Everything and the Kitchen Sink
IMAGINE THAT YOU RECENTLY borrowed your friend’s car and now you can’t seem to find it. It wasn’t stolen, it wasn’t towed, you’ve simply misplaced it. You’re in trouble, and your friend is definitely going to be angry. Isn’t now the best time to also tell him any other bad news that he may have coming to him? He’s already mad, how much worse could it get? Apparently this rationale is also applied by some of the country’s largest companies.
In September at the Lehman Brothers’ Financial Services Conference, Citigroup’s CEO of North American consumer operations, Steven Freiberg, boasted, “Where you think there would be a fire — in our subprime portfolio — it actually looks pretty good.” He even provided a chart showing Citigroup’s industry-beating mortgage-delinquency stats.
Three weeks later, Citigroup announced that its third-quarter net income would fall roughly 60% from a year earlier, blaming “dislocations in the mortgage-backed securities and credit markets, and deterioration in the consumer credit environment.”
Apparently, “pretty good” in the current environment is “pretty dismal.”
Additionally, Citi disclosed that its securities and banking unit would be writing off $3.3 billion worth of losses — a large figure for even a megabank like Citi. This loss stems from its LBO-related leveraged loan commitments and the frozen CDO market.
The most troubling part of this preannouncement was the $2.6 billion increase in credit costs in Citi’s global consumer business. Of this figure, nearly $2 billion was an increase in Citi’s loan loss reserve. (The loan loss reserve account is a bank’s estimate of the losses it expects to take on its loan portfolio.) This large write-off was a clear message from Citi that the credit quality of its loans is deteriorating much faster than expected. To put Citi’s $2 billion allocation to loan losses in context, during the first and second quarters of 2007, Citi added just $646 million and $545 million, respectively, to its loan loss reserve account.
Many more dismal announcements from the banking industry were expected, and last week that’s exactly what we got. Merrill Lynch reported a $2.4 billion loss for the quarter following its massive write-downs. Merrill was the only one of the five largest investment banks to end the third quarter in the red. This was capped off by the retirement of CEO Stan O’Neal.
Once a major asset bubble pops — and the housing bubble was one of the largest asset bubbles of all time — the companies at the center of the mess usually try to take their lumps in a single quarter, often referred to as a “kitchen sink” quarter. By cramming losses and write-offs into a single quarter, they try to give Wall Street the impression that the bad news is out of the way and nothing but blue skies are ahead.
This game works very nicely sometimes…especially among gullible investors.
But “kitchen sink” quarters have an inconvenient way of recurring. It is improbable to believe, for example, that banks will be able to cram five years of reckless lending into a single quarter of write-offs. More likely, this quarter’s write-offs will begin a long-running trend.
“Kitchen sink” quarters will occur repeatedly in the financial sector, just like they did in the tech sector after the dot-com bust of 2000. Cisco, Intel and Corning reported a series of disappointing quarters.
The homebuilders are also playing the “kitchen sink” game, as Lennar and KB Home demonstrated in their most recent horrid results. Both of these homebuilders sliced large chunks off of their book values by writing off $848 million and $690 million worth of shareholder equity, respectively.
These massive write-offs illustrate how much raw land inflation and irrationally priced finished homes were hiding in the homebuilders’ inventory accounts. The most indebted homebuilders will likely experience some form of bankruptcy.
A little over a year ago, I wrote a Whiskey article entitled, “Are Homebuilder Stocks Actually Cheap ?” in which I warned that low price-to-earnings and price-to-book multiples were deceptive:
“After major declines, [homebuilder] stocks are trading for an average trailing P/E ratio of 4.7. This is incredibly cheap in the current market, but trailing earnings represent the very peak of the most speculative housing market in history (in other words, 2007 earnings are likely to decline significantly, making the forward P/E ratio potentially double or triple the trailing ratio). Your macro outlook for the housing market over the next couple of years will determine whether you think these stocks are bottoming or just pausing before another round of declines…
“The measure of book value for most homebuilders will be a moving target in the future, as further inventory charges and margin compression is very likely. So the argument that homebuilders are cheap rests on shaky accounting and extrapolation of the past into the future. That adds up to a ‘value trap,’ in my opinion.”
I see a similar value trap unfolding among the bank stocks. Most of the analysis I read doesn’t extend much beyond the parroted mantra: “Bank stocks are cheap on a price-to-earnings and price-to-book basis.” Citi’s earnings preannouncement reminds us that earnings and book values only reflect past results, not future results.
But for the moment, very few investors seem to fear the uncertainties of the future. So financial stocks have rallied on the garbage rationale that “bad economic news is cause for celebration because it will bring more interest rate cuts from the Fed.”
Unfortunately, negative surprises on bank balance sheets will far outweigh any benefits they receive from Fed rate cuts — benefits that tend to re-stimulate the credit creation process only after a very long time lag.
Finally, on the subject of recent Fed rate cuts, the financial markets are flashing many glaring signs that monetary inflation is spiraling out of control. And Fed Chairman Bernanke has received ample opportunities to establish his credentials as an inflation fighter. Despite gold and commodities soaring, and most global stock markets either approaching or blasting through July peaks, Bernanke has decided that federal rate cuts could not be put on hold any longer.
Last week the fed decided to cut interest rates by a quarter point in response to the credit and housing crises, and their potential to seep into other markets. The fed still has their eye on inflation, and has stated that further rate cuts should not be expected.
Indeed, if the dollar continues sinking — and commodities continue soaring — rate cuts may be on hold permanently…and that’s when the real carnage in the finance sector might begin.
Dan Amoss, CFA
November 5, 2007