Opinion: Avoid Financial Stocks & Zombie Banks

Nothing is easier than self-deceit. For what each man wishes, he also believes to be true.

--Demosthenes

Ever since the financial markets started to crumble a year and half ago, bankers just can't seem to tell the truth, even to themselves. From Dick Fuld saying that everything was fine at Lehman until days before he filed for bankruptcy, to Ken Lewis still saying that he did a good job for Bank of America ( BAC) by buying Countrywide and Merrill Lynch -- there seems to be a disconnect from reality among many bankers.

As an investor, you should avoid financials and sell any rally in the sector until bankers finally start to throw in the towel and tell the truth or be put out of their misery by FDIC takeovers. Why haven't bankers been telling the truth? It is just too ugly for them to accept. Their false statements are as much self-deception as market manipulation, especially since many of them would have been personally better of admitting their problems a long time ago.

Let's start with the scope of the problem. Most banks are insolvent. I'm not just talking about the big banks such as Citigroup ( C), Bank of America, Goldman Sachs ( GS), Morgan Stanley ( MS), JPMorgan Chase ( JPM), et al. I am talking about most banks in the entire country if they were doing any significant amount of real estate lending during the bubble, and most of them were doing a lot of it.

What do I mean by insolvent? I mean that the value of their liabilities far exceeds the value of their assets using any reasonable valuation metric. This is why bankers are so aggressively pushing for a change or suspension of mark to market accounting and also for regulatory forbearance as far as their capital ratios. What is regulatory forbearance? It is basically the government turning a blind eye to the obvious insolvency of banks in the hope that asset values will ultimately recover and fix the problem without putting the banks into receivership.

The only way for most banks to survive and avoid FDIC receivership in this downturn is to make believe that their assets are worth a lot more than they really are, and for the government to help them sustain that fantasy through regulatory forbearance.

This is a very dangerous game that the banks and the government are playing. This process of regulatory forbearance is just another way of saying "see no evil, hear no evil", "don't ask, don't tell", or as Sergeant Schultz from Hogan's Heroes used to famously say, "I hear nothing. I see nothing. I know nothing." This is no way to run a financial system, especially since it was already tried in Japan for over a decade in the 1990s with disastrous results for their economy and credit markets.

Keeping insolvent banks alive through regulatory forbearance is the most reliable way of reducing liquidity in the financial system, destroying confidence in financial markets, prolonging the economic downturn, and promoting deflation. The only people who benefit from doing this are the executives, shareholders, and bondholders of these insolvent "zombie" banks. Everyone else loses.

Why is that? The taxpayer loses because more bailout money is needed than if the zombie banks were allowed to fail. Healthy banks lose because they suffer from unfair competition by government-supported zombie banks. Depositors lose because the Fed needs to keep interest rates artificially low to support the toxic balance sheets of zombie banks. The economy loses because zombie banks are just a drag on the whole system. They consume resources that could be used to invest in companies or projects that would generate economic growth rather than just prop up failed enterprises in an effort to protect their politically connected stakeholders.

Nouriel Roubini, the recently famous NYU economist who people are calling Dr. Doom these days, has explained this a different way, by saying that nationalizing the insolvent banks is more efficient and more market friendly than keep them alive. I agree with him. Also, Roubini and others have said that banks are only about halfway through their losses from this economic collapse. This means that the problem of insolvency among banks is only going to get a lot worse before it gets better.

The longer we wait to start going down the right path, the more expensive and disastrous this problem is going to become. We could suffer from an entire "lost decade" as they did in Japan if we waste our money and efforts trying to bail out defunct financial institutions.

We need to allow the FDIC to do the job it is chartered to do, as it did very effectively with Washington Mutual and Indymac. The regulators at the FDIC know how to take over an insolvent bank, sell off its good assets and deposits to a healthier institution, and create a bad bank receivership structure for its bad assets. This is how the system is supposed to work, and it did work that way in the early 1990s during the last banking crisis. We need to start letting the system work that way again and stop exempting certain politically favored banks from the law of the jungle via regulatory forbearance and endless capital injections with taxpayer money.

This is not just some academic or intellectual issue. There are real world consequences on the ground to this policy of letting bankers think that they can keep hiding their insolvency and somehow live through this downturn.

My business involves working with banks in situations with distressed loans to commercial real estate borrowers and developers. We're involved in many situations right now that involve negotiations with various banks regarding the value of the real estate assets securing their loans. What we're seeing almost across the board is that banks will not even come close to accepting the true market value of their assets. Some of these banks have actually failed and been taken over by the FDIC during our negotiations with them, and even up until the days before they were taken over the bank would still insist that its loans were money good and they should not have to take any significant losses.

The real world impact of this intransigence by the banks is that transaction activity in commercial real estate is down about 90%. Our entire industry is frozen because these banks will not accept the changes in value to their assets. They can't make new loans because they have no capital, and they can't or won't take the hits on their current loans by selling them at market value to investors who have money and want to buy the loans. So nothing happens, and an entire sector of the economy is shut down. This is the real world impact of allowing bankers to think that they are going to get a free pass. It is causing economic stagnation, further illiquidity in the market, and massive unemployment in sectors like commercial real estate because there is hardly any new lending or transaction activity to keep people employed.

Until all of the large banks are nationalized and thousands of smaller banks fail and are put into FDIC receivership, it is too early to become optimistic about the financial sector as an investor. The process of bankers acknowledging their losses, and in many cases admitting insolvency, is far from over. So investors should sell any major rally in this sector until there are a lot more carcasses of dead banks in the streets and no more zombie banks walking around and pretending to be alive. Do not waste your cash investing in a sector that is being run by people living in denial and hoping for a miracle or government largess to save their businesses. There are much better things you can do with your money, including doing nothing.

Christopher Grey is a Managing Partner of Third Wave Partners. He currently has no positions mentioned in this article. This article should not be interpreted as personal investment advice or a recommendation to buy or sell any security. Interested readers may contact the writer by e-mailing cg@thirdwavepartners.net or visiting the company's website, www.thirdwavepartners.net.

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