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Bad Times, Bad Companies: More Finance Industry

Time to re-visit some confessionals. In case you didn't notice the recent market rally was driven by the Financials ! Of all things. And they were driven by better than expected earnings, i.e. smaller than disastrous write-offs and terrible but not catastrophic impacts to their bottomlines. Unfortunately when you actually start parsing the news instead of reading the newswires PR announcements a slightly different set of pictures emerges. But let's start with this "simple", by our standards, little chart of the Finance ETF, XLF. On the "since Oct" chart the recent runup was huge IOHO - more even than the April surprise when it was all over. When you look at the 10-day chart you get the more granular anatomy and that it's starting to fade. Hopefully as some semblance of reality fades in. It hardly took a day, or less than, for the talking heads to get trotted out to talk about "worst is over" again and the time to be investigating putting money to work in the financials was now. One of the readings you'll see excerpted is about Bill Miller - the most exemplary fund manager of legend of the last two decades - who got completely trimmed up by large and bad bets on just that thesis. What happened ? Well for one thing let's remind ourselves of the arguments from the last post about what constitutes a good company (Bad Times, Good Companies: Who's Swimming Naked). And then suggest that we're looking at bad times for bad companies.

 Economic Consequences

 But, before pursuing that, you need to think about the consequences which are complex, convoluted but ultimately not surprising. When banks start writing off big numbers they take big hits on their capital and have less to loan. When they think the economic situation isn't good they tighten up lending standards. The end results is that credit gets scarcer and the economy experiences more down-pressure. Which gets reflected in interest rates and the money supply. Which is worsened in a credit crisis by elevated rates as risks are re-priced. All of which you see in this chart. On the top the 3Mo spread between Treasuries and Financial commercial paper remain at elevated levels while the spread between higher quality and more risky corporate bonds does as well. The really fascinating, puzzling and scary thing is that the spread between very short-term Fed Funds and 10Yr Treasuries has widened out enormously. That usually only happens when the economy is booming, there's a serious fear of inflation or rates are getting driven up by exchange rate pressures. Almost none of that seems to be the problem right now though. The middle chart shows the YoY% growth in the inflation-adjusted monetary base - and it's approx. 3.5% and returning to a downtrend. In other words despite a slowing economy, very low Fed rates and everything else that should be mitigating things credit is drying up at a serious rate. And it's NOT inflation as you can see on the bottom which compares core CPI to the spread between TIPs and 10YRs. The biggest, most astute and biggest bettors in the world don't see inflation as a problem. After parsing all the puts and takes we end up with a metastasizing credit crunch slowly oozing its' way/weight thru the economy. And you wondered why mortgage rates were jumping !

Business Implications & Inferences

Returning to contemplate the XLF jump leaves one more than a bit puzzled. Here's a set of hypothesis that you might want to kick around.

1. The Fed thru magic, innovation and cojones has created enough instruments to provide technical tools to address the credit crisis but we're still faced with the consequences of bad business decisions and a slowing economy. At least we're not facing collapse as we were in March.

2. The Financials have "merely" worked their way thru the immediate consequences of the crisis, not the crunch. As the economy slows the "credit death spiral" we've talked about before will start working it's way on their balance sheets, losses and loss provisions. With attendant impacts on profit and credit availability. IN other words this still has a long way to go. AmExp's results should be reviewed for the reality check.

3. None of this is/was being factored into the market's thinking on the financials....otherwise we shouldn't have seen a bounce.

4. Another thing we've talked about is broken business models, the strategic consequences of de-leveraging and the need to fundamental re-think all the major banking/finance segments for future prospects when leverage gets driven to a more rational 10X or less from the 20-30X that many were depending on for profits.

5. While several commentators have noted this from Charlie Gasparino to Bill Gross it would appear to not be being reflected in much of anyone's real thinking or investing. We refer you to Jim Jubak's recent column (today ?) on the terrible outlook for several major financials. In his and our estimation this is going to take years to re-engineer. And nobody is facing that music that we can tell. On any front.

We'll refer you back to a prior post (Red Sky Mornings, Investor Take Warning: More Finance Industry) for more graphics and discussion of leverage vs business models vs breakage. But if you don't look at much else please take a moment and consider these two CNBC vidclips:

  • Getting Back to the Basics The future of Wall Street lies in its simpler sleeker past, says George Ball, Sanders Morris Harris Group.
  • Merrill's Comeback Man CNBC's Charlie Gasparino takes a look at the executive who helped Merrill Lynch raise billions in new capital seven months ago.

UPDATE: One of the great recent discovers I"ve made is how truly balanced and sensible the Canadian Business News Network is. More on that later but for now here's a very recent clip outlining why a sensible sounding sr. investor thinks it's time to get back into Financials:

As it happens I continue to disagree with him for all the reasons discussed but his reasoning would be reasonable if we were in normal times. Nonetheless he's clear, articulate and intelligent interviewed. A real pleasure to listen to !! 

Finance Industry Problems 

How Bad Will It Get on Wall Street? July's rat-a-tat-tat of dismal news suggests that the scope of the credit crunch is much broader than most people thought. Traders, investors, bankers, and economists are waking up to the possibility that Wall Street's recovery from the worst financial disaster since the Great Depression could grind on for years. And they're realizing that while the debacle was of Wall Street's making, its aftermath will weigh on banks, other companies, and consumers alike. One thing is for sure: The new normal won't be as fun as the recent past. Banks will be smaller and fewer. Capital will be harder to get for some consumers and companies. And more of that capital will be parceled out by lightly regulated hedge funds and private equity firms, for better or worse, as the balance of power on Wall Street shifts. Why hasn't the healing begun? The answer lies in the mechanics of leverage, or borrowed money, which banks not only provide to customers but also use themselves. Leverage is a powerful but dangerous tool, intoxicating on the way up and devastating on the way down. Banks live on the stuff: When they post profits, they borrow more money to make more loans and book still more profits. During the boom, bigger mortgage loans pumped up home prices until people couldn't handle the debt and the bubble burst. Then the banks, poorer from the losses, had to cut back their own borrowing, too. Now the damage is spreading. How far? Simplified, for every dollar of bank wealth lost, government-regulated commercial banks must eliminate some $10 of lending; for investment banks, the figure can be $30. The extent of the credit contraction to come will depend on the banks' initial losses—an elusive figure, to be sure, and one that keeps growing. The latest loss tally is $400 billion across the credit markets, but the International Monetary Fund says the total could swell to $1 trillion. Slap on a leverage multiplier of 10 or 15, and the math turns grim.

Even More Writedowns Coming Yes, we've turned the corner, out of the woods, always darkest before the dawn. What -- whats that you say? More writedowns? More bad loans? Yes, we know the market has correctly anticipated that. Worse? Even worse than the market expects? How can that be? Its already in the tens of billions? But the earnings have been posh! Its the 9th inning for heaven's sake! Wait -- you mean to say that Bank of America's reported write-downs of only $1.22B for ‘market disruptions’ -- more than 50% lower than the $2.81B ‘market disruptions’ write-down in Q1 -- wasn't the whole story? What about Countrywide, whose results weren't part of Bank of America's figures? We have a plan, you see, to keep more of the bad stuff off of our books: "Bankers who've been briefed by BAC officials tell The IRA that CEO Ken Lewis intends to keep the crippled thrift holding company "bankruptcy remote" by merging CFC with a new vehicle, called Red Oak Merger Corp in the merger plan, and that BAC does not intend to consolidate the entity or take full responsibility for the CFC debt." You can do that? Buy the corporate assets, but stiff the bond holders on the debt? How does THAT work?

Investors question financial sector rebound Surprisingly large second-quarter losses at Wachovia Corp. and Washington Mutual Inc. have quickly revived concerns that the financial sector still has a long way to go before it recovers from the year-old credit crisis. Investors who were growing optimistic after a string of upbeat bank results in recent days were jolted Tuesday when Wachovia, the nation's fourth-largest bank, racked up an $8.86 billion loss because of charges and reserves for bad mortgage loans. The Charlotte-based bank also cut its dividend for the second time this year and eliminated 10,750 positions. Washington Mutual, the nation's largest savings and loan, delivered a further blow, swinging to a $3.33 billion loss as it boosted its loan loss reserve to more than $8 billion, betting it will have more soured mortgages. Both companies warned of steep cost cuts -- Wachovia said it was eliminating 10,750, positions, including those held by 6,350 current workers. Seattle-based WaMu said it would be cutting up to $1 billion in expenses by the end of 2009. And several regional banks also posted losses Tuesday or said their profits fell. "Wachovia's news isn't isolated. I think there is still a structural issue with U.S. banks," said Russell Walker, a risk management professor at the Kellogg School of Management at Northwestern University. "Many of the banks, including Wachovia, are still facing challenges."

Top Fund Managers Socked by Bank Bets A two-day rally aside, the beating that financial stocks have taken lately have knocked out some top money managers and their brand-name mutual funds. No champ has endured more pain than Bill Miller of Legg Mason Value Trust (LMVTX). Until 2006, Miller held the distinction of beating the S&P 500 for 15 consecutive calendar years, but lately the fund has struggled. Last year, LMVT fell nearly 7%, while the S&P finished up more than 5%. Even after losing 20% in the first quarter, Miller wrote to shareholders that he thought the worst was over.If only that were true: as of Wednesday's close, Miller's fund is down 41% year-over-year, according to Morningstar. The S&P 500 is down 18% over the same period. Since Miller is also the chief investment officer for Legg Mason, his stock picks have weighed on many of the firm's funds. Miller bought Countrywide even as the company unraveled, and his top ten holdings at the end of June included Citigroup (C, Fortune 500), off 43% year-to-date, JPMorgan Chase, and Aetna.One bright spot: Miller lowered his exposure to Freddie Mac in the second quarter. On the other hand, his other big holdings include Amazon and UnitedHealth. See the graphic at right for the performance of Miller's top holdings.Miller, whose fund still holds $9.7 billion in assets, isn't suffering alone. Several top funds whose managers loaded up on financial stocks when they were booming before the credit crunch hit a year ago have taken a beating.

5 big losers in the banking crisis These financial companies have suffered serious, long-term damage to their businesses. They may not be going under, but their futures look grim. Right now every time a bank announces earnings that aren't quite as bad as Wall Street expected, its stock rallies. That market action actually makes a kind of perverse sense. These stocks have been beaten up so badly that any news that signals something less than the end of the world is good news. Citigroup shares were down 49% from the start of 2008 to the beginning of the July rally in financials. Bank of America shares were down 53%. These train wrecks make a great short-term trade -- if you can catch the bounce and avoid the next tumble. But in the long term, I think it's a very different story. The stocks that have taken the biggest beatings from the financial crisis are exactly those you want to avoid -- for anything other than a short-term trade -- because these companies have suffered large and lasting damage to their businesses. They aren't going under in most cases, but they will lose markets and market share to other, less damaged competitors. Some will wind up being sold to their rivals. What I'm going to call the losers of the financial sector have lost key people. They've had to sell off what once were key business units. They're undergoing reorganizations that will take years and will continue to distract management until they're completed. And, most important, because of their troubles, they're falling behind competitors that have been investing billions to seize new markets and lock up new customers instead of writing off billions in losses. Buy these beaten-up stocks for the bounce, by all means -- if you can get the timing right. But remember that these financial companies have suffered lasting damage, making them long-term losers. Which financial companies would I put among the losers? Here are five, in alphabetical order.

Interest Rate Derivatives Indicate Bank Funding Difficulties Will Persist Interest-rate derivatives traders are increasingly betting that banks' difficulties shoring up balance sheets won't abate this year. The difference, or spread, between the dollar London interbank offered rate and the overnight index swap rate on contracts trading in the forwards market reached all-time highs this week, according to data tracked by Lehman Brothers Holdings Inc. The spread is an indirect measure of the availability of funds in the money market and of banks' willingness to lend. Forwards signal what traders expect in the future. Investors weren't reassured after Treasury Secretary Henry Paulson's announced plans this week to help rescue Fannie Mae and Freddie Mac, the largest U.S. mortgage lenders. Investors are also wary bank failures may spread after the collapse of IndyMac Bancorp Inc. earlier this month.

  • Analysts Back Off Dire Bank Predictions After the FDIC took over IndyMac, the analyst community was quick to point out banks that could be the next big failures. Today, however, they're backing off their aggressive predictions, reports CNBC's Jane Wells.

Tornadoes Hit Insurers With Worst Profits Since '02 on Shrinking Premiums Record tornado damages, the weakening economy and a drop in premiums may reduce insurers' earnings by 30 percent, the steepest second-quarter decline since 2002. The industry's slump in profits is worse than all 24 groups in the Standard & Poor's 500 Index except for banks, financial- services firms and automobile companies, analysts surveyed by Bloomberg said. Sixteen of 20 insurers in the S&P 500, led by American International Group Inc. and Allstate Corp., may report lower net income or a loss. Losses from catastrophes, including the most tornadoes in the U.S. since at least 1950, were about $5.5 billion. At the same time, investment returns and opportunities to sell residential and corporate coverage declined as the economy slowed and home sales dropped. The estimated decline in profit, the most since earnings per share fell about 45 percent in 2002, may be driven by tornado losses at insurers such as Allstate, lower investment returns for companies like AIG and falling rates at commercial insurers including Travelers Cos., said Paul Newsome, an analyst at Sandler O'Neill & Partners in Chicago. ``You rarely get all three of those factors at once,'' Newsome said.

Check Banks' Provisions Big loan-loss provisions may be hurting banks' income statements today, but earnings could soar when credit quality starts to recover. The quandary for investors is assessing which banks will clean up their credit problems the quickest.

Blackstone Risks Return From Hedge Funds as Bank Lending for LBOs Dries Up When Blackstone Group LP, the world's biggest buyout firm, was pursuing the takeover of the Weather Channel cable network earlier this month with General Electric Co. and Bain Capital LLC, Wall Street balked at providing financing. So the New York-based company turned to GSO Capital Partners LP, the hedge-fund manager it acquired in March, to pull off the largest U.S. leveraged buyout this year. Blackstone can't wait for banks, stuck with almost $100 billion of debt from earlier LBOs, to start lending again. Instead, it's pushing deeper into deal financing with GSO. The strategy may hurt the hedge-fund unit's returns -- some approaching 40 percent -- if slowing economies lead companies taken private by Blackstone to default on their debt. The $153.9 billion of announced buyouts this year is down more than 70 percent from the same point in 2007, according to data compiled by Bloomberg. Lenders and debt investors pulled out of the LBO market last August as losses mounted on subprime- mortgage securities. Blackstone must rely more on non-buyout businesses such as restructuring advice and hedge funds as private-equity fees plunge. Its hedge-fund unit, which also includes proprietary funds and fund-of-funds, rose to $56.6 billion in the first quarter, making it the firm's largest unit by assets. Blackstone, which oversees $113.5 billion, has lost 44 percent of market value since it went public at $31 a share in June 2007.

American Express Profit Drops 37% as More Cardholders Default; Shares Fall American Express Co., the biggest U.S. credit-card company by purchases, withdrew its 2008 earnings forecast after second-quarter profit fell 37 percent on worse-than-expected consumer defaults. The shares slumped 11 percent in extended trading. Profit from continuing operations declined to $655 million, or 56 cents a share, from $1.04 billion, or 86 cents a year earlier, the company said today in a statement. The average estimate of 17 analysts surveyed by Bloomberg was 82 cents. American Express said it added $600 million before taxes to reserves for U.S. loan losses. ``By almost any measure, the U.S. economy and business environment are much weaker than the assumptions'' the company had in January, Chief Executive Officer Kenneth Chenault said today in a conference call. ``Unemployment rates took the largest jump in over twenty years. Home prices declined at the fastest rate in decades and consumer confidence is at one of its all-time low points.'' The U.S. economic slowdown worsened in June, affecting even American Express's wealthier cardholders with high credit scores, Chenault, 57, said in the call. Late and uncollectible loans were higher than expectations in the quarter and will rise as the year progresses, Chenault said. The U.S. lost 62,000 jobs in June, the sixth straight period of shrinking payrolls. AmEx: "Super Prime" Problems, American Express feels consumers' pain

Posted by dblwyo on July 25, 2008 01:50 PM |

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