spend more time and effort chasing down rumors and the spreading of false information given its ability to damage financial companies, and even the entire financial system with greater ease than ever before.

Investors Business Daily article regarding inflation in the developing world, and how 2/3 of global inflation increases are coming from emerging markets - the very same markets that are hoped to out-perform other markets in the future.

..... and on and on and on.

Of course, is it enough to have bad news reported again and again, or do we need to really feel the bad news? Even a recent BusinessWeek article highlights how we still do not seem to have enough fear in the markets. While the recent sell-off has been consistent, the slope of the sell-off has not been very steep, nor displaying the types of spikes that often indicate fear and panic.

As of last week, the put/call ratios were not at the panic levels of the last year. The recent high for the 10 day CBOE total put/call ratio was 1.1, off from the recent peaks of 1.28 in March. The 30 day CBOE put/call ratio had a recent high of 1.0, compared to 1.17 in March. The 10 day equity only put/call reached 0.82, below the 1.00 level in March. The VIX is showing a little more fear, moving above 30% today for a short time, but falling back below 28% mid-day. Stronger, but not really the mid-30s spike that many traders are looking for.

Some indicators are beginning to show more fear. The latest Investor’s Intelligence poll had the bulls declining to 27.4% and bears rising to 47.3%. The bullish sentiment has not been this low since 1994. The bearish sentiment has not been this high since 1998. This gives a difference of 19.9 percentage points, the biggest bearish spread since 1994. The recent AAII poll shows 22% bulls and 55% bears, a number that is similar to March levels.

Overall, still a mixed bag, but looking better. Given the recent events and news, it does make you a little fearful (pardon the pun) about what it is going to take to get the capitulation the market is looking for. Interesting times indeed.

As reported a few days ago at the Financial Times, the Federal Reserve is reviewing whether or not to consider changing or loosen existing restrictions for non-bank holding companies, allowing them to take larger stakes in the banks without getting regulators involved. Some private equity firms have been interested in taking larger stakes, and providing the banks with much needed capital, but have stayed away due to existing limitations. Currently, companies that are not holding companies are prevented from owning more than 25% of a bank, and even less if they hold a board seat. Holders of large positions are also required to make what are called "source of strength" commitments, in essence agreeing to put up additional funds if necessary. While private equity funds are willing to take initial positions, many are reluctant to keep funding a decreasing asset.

The review by the Fed is in response to the need from banks to raise additional capital. Sovereign wealth funds provided some initial capital, but many have been shying away from U.S. financial companies, even at their current cheaper levels. To date banks have raised as much as $400 billion, but may need closer to $1,300 billion. To close the gap, the Fed may be forced to loosen restrictions in order to provide new ways to get the necessary capital to the struggling financial companies. The fact that the Fed is even considering such actions gives you an idea of how worried they are that another failure could develop. Even today there is an article in Vanity Fair discussing how rumor may have been the main contributer for initiating the run on Bear Stearns. The last thing the Fed, or the U.S. economy needs right now is for worries of capital concerns to cause another financial company to go under. Given the recent price action in LEH, C, JPM, MER, MS, and GS, the market certainly seems to be hinting at this possibility. Given that the Fed has its hands tied with regard to interest rates, unconventional approaches, such as making it easier for private equity to invest, or continuing to work through the discount window, may be its only current options.

Nice article at seekingalpha.com from Roger Nusbaum regarding whether or not it is time to buy financials. Roger says no, and makes the case why not. I agree. Wait for confirmation of a reversal, both technically and fundamentally. Of particular worry now are the regional banks, many which have some of the same issues as the bigger banks, and may be the next group to take a hit (and currently are for some). Many regionals are moving into municipal bonds (see post here). Hopefully, they will not fall into the same capitalization problems.