There’s always some danger.
If you live in the Gulf, you’re going to have to deal with hurricanes, like the one that’s bearing down on me right now. The question is simply when, and how severe it’ll be.
When I was living in San Diego, the biggest problem was the dry brush that would accumulate. Hot, dry winds meant that a single errant spark could fly considerably and start a fire anywhere. I’ve had to deal with a few of those—they’re even more prevalent than the earthquakes that plague the rest of the state.
In financial markets, we have to deal with eventual crises as well too. Today’s investors are primarily worried about a new crisis akin to the 2007-2008 financial crisis. That’s lately been centered on one of the world’s biggest money-center banks, Germany’s Deutsche Bank (DB).
In addition to being a major center for global financial trade, the company has a large book of derivatives. Don’t let the Wall Street speak fool you. They’re essentially side bets on what the economy, interest rates, and even individual stocks and bonds will do.
Normally, that’s not a problem. Every time I sell a covered call option, I’m making a side bet. I’m not risking the entire global financial system, or even my entire portfolio. I’m simply betting that a position that I own won’t rise too much higher before the option expires. If I’m right, I keep the shares and the premium I sold. If I’m wrong, I’m covered by the shares that I own.
So generally, no, many derivatives aren’t a problem. Unless there’s outright fear in our supposedly rational markets. Then the rush to capital can create the volatility and danger that was trying to be avoided in the first place.
Most of Deutsche Bank's derivate exposure is likewise covered. It doesn’t look as bad in reality as it appears on paper, and many positions cancel or come close to cancelling each other out. But the bank has sustained losses lately, and has even been hit with a large penalty by the U.S. Justice Department for (allegedly) mis-selling mortgage-backed securities. Thanks to all these events, traders smell blood in the water.
But there’s a funny thing about a market panic. Each one is different. The housing market is rising again. In markets like Washington D.C. and California’s Bay Area, it’s even at new highs. But that reflects rising demand and sticky supply. Luxury markets in Miami and New York City have slowed tremendously in the past year.
We’re back to all real estate being local. Bankers aren’t stamping anything that comes their way anymore either. With interest rates so low, there’s no profit in a loan that goes belly-up anymore. It’s crucial that they stick with higher lending standards that prevailed in the mid-2000’s, when anyone could get a mortgage so long as they had a pulse.
If we are on the cusp of a financial crisis, however, it’s not a new one. Rather, it’s simply the failure of the previous crisis to fully weed out the dry brush of our financial system.
That could be the case with Deutsche Bank and its book of derivatives. But many of the big banks also have a large position there without looking like a systemic risk to the global financial system. Indeed, one of the hallmarks of the stock market rally from 2009 to present is that big banks have rallied, but are still treated with major skepticism.
Firms like Bank of America (BAC) and Citigroup (C) trade at a huge discount to their book value—the stated value of all the loans outstanding as well as other assets. Other major banks with less derivative exposure have held up better like JP Morgan Chase (JPM) and Goldman Sachs (GS), although that might reflect their reputation for serving trading clients more than traditional banking roles.
One outlier at the moment is Wells Fargo (WFC), which is the current U.S. bank in the regulatory hot seat following disclosure that millions of fake accounts were created to meet the goals of its salespeople. If there’s been any one permanent feature following the financial crisis, it’s been the recurring grilling by Congress, with no real reforms as a result.
I share the skepticism of today’s traders in avoiding the big banks, mostly because of the intense scrutiny they’re getting from economically-challenged politicians. But instead of the common shares, you can buy the preferred shares of many of these top banking names.
The yields are better, and the preferred shares are bond-like in the sense that you’re higher up on the pecking order in the event of bankruptcy.
But I wouldn’t worry about bankruptcy. Even during the financial crisis, the preferred shareholders got their money, even as the common shares eliminated the dividends or dropped them to a measly penny.
Besides the preferred offerings of major bank stocks, there’s an opportunity in smaller banks. They tend to trade a bit higher in terms of book value, but still offer solid returns and decent yields. This is a longer-term play, and a bet on an industry that’s consolidating over the long term. In terms of sheer companies outstanding, the banking sector has shrunk by over half since the 1950’s, and even a big financial crisis can’t keep it down.
Bottom line, I don’t see a new financial crisis on the horizon. But there could be a flare-up of the old one. After all, that one arguably wasn’t fully extinguished thanks to hasty bailouts and piecework legislation to ease immediate fear rather than address long-term issues.
But that doesn’t mean you should avoid the financial sector. You can either go down on the risk scale to preferred shares, or buy smaller banks that avoid the major leverage temptations of derivatives in the first place. They’re simple strategies, but they work.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and is managing editor of Financial Intelligence Report. To read more of his work, GO HERE NOW.
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