Although Ben Bernanke’s promise to America that “major financial institutions will not be allowed to fail” does not mean that he’s betting on their collapse, it does, nevertheless, have serious implications for investors. As this crisis has taught the beginners and reminded the experts, full government backing of a financial institution does not always imply that the company’s common stock will make it out alive. As in the case of mortgage giants Fannie Mae (FNM) and Freddie Mac (FRE), as well as the world’s largest insurer of financial instruments, AIG (AIG), they have been lucky enough to obtain the “full faith and backing” of the U.S. government, but their common stock prices have virtually gone to zero.
Investors buying the stock of large financial institutions could easily find themselves in the same place: excited to hear the news that the company they just invested in will be rescued by the government, and then open up their portfolio to find the stock price down 80%. Professional investors and commentators spend hours writing articles and interviewing on TV about which of these financial institutions will survive. Each professional argues that the banks who survive will be severely undervalued and therefore offer tremendous upside potential for early investors. Though this may be true in a few select cases, picking winners in this environment is like throwing darts at a moving target: you could get a bulls eye, but most likely you’ll miss.
The reason so many investors will incorrectly choose the “winners” of the bank stocks, is because the U.S. government has not and will not apply a consistent strategy in backing these banks. In the recent case of Citigroup (C), once one of the world’s largest financial institutions, the company issued the government preferred stock in its first bailout, preferred stock again in its second bailout, but then in the third bailout allowed the government to convert $25 billion of preferred shares into common shares, significantly diluting the common shares and giving all investors a smaller piece of the pie. As each common share was then worth less, the stock price adjusted accordingly; it went down, significantly.
The Obama administration may continue throwing money at these banks through buying preferred shares, which the companies will have to reward with dividends, but will not dilute the common shareholders. However, in the next bailout package the company may issue them common shares. Or, they may realize the burden they are placing on future generations by issuing so much debt to finance their purchases, and they may allow the common shares to go to zero, the bondholders to absorb the losses, and then repackage these companies for public offerings after the market has turned around.
Investing in the financial stocks is like playing the roulette wheel. If your number hits there is a payout substantially greater than your original investment. However, the odds of that happening are not in your favor. There are so many other undervalued stocks in the market right now that will also see exponential gains if the banks recover. These stocks don’t poise the risk of the financials. As always, investors must analyze the risk-to-reward ratio of their investments before making them. In the case of most financials, there is a risk of nearly 100% loss. Does the potential reward outweigh that risk? Even if the reward could be 100% or 200% on your money, there are better ratios available right now.
As Warren Buffet has always preached, “Rule #1 about investing is don’t lose money. Rule #2 is to never forget rule #1”. The potential for significant loss, which will impact investors annual returns for years to come, is not worth the homerun that they might hit in the stock. Especially because those same homeruns will be hit in many other ballparks.