What the big banks aren't telling you -- yet

By Jon Markman

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, news, msgs), Washington Mutual (WM, news, msgs) and Bank of America (BAC, news, msgs), 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 (BSC, news, msgs) 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.

Continued: Two views on the monetary 'surge'

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