How bad are the Financials?

The bad news keeps coming on a daily basis for the Financials:

• FDIC's Bair sounds alarm on foreclosure litigation - Sheila Bair: ""I fear that the litigation generated by this issue could ultimately be very damaging to our housing markets if it ends up unduly prolonging those foreclosures that are necessary and justified. The regrettable truth is that many of the properties currently in the foreclosure process are either vacant or occupied by borrowers who simply cannot make even a significantly reduced payment and have been in arrears for an extended time."
• New York Fed and bond investors gear up for a battle on MBS - Bloomberg has reported that the New York Fed, Blackrock and others has hired Kathy Patrick, a lawyer who has been characterized as a "pit bull on steroids", to take on BoA and others on the mortgage foreclosure litigation.
• Another analyst rhetorically asked the question if student loans are the next bubble [emphasis added]:

According to FinAid.org, student loan debt is now surpassing credit card debt. College graduates no owe $850 billion in student loans versus the $828 billion consumers owe credit card companies. This number is staggering. We’ll have to look it up, but it seems like this is the first time in history, given the short history of student loans, that credit card debt is less than student loan debt in the United States.

Moving forward, we will need to keep our eyes on two key metrics. First, we want to watch the number of defaults on student debt. Student debt is the only debt in our legal system that cannot be ‘forgiven’ during a personal bankruptcy. We could seriously find a generation without a job, without capabilities to pay the debt, and with no choice but to be servants to the banks to some degree. Although a “Lost Generation” is very unlikely, it is still a very small possibility. Secondly, we want to watch the employment rate. If employment does not improve, all of these new graduates will face uncertain futures moving forward. Some schools require students to take out six figures of debt which they could be paying on until the day they die. This grim future could be a reality for many. Could Sallie Mae (SLM) be the new owner of a slave generation induced by student debt?

I suggested a week ago that the relative performance of the Financials to the stock market is one indicator to watch of market health. The chart below shows that the sector has broken down from a relative support level and remains in a relative downtrend.

Is this another Lehman waiting to happen?
I think that everyone needs to take a deep breath. The market is starting to discount the Apocalypse for the sector.

I have heard bandied around is that the banks will have to take losses in the order of $100 billion. While that is a big number, it's not the kind of world ending figure that took down Bear Stearns and Lehman Brothers. $100 billion is roughly the total market capitalization of Citigroup, or about 10% of the BKX.

Yves Smith, who has been all over the foreclosure problems, believes that the magnitude of the problem may be overblown:

We did a quick and dirty analysis last week that showed that even if this effort succeeds, the recovery amount is likely to be far less than is widely anticipated.

In this excellent post on the problem, Smith went on the detail some of the legal and procedural issues surrounding the litigation and concluded:

We are no fans of Countrywide, but that should not stand in the way of recognizing that not every legal case against them is necessarily a slam dunk.

As for the student loan problem, which has a high probability of becoming a drag on economic growth and consumer spending, does not have the size to spark another Lehman-like crisis. (Note that the entire student loan market is $850 billion and not all of them are going to go sour.)


A correction likely, but this is not 2008
Today, investor sentiment is overly bullish, the market is overbought and showing signs of rolling over. These conditions are suggestive of an intermediate term top, followed by a correction with a 10-15% downside risk.

Barring some other unforeseen catastrophe, the problems of the Financials do not have the potential to return the major market indices to their 2008-9 lows.