Financials Have Further to Fall

11/21/2007 12:00 am EST

Focus: ETFs

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says large financial firms have a lot more bad loans to write off, and he recommends shorting the ETF that covers them.

Financial institutions have taken a ferocious hit. [Recently] the CEO of Goldman Sachs (NYSE: GS), Lloyd Blankfein, said his firm would not have any real write-downs. He also said Goldman has learned how to value subprime and related debt.

Then Blankfein's optimism waned when he said his firm was short the financial sector, because he thought there was a lot more damage to be unveiled.

Bear Stearns (NYSE: BSC) also tried to provide a rosy view of the dark picture. It said that as far as it was concerned, the subprime mess was essentially over. Bear also said it was net short in the subprime market because-you guessed it-the company sees more bad news to come.

The CEO of Goldman Sachs' optimism regarding his company temporarily pushed up the Financial Select Sector SPDR (AMEX: XLF).
 
Yet this sector has a tremendous amount of trouble to come. Given that a bunch of high-profile individual banks do not know what they own, or how much it is worth, how can we determine winners and losers? We can't, so it's time to short the entire sector through puts on the XLF.

The XLF is an exchange traded fund (ETF) that owns baskets of stocks representing the sector. [Its five largest holdings are] American Express, American International Group, Bank of America, Citigroup, and Goldman.

Why [short it] now?

1. These institutions, for the most part, still cannot properly value the amount of bad loans on their books. This is spooking investors who, therefore, cannot properly value the stocks.

2. A day of reckoning was forced upon banks that saw new accounting standards take effect this week. Banks must now provide investors with a lot more detail about what they own and what it is worth.

3. Many of these companies had large profits in 2005 and 2006 generated by the fees and trading gains from the collateralized debt obligation, or CDO, market. That market and those profits no longer exist.

4. Some institutions will have to sell assets to balance write-downs, impairing their ability to generate earnings and support dividends.

 * The core inflation number for the month of October may have been tame but year over year, it was very hot at 6.5%, and this will probably restrain the Fed from future rate cuts. Earnings estimates for banks are building in additional rate cuts, so there could be another nasty surprise ahead for these companies.

So, buy the Financial Select Sector SPDR (XLF) March $28 Puts (XLFOB) under $1.52-they are priced in pennies. (They closed above $2.00 Tuesday-Editor.)

If we make a 25% or 50% gain, I am going to close the position and put you in a different strike price or month, or both.

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