By Jim Jubak | 2 October 2007
Citigroup's warning that profit fell 60% in the third quarter is just the start. The worst isn't over, and banks' mid-October earnings reports could be bad, bad, bad.
"We think the worst is definitely behind us," Sam Molinaro, the chief financial officer at Bear Stearns, told Wall Street analysts and investors during a company earnings conference call Sept. 20.
Wall Street would be happy if you believed that. The belief "the worst is over" in the crisis that panicked the financial markets in August and still hasn't let go of its death grip on the debt markets is the best hope that Wall Street's investment banks have of getting out of this mess with their skins intact.
But don't you believe it. There's not a chance the worst is over, and Wall Street knows it.
Wall Street knows the big investment banks that reported in mid-September aren't out of the woods. They all took relatively tiny write-offs— $700 million on the fixed-income portfolio at Bear Stearns, for example— on the damaged goods in their portfolios and, if they can't trade their way out of this mess, they've got more big losses to write off in the quarters ahead.
Will news be worse than bad?
Wall Street is afraid that the big banks still to report in mid-October could drop a bomb on the markets. Bank of America, JPMorgan Chase, Wachovia, Washington Mutual and Wells Fargo all report Oct. 17, 18 or 19.
The fear is that because these banks held on to more of the mortgages, credit card debt and buyout loans they packaged than the big investment houses did, they'll have more to write off. Citigroup, which reports officially Oct. 15, delivered a bomb last Monday, when it warned that earnings would fall by 60% for the third quarter as a result of a $1.3 billion write-down of its debt portfolio and $600 million in fixed-income trading losses.
Wall Street doesn't believe any of the banks have trading desks capable of generating profits from this meltdown as Goldman Sachs did, and the warning from Citigroup certainly won't make that fear go away.
The fear isn't that the quarterly reports from these banks will be bad— everyone knows that they will be— but that they'll be much worse than expected. So bad, perhaps, that someone will blurt out the message Wall Street doesn't want you to hear: "The worst isn't over."
And that, Wall Street fears, would be enough to spook the debt markets again and remove any hope that the big investment banks that created this mess will be able to dance their way out of it.
Will Merrill take a hit?
Now that Citigroup has announced a $2 billion drop in third-quarter profits, Wall Street’s worries shift to Merrill Lynch. The fear is that Merrill will show losses in its loan portfolios without making up the difference with trading gains.
Stock prices reflect doubts
Am I being too cynical? Surely, Wall Street executives wouldn't say one thing while they believe another, would they? Let's look at the price action in the shares of the big investment houses and the big banks in the days after Bear Stearns reported that the worst is over.
The financial markets breathed a sigh of relief that the third-quarter results reported in mid-September by Bear Stearns and Lehman Bros. weren't any worse. And Wall Street was shocked speechless when Goldman Sachs, a third big investment power in the asset-backed debt market, reported third-quarter earnings $1.76 a share above Wall Street estimates and up 88% from the third quarter of 2006.
But notice what's happened since then. No one has panicked and sold, but no one is snapping up these shares, either. Lehman Bros. climbed 10% on Sept. 19, the day after it announced earnings, but has given all of that back and then some.
Bear Stearns jumped all of 1% on its positive earnings news, gave all that back and more by Sept. 24, then shot up 7.5% on Sept. 27 on rumors, since debunked, that Warren Buffett was interested in buying a stake in the company. Goldman Sachs actually fell the day it announced its phenomenal earnings news, but it climbed 5.5% between Sept. 19 and 27.
And the big banks still to report? For the Sept. 19-27 period, they were down 1.6% to 6.4%:
| Bank | Sept. 19 price | Sept. 27 price | % change |
$64.11 | $62.42 | -2.6% | |
$115.64 | $122.60 | 6.0% | |
$205.50 | $216.84 | 5.5% | |
$51.07 | $50.27 | -1.6% | |
$48.27 | $46.88 | -2.9% | |
$47.57 | $46.21 | -2.9% | |
$51.91 | $50.66 | -2.4% | |
$38.32 | $35.87 | -6.4% | |
$37.30 | $36.02 | -3.4% |
That's hardly the kind of relief rally you'd expect if the worst were over. And that performance is especially anemic considering the Federal Reserve cut short-term interest rates by a half-point Sept. 18, unleashing a rally in much of the rest of the market.
Banks make more money when interest rates fall, and their net interest margins go up. So these stocks had reason to rally. That they didn't is testimony to the fear that something will blow up in mid-October.
What's happening at Lehman Bros.
What's the basis of that fear? To understand why Wall Street isn't ready to relax, take a look not at the top-line results reported by an investment bank such as Lehman Bros. but at what the company did— and didn't do— to get to "better than expected" results announced Sept. 18:
- $700 million. That's a big number. It's the size of the write-down that Lehman took in the third quarter on its portfolio of leveraged loan commitments and investments backed by residential mortgages.
- $6.3 billion. That's a bigger number. It's the size of Lehman's subprime-mortgage inventory at the end of its quarter Aug. 31. Lehman's big write-down amounts to just about 11% of the subprime-mortgage paper in its inventory. Remember that rising delinquencies and defaults by credit-challenged home buyers has been a major cause of the panic that has rattled debt markets around the world.
- $22 billion. That's an even bigger number. It's the size of Lehman's portfolio of Level 3 assets at the end of the second quarter. Level 3 assets are those that trade so infrequently that there are no reliable market prices for them. Valuations for Level 3 assets— which include exactly the securitized packages of subprime mortgages, buyout loans and other debt that have plunged in value at some financial firms by 20% or more in a month— are set not by market prices but internal calculations at Lehman and other financial companies. In other words, the prices of Level 3 assets are subject to management judgment. The $700 million write-down by Lehman is just 3.2% of the total Level 3 assets at the company.
Lehman may turn out to be right not to have written off more of the value of this portfolio. The panic prices of the past two months may indeed bounce back, and these assets may indeed be worth exactly what Lehman's fair-value calculations say they are. But by no means is it possible to say, as company Chief Financial Officer Chris O'Meara said during the conference call, that the worst of the debt markets' dislocation is behind us.
Bank of America's troubles
Now let's see how one of the big banks due to report in a couple of weeks, Bank of America, compares to Lehman in these areas.
If you dig through the footnotes to Bank of America's second quarter 10-Q filing with the Securities and Exchange Commission, you find that the bank had just about the same amount of Level 3 assets at the end of June as Lehman Bros. did: $21.6 billion at B of A to $22 billion at Lehman. And you'll see that the value of these assets— remember this is the fair value calculated internally— has declined this year, and that decrease in value seems to be accelerating.
Bank of America recorded an unrealized loss for the Level 3 assets of $748 million for the first six months of the year. Of that six-month loss, $148 million took place in the first quarter, and a whopping $601 million occurred in the quarter that ended June 30.
Clearly, the bank's Level 3 assets are under stress. In addition to its $21.6 billion in Level 3 assets, it [also] has a whopping $609 billion in Level 2 assets, where there may be market activity, but valuations often depend on internal valuation models in the absence of quoted prices. Only $64 billion of Bank of America's assets fall into Level 1, where valuations are set by quoted prices.
Is there the raw material here for a write-off as big as Lehman's? Sure. Would a write-off as big as Lehman's mean the worst is behind the bank? No way. Could investors get a nasty surprise when Bank of America reports? Absolutely. Especially because the average investor doesn't realize how exposed a big bank like this one is to the crumbling market for buyout loans.
Billions and billions to worry about
Lenders, including banks and investment banks, went into July on the hook for about $330 billion in loans to finance buyout deals. In ordinary times, the lenders would have held on to a relatively small portion of these loans and sold off the rest to other investors. But these aren't ordinary times, and the market to syndicate these loans has just about dried up for lack of buyers. That has sent Wall Street dancing in anxiety.
It's one thing to act as the facilitator for a $26 billion deal— such as the troubled buyout of First Data— earning a fee and keeping a billion or two in loans on the books as a kicker, and it's something entirely different to be on the hook for the entire $26 billion. Or to have to take 95 cents on the dollar or even less to get other investors to buy these loans, which is what Wall Street has had to do in a couple of recent deals.
So who are the biggest fish on this hook? The usual suspects, of course. Lehman for $16 billion, Bear Stearns for $9 billion and, in the whale category, Goldman Sachs for $20 billion.
And some surprising names: Citigroup, Bank of America and Deutsche Bank. Each of these had a piece of more buyout deals over $2 billion in size— 11, 11 and 13, respectively— than did Goldman Sachs (with nine), according to a recent count by The New York Times.
Think there might be a surprise in there somewhere? That's exactly what Wall Street is worried about. Because then those companies would really have to mark down the price of all that Level 3 paper they're still holding.
Editor's note: A new Jubak's Journal is posted every Tuesday and Friday. Recommendations in Jubak's Picks are for a 12— to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend Stocks for Income Investors. For picks with a truly long-term perspective, see Jubak's 50 Best Stocks in the World or Future Fantastic 50 Portfolio. E-mail Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equity mentioned in this column: Ito En and SiRF Technology Holdings. He did not own short positions in any stock mentioned in this column.
What the big banks aren't telling you— yet
By Jon Markman | 14 September 2007
The third quarter could end up as the worst in the past decade for the financial-services industry, but you wouldn't know it from the earnings forecasts. The banks are in denial.
With credit markets still largely frozen, unemployment rising and major corporate expenditures slowing to a halt, every indication suggests that a surprising number of major financial firms, including Wachovia, Washington Mutual and Bank of America, will come up short of expectations in October, kicking off an unpleasant autumn for investors.
Investors need to care more about financial stocks than any others because they make up more than 20% of the broad market indexes. So let's get some clarity on exactly what they're facing.
At the moment, the estimated growth rate for all S&P 500 Index ($INX) companies in the third quarter is clocking in at 5.1%. That's down sharply from the 6.2% growth rate estimated two months ago and half last year's growth rate. The funny thing is that most of those downward revisions of estimates have come in the industrial, consumer staples and retail sectors of the economy. Yet the financial industry, which has undoubtedly experienced the worst business shortfall, has barely received any material earnings-estimate cuts yet.
You could see that as great news if you're a glass-is-half-full kind of person. But it could also be interpreted as absolutely nuts. At the moment, I am inclined toward the latter and think it's emblematic of an entire industry that is whistling past the graveyard. Bank and brokerage chief executives such as Jimmy Cayne at Bear Stearns and Ken Thompson at Wachovia appear to have mesmerized industry analysts into a state of total denial. Or it could be they've had their mouths taped shut by attorneys afraid that any premature announcements, positive or negative, might get them into trouble with securities regulators and plaintiff lawyers now studying their loan books for misdeeds.
Before they take down the entire market this fall by shocking Wall Street with unexpected losses, I suggest that they brush aside their attorneys and media handlers and come clean. They need to tell the world about the reality of their home lending and loan securitization teams' failures of the past four years— and the truth about the toxic paper that they've flushed into the world economic system, or stuffed into Enron-like off-balance sheet entities— before the markets make them walk the plank.
Crime and punishment
In interviews and public appearances, these guys and their peers have made modest mea culpas, to be sure, but always end up pointing the finger elsewhere. They have asked for another chance in the future but have not admitted or illuminated past blunders.
Bear Stearns announced its earnings [as down 62% in 3Q], it [had] not yet pre-announced an earnings shortfall [as of the date of this original report], we can only guess that Cayne and his team [were] administering hope and faith to the company's balance-sheet wounds— and waiting for a big bandage from the Federal Reserve to help cover things up.
This reticence in the face of danger is ringing out like an alarm bell to big investors, who have already knocked financial stocks down by 25% or more but could easily land another round of blows. And these companies will deserve it. Since government regulators and Congress have flinched from their responsibility to administer "tough love" with rules forcing financial institutions to detail the creation, securitization and disposition of every ill-conceived subprime loan, off-balance sheet "structured investment vehicle," secretive money-market "conduit" and commercial-paper-financing vehicle, the market will do it with a vengeance.
- The Fed seems determined to ride to the rescue of banks and the stock market. But don't expect to benefit personally from any interest-rate cut, says MSN Money's Jim Jubak. Instead, count on higher bank fees.
Add to this slippery stew the fact that the past few years' efforts to acquire rivals has led to higher fixed costs without added income, and you must consider the possibility that the third quarter could end up as the worst in the past decade for the financial-services industry.
Gimme shock treatment
And yet earnings estimates are still relatively lofty? Are they kidding us? Bulls will say that all of these problems are already reflected in share prices, but you know they said the same thing about the home-building companies a few months back. Despite their already pummeled status, it's not unreasonable to expect another leg down for financials this fall— just like the home builders have had repeated punches in the gut after it already seemed like the worst was over.
Last week, it's true, I raised the possibility that aggressive, coordinated, rapid action by the Federal Reserve, the Bush administration and Congress could lead to a massive bailout of distressed property owners before the 2008 election— a monetary "surge" to match the troop surge in Iraq this year. Yet neither the industry nor the administration have proved themselves capable of smart, aggressive action on any topic, much less the most complicated financial mess of all time— so a sudden revival of financials' fortunes seems as remote as peace in Baghdad.
As government officials and bank officers have dragged their feet— deploying misplaced faith in the Fed as their main weapon— the investment world has become divided into two camps:
- Optimists think the "real" global industrial economy is so robust, driven by insatiable Asian demand, that it cannot be driven off track by some dinky problem with subprime mortgages in California and Florida. They think every sell-off is a buying opportunity and that all ailments can be fixed by prudent, measured liquidity injections by an accommodating Fed. This point of view accounts for rallies like the one on Sept. 11.
- Pessimists think that the financial "plumbing" that underlies the global economy has become hopelessly clogged and is much too complicated to fix merely by trying to flood it with more money. They believe that a dysfunctional financial system will lead inevitably to cracks in the optimists' idealized "real" economy, preventing businesses from being financed. They point to evidence the trillion-dollar market for a type of corporate short-term debt known as commercial paper has frozen, as investors who would normally buy it without question are afraid that it is fatally tainted with hidden pockets of broken mortgage loans. They further point out that the Fed cannot rescue the market, as the trouble with bad paper extends to Europe and Asia, where central banks are actually still raising rates.
How will these divergent views be reconciled? I think that slowly but surely, the optimists and pessimists will merge into a consensus dominated by skepticism and anger. My guess is that financial stocks will suffer through the end of the year unless the Fed applies shock treatment to the financial system by slashing the federal funds rates [further] and joining hands with their European counterparts to do the same.
Without coordinated action, the dollar will be crushed, foreign investors will come to U.S. markets simply to borrow cheaply and invest elsewhere in higher-yielding currencies, U.S. economic growth will remain stagnant, more layoffs will ensue, and we'll see a spike in inflation to boot. In that case, the best position to own will be the ProShares UltraShort Financials exchange-traded fund, which supplies twice the inverse action of the Dow Jones Financials Index.
In short, the only real way out of this mess is the hardest. Financial executives need to bare their souls and balance sheets, let bad loans default and permit companies and individuals that took inappropriate risks to go under. Only after the true value of assets are laid open for all to see will the financial institutions reach fair value and we can move on.
You've probably heard that September [and October are] historically not very good month[s] for stocks. But just to throw some more fuel on the fire, it turns out that in the eighth years of decades (those ending with 7) they're especially bad.
Logical Information Machines asked its database: How has the Dow performed in September and October in years that end with the digit seven? The answer: According to the 11 previous occurrences, the Dow has shown a strong bearish edge that peaks on Oct. 31. The Dow has declined from the first week of the month forward by 38 trading days in 10 of the 11 cases since the late 1800s by an average of 12.1%. The one rally provided a gain of 3.8%.
The overall return of the 11 cases is minus 10.6%, which, if it were to transpire now, would result in a Dow of 11,723 by the end of next month. The 1987 crash is included in the results, of course, but there are also several other years, especially early in the Dow's history, when there were double-digit declines. History is not destiny, however, so hopefully this fate will be avoided in 2007.
Normxxx
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The contents of any third-party letters/reports above do not necessarily reflect the opinions or viewpoint of normxxx. They are provided for informational/educational purposes only.
The content of any message or post by normxxx anywhere on this site is not to be construed as constituting market or investment advice. Such is intended for educational purposes only. Individuals should always consult with their own advisors for specific investment advice.
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