How To Play The Banks Without Investing In Their Common Stocks

I have been a long-time bear on the financials, especially the banks. However, at this point I think there are some serious values there that investors should seriously consider. No, not the common stocks - they are likely to be severely diluted (if you dump a shot of Dewar’s into Lake Michigan, can you call it scotch and water?).

A good part of the banking system is, in all, probability insolvent. However, if one thing has been made clear over the past 6 months, it is that the government, regardless of party, is not going to let the big guys fail. Helping prevent that has a higher calling on the Treasury than anything else - more than national defense, more than providing health care, more than paying the salaries of government employees. How else could one explain the never-ending stream of ever-larger checks going into the black hole known as AIG (NYSE:AIG)?

Instead of buying the common stocks, look higher up on the capital structure. Bonds, look at the bonds. There is a very high probability that the government will backstop the value of the bonds. Heck, the market cap of Citigroup (NYSE:C) is just $5.5 billion, after the government has already poured $45 billion into it. What is that money protecting? Not the common stock, but the bonds.

No, they are not going to be 20-bagger investments. If you want that, go down to the local 7-11 and buy a lottery ticket. It will cost you the same as a share of Citigroup, with about the same probability of making you money.

Also, don’t go too long. Right now the problem in the economy is deflation, but the money supply has been increasing rapidly to offset the plunge in velocity. If velocity turns around there is a very significant risk that inflation could make a very big comeback - possibly to Ford-Carter levels, if not higher. So it is best to concentrate on the 3 to 5 year maturities. But inflation is not the immediate problem.

Both Bank of America (NYSE:BAC) and Citigroup are currently rated A- by S&P, not that the bond ratings have been useful for anything more than toilet paper over the last few years, but some people still care about them.

Yet there is a Citigroup issue due in August 2012 that is yielding 18.47% to the worst possible outcome (other than total failure, nuclear war or the Rapture - all of which are functionally equivalent and equally probable). To my mind, that sure beats the 1.86% you could earn in a 5-year T-note, which due to its longer duration has more interest rate (and inflation) risk that the Citigroup issue.

Is August 2012 too long to wait to get your money back? How about a Bank of America issue due in September 2011 with a yield to worst of 16.79%? Much better bet to my eyes than the 1.33% available on a 2-year T-note. That is pretty senior debt, folks.

If you want to be a bit more adventuresome, some of the subordinated stuff is even cheaper. How about a Citigroup issue due in October 2010 with a 27% yield?

In the event of liquidation, common shareholders would get totally wiped out, while debt holders might take a haircut from par, but the bonds are already trading well below par. That’s the way the capital structure works - in liquidation, first common gets wiped out entirely, then if there is anything left over, the preferred takes a hit, then subordinated debt, then the senior stuff. Only depositors come first, and these yields sure beat what you can get on CDs of similar length.

While the liabilities of the banks might exceed their assets (if they were to come clean about the value of their assets), it is not like the value of the assets is zero.

While some of the smaller banks would not have the end of the world type effects if they failed, there is still a good probability that the Government would still prevent a default on their debt. The debt there still looks much more attractive than the equities.

For example, Marshall & Ilsley Corp. (NYSE:MI), rated BBB+ has an issue due in April 2011 that is yielding 20.1%. Buying and holding this sort of debt to maturity will give you a much better return than you are likely to get from equities over the same time horizon, and with much less risk.

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