Bailout

Why financial stocks haven?t fallen much

By Felix Salmon

Bank stocks didn’t do so well this week, what with foreclosuregate coming to a boil. But they didn’t do all that badly, either, as a group: the XLF financial sector ETF ended the week down a pretty modest 2.45% from where it started.

You might remember the XLF fund from a famous column by Evan Newmark two years ago, a few weeks after Lehman Brothers declared bankruptcy and the global financial system threatened to implode into a mess of nationalization and mass insolvency:

Bear Stearns, gone. Lehman Brothers, gone. Merrill Lynch, gone. Washington Mutual, gone. Wachovia, gone. Fannie and Freddie, basically gone. AIG, almost gone.

Absolute carnage. The fastest restructuring of a banking system in economic history.

Will the U.S. financial-services industry survive? Plenty of folks think not. But if you believe yes, now is the time to buy financial stocks.

Which is why I have been buying the XLF, the financial sector exchange-traded fund…

The optimist will tell you that we have a crisis of confidence. That with the Treasury?s bailout program in place, bad assets will be speedily removed from balance sheets and credit will again flow. Throw in a Federal Reserve interest-rate cut and soon banks profits will follow.

Frankly, I don?t know who is right today. But I have a five- to 10-year time horizon, so I don?t have to know that.

All I have to do is believe that the US financial-services industry will survive…

For the XLF a break down of more than 20% from Friday?s close, would put it at less than $15.

This would probably indicate the total collapse of the U.S. financial system. And I just don?t buy that. I am buying the XLF instead.

In many ways, the column was prescient. The US financial system did survive. Treasury’s bailout program, along with Fed rate cuts, did indeed break the back of the financial crisis, and large bank profits have followed as a result.

Yet XLF has been trading between $13 and $15 since May — a level which, according to Newmark, “would probably indicate the total collapse of the U.S. financial system”. And looked at over the past three years, it’s pretty clear what happened to the XLF: it fell off a cliff and then recovered to settle happily at a new, low level. Here’s the chart; the vertical line marks the date that Newmark’s column appeared.

I think that this helps to provide, at least in part, an answer to Ezra’s question about why the markets don’t seem to care about the foreclosure crisis: they’ve known about it all along. (For instance, see this story from Reuters’s Patrick Rucker, dated July 27 2007.)

What’s happened over the past week or so is that the mortgage shoe has finally dropped, as it inevitably was going to do sooner or later. But since the markets were already pricing in that shoe-drop, they haven’t needed to overreact this week. They didn’t know when all this was going to happen, but they were relatively well prepared for this: it’s a slow trainwreck, not a sudden crisis. And the still-depressed level of financial stocks is testament to how none of this comes as much of a surprise.

Full post as published by Macroprudential on October 15, 2010 (boomark / email).