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Monday, October 08, 2007

Through The Fly's Eyes: Financial Stocks


Is It Time To Jump Into Financial Stocks?

Historically, when the Fed has started cutting rates, investing in financial stocks has proven profitable for investors. Will the same hold true in today's easing cycle? Probably not.

The Bear Stearns (BSC) model for its mortgage business might point to problems ahead for the financial industry in general. The financial services industry has done an outstanding job during the past twenty years developing new products and marketing them to institutions who specialize in buying these new instruments -- primarily hedge funds. With mortgage hedge funds, publicly traded vehicles such as mortgage REITs and other investors now shutting their doors to these products, who gets stuck with them? You guessed it! The investment firms and large commercial banks.

Now let's go to $300 billion of private equity debt that needs to be placed. Who is buying that up? While some institutions are, much of it is staying on the books of the investment firms and banks. Will funds be formed to invest in this debt? Yes, but it will take time.

Also, a point worth noting is that much of the debt for private equity deals is in the form of leveraged loans -- meaning floating rate debt. If a series of events unfold where these interest rates have to be set higher, many companies that have gone private will have a tough time making their interest payments. Not too different than what is currently happening to homebuyers who purchased homes with adjustable rate mortgages.

Further, as the Fed starts priming the pump to keep the economy going, the liquidity will not flow into the sector that just went bust. Following the tech and telecom bubble of the late 1990s, when the Fed dropped rates, money went into real estate, not back into tech and telecom. As this current easing cycle unfolds, money is unlikely to flow back into the mortgage market and PE deals.

While the investment firms and commercial banks are not going bust like many did in the earlier 1980s and early 1990s, they will have trouble growing earnings for the next few years. Also, it appears the Fed's easing cycle may not create the steep yield curve for financial firms to make easy money. All totaled, earnings growth in the financial sector will be hard to come by during the next few years and the stocks' performance will mirror the companies' inconsistent earnings performance.


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