As someone who has been quite negative on financial sector for as long as I can remember, and as someone who has thus largely avoided the immense pain caused by falling for the "deep value" (also now as low P/E) argument of permanent financial bulls like Bill Miller, I have been able to patiently stay on the sidelines until very recently. As most of the readers noticed, several weeks ago I've taken a contrarian short position in the Ultra Short Financials ETF and enjoyed a 50%+ profit since then.

Let's start with explaining the logic behind my decision. Using a little bit of imagination one can think of the entire US financial sector situation as being very similar to a hypothetical encounter of a herd of sheep (financial sector players) and a pack of wolfs (hedge funds, short sellers, permanent "doom and gloomers" like Roubini etc). This encounter so far has been proceeding in accordance with the basic rules of nature- wolfs (short sellers) have very methodically focused their attention on the weakest sheep in the group by taking them out one at a time.

They have clearly defined their targets (Ambac and MBIA, followed by Bear Sterns, Lehman, WaMu, AIG, Wachovia and most recently Citigroup) and have employed a very effective "tried and true" strategy of:

1. Separating the weakest member of the group (usually easily identifiable by sky rocketing short interest and increasingly negative media (especially blog) headlines)
2. Hunting him/her down (forcing the stock price into the single digit territory thus triggering a run by clients and trading counterparties)
3. Enjoying the ensuing feast (just look at all the media attention gathered over the last 12 months by David Einhorn, Meredith Whitney and Noriel Roubini)

But as a direct result of their success, this wolf pack has not only grown in size exponentially (everyone and their mother now believes that shorting financials is the most "bullet proof" investment strategy out there), but have also increased their overall confidence to a point where most of its members are now predicting that every bank in the herd will eventually fail. This field of financial sector "bears" now looks just way too crowded and way too emotionally committed to their argument to rationally change their mind. This by itself is a pretty bullish sign as it will likely lead to a massive short covering rally at some point.

While being realistic about the severity and length of the current recession, and readily acknowledging that hundreds of smaller banks are still likely to fail, I now believe that massive declines in the large cap financial players valuations, combined with government's determination to help out utilizing whatever means necessary and the misguided focus on the part of too many short sellers on the wrong next "weak target"- BofA, have finally made "betting on the large cap financial sector players" rebound much more profitable opportunity.

Why BofA was chosen as the next target? I don't really know as it does not make sense to me. Bank of America is one of the very few banks that has actually stayed profitable through all the recent turmoil, and while it is quite possible that they might report a negative quarter sometime during the next 12 months, not a single analyst is projecting today that BofA will make less money in 2009 than they are projected to make for 2008.

Let's make it clear- it is very possible and actually likely, that BofA will be forced to reduce its common stock dividend or will be forced to sell their strategic equity stakes in Chinese and Brazilian Banks instead of diluting common stock shareholders until the stock price moves back above $20 a share. But while the multibillion dollar "in potential writedowns" speculative headlines from many media outlets in the country keep pouring in, there is one very important detail many of the critics forget- as third quarter results have shown, Bank of America has an important ability to absorb astounding $6.5 in credit loss provisions each quarter ($26B on an annualized basis) while still reporting a $1B+ profit.

Also, because current charge offs have been running lower than loss provisions, BofA has added $2B+ more to reserves during the most recent quarter alone, and now has more than $20B in total, which means that BofA's earnings will actually start stabilizing and turning well before the economy turns for the better because charge offs are still running behind provisions today.

Does it mean that Ken Lewis and Co will be able to avoid posting at least one negative quarter especially after accounting for all the upcoming restructuring charges and layoffs? I honestly doubt it. Loss provisions are still likely to head higher in the short run and will stay elevated for at least two more quarters. And the continued disparity in the spread between Fed Funds and Libor could another multi hundred million dollar hit during the current quarter, but despite all the short term negatives, it is quite clear that BofA is not Citigroup, Wachovia or WaMu. It has made money consistently, has a very valuable "safe" brand, competent management, valuable equity stakes China and Brazil and no huge exposure to deadly "credit default" swap derivatives.

It also has very limited exposure to the now "infamous" off balance sheet investment vehicles (estimated by Meredith Whitney to be around $70B+ vs. $1.2T for the Citigroup), and despite all the negative headlines about logic behind its purchase of Countrywide, one needs to note that this acquisition was actually accretive to BofA's earnings during the third quarter. Short sellers also seem to forget that BofA bought CFC because of its recurring and predictable mortgage servicing revenue stream, and has written down many of the purchased mortgage assets at the time of the actual transaction, which I turn means additional losses from CFC's mortgage portfolio should be somewhat limited. Plus with Federal Reserve determined to reduce mortgage rates recently, BofA should benefit disproportionately from the all-but-inevitable pick up in refinancing volumes.

And last but not least - acquisition of Merrill Lynch. I wholeheartedly agree that BofA has very likely overpaid for MER, but given the fact that transaction was an all-stock deal, one would expect MER to write down even more of their assets to at least their book value (which by the way is almost 50% higher than current purchase price) which should limit pain for the BofA shareholders. Plus I think that the actual strategic rationale behind the MER purchase is a very solid one, and with cost synergies potentially reaching $7B+, BofA's franchise normalized earning potential could easily approach $10B a quarter once the economy stabilizes.

All-in-all, I believe that Ken Lewis has a decent shot of fighting off the short sellers and thus avoiding the next government bailout. Yesterday's run up in price could mean that short sellers are finally giving up on running them into ground, this should in turn stop the deadly cycle of runs on the large US financial institutions, and signal that the bottom in the financial sector has been finally hit in November.

And while I am somewhat optimistic that has been the case, another government injection of any sort into BofA would be a big negative, because in my opinion it could very easily lead to another run on the two remaining titans- JPM and WFC, which would in turn lead to the eventual nationalization of the entire domestic financial services industry.

Stay safe out there and e-mail me at skepticalcapitalist@gmail.com