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By: Costas Bocelli — October 21, 2010

3 Risky Stocks to Avoid Now

In my article three weeks ago, Three Banks To Avoid Right Now, I outlined how the banking sector had been detracting from the bull market rally.

I specifically identified Bank of America (Sym: BAC), Wells Fargo (Sym: WFC), and JP Morgan (Sym: JPM) as the three under-performers.  All three have struggled in the continued headwinds that plague the housing sector recovery.

Since the release of that article, these banks have continued to lag the broad market and, in the case of BAC, even made a fresh 52-week low yesterday.

Below is a chart on the S&P 500 Index, coupled with the relative performance of all three of these bank stocks since the release of that article on September 30 ...

Why the Banks are Struggling

The ongoing foreclosure mess is weighing heavily on the fledgling economic recovery, and the banking industry in particular has been under heavy scrutiny in the mainstream media and regulatory circles.  How these mortgage servicers are handling the default process has been big news lately.

Confidence in the way the banks were handling foreclosures got so bad that the foreclosure process was temporarily halted in 23 states where the process is completed in the court systems.

The main issue stems from affidavits that needed to be attested to by the servicers, saying that all the paperwork is accurate and complete prior to judicial filing on the foreclosure.  Turns out that, in many cases, the affidavits were signed off on without any documents being reviewed. 

The term “Robosigner” has now been added to the investor vocabulary.  These “Robosigners” became overwhelmed with foreclosure files and simply began their own version of fast-tracking the growing pile of case files.

Now, for the most part, these are simply procedural mistakes that can easily be fixed.  In a review of previous foreclosure files, in most cases, the paperwork was found to be correct and the default was accurate and valid.

Yet this procedural misstep is yet another black eye to the housing finance industry, and certainly an embarrassment that will add additional costs and expenses from the delays and reviews.  However, are there deeper issues that will intensify the negativity that weigh on the banks stocks?

In my Tycoon Report article last week, Market May Have Peaked for Now: 3 Warning Signs, I again reiterated the point that the financials continue to lag this rally.  By this point, JPM had reported their earnings, which were received poorly by investors, sending the stock 1.5% lower on that day.
 

BAC and WFC reported earnings as well earlier this week.  All three of these banks have heavy exposure in the residential loan market as top loan originators and servicers.  All three sang pretty much the same tune, with weaker top line revenue numbers and goosed up bottom line earnings numbers glazed over by reduction in loan reserves against non performing debt.

Is There Another Storm on the Horizon?

This is where things could get interesting -- the broad market rally has been strong and continues to be in overbought territory, but Tuesday’s action was quite compelling.  The market was certainly taken by surprise at the unexpected rate hike by the Central Bank of China, but then the market took another severe leg downward with the surprise announcement of a lawsuit filed against Bank of America.

A consortium of 8 major mortgage backed securities investors are suing Bank of America to essentially force the bank to buy back $47 Billion worth of collateralized mortgage securities.

This certainly spooked the market, sending BAC to fresh 52 week lows as I mentioned earlier.  But this could go well beyond BAC, especially if fellow banks like JPM and WFC are dragged into the fire.  All three of these lenders originated agency and non agency paper that was pooled and sold to investors.

Bank of America’s biggest skeleton stems from the acquisition of Countrywide, which was the largest originator of subprime loans. 

Wells Fargo bought Wachovia, which had bought World Savings Loans, which has a great deal of those stated income, pay option loans that they were famous for. 

Finally, JP Morgan Chase was not only a huge originator of subprime loans through its Chase subsidiary, but they acquired Washington Mutual, which was fire sold to them in the wake of their bankruptcy.  Washington Mutual also was notorious for originating the stated income pay option arms as well.

Buy backs are a very serious thing, and banks do not want to buy back loans.  They want to write them and sell them and get them off their lines of credit and into the hands of fixed income investors.  Freeing up that capital allows them to repeat the process all over again.

Buy backs force the lenders to bear the full risk of the loans, and eats up capital that can be used for income generating opportunities.

The banks' responses to these buy back requests basically imply that they are "not responsible" for the poor performance of loans as a result of a bad economy. 

The reality here is that these investors suing BAC are not the average Joe Blow investors -- they knew what they were getting into when they were trying to squeeze out those extra basis points in yield, buying mortgage backed securities. 

They need to quit crying the blues, and should just buck up and take the loss with dignity.

One of the major plaintiffs is PIMCO, the smartest bond players around, and not exactly a sheep in the industry.

A big problem lies in that one of the investors named as plaintiff is the Federal Reserve Bank of New York.  This is potentially a serious problem that adds significant implications to this issue.  The Federal Reserve Bank owns some of these securities through the TARP rescue fund that was set up to stave off the credit crisis.

Having the feds on your back is never a good thing.

If the buy backs gain traction against Bank of America, or if the contagion spreads to the other major mortgage originators such as WFC and JPM, this can cause a major overhang to these banks.

The risk is in the hundreds of billions of dollars in “put back” risk, which would hit earnings substantially.  This story may have legs for some time, and I reaffirm that these banks should be sold or avoided until this mess is hashed out.

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