Some Bank Stocks Are Still Too High

04/28/2008 12:00 am EST

Focus: STOCKS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says bank stocks don’t reflect a weak consumer economy, and he finds two he thinks are likely to fall.

In terms of the credit crunch, the worst is over as measured by "panic." However, I don't know anyone who would say they believe the worst of the actual write-downs are behind us. 

The CEOs of JPMorgan Chase, Wachovia, and Bank of America said they see continued pressure on earnings due to consumer debt problems and the slowdown in the economy.

The heart of the problem continues to lie in the decline in housing values—and these will not stabilize until late in 2010 at the earliest. Foreclosures will rise for another year (they were up 57% in March), prompting more write-downs and roiling markets.

[Meanwhile,] many financial stocks are still fundamentally flawed and grossly overvalued. The financial sector has traded up, but it hit a wall mostly due to decidedly unexpected and very poor earnings from Bank of America (NYSE: BAC). To me, this means:

1. The market believes write-downs from subprime loans are built into stock prices, and
2. Problems with traditional consumer lending and a recession are not yet built into the prices of many stocks.

What does this mean? We need to invest in those banks that will have larger-than-expected write-downs and will suffer from problems with traditional consumer debt and the recession.

While Bank of America is very well-run, its earnings announcement was much worse than even I expected. It announced $6 billion in write-downs related to home equity and consumer and small business debt in the current quarter—not subprime loans, which was less than $1 billion. This is a play on consumer problems and a recession, not on the subprime loan mess.

The stock currently has a 6.7% dividend, but this is not sustainable. [Also,] on January 1st, US banks will begin complying with a new set of international banking standards called Basel II that will force banks to adjust their capital based on the riskiness of their assets. There will be a massive write-down of risky assets and a massive raising of capital as the new standards are implemented.

All you need to know to benefit from these developments is to buy the BAC January 2010 35 Puts under $6.35. (Editor’s Note: Shulman says he holds a small position in BAC puts. The stock closed above $38 Friday and the puts were trading at $5.65.)

Sovereign Bancorp (NYSE: SOV) has many problems directly related to nonmortgage consumer lending and its put premiums are very high. A lot of puts are being bought for July, but take a stronger position and buy the SOV January 2010 7.50 Puts under $1.75. (The stock closed below $8 Friday and the puts traded above $2—Editor.)

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