Why There Is Still Risk Out There, Especially In Financials

Yesterday I commented on the technical reasons why the financials may rebound. Technical analysis is a self-fulfilling discipline. Because people/traders/computer models pay attention to it, understanding technical buy and sell signals can explain why the market may behave in certain ways. Yesterday's chart showed there are technical reasons for moving into financials.

I will also add that I started the post with this observation:

The fundamental side of the financials is terrible. For the last month or so we have seen bankruptcies, fund blow-ups and bail-outs.

Like an good economist or lawyer, I of course qualified my answer.

Here is one of the fundamental reasons that may effect the financials in the coming quarters:

As the leveraged buyout boom peaked earlier this year, large banks such as Citigroup (C) and JPMorgan Chase (JPM) indulged powerful private equity clients by granting them temporary equity, or bridge loans, to help fund the monster deals.

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In theory, a bridge loan is similar to a home buyer who takes out a short-term loan to cover the down payment, which he plans to repay as soon as he sells his current home. But what if the current home can't be resold? The lender can try to resell the loan, but as current market conditions suggest, that isn't always possible. Banks now face a similar quandary. They lent private equity firms hundreds of millions of dollars to use as equity in the buyouts. The bridge loans were supposed to be repaid as soon as the buyout firms found other investors who wanted an equity stake in the leveraged buyouts. But as market conditions have tightened, private equity firms have found it difficult to find investors to take some of the bridge loans from the banks. The banks can keep trying to sell the loans, a tough bet in the current market. Or they can keep them on their books—and possibly have to write down their value.

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JPMorgan and Citi declined to comment beyond their previous public statements. Bank of America (BAC) officials referred inquiries to the company's second-quarter conference call on July 19, during which executives declined to specify the bank's exposure.

The bottom line is there is a reason why traders have sold their financial shares over the last month or so. If you're reentering the financials, pay particular attention to their balance sheet.