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The Daily Reckoning | Thursday, March 4, 2010 Sell Bank Stocks Now Discovering the "Truth" Behind Non-Performing Loans Eric Fry Whoever said, “Opposites attract,” didn’t know what they were talking about...or maybe they did know and just didn’t provide all the details. The world around us provides ample evidence that opposites do, in fact, attract...but not always toward a favorable outcome. Sometimes opposites attract like gravity attracts a crippled airliner...or like a field mouse attracts a rattlesnake...or a bare foot attracts a rusty nail...or a Rusty Nail attracts an alcoholic...or accounting chicanery attracts a gullible investor. Accounting chicanery converts sad truths into happy stories and statistics. And no one loves a happy story more than a gullible investor. If it were not so, dear reader, Wall Street would still be an anonymous little alley in Lower Manhattan. Instead, Wall Street has enriched itself by converting sad truths into happy stories as often as possible. Wall Street doesn’t usually lie; it merely fails to tell the truth. The resulting deceptions cause their clients to suffer delusionary episodes at inopportune moments. Sometimes their clients mistake the very top of a bull market for a “deep value opportunity”; and sometimes they mistake a fraudulent earnings report for “a great growth play.” These classic investment errors are not entirely Wall Street’s fault. But behind every major investment error you usually find at least one glossy research report. The Wall Street research machinery knows how to tell the kinds of happy stories that will elicit buy orders from gullible investors. And they keep telling these stories because gullible investors keep believing them. Remember Enron? That was a happy story for many years...so was Boston Chicken...and Worldcom...and AIG...and Fannie Mae...and Lehman Bros. But these infamous disasters all featured a variety of sad truths in their financial statements, well before disaster struck their stock prices. A handful of insightful short-sellers made some money as these stocks collapsed, but gullible investors simply lost everything...or almost everything. Accounting chicanery takes many different forms, but it always produces the identical result: deception. Remember, we’re not talking about lying; we’re talking about not telling the truth. Lying is not usually legal; but not telling the truth is not usually illegal. Let’s consider a bit of chicanery that is unfolding right below our noses at this very moment: Many banks across the country are reporting a drop in non-performing loans (NPLs). That’s usually a sign that credit conditions are improving. But this time around, falling NPLs sometimes has more to do with accounting games than with credit quality. Some banks are utilizing every accounting mechanism in their toolbox to move lousy loans into a loan category – any loan category – other than “NPL.” The astute minds at M3 Funds, an investment management firm specializing in bank stocks, provide this worrisome observation: “Much of the enthusiasm in the bank sector [is] based on perceived signs of a turning point in the credit cycle. However, in many cases, improvement in credit quality is the result of loan modifications, a financial sleight-of-hand tactic that only optically improves credit quality in the near-term. “A modified loan appears when a bank takes an existing loan on its balance sheet (often one that is no longer paying) and alters the terms to keep the borrower from defaulting. Modifications usually take the form of an extension, temporary below-market interest rate, or an interest-only grace period. They help banks delay collateral repossession, but in doing so only push problems down the road. In past cycles, the re-default rate on modified loans was more than 50%. Despite such a high failure rate, banks utilize modifications, in part, because they instantly improve credit, as most institutions do not classify a modified loan as nonperforming. “Nowhere was this practice more evident than in the regional bank space...SunTrust Banks (STI) reported a 2.5% decline in non-performing loans (‘NPLs’) for the fourth quarter, and many analysts were quick to anoint this second consecutive quarter of improvement as an inflection point in the credit cycle. Consider though, that over the past two quarters, NPLs have declined by $101mm, but modified loans increased by $716mm! Still, shares of STI increased by 20% in January, despite losing $245 million for the quarter. TCF Financial (TCB) and Zions Bancorp (ZION) reported similar trends: modest increases in NPLs coupled with dramatically higher loan modifications... “With negative trends in commercial loan quality beginning to develop and loan modifications being used as a temporary crutch, we believe the banking sector is still facing meaningful credit losses over the upcoming years...” Beat the rush; sell bank stocks now. The Daily Reckoning Presents Invest in Aviation's Startling Growth Chris Mayer The economic center of gravity will not always reside in the United States. In fact, it’s already in the process of shifting from the US to Asia and the Middle East. Forward-looking investors cannot afford to ignore this trend. One of my favorite ways to invest in the rapidly growing emerging markets is through the back door, so to speak. Invest in companies, wherever they are, that have what these economies need or want, but don’t have. Airliner production is a classic example. I bet most Americans would be surprised to learn, for example, that the Middle East is a very important market for new jets. The Gulf’s leading airlines – Emirates (out of Dubai), Etihad (out of Abu Dhabi) and Qatar Airways have become big reasons why Boeing and Airbus make any money. “The Middle East is still the hub of aviation growth,” says Airbus CEO, Tom Enders. According to informed guesses, the Middle East will buy 1,400-1,700 planes over the next twenty years, at a cost of $240-300 billion. These planes will support passenger growth of nearly 5% annually over that timeframe. Many other developing nations around the globe are also becoming active buyers of passenger jets. Airbus just signed a $1.8 billion deal with Vietnam Airlines for four A380 super-jumbos and two A350s. Ethiopian Airlines recently put in an order for 12 A350s, at a cost of $3 billion. These are just two examples. The Asia-Pacific region, despite the impressive growth out of the Middle East, is still the largest buyer of aircraft. Over the next 20 years, for instance, the Asia-Pacific region will require close to 9,000 planes, at a cost of over $1 trillion. I’ve focused mostly on civil aviation. But there is also defense spending. In the Middle East, defense spending will probably rise to more than $100 billion by 2014, from only $36 billion now, according to a new study by consultancy Frost & Sullivan. That’s why Lockheed Martin recently announced it would double its capacity to produce the C-130 Super Hercules – because of increased demand from the Middle East. Also, I can’t end without saying a word about the world’s urge to lower carbon emissions. The industry has pledged to cut its carbon emissions in half by 2050 – an effort that will require new planes with lighter material, different design and innovative engines. Despite all the good news on the aviation front, there is a fly in the soup that Boeing and Airbus will have to fish out before long: They are having a hard time making the planes on time. This is a rather fascinating subject on its own, given the history of aviation. In 1944, for example, Boeing used to crank out 16 B-17 bombers every 24 hours. Today, it’s having a hard time producing one of its ballyhooed Dreamliners after more than two years of trying. Airbus has had its share of delays as well. Eventually, they’ll sort it out. Eventually, they will build the new planes. There are lots of ways to play on these ideas as an investor, as these new planes ripple through the supply chain. My favorites are the titanium producers. Titanium is a lightweight metal. In fact, it has the highest strength-to-weight ratio of any metal, making it ideal for aircraft. The newer planes are titanium intensive, more so than in the past. Our play here is Titanium Metals (NYSE:TIE), the second-largest producer of titanium in the world. It has a solid financial position with lots of cash and no debt. It’s stayed profitable, even through the slump. And Wall Street doesn’t expect much from it, as analysts rate the stock as a poor performer. The potential upside when it comes makes it worth hanging onto. In TIE’s heyday back in 2006, it was a $40 stock. Today, it’s about $13. All cycles turn, remember. And this one will, too. The company only recently signed a new agreement with Boeing that will keep it as a key supplier through 2015. Titanium Metals has the potential to be a big winner once the aviation cycle gets in full swing again. Regards, Chris Mayer for The Daily Reckoning Joel’s Note: As regular readers well know, Chris Mayer’s work is pretty much considered required reading around our various offices. 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