Stocks' wild ride isn't over

Betting on a bust

To get a glimpse of this reality far from the cheers of the crowd, consider the action this week that led Punk Ziegel bank analyst Richard Bove to cut his 2008 estimate for Wachovia Bank (WB, news, msgs) by 14%, to $2.74 per share, from $3.17.

Bove noted that despite a decline in interest rates that should have boosted investors' confidence in debt repayments, the indexes that are used to value loans on bank balance sheets plunged 22% in March alone. The ABX index measuring the highest quality home-equity loans, ABX-HE-AAA 07-2, stood at $51.93 this week, down 48% from September, while one measuring loans a notch lower in quality, ABX-HE-AA 07-2, was down 79% from September.

This means the market is forecasting that half to three-quarters of home-equity loans will go bad over their terms, even though less than 1.5% are delinquent right now and the annualized rate of charge-offs is just 3.5%. Bove notes that the current rate is very bad -- the highest since data was first collected in 1991, and up fourfold from last year -- yet it would have to rise 12-fold to reach the level of investors' skeptical assumptions.

That kind of default rate would occur only in a severe depression. That says more about the state of credit investors' anxiety than it does about the likelihood of a severe downturn, yet it's a factor that will impede banks' earnings this year no matter how much traders try to bull up shares.

For another look at the corporate-financing disaster that stock investors are ignoring this week, M.S. Howells strategist Brian Reynolds called attention to all the major companies -- including Sprint (S, news, msgs), CIT Group (CIT, news, msgs) and, in Germany, Porsche Automobil Holding (PSEPF, news, msgs) -- that have drawn down their bank lines of credit in the past three weeks.

This is always a company's last resort after failing to convince underwriters that its business is sound enough to allow a much cheaper financing mechanism, such as the issuance of new shares or bonds. But it also has negative implications for banks, as it forces them to expand their lending to poor creditors. Reynolds says this forces banks to tighten credit in areas ranging from mortgages to student and small-business loans, restricting the growth of the economy in ways that are hard to see.

It's a negative credit-feedback loop similar to one that got rolling in early 2002, before the last leg of the millennial bear. As a coup de grâce along these lines, Bloomberg reports that Morgan Stanley (MS, news, msgs) last week wanted to renew its own $11 billion credit line but asked for only $7.5 billion, realizing that it wasn't likely to get double digits. It was offered only $4.9 billion. It's shocking to see a financial institution of Morgan's size get dissed by its own peers, and it gives you a sense of how much less money is available throughout the system today than last year, from the lowliest dry cleaner seeking to expand his business to hedge funds and major banks.

There's no silver lining to this cloud, I'm afraid, just darkness and rain. Bulls can probably push the market an additional 6% higher, to around 1,450 on the S&P 500 Index ($INX), but then look for bears to lock 'n' load for their next round of mayhem. The financial stocks' recovery will come, but like the modest tech-stock recovery since 2003, it will be long, slow, tedious and frustrating.

Fine print

To follow credit index pricing, check out this page at Markit. Punk Ziegel does a nice job of covering banks.

M.S. Howells provides execution services and prime brokerage services to hedge funds.

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At the time of publication, Jon Markman did not own or control shares of companies mentioned in this column.

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