The Coming Systemic Bust of the U.S. Banking System: “Dead Stocks Rallying”

This past week started with concerns about another systemic meltdown of the U.S. financial system as the insolvency of Fannie and Freddie was revealed and as Indy Mac went bust (this is the third largest bank collapse in U.S. history). But the week ended with a remarkable rally of financial stocks as better than expected results from Wells Fargo, JP Morgan and Citi soothed the fears that major financial institutions were in even more distress than already predicted by market analysts.

Unfortunately, this massive rally of financial stocks in the latter part of the week is just another temporary bear market rally that will fizzle away once the onslaught of bad financial and macro news builds up again.

The views I presented in a recent blog that we will experience a severe financial and banking crisis received the support of many well respected commentators. Alan Abelson – at Barron’s – is one of the most senior and well known commentators on financial issues and on Wall Street. In his latest Barron’s column – aptly titled “Dead Stocks Rallying” he wrote:

WHY WE'RE STILL BEARISH WAS SPELLED out starkly in a dispatch we received last week from Nouriel Roubini. Nouriel is a professor of economics at NYU Stern School of Business (but don't hold that against him) and runs an economic advisory firm called RGE Monitor that casts a knowing and clear eye on the global financial and economic scene. We think he's top-notch (which means we agree with him, a lot of the time).

The nub of his argument is that we're suffering the worst financial crisis since the Great Depression, and he proceeds to give chilling chapter and verse. He predicts that hundreds of small banks loaded with real estate will go bust and dozens of large regional and national banks will also find themselves in deep do-do.

He reckons that, in a few years, there'll be no major independent broker-dealers left: They'll either pack it in or merge, victims of excessive leverage and a badly flawed and discredited business model.

The Federal Deposit Insurance Corp., after it gets through picking up the pieces of IndyMac, will sooner or later have to get a capital transfusion, Nouriel asserts, because its insurance premiums won't cover the tab of rescuing all the troubled banks. He foresees credit losses ultimately reaching at least $1 trillion and anticipates a heap of woe for credit purveyors across the board.

The poor consumer, he contends, is shopped out and being hammered by falling home prices, falling equity prices, falling jobs and incomes, rising inflation. The recession he anticipates will last 12 to 18 months. And the rest of the world won't escape: He looks for hard landings for 12 major economies. As for the stock market, he hazards that there's plenty of room left on the downside. In fact, he feels the bear market won't end until equities are down a full 40% from their peaks.

We must say this vision is a mite too apocalyptic even for us. But Nouriel is not a professional fear-monger out to make a splash with end-of-the-world prognostications He's a sound guy with a solid record and an impressive résumé. We obviously believe his views are worth pondering, even if they ruin your appetite.

That was a very nice summary by Abelson of my views and a kind endorsement of them.

But how to square the views that a large fraction of the US financial system is in trouble with the apparently better than expected earnings results and lower than expected writedowns presented by financial institutions such as Wells Fargo, JP Morgan and Citi that led to the financials’ stocks most recent rally? There are many reasons why those earnings results are misleading and cosmetically retouched upward while the true financial conditions of the financial system are more dire than otherwise presented.

Let us discuss next in some detail the various reasons why financial conditions of financial firms and banks are much worse than those headline figures and why we the US will experience a systemic financial crisis…