"We think the worst is definitely behind us," Sam Molinaro, the chief financial officer at Bear Stearns (BSC, news, msgs), 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 (BAC, news, msgs), JPMorgan Chase (JPM, news, msgs), Wachovia (WB, news, msgs), Washington Mutual (WM, news, msgs) and Wells Fargo (WFC, news, msgs) 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 (C, news, msgs), which reports officially Oct. 15, delivered a bomb 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.
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. (LEH, news, msgs) weren't any worse. And Wall Street was shocked speechless when Goldman Sachs (GS, news, msgs), 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.
Video on MSN Money
Jubak’s Journal: 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.
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.
Continued: What's happening at Lehman Bros.
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.
Video on MSN Money
Jubak’s Journal: 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.
Clearly, the bank's Level 3 assets are under stress. In addition to its $21.6 billion in Level 3 assets, it 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 (FDC, news, msgs) -- 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 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 (DB, news, msgs). 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.
Continued: Developments on past columns
Developments on past columns
"Can tech stocks spark a 2007 rally?": The Sept. 27 upgrade to "outperform" from "neutral" by Credit Suisse (target price $24, up from $18) has kept the rally going for SiRF Technology Holdings (SIRF, news, msgs). Since a low on Aug. 31, shares are up 37%. Nothing really has changed in the company's story, but share prices are now behaving as if investors believed it.The company had said that sales to Motorola (MOT, news, msgs) would kick in during the third quarter after delays at Motorola's wireless-phone business. The company had also announced a significant win in the European market for its GSM, or Global System for Mobile communications, wireless phones. All this should reward investors in the fourth quarter who stuck with this stock through the hard times in the first half of the year. As of Oct. 2, I'm keeping my target price at $34.50 a share by December 2007. (Full disclosure: I own shares of SiRF Technology Holdings in my personal portfolio.)
"10 stocks for 2007 and beyond": It's been hard for U.S. investors to tell exactly what they hold in the month since Ito En (ITOEF, news, msgs) issued 0.3 share of preferred stock (yield 1.8%) for each share of common stock on Sept. 4. It's been hard to price the stock, and rumors ran riot about whether or not a U.S. investor could sell the preferred shares. But thanks to reader Mike Frantz, we have all the details straight from the company itself.
Frantz e-mailed Ito En in Japan with the following questions: "I am located in the United States and own 130 shares of ITOEF. I now also own 39 shares of your preferred stock, although I am told this is not currently traded in the United States. The representative at ITO EN (in New York) mentioned that I either need to own 100 shares of the preferred stock for these to have any marketable value, or I need to give up these shares at zero value. I am unwilling to give up the preferred shares since the value of ITOEF value declined substantially after the '0.3 preferred share for each regular share' announcement was made."
And Toru Akimoto of the Ito En investor relations department answered: "Thank you for your e-mail.
"I am sorry for the delay in replying to your questions. ITO EN buys back odd-lot preferred shares. Please tell your custodian bank's standing proxy in Japan who holds the preferred shares in your behalf to ask our custody bank (The Chuo-Mitsui Trust and Banking Co.).
"Purchase price of your preferred shares will be the closing price of the day when our custody bank deals with the document. You can check the price of preferred shares by hitting '25935 Equity' on Bloomberg. If you would like to purchase 61 more shares, please tell your custodian bank to do so after Nov. 1. But we cannot sell you such shares if we do not have enough shares."
I hope that clarifies the status of Ito En preferred stock, and thanks to Mike Frantz for tracking down the answers.
Video on MSN Money
Jubak’s Journal: 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.
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.