Why I'm Not Buying the Financials

At 10am this morning, Evan Newmark stuck his neck out, with a blog entry entitled "Why I'm Buying the Financials". They were spiralling downwards nastily at the time, but obviously the piece had been written long before the market opened. And in any case, Newmark's a long-term investor:

Since early July, I have been building a position in XLF shares. My average cost is $19.70 a share. By Friday's market close, that put me down a buck a share, or just under 5%...
These are strange and volatile markets. But for most of the third quarter, the XLF has been steady ­bouncing between $18 and $22.
All I have to do is believe that the US financial-services industry will survive. That is why I lean toward the camp of the optimists.
Can the XLF go down further? Absolutely. Look how vulnerable Citigroup's stock was Friday. But how much further down? For the XLF a break down of more than 20% from Friday's close, would put it at less than $15.
This would probably indicate the total collapse of the U.S. financial system. And I just don't buy that.

The XLF closed at $17.80, which means Newmark's now down 10%. But never mind that -- as he says, he's a long-term investor. What are the real reasons not to buy financials right now, or, for that matter, any leveraged stocks?

1. You're hitting the most overpriced part of the capital structure. If you want to buy banks, buy their bonds. Or their sub debt. Or their preferred shares. Or their convertibles. Or just about anything, really, except for their equity. The stocks might look beaten-down to you, but they're actually much healthier than the bonds, which now offer the potential for healthy capital gains on top of their current high yields, if, as Newmark predicts, the financial-services industry will survive.
2. The banks haven't written down their assets to true mark-to-market levels, probably because if they did so they would violate minimum capital ratios and quite possibly be revealed to be insolvent. Insolvent banks can and do continue as going concerns -- but if I'm buying an insolvent bank, I want to know I'm buying an insolvent bank. Instead, we get lies.
3. If you thought the asset side of the balance sheet was bad, just wait till you see the liability side. Yes, banks have access to central bank liquidity facilities, although they hesitate to suck on that particular teat because of the stigma involved. But other financials, and other leveraged companies, can't tap the Fed. They have to fund themselves in the market. And that's pretty much an impossible thing to do, these days. If you find yourself -- just once -- incapable of rolling over your debt, then you have to liquidate. And what are the chances of any given company once being unable to roll over its debt, in this market? Pretty high, I'd say.
4. It's easy to get misled by the stock chart. Consider a comparison of Apple with GE. Let's say that Apple, with no debt and $20 a share in cash, goes from $200 a share to $100 a share. And let's say that GE, with $55 a share in debt and a negligible amount of cash, goes from $40 a share to $20 a share.
   On the face of it, they've both fallen the same amount: 50%. But Apple's enterprise value has fallen from $180 per share to $80 per share: a drop of 55%. While GE's enterprise value has fallen from $95 per share to $75 per share: a drop of just 20%.
   In other words, a large percentage fall in the stock price of a leveraged company is actually a much smaller event, in terms of what's happened to that company's total value, than an equally-large fall in the stock price of an unlevered company. If you want to go bottom-fishing right now, look to the companies without lots of debt. Not the companies with it.