Financial Armageddon

In "Goldman Sachs: The "Smart" Money?!" I called attention to the fact that the banks team at one of Wall Street's best known firms has not exactly been on target with its calls on the sector (e.g., they were negative when the stocks were trading at their lows).

However, one firm that has been ahead of the curve as far as financial sector realities are concerned is Institutional Risk Analytics (IRA), which specializes in providing "customized risk management solutions and advisory services to global enterprises."

As it happens, Yahoo! Finance's Tech Ticker yesterday featured an interview with a principal of IRA, entitled "The "Real" Economy Is Dying: Q4 "Going to Be a Bloodbath," Whalen Says," in which he expressed views that were in marked contrast to those of the gang that couldn't rate straight.

Stocks rallied to start the week thanks to a better-than-expected ISM services sector report and a Goldman Sachs upgrade of big banks, including Wells Fargo, Comerica and Capital One.

But all is not right in either the economy or the banking sector, according to Christopher Whalen, managing director at Institutional Risk Analytics. In fact, Whalen says most observers are drawing the wrong economic conclusions from the stock market's robust rally.

"Why is liquidity going into the financial sector? It's because the real economy is dying [and] everyone is fleeing into the stocks and bonds because they're liquid at the moment," Whalen says. "That's not a good sign."

The banking sector's assets shrunk by about $300 billion per quarter in the first half of 2009, a sign of banks hoarding cash in anticipation of additional future losses, according to Whalen. "The real economy is shrinking because of a lack of credit."

The shrinkage will continue into 2010, Whalen predicts, suggesting the banking sector hasn't yet seen the peak in loan losses. Institutional Risk Analytics forecasts the FDIC will ultimately need $300 billion to $400 billion to recoup losses to its bank insurance fund. (In other words, the $45 billion the FDIC sought to raise last week by asking banks to prepay fees is just a drop in the bucket.)

"Investors should think about this because the fourth quarter in the banking industry is going to be a bloodbath," says Whalen, who believes smaller and regional banks like Hudson City Bancorp may come into favor vs. larger peers, which have dramatically outperformed since the March lows.

"When you see the markets rallying when the real economy is shrinking that tells you this [recovery] is not going to be very enduring," Whalen says.

In this regard, Whalen finds himself in philosophical agreement with Nouriel Roubini, George Soros and Meredith Whitney, among other "prophets of the apocalypse" who've once again been raising red flags in recent days.

Click here to view the online video of Tech Ticker's interview with Chris Whalen.