Using Options To Trade the Banks in Early 2009
Options On The Banks
Options are not just a way to make money -- they are also indicators of sentiment. Take a look at the July 2009 put and call options on the double inverse exchange-traded fund (ETF) on the Dow Jones Financial Index, the UltraShort Financials ProShares (SKF).
Nothing in the options market reflects the positive or negative opinion about a market segment better than a call or put on a double inverse ETF.
The January call buyers see a 5.5% or so decline in the index, while the put buyers see an 8% rise. The buyers of April calls see a more than 13% fall in the index, and the put buyers are betting on an 18% rise.
I see this pricing as an indication that the market is split -- the difference between the two positions is not all that great. So, it is time to look at fundamentals and see how January earnings -- and beyond -- could dictate the winners or losers in this trade.
The Housing Mess
Looking at fundamentals, the banks are, to use a technical term, a mess. And they will get a lot messier in 2009.
The core, as always, is housing -- falling home prices, defaults, foreclosures and more bad mortgages than forecast.
Let's review the stats:
- One in 11 American homeowners is in default or foreclosure.
- One in 5 American homeowners (or 1 in 4, depending on who you read) lives in house worth less than their mortgage.
- Home sales were, arguably, the worst ever on record in November: Existing home sales fell 8.6%; existing home prices in Q4 fell 12% across all regions of the United States, led by a 12% drop in the Northeast; and new home sales fell 2.9% in November compared to a disastrous November 2007.
- More than 600,000 homes went into foreclosures proceedings in Q3, credit quality deteriorated and almost 9% of Americans are not paying their mortgages on time.
- More than half of modified loans are back in default or foreclosure.
Some analysts see the option ARM, Alt-A and recession-driven mortgage meltdown in 2009 and 2010 as greater than the subprime mess.
But wait, you say, the Fed is buying this stuff. Wrong -- the Fed is buying new stuff. And according to its charter, not policy but its legislative mandate, the Fed can only buy high-quality debt -- and that's not what we're dealing with here.
It starts with housing, then home prices, and then it goes to credit in general.
Did you know that $530 billion in commercial property loans come due in the next three years, and there isn't any money to roll them over? Or that credit card debt is no longer being securitized as no one will buy the bonds?
And this stuff stays on bank balance sheets. Again, Uncle Ben cannot buy these assets unless they are very highly rated and have truly secure collateral.
Wall Street Still Has Its Head in the Sand
Thus far, I have been focusing on the new problems Wall Street is underestimating. They are also underestimating old ones.
Here's an example: Citigroup (C) has more than $1.2 trillion in off-balance sheet assets of unknown quality -- that's trillion with a "T." They are held on Enron-like entities called "qualified special-purpose entities" (QSPEs) and "variable interest entities" (VIEs).
Morgan Stanley (MS) has to deal with the option ARMs it got when it bought Washington Mutual. Wells Fargo (WFC) must do the same with Wachovia's option ARMs. And Bank of America (BAC) has to digest Countrywide and Merrill Lynch's (MER) dodgy assets.
These are the big names, and core banks like these make up more than 40% of the Dow Jones Financial Index. General financial stocks make up 23%, and their businesses are cratering. Real Estate Investment Trusts (REITs) having trouble collecting rents comprise 13% of the index. Insurance companies writing off assets every day and getting 2% on their T-bills are 20% of the index.
So, the Dow Jones Financial Index is in deep yogurt as earnings and losses come in over the course of 2009. And as the index falls due to weakening fundamentals, the SKF will rise.
How to Play the Banks
The fundamentals tell me the banks are going to take a big hit, but when?
Let's go back to the put and call premiums. Many in the market are betting that the banks will have horrific earnings -- the big ones report in mid-January -- and their stocks will fall. Many also think this is already built in.
So I want you to forget about January and look further out -- perhaps as far out as April -- when you play the fundamentals.
I am not suggesting that you buy a call on a double inverse ETF. Yes, it is the ultimate rocket-fueled short trade, but the SKF is very volatile, making calls a very high-risk play.
I picked the SKF to illustrate current sentiment. That said, based on fundamentals, there could be some very rewarding opportunities in bank puts after January. So, I suggest you take a look.
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