Market Report: Investing in Bank Stocks: "I am shocked – shocked! – to discover gambling going on here."

Abstract:
The largest bank we’ve got has put all on notice that its losses are on par with UBS. Word received out of 399 Park Ave. has Citigroup (C: NYSE)’s third-quarter earnings slated to decline 60%, as it writes down $3 billion plus for securities backed by underperforming mortgages and loans tied to corporate buyouts.

Bullets:
- UBS has announced that it will accept billions in Q3 losses,
- Citibank is warning that it will match UBS’s losses dollar for dollar,
- Conservative investors should purge Citibank (C: NYSE), Bank of America (BAC: NYSE), and Wachovia (WB: NYSE), while the adventurous should purchase mid-term put contracts against them.

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I have said it repeatedly, and I will say it again today.

Yes, I like US stocks in general. Yes, by and large, the 3rd quarter ended up. And yes, the markets are showing broad strength today.

But (and this is a really big but), you do not want to own banking shares right now.

Yeah, yeah, I know: The Fed has acted to insure that none of the major players will go bankrupt by exchanging lousy bonds for good cash (at least we assume it’s good cash), and offering marked discounts in the price the central bank charges petitioners for capital.

What’s more, rumor has it that the Fed will lower rates again come Halloween. This rumor appears to have its source not in the Fed itself, but rather the folks who hope to blackmail the Board of Governors.

These threats are much akin to an ill-mannered toddler in a supermarket threatening to hold his breath if his mother does not buy him half a dozen packages of his favorite sugary snack. My advice to both the mom and the Fed? Neither our proverbial youngster nor the American markets will truly behave any better if we feed their constant cravings.

The most any of this largesse (we’re back to just banks now) will achieve is to keep liquid cash moving through the system. The Fed has basically told most banks not to worry about other banks’ checks clearing, and assured depositors that ATMs will continue to disgorge $20s on Friday nights.

It has not promised that they will make a profit, and indeed has broadly hinted that speculators who so loved the insane profits garnered from lending to virtually any and all who could scratch an X on the dotted line, are overdue for a well-deserved soaking.

Already hints as to how bad last quarter was profit-wise are coming across the transom: First we hear in the predawn hours from that Swiss banker UBS (UBS: NYSE) that it anticipates writing down assets of roughly 4.0 billion Swiss francs (don’t bother with the calculator: it’s 3.4 billion dollars, more or less) from its investment banking arm's fixed income, rates and currencies division.

When the dust settles, we are probably looking at a Q3 pre-tax loss in the vicinity of 800 million Swiss francs (again, I will save you the effort: it comes in at around $690 million).

Apparently, the Euro’s strength is not conferring automatic invulnerability on its progenitors. UBS peer Credit Suisse has also conceded that its Q3 report will be drenched in red ink, as has German bank IKB. All blame the “turbulent, high-risk US market they were desperate to get a piece all of a few months ago.

“Ahhh, who cares about a bunch of Brie-eating, wine drinking Euro bankers anyway? Where were they when we went to war anyway?” Ummm, apparently, they were propping up our bond and real estate markets, much to their newfound dismay.

Do not be so sanguine, my Stateside friend. The largest bank we’ve got has put all on notice that its losses are on par with UBS. Word received out of 399 Park Ave. has Citigroup (C: NYSE)’s third-quarter earnings slated to decline 60%, as it writes down $3 billion plus for securities backed by underperforming mortgages and loans tied to corporate buyouts.

Citigroup will write down some $1.4 billion on funded and unfunded loan commitments, accept losses of $1.3 billion on securities backed by subprime loans and admit to the loss of $600 million in fixed-income credit trading due to market volatility. Not only that, but now the poor fellows must actually set aside additional cash against further defaults, costing them another $2 billion or so in profits.

Oh that darned turbulence! Who could have seen this coming?

Actually, several us here at the Taipan group have done our best to warn all who would listen away from the bankers. One can argue till the cows come home as to whether or not housing has bottomed (most probably not just yet), and whether or not certain REITs deserve to be tarred with the same ugly brush as home building stocks (they certainly don’t if they are primarily populated with office and mall managers).

But this much is cold hard fact, as the costs that are driving it are already on the books: As the reporting season wears on, banking shares such as Citibank (C: NYSE), Bank of America (BAC: NYSE), and Wachovia (WB: NYSE), just to name a few, will be deservedly punished for the short-sighted actions of their managers (who really should have seen this coming).

If you are conservative, purge them from your holdings. If you are adventurous, purchase mid-term put contracts against them.

Adam

PS: The quote in the title is from the world’s greatest movie, Casablanca (as if I really need to tell you that).