Is the short covering rally over?

The day is almost over for the market (thank goodness) and it seems that financal service investors are in panic mode again. The market is down over 250 points and some shares in financial services are down over 15%. What gives?

As we may soon find out, non-market based economic solutions, like the infamous SEC list of 19, always have unintended consequences. After a great rally in financial shares of more than 50% to the upside, we are having another bruising day — and for no apparent reason. It seems likely we have just seen the end of a terrific short-covering rally.

Since the SEC has scared the shorts out of financials in order to prop the sector up, fewer investors are willing to buy bank shares when they fall. This means we could see some gapping down in financials on minimal signs of stress in the sector. That leaves the weaker financials exposed to bankruptcy.

Certainly, the awful home sales data has a lot to do with the selling as homebuilders like Lennar are off over 20% on the day. But, one month’s housing data does not a trend make. Another possible reason for today’s market selloff in financials in particular is rumors about Washington Mutual’s solvency.

Washington Mutual Inc. tumbled more than 20 percent for a second day as Gimme Credit LLC said unsecured creditors were “pulling funds” from the biggest U.S. savings and loan.

Gimme Credit analyst Kathleen Shanley cited the decline in federal funds purchased and commercial paper to $75 million from $2 billion at year-end, which Washington Mutual reported this week in its second-quarter results. Securities sold under agreements to repurchase dropped to $214 million from $4.1 billion at the end of 2007, she wrote.

Washington Mutual, known as WaMu, reported a $3.3 billion second-quarter loss on July 23. Rising delinquencies forced the Seattle-based company to boost provisions for bad loans. While WaMu said it has enough capital after raising more than $7 billion earlier this year, Shanley said liquidity remains a concern.

“We won’t use the phrase `run on the bank,’ but we would be remiss if we did not observe that many creditors have quietly been pulling funds,” wrote Shanley, based in Chicago. Their actions are “presenting an increasing funding challenge,” she wrote. Gimme Credit is an independent research firm serving corporate bond investors.

Bloomberg, 24 Jul 2008

Rumors don’t cause banks to implode. Inherent distrust and financial institution weakness do. Is anyone spreading rumor about Goldman or Credit Suisse? The ironic thing about this particularly ugly day is that Fannie and Freddie are both down over 15% when the government’s actions were suposed to stop selling pressure.

When selling pressure begins again in earnest, the weakest financial institutions will be exposed to downside pressure like never before — with no shorts to buy when their shares fall. A major financial sector bankruptcy will then be in the offing. And some home builders are sure to go down as well. These are some unintended consequences that are sure to anger taxpayers when the GSE and FDIC bills comes due.

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