What the big banks aren't telling you -- yet
9/14/2007 12:01 AM ET
By Jon Markman
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 (WB), Washington Mutual (WM) and Bank of America (BAC), 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 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 (BSC) 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 will announce its earnings late next week, and since it has not yet pre-announced an earnings shortfall, we can only guess that Cayne and his team are administering hope and faith to the company's balance-sheet wounds -- and waiting for a big bandage from the Federal Reserve early next week 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.
Too harsh? Consider how bad business has been for these guys lately. The past 45 days have featured lower trading activity, lousy stock-trading results, falling bond prices, a plunging dollar, a virtually nonexistent mortgage business, scant investment-banking and mergers activity, stunted prime brokerage trading and a sharp slowdown in both initial public offerings and secondary stock offerings. There's also widespread suspicion that billions of dollars worth of their asset-backed securities are worthless.
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.
Two views on the monetary 'surge'
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 by 50 basis points or more next week 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. The best position to own will be the ProShares UltraShort Financials (SKF) 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.
Fine print
You've probably heard that September is historically not a very good month 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%.
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