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S&P500 ex-Risk ?

Tuesday, November 06, 2007 | 06:48 AM

Here's an issue I have been mulling over, without a satisfactory answer:

There have been many investment thesis (thesii?) over the past few years about the market which supported the bullish side of the ledger: Earnings were high, stocks were cheap, risk was moderate, the Fed model favored stocks over bonds.

Regardless of whether you found these arguments persuasive or not, global markets have gone higher. While the U.S. indices may have lagged the rest of the world's bourses, they too, have powered higher.

Here's the odd factor: It turns out that many of the arguments made in favor of U.S. domestic growth have been based on an assumption that turned out to be false. To wit: The Financials, the largest sector in the S&P500, had legitimate, sustainable, normalized risk-based earnings.

That basic premise turned out to be wrong.

Picture a race car driver, going way too fast in the first half of a track. He puts up record breaking lap times, only to crash and burn in the last turn. His driving coach would say his risk-adjusted speeds were irresponsible.

That's how I perceive what has been going on with the Financial sector. It wasn't Fraud, but rather a reckless disregard for Risk that led to outsized returns on many big cap stocks in the group.

Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC -- there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately. (UPDATE: Morgan Stanley (MS) now rumored to take a $3-6B writedown)

What's truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades -- not years -- of profits to be wiped out.

To paraphrase the WSJ, "the financial crisis is becoming Shakespearean comedy."

So here's the odd question that I have been wrestling with: Given what we now know about how the true nature of the S&P500 earnings in this group, what did the past few years of data actually look like? Now that the big Banks have erased nearly all of their earnings of the past few years, what should that data have looked like from 2003-2007 with most of the Fins as a goose egg?

I would like to see historical data adjusted for the S&P500 for the Financial sector's losses. Specifically, if we back out the earnings that turned out to be based on a reckless disregard for risk, what does the following data look like?

• What were year-over-year Earnings?

• How cheap were stocks really?

• What were the actual risk adjusted returns?

• Were stocks as undervalued as the Fed model suggested?

Consider our race car driver from before. If he fails to finish the lap, his time gets voided. Any Financial compan's earnings are a function of measured risk versus potential reward. If earnings turn out to be based on far greater risk than assumed, and subsequent losses offset them -- i.e., they are not sustainable -- they too have been voided.

Question for our mathematics wizard readers: Can we figure out an easy way to take the historical data, and adjust these reckless risk-based earnings, now that they have been wiped out?

I don't know the answer to these questions -- but they certainly are food for thought . . .

Sources:
Markets fear banks have $1 trillion in toxic debt
Sean O’Grady
The Independent, 06 November 2007
http://news.independent.co.uk/business/news/article3132507.ece

Why Street Bankers Get Away With Repeating Old Mistakes
DENNIS K. BERMAN
WSJ, November 6, 2007; Page C1
http://online.wsj.com/article/SB119431284681383384.html

Fears intensify for prolonged turmoil
FT Reporters
November 5 2007 21:27 |
http://www.ft.com/cms/s/0/4cd5c262-8bd6-11dc-af4d-0000779fd2ac.html

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Tracked on Nov 6, 2007 4:26:10 PM

Comments

Stocks are set to rebound today, and the economy's looking better than ever. I read that on the news this morning. What on earth are -you- talking about?

Posted by: CR | Nov 6, 2007 7:37:57 AM

The plural of thesis would be theses.

Posted by: rjrj | Nov 6, 2007 7:42:20 AM

BR:
Your post implies that an $8 billion accounting writedown is equivalent to $8 billion in profits, and thus they offset in your view of the situation. However, as was noted on the Citi call yesterday, these writedowns are not cash outflows, they are simply accounting adjustments. These ABS are still generating cash flow in-line with expectations (downward adjustments will occur, but not at the magnitude that an ABX index would imply).

This is one reason why Citi doesn't have to cut the dividend. The writedowns are simply accounting entries, not actual cash flow hits. As a result, I don't think $1 of cash earnings would be equivalent to $1 in CDO writedowns, as in your example.

Posted by: Chad Brand | Nov 6, 2007 7:48:41 AM

Barry, I do think what the financials have been doing is out and out fraud. I wish I could use Level 3 accounting to count the value of my assets...don't you?

Posted by: dukes | Nov 6, 2007 7:53:36 AM

BR, Is this really a useful exercise? Would you do the same thing for commodity driven stocks where their earnings were "inflated" due to commodity prices being high that subsequently collapsed?

Also, the previously reported "income" that showed up in the income statements were due to fees. The losses experienced are asset valuation writedowns--balance sheet items. You'd have to do the same thing for homebuilders. A bit of apples/oranges.

Posted by: Leisa | Nov 6, 2007 7:59:29 AM

It erased 5 years of profits in the sense that most of those profits were also just accounting adjustments, not cash. The cash-flow citi has certainly does help them, but those "accounting adjustments" significantly affect their capital ratios and their ratings thereby jeopardizing their dividend. I don't think you were listening to the same CC as I, because it was actually quite scary, and the market agreed.

Posted by: RichardN | Nov 6, 2007 8:03:43 AM

@chad brand: If you are marking your assets to market prices, these prices reflect the discounted value of their cashflows (if you beleive in financial theory of market values).
this assumes the writedown is actually anticipating a future loss.
however, one could say the ABS are UNDERVALUED at their current market value, then one should buy them (as one could argue, chinese equities are overvalued).

So those writdowns anticipate the cash-flow losses in the future.....it's just paper money, but if markets turn out to be right, the cash flows will be missing in the future.....

thank you, IFRS mark to market, the greates bubble generating accounting sceme invented

Posted by: Gustav | Nov 6, 2007 8:04:59 AM

As with the presumably dead driver, analysis of his recklessness will help neither him nor the spectators (other drivers might take heed - but then again, they apparently understood the risk before coming onto the track).

P.S: Autopsy of the driver woud confirm that he had beeen smoking crack and drinking martinis prior to and during the race.

Posted by: Marcus Aurelius | Nov 6, 2007 8:07:23 AM

Very interesting Barry.

Posted by: shrek | Nov 6, 2007 8:08:41 AM

Chad - I agree on your write down thesis. No money gone, just the ability to buy something with #'s in an account.

BR - The Fed and the general system has been forcing folks to gamble in markets. Add pay to play. But IMO working class folks only have time to deposit in savings accounts for a guaranteed return for the later years when the body is worn out.

Chad - What were they buying? Cheap labor in foreign lands. Domestic companies play'g the game and struggling. Consolidate then Break-up ... for those #'s.

Posted by: Greg0658 | Nov 6, 2007 8:10:10 AM

I have to agree. Since 1990 financials have moved from a 8% weighting as a percentage of the S&P 500 to a 21% weighting with profit margins in the sector jumping from 6% to 14%. I would give equal credit for the jumps to deregulation and increased risk appetite.

Posted by: Will G | Nov 6, 2007 8:11:19 AM

ps - fast moving trade in this thread

My personal conundrum - I was always hoping for Unity in the World and balanced living standards abroad, but home community 1st please.

Posted by: Greg0658 | Nov 6, 2007 8:18:57 AM

by: Chad Brand | Nov 6, 2007 7:48:41 AM

- is absolutely correct.

99 % of market participants don't understand that these are non-cash charges that dramatically overestimate the risk to cash flow.

Posted by: GST | Nov 6, 2007 8:27:46 AM

Barry,

I think that you're describing an awful lot of work - it might seem do-able at first if you limit the analysis to the dedicated home lenders, investment banks, etc. but I think the problems scale substantially when you start expanding the "extraction" process into the holders of the debt (hedge funds, non-primary home lenders, etc.) How much of this kind of debt holding would be enough to exclude a company from the index? Worse, this is the kind of thing that you really have to mine the footnotes in dozens, if not hundreds, of annual reports to discover the full scope.

There might be an easier way to do this. Over it's history, there's been a remarkably strong correlation between the S&P 500's index price and dividends per share, particularly in the modern age (since 1952).

If you accept that dividends represent the portion of earnings that the S&P component companies believe to be "sustainable", there's a pretty straightforward mathematical relationship between the two while the market is in what passes for an equilibrium growth phase:

P = Po * D^R

Here, Po is the effective value of the S&P 500 index with zero dividends per share, D is Dividends per Share (over the preceding 12 months) and R is the ratio of the average growth rate of index value to the average growth rate of dividends per share, which is fairly constant during these phases. P would be the average monthly price per share of the index (the index value).

The current growth period that began in June 2003 with the end of the bubble. Po is 121.74, R is 0.7574 (being less than 1, this indicates that the dividend growth rate has been faster than the growth rate of stock prices), and through September 2007, dividends per share for the S&P 500 is 27.06.

Assuming the growth phase for stocks is fairly broad-based, if you can anticipate how the financials might change their dividends (which affects both the dividends and dividend growth rate), you can use this relationship to anticipate where the S&P 500 index will go.

Otherwise, expect the market to continue tracking on its current course, absent serious (and highly disruptive) disturbances.

Posted by: Ironman | Nov 6, 2007 8:32:48 AM

I think going back and readjusting what were projected earnings before is an exercise in futility. It does not change anything. It is just psychologically comforting for the perennial pessimists, who can now claim that they were right all along.
The entire return vs. risk scenario is basically very simple. In order to earn a return over the risk free rate you have to assume risk. There is no way around that. And risk means the possibility of a real tangible loss. In some cases the loss may be big enough that it really hurts.
So the perennial bulls have to suck up one of those biting losses every now and again. It is just the nature of the financial markets.

Posted by: Werner Merthens | Nov 6, 2007 8:38:13 AM

It may be difficult to restate past profits in accordance with level 2 level 3 abscond accounting from the banks (assets value are estimated in accordance with the banks management opinion please read "there is no market matching their prices".
As far as I am concerned the net assets value is the only method to assess the banks.
It is to be read very often that central banks in their capacity of Banks supervisors are not able to assess the banks.It is harder to back value date their level 2/3 past profits and actual profits

Posted by: Philippe | Nov 6, 2007 8:38:19 AM

To the unbelievably naive people who think Chad makes a good point and to Chad:

There are two sides to the balance sheet. Clearly you do not understand this. When you write down assets, you are not miraculously able to write down your liabs, too. You cannot say, "Hey, I borrowed $100B to finance $100B of bullshit assets. Gee, now those assets are worth 10% less so I'm going to write them down. Awesome! I can write the liabs funding those assets down, too." You cannot do that, folks. That is NOT how it works. You take a hit to equity. Why? Because A = L + OE. If your A's get smoked, you better believe your OE is going to get smoked, too. That is a HUGE deal, folks, that is why people are puking their bank and b/d shares. In short, the assets on the balance sheet of MANY of these fins are totally mismarked. TOTALLY. And when I see Maria Bartiromo bullshitting on CNBS with a bunch of dumbass talking heads about "Gee, is it time to buy the fins yet?" I want to puke. Let me reiterate: the assets on these firm's balance sheets are STILL mismarked. Ask yourself this: "Gee, Citi's Level 3 assets jumped to $135B last quarter. How do I feel about that?" Mark-to-mystery assets are not a good thing, folks. Asset QUALITY will continue to erode as defaults on home mortgages continue to ramp up, and the ramp in write-offs (write-oofs?) will continue as all the b.s. borrowers have a come-to-Jesus moment and realize their ability to pay off their now-underwater home loan is ZERO.

Want to know the best part? According to ISI, a significant portion of defaults in the mortgage space are NOT due to ARM resets (yet). That's right, people are defaulting now because they cannot pay the TEASER rate. Think about that. Also, consider thinking about what the reset curve looks like for vanilla ARMs and option ARMs in 2008 and 2009. Just wait. The horror show for the banks is just beginning.

P.S. BR, MER's $8B writedown is equivalent to only FY06's total PnL, not five year's worth. I believe the "five year's worth" we heard bandied about relates to 5 years of fixed-income PnL.

Posted by: Vega | Nov 6, 2007 8:52:35 AM

Citi takes a write down. I must pass thru the income statement and wind up as a charge against equity. Not a cash charge for sure. Perversly reducing equity increases the future return on equity. Value players, anyone anyone?
Just follow Dick Bove's lead. He is one smart cookie.

Posted by: Ross | Nov 6, 2007 8:54:52 AM

At least now the bulls are getting their "multiple expansion"

Posted by: s0mebody | Nov 6, 2007 8:55:13 AM

If I understand the sentiment presented, the banks are marking these assets to a fair estimated value based on cash flow, while the markets that trades these assets are wrong?

However, many of these products were financed and refinanced with short term loans.

The problem it seems is twofold: first, the assets backing these products is falling in value, so the package itself was originally mispriced; second, the default/foreclosure rate is much higher than anticipated, meaning risk, too, was mispriced.

The banks seem to be saying that if we can hold onto these assets long enough, we can reduce our losses, while the markets seem to say otherwise.

With a home inventory glut continuing to plut downward pressure on home prices and ARM resets pressuring default rates, it doesn't appear that these assets will recover anytime soon.

So if you are depending on short term loans to refinance, who is going to lend on an asset whose value is doubtful? And if you can't refinance....

So I think the argument is right...up to a point. The real losses will occur when the products have to be liquidated in the markets.

Posted by: Winston Munn | Nov 6, 2007 9:04:21 AM

I have skimmed these posts, so I apologize if this point was made already.

Citi and all banks are in the leverage business. When capital is decreased for any reason, the amount of assets the bank can support will decrease by the amount of capital times the equity multiplier. So, there is a substantial opportunity cost even though there may not be an immediate cash flow loss.

Posted by: The Dirty Mac | Nov 6, 2007 9:13:28 AM

I like the analogy, and to advance it one more step. All the bonus money paid during the time the car and driver were in the straight away are gone for good. There is no claw back as car and driver are crashed in the turn.

Same happened during internet bubble, similiar happened with Enron.

The good times aren't that good and the insiders know it, so they cash out. This and NOT Martha Stewart type insider trading is a problem.

Posted by: Michael Donnelly | Nov 6, 2007 9:31:05 AM

Umm, I thought the money was mostly made from the securitization and custodial fees, not from cash flows associated with HOLDING these bullshit derivatives. Income from the fees is REAL, and does count.

Isn't this the halmark of the IB business model? Find new and innovative ways of repackaging and reselling....never have to actually hold on to the toxic waste. What we are seeing IS the worst case scenario. The music stopped...the lights came on...and the IB's crap conveyor belts grinded to a halt.

Anyway I think it's wrong to look at it as erasing past earnings. It only affects future earnings expectations, and I thought that what stock prices are supposed to mirror.

Posted by: Kp | Nov 6, 2007 9:38:47 AM

I think my point would be to focus on whether or not the ABX index, at today's quote, really reflects what will wind up being the true "present value of future cash flows from the MBS." If you believe the markets are efficient right now, then yes, you would disagree with my prior point above.

I would argue, however, that a subprime loan index like the ABX trading at 18 cents on the dollar when subprime delinquency rates are in the 30% range (this is just the last number I saw, it could be off) might indicate that writing assets down based on current market prices might proof inaccurate. Do we really think 88% of subprime will default? Even if we say 50% will, the ABX isn't indicative of reality.

Nobody knows where the numbers will wind up, but I can certainly understand why the banks aren't rushing to mark everything they have down to zero or 18 cents on the dollar.

Posted by: Chad Brand | Nov 6, 2007 9:41:06 AM

Nobody knows where the numbers will wind up, but I can certainly understand why the banks aren't rushing to mark everything they have down to zero or 18 cents on the dollar.

Posted by: Chad Brand | Nov 6, 2007 9:42:24 AM

Barry,

The financials contributed x% (30+?) of S&P earnings, therefore, real S&P earnings were actually smaller by that percentage 9whatever it was -- I'm estimating between 20-30%).

Therefore, the real P/E of the index was much higher than actually claimed and stocks were not nearly as cheap as advertised.

When you buy stocks when they're expensive, you tend to not get good results over time. . . .

Posted by: Scott Frew | Nov 6, 2007 9:46:08 AM

To puker vega:

Your analysis is as good as the totally erroneous “five year's worth” in this post.

You don’t understand Chad’s point, because you don’t understand the difference between cash flow and ‘asset marks’.

Read the comment following yours.

Posted by: GST | Nov 6, 2007 9:49:49 AM

Posted by: Chad Brand | Nov 6, 2007 9:42:24 AM

- again is exactly correct. The ABX is way off likely cash flow realizations.

Posted by: GST | Nov 6, 2007 9:56:23 AM

Here is the Level 3 assets to equity ratio summary:

(Courtesy of Roubini's Blog)

Citigroup 105%

Goldman Sachs 185%

Morgan Stanley 251%

Bear Stearns 154%

Lehman Brothers 159%

Merrill Lynch 38%

This becomes very interesting now, doesn't it?

Looks to me like Goldman Sachs and Morgan Stanley are by far in the WORST situation among the investment banks.

And yet the media is focusing all of their attention on Merrill Lynch---which actually has by far THE LEAST EXPOSURE of all of them. What a joke.

Posted by: spcwby | Nov 6, 2007 9:58:17 AM

Does'nt matter how you paraphrase it however the banks are increasingly using words that do not really equate to what they are doing.

The bottom line is that a "write down"= some measurable and equity changing loss.

No other way to look at it, you can parse it any way you like (the banks and brokers are spending millions of dollars just so YOU understand that a write down is "different" than a loss). And the best part about it is that they are trying, yet again, to put some gift wrap on it and present it to you as another opportunity.......

Banks/Brokers are scumbags that lie at every opportunity they have. Because out country is financially ignorant they get away with telling you that a write down is not a loss and people actually (in this thread) believe it.

But wait...this is only really starting. What happens in Q2 '08 when Merrill can't blame O'Neal for the continuing "write-downs" or Citigroup who can't blame Prince for it either. These brokers get one qtr "free pass" so that they can blame the ex CEO's. After that what do they do???

A loss is a loss NO MATTER how you gift wrap it.

Ciao
MS

Posted by: michael schumacher | Nov 6, 2007 10:00:45 AM

Chad, you don't understand how ABS works if you think 88% of subprime mortgages have to default to wipe out the BBB- tranche of a mortgage backed security.

Further, you definitely don't understand how CDO's work. Once the BBB- tranche of MBS defaults, all the mezzanine CDO's, which are collections of BBB- tranches of MBS repackaged magically into 80% AAA CDO securities, will start to face downgrades (or already have).

Posted by: joe | Nov 6, 2007 10:10:05 AM

I'm with Barry and Vega. If you retain your earnings to capital and then subsequently write down some other asset, it's the same as if those earnings never occurred.

What will really be interesting is when all this gets extrapolated to GDP.

Posted by: MikeinMT | Nov 6, 2007 10:11:32 AM

Cash flow is king and I understand what is a non-cash charge (ex: write-offs and depreciation) but the bill does come due at some point if capital is vaporized, no? The Liability side of the B/S increases which will require more of the cash flow directed to pay off the cost of carrying those liabilities (higher interest expense). At the same time, the cash inflow from the overvalued assets will decrease. Therefore, a bank will have to tie up more capital in non-cash inflow generating activities so while these are non-cash charges, if they become sizable enough to cripple the capital base then we have a problem Houston. Also, dividends are paid out of retained earnings, so what do you think happens if a company has big write-downs and less capital to return to shareholders? Am I missing something here? I'm not saying Citi is going under but I think balance sheets are far from healthy across the sector at a time when loan growth is slowing (residential mortgages are just the start).

Posted by: Lloyd | Nov 6, 2007 10:21:24 AM

Don't have to be a math wizard to generate a wild-assed guess:

Losses per Bill Gross: $250 billion (others say $400 billion)

NIPA annual corporate profits: ~$1,600 billion

Can't immediately find exact number, but S&P 500 profits are on the order of $600 billion.

Banks are around 25% of the S&P.

So as a WAG about 1-2 years' bank profits got wiped out, about 1-2 quarters S&P profits.

So if you go back 6 years to 2001 when the insanity kicked off, figure bank earnings could have been 15-30% too high, S&P 4-8%.

Disregarding the losses they were able to fob off on MBS buyers.

Posted by: drucev | Nov 6, 2007 10:21:48 AM

i think this is the critical point. if this were a capital-only business, i agree completely that writedowns on this scale would not be a big deal, and that cash flow in time -- even if it doesn't even approach previous expectations, which is guaranteed in the case of much of this level 3 cdo-squared trash -- would repair their balance sheet and keep banks like citi in a tenable position.

unfortunately, that is not the case. citi is levered after these writedowns something like 20:1. the five IB are collectively levered closer to 35:1. continued writedowns are going to force the banks to regurgitate assets in an effort to raise capital, even in an environment of regulatory forebearance. and because of liquidity issues, they will probably have to sell their better assets -- the reliable cash flow generators -- at a discount.

THIS is the problem facing the banks, and why looking at their current cash flow as proof of concept is probably a fool's game.

the $64 question: given the extended condition of all the banks at once, who buys these assets? and if there aren't enough capital-strong buyers -- and it seems guaranteed that there are not, outside of governments -- do the sales force a deflationary liquidation in which asset sales force prices down so quickly that further writedowns (this time on even strong assets) outpace capital building?

Posted by: gaius marius | Nov 6, 2007 10:32:14 AM

--------

"theses"

From The Kirk Report:

"Meanwhile, analysts currently project earnings growth to be in the 9% range over the next three quarters. Either that expectation is too high or the economy is doing a lot better now."

http://www.thekirkreport.com/2007/11/a-forward-looki.html

Posted by: Grodge | Nov 6, 2007 10:32:38 AM

any exercise in realizing the "loss" should also focus on companies who have booked profits and then had an accounting "issue"(like Dell's share price EVER adjusted to reflect the known chicanery going on with it) that basically removes that gain from the books however it never seems to affect the share price much since it's being "properly accounted" for on the books but not in reality.

What you are asking to do (the realization of perceived gains and losses) will never have a definitive answer because the market does not work in a linear fashion.....it's really only presented in that way....much like a loss is not a loss but a "write down"

LOL

Ciao
MS

Posted by: michael schumacher | Nov 6, 2007 10:32:41 AM

chad, that depends on loss severity as well as default rate.

if a pool of mortgages sees a 30% default rate and loss severity of 50% on those defaults, 15% of the capital is gone, as well as 30% of the income stream.

now of you're in the AAA tranches of that loan pool, perhaps you're still okay.

if you're in the lower-grade tranches though, you won't see any income and your capital is gone. and those are the tranches that are selling for 18 cents. that price is in fact probably too high for what the securities are actually worth, imo.

Posted by: gaius marius | Nov 6, 2007 10:41:46 AM

GST, there is a distinction I make between the impact on CF from Ops and the health of the balance sheet. It doesn't matter if cash flow is not affected. The fact of the matter is that when you take a write-off like Citi did, that hit flows through both sides of the balance sheet. That is a big deal, that's why people think bank stocks are bogus. Do you think through the magic of accounting that I can take a loss today on money I supposedly "made" last year and not have an impact on the level of that money I already "made" that's stored on the balance sheet in the form of equity? You can't write down the liabs (you've borrowed $X from whoever, they demand you repay them $X), but you've written down the assets, so now you take a hit to equity because that's how accounting works. And when your write down your equity / retained earnings, you better believe that is something to take note of. People who watch that sort of thing (equity levels in relation to assets) have solvency in mind. That's the issue here. At what point did the money LTCM owe banks dwarf the value of assets those liabs funded? That's the dance Prince was dancing, that is the dance Citi continues to dance. Sure, the amount of the hit may be an add-back to CF from Ops, but that does not mean the company is better off or even in the same position fiscally as it was prior to the write-down. Again, equity has been impaired. Leverage / capital ratios, debt covs, etc., are all impacted. To say that the "write-down" is a non-event because they are "just asset marks" is like saying the Dolphins don't suck "just because they haven't won a game." Asset marks are what matter for Citi and all the other banks now. Their ability to fund those assets is totally dependent on the integrity of their marks. Look at CFC and WM. The pool of capital willing to suspend disbelief in stated asset marks at those companies seems to shrink daily.

Posted by: Vega | Nov 6, 2007 10:44:27 AM

and i might further note, some have noted that loss recovery in much of subprime is not going to make it to 50%, thanks to declining prices, long reo holding times and considerable legal delays and expenses. and further, default rates of 30% are being seen before rate resets have truly become an issue.

does anyone think the level 3 stuff has been marked to the eventuality of 70% loss severity and 50% default rates?

Posted by: gaius marius | Nov 6, 2007 10:47:01 AM

But -- isn't a "relentless disregard for risk" just another way of saying that a large number of people preyed on the greed of others, by creating investment vehicles and performing acts which weren't illegal only because they hadn't been done in that specific way before?

And that we're sort of hosed now because the basis for the Market has become a massive exercise in ass-covering and debt-juggling? Which could reasonably be referred to as Fraud?

Nah; that couldn't be it.

Posted by: Mongo | Nov 6, 2007 10:48:30 AM

gaius marius, the Level 3 stuff is wildly mismarked. Most banks are marking their CDOs at about 80 cents on the dollar, probably anywhere from 50% to 75% above where they could sell them if forced to.

Here's the rub: Through the magic of a rising real estate market, banks chose to fund an asinine amount of loans that are now not going to be repaid. That's a fact. The problem is, the banks borrowed money to make those loans. Now the loans are worth a lot less AND the banks are having trouble funding them on their balance sheet. So what happens when that funding goes in reverse? I'll tell you what happens: banks, funds, EVERYBODY comes to the conclusion that they cannot carry as many loans (assets) on their books because they cannot fund those loans. So slowly but surely banks and funds unload the assets to a pool of buyers that shrinks daily. The pool of buyers is shrinking because the money to buy those loans is shrinking. So you've got $X trillion in loans that people want to get rid of because they can't fund them any more. Sure, most mortgages have a real life of about 10 years. So if you hold your paper for ten years you'll probably make more than many of the ABX indices imply. But the fact of the matter is that the ABX indices trade at a discount because the funding will not be there for the whole ten year useful life of a typical mortgage. That will of course change by the time NOBODY wants to loan ANYBODY ANYTHING. Trust me, it's happened before and it will happen again.

Posted by: Vega | Nov 6, 2007 11:01:09 AM

Uh...safety in the bond market? Insurance?

Well, your mileage may vary.....

The $2.5 trillion bond insurance problem
Tue Nov 6, 2007 10:28am EST

By James Saft

LONDON (Reuters) - Bond insurance, a key safety net of the financial system, is looking vulnerable, raising the possibility of another round of forced sales, writedowns and contagion.

Fitch Ratings said on Tuesday that it may cut the AAA ratings of bond insurers after an upcoming review of their exposure to complex collateralized debt obligations.

This matters a lot, because the bond insurance companies, such as Ambac and Financial Guaranty Insurance Company, have insured a collective $2.5 trillion of bonds and structured financings.

If the ratings of one or more of the bond insurers are cut, the rating on the bonds they insure, many of which are municipal bonds, will fall too. This may force some investors who can only hold very secure debt to sell, depressing prices which would already be under pressure due to the lower value of an insurance policy from a lower rated company.

It could also touch off another round of writedowns by banks, insurance companies and others who hold instruments insured by these companies.

It could hit the staid municipal bond market especially hard, as about $1.6 trillion of the bond insurance in force is municipal. The rest is asset-backed debt of various types, including subprime.

None of this, including the review, will make it easier for the insurers to raise capital to shore themselves up.

In the unlikely event of a default, things could get really dire.

"What if the bond insurers default? You could think it does not matter because they are small companies," Credit Suisse analyst Guillaume Tiberghien wrote in a note to clients.

"The problem is that overnight the $2.5 trillion of insured bonds would reverse back to the ratings of the issuer... Imagine the impact on the economy of a downgrade of $2.5 trillion of assets.

"The current LBO and CDO write-downs experienced by the banks during the third quarter would appear very small in comparison."

While Tiberghien cautions that what he lays out is a very gloomy scenario, fear of it is probably a large factor behind the recent market sell-offs.

SAFE AS HOUSES?

So, how did the insurers get themselves into this situation and how worried should we be?

Fitch said it was carrying out a review after a series of downgrades of CDOs tied to subprime mortgages by itself, Standard & Poor's and Moody's, saying they had been "broader and deeper" than previously anticipated.

Fitch said it would take four to six weeks to review the situation and if needed give any companies facing a downgrade a month to raise capital or take other steps.

Given that the rest of the world has taken a bit of notice of how badly subprime and some CDOs are performing, that wouldn't be easy.

Fitch said that CIFG Guaranty, owned by French bank Natixis (CNAT.PA: Quote, Profile, Research), and Financial Guaranty Insurance Co, the bond insurer whose owners include private equity firm Blackstone Group (BX.N: Quote, Profile, Research), had a "high probability" of facing erosion of their capital cushions.

AMBAC (ABK.N: Quote, Profile, Research) and Security Capital Assurance (SCA.N: Quote, Profile, Research) faced a "moderate probability" and MBIA Insurance (MBI.N: Quote, Profile, Research) had a "low probability."

Standard & Poor's is carrying out a similar review.

Markets, for their part, have voted with their feet on the insurers.

Credit derivative traders have recently valued Ambac and MBIA as deep junk. The cost of insuring AMBAC against default has soared from 185 basis points a month ago to 620 basis points last week, while its shares are down about 60 percent since the beginning of October. Security Capital shares have fallen by more than 75 percent from their 2007 peak.

Ambac on Tuesday posted a rebuttal on its website to a critical Morgan Stanley report, saying it was confident in the quality of its internal credit rating process.

To be sure, Ambac and others have been vigorous in defending their creditworthiness.

But two points make me very cautious, if the Fitch review passes without issue.

First, a spreading of contagion into municipal debt is likely to bring up another round of unforeseen and unmeasurable consequences, few of them good.

Second, the housing, subprime and prime, that is causing the problem in the first place is worth less day by day, is falling farther and faster than credit committees could reasonably have expected, and will continue to fall for quite some time.

(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: saft@reuters.com)

Posted by: spcwby | Nov 6, 2007 11:10:41 AM

evidence that it's mismarked, vega, at least at citi:

In a statement, Citigroup said the declines in the value of the bank's subprime exposure "followed a series of rating-agency downgrades of subprime U.S. mortgage-related assets and other market developments which occurred after the end of the third quarter."

When trading in the subprime-linked securities all but dried up amid this summer's credit-market turmoil, Citigroup and other banks suddenly faced the difficult task of putting a value on securities that investors no longer wanted to trade.

For lack of any market pricing, Citigroup used credit ratings as a key input in figuring out the value of the future payments it expected to receive on the securities, according to a person familiar with the bank's valuation models. For example, in valuing the payments on pieces of subprime-backed CDOs with the highest triple-A rating, the bank would look to how the market was valuing payments on corporate bonds with the same rating.

of course, virtually all these securities are on credit watch now at the heretofore-complicit ratings agencies, and many are being downgraded not incrementally but five, seven, ten notches at a time as year-end approaches.

one gets the feeling that citi's assets are just beginning to be written down to their realistic value. of course, they're going to receive every forebearance from the regulators in an effort to slow the process down. and that because, as you say:

banks, funds, EVERYBODY comes to the conclusion that they cannot carry as many loans (assets) on their books because they cannot fund those loans. So slowly but surely banks and funds unload the assets to a pool of buyers that shrinks daily. The pool of buyers is shrinking because the money to buy those loans is shrinking. So you've got $X trillion in loans that people want to get rid of because they can't fund them any more.

if there's a forced deleveraging from citi and the IB complex, it spells deflationary depression short of the fed wrecking its own balance sheet and doubling m1. with the amount of leverage in the system and the deficiency of capital-strong buyers (as opposed to liability-dependent buyers), it's just possible that we're beyond that tipping point after which asset sales lead to such rapid price declines that balance sheet repair from asset sales just isn't possible, as writedowns on your remaining assets outpace the liabilities you're able to pay down.

Posted by: gaius marius | Nov 6, 2007 11:18:18 AM

Found this comment yesterday (NBF) and covers all the issues with the write down of the big players and the impact on future earnings:

The banks that have reported their Q3 results so far saw their tier 1 capital ratio decline to 8.4% on average, the lowest level in years (1999). Tier 1 capital ratio, a measure of capital adequacy for banks, is the ratio of a bank's core equity capital to its total risk weighted assets. Even tough the ratio is still higher than required by regulators; banks now have less leeway to create value for shareholders. For this reason, banks are likely to put a lot of efforts in restoring their tier 1 capital ratio to pre-crisis levels.

There are only two ways to recapitalize and both of them will weigh on their stock performance. First, banks can lower the level of their risk-adjusted assets. This solution would reduce expected growth as riskier market assets or credit assets often are the ones that contribute most to a bank’s profit growth.

Alternatively, banks could try to raise their core equity capital. This could be done by increasing common or non-cumulative preferred shares through an equity offering. This would result in earnings dilution.

They could also focus on increasing retained earnings, but this solution would then put dividend payment at risk. Asset write downs is only the first step in restoring the health of the industry. Restoration of the tier 1 capital ratio will bring news of suspended stock buybacks, new equity offerings and dividend cuts, which will not sit well with investors.

Posted by: London | Nov 6, 2007 11:18:46 AM

Vega-

could'nt agree more with your post(s) however people will only see what they want. They will find a way to convince themselves that a loss just CAN'T occur when it is cloaked in language that does'nt reflect the meaning of what they are really seeing. Just like inflation......

That, in essence, is what the banks and brokers excel at.....presenting confusion...

How would you have liked to have been a customer of Goldman Sachs when it announced it's results.........you're euphoria would have quickly died down when the rest of information was available ala the 8-k.

"we did fabulous with OUR money.........your money??? oh...come on in we need to talk about that see we made a few boo-boo's"

Ciao
MS

Posted by: michael schumacher | Nov 6, 2007 11:22:53 AM

Bingo.

That's why P/E ratios paint an innacurate picture and price-to-book values are a joke. Just like what happened to the home builders.

Posted by: Lloyd | Nov 6, 2007 11:23:21 AM

" So as a WAG about 1-2 years' bank profits got wiped out, about 1-2 quarters S&P profits."

Not quite so. The losses Gross estimates will be distributed globally, much of it outside the US. Anecdotal incoming data suggests the non-US share of losses will be quite large.

This is very important to the overall risk assessment of US banks.

Posted by: GST | Nov 6, 2007 11:32:02 AM

" Cash flow is king and I understand what is a non-cash charge (ex: write-offs and depreciation) but the bill does come due at some point if capital is vaporized, no? "

Not quite so. Write-downs in the early phase of a credit cycle are always estimates. They can be adjusted up or down as the cycle proceeds. It takes a long time for write-downs to eventually converge to the 'final' true accounting number - due to the uncertainty of what form the residual assets left on the balance sheet will be (from recoveries, restructurings, sales etc., etc.)

Posted by: GST | Nov 6, 2007 11:37:41 AM

Barry, you pose what I think to be a difficult problem, in no small part due to the difficulties in measuring risk and knowing when losses are due to "reckless disregard for risk" or something else.

Here is an easier problem: (this is what we typically do in mathematics and in mathematical modeling - if we can't solve the original problem we think of another (related) problem that we can solve)

What would be the earnings per share for each company in the S&P500 adjusted for share buybacks funded through borrowing? It is one thing to fund a share buyback program from free cash flow; quite another to leverage up the balance sheet to accomplish it.

You could then take a weighted average and see how cheap the S&P looks then. And you could determine to what extent the increase in earnings per share over the past few years was due solely to borrowing for share buybacks (and to avoid dilution due to option exercise) and what part was due to the expansion of business. This could give you another measure of relative "cheapness".

Posted by: sn | Nov 6, 2007 11:45:24 AM

This wouldn't fully answer your questions, but I did a post on this. Risk control happens through a focus on credit spreads, which provides a pad against adverse deviation.

http://alephblog.com/2007/07/09/the-fed-model/

Posted by: David Merkel | Nov 6, 2007 11:46:51 AM

Vega – agreed a write-down is a big event. But until cash flow evolving from the assets being written down starts to correlate more closely with the size of the write-down, the write-down is only an estimate. The problem here is that there is structurally no market for these assets. Because they are not liquid, they must be valued on the basis of expected cash flow. The ABX is an unreliable WAG version of expected cash flow, because it takes no account of the eventual off-market balance sheet workouts that will be required to establish ultimate values on instruments for which there is essentially no market. Just because there is no market doesn’t mean there is no value. It certainly doesn’t mean there’s no cash flow. Quite the contrary – in comparison to the write-downs already taken, cash flow has barely been affected so far. It will be. That’s the point. Something isn’t worth 0 on a cash flow basis simply because there’s no market for it. The cash flow has proprietary value to shareholders. It should be taken into account in the valuation – which shouldn’t be left entirely to some ABX index for something that is completely unmarketable but yet still has remaining cash flow. That’s why there has to be proprietary judgment beyond a simple ABX formula and beyond the hysterical notion that something for which there is no market has no value. That’s ridiculous. There's way too much hysteria in the market about this.

Posted by: GST | Nov 6, 2007 12:01:17 PM

Citigroup is in violation of the banking regulations and yet will never be prosecuted for it.

That's what's wrong with the U.S. right now. Too many crooks, including in our government, who will never see the inside of a cell.

And the rest of us have to pay for their crimes.

Posted by: donna | Nov 6, 2007 12:34:45 PM

One simple question: Had Citi hedged their subprime portfolio by shorting the ABX-indices, would they be reducing the amount of market gains on their short because the market is not pricing it efficiently?

Posted by: Intellivestia | Nov 6, 2007 1:37:46 PM

sn - I like the plan

debate:
To my mind a SP500 company offers a note.
You may cashout or wait for dividends.
This money is the petty cash account to do more business with.
That note is #s in an account unrelated to the business being done. The petty cash account described can be dwindled without affecting A=L+OE by design. And why I still agree with Chad.

The business is: loaning with those #s, usually for a tangable asset which the final paper holder owns (if it has the means to get/collect it). Collateralized loans: House'g (80 to 180% ??) New Car (50% off the floor) Vacation (0%) New Kitchen (10%) Food & Gas (0%)
This loan business account matters, unless your to big to fail and a bailout is required. Unlike small business and families. Sorta - our system does have a get out of debt mechanism .

If the SP500 company does good or makes you believe its doing good, all is fine in the petty cash account and the bonus for the executives and your future sale or dividend.

Posted by: Greg0658 | Nov 6, 2007 1:59:06 PM

Taleb in "Black Swans" said bankers wiped out all previous industry profits in the Latin America Debt Crisis (Brady Bonds were the workout). So, Barry, your calculation really need use bank profits since that crisis.

Posted by: sanjosie | Nov 6, 2007 2:05:52 PM

The prices of these companies and these companies were both operating under the assumption they were too big to fail. Thanks to the conditioning of the fed and Greenspan over the previous decade those companies were operating in the way the market environment rewarded them most lucratively. It wasn't until the rules of the game changed with the new fed board that the conditioning failed and the fraud was exposed

Posted by: DavidB | Nov 6, 2007 2:35:24 PM

Your racecar analogy reminds me of a discussion that we had over at calculated risk the other day. Simply put, if you put stickier tires on passenger cars, you increase safety, because for most of us, the limit on our speed is our fear of speeding tickets and our insurance rates. if OTOH, you put stickier tires on racecars, you decrease risk NOT ONE BIT. Since the risk of losing control is the primary limiting factor on the speed through the turns, everyone simply drives faster. THIS is what we've seen in the financial sector in the past few years. The process of Pooling, tranching, and securitizing loans might well reduce risk if everyone wrote the same loans as they did before. But instead they wrote riskier loans, for greater amounts.

The problem is that if there are OTHER hazards proportional to the speed of the racecars, you have just increased them. The financial wizards have engineered bonds that are pretty safe unless their is a protracted, national decline in RE prices. By minimizing other risks, they have ensured that this will be the way their cookie crumbles.

When engineers make something "fail safe" they have no illusion that they have rendered a system safe from failure. Failures will ALWAYS happen. Instead, a "fail-safe" is designed so that WHEN it fails, the device is in a safe situation. The engine stops working, rather than exploding.

Posted by: Jim A | Nov 6, 2007 3:22:52 PM

Dumb question: All this while I was given to understand that the risk has been distributed in secondary markets. The other day I heard a news item talking about the losses a Chinese bank incurred as a result of sub-prime loan losses. Is this the reason why bank managements are not panicking? Something like this in the past would have brought a crash in the economy. Instead, the economy keeps growing

Posted by: Kishore Jethanandani | Nov 6, 2007 3:26:36 PM

MS, Vega, thank you for your posts. Without them, I might find myself unnecessarily confused.

Posted by: wunsacon | Nov 6, 2007 3:48:43 PM

Thought BR's original post was great but the comment thread should be a seminar for which we get credit (what's the name of that for you in the community ? CFR or somesuch ?) Think I've got the gist and sorta understand B/S vs P&L and that writedowns aren't real earnings. Nonetheless there will be real hits on real cash flow - partly as was pointed out because the liabilities and their payments don't go away.
BUT....but...the really scary thing to me is that this whole hoorah is about the ripples in the pond from "just" a small part of the assets markets - sub-prime. And as the ripples spread across CDOS it got to many other assets and players.
NOW - a key thing. 1) There are more and bigger rocks about to topple in the sub-prime and mortgage markets.
2) There are other asset classes who've gone thru the same magical securitization exercises and have bigger rocks lined up as well; they just aren't rocking as hard so far.
As they say pictures at 11:
Stages of Denial: http://tinyurl.com/397fov
My feeble attempt to put that argument, the rocks toppling into the pool and causing tsunamic ripples, in a pretty picture. FWIW.

Posted by: dblwyo | Nov 6, 2007 3:50:56 PM

Lost in a lot of this is the impact of derivatives and FAS 133.

For five years, we've had a lot of cash flow derivatives bypassing the earnings statement and winding up on balance sheets, folded in with all the M&A activity going on. Had they been fair value derivatives, earnings would have been much less robush (via the effect on RE), and all holy hell would be breaking loose at the moment.

Subprime is a red herring; should the derivatives ever begin to unwind...

BTW, hiring in the financial services industry is non-existent at the moment. FWIW.

Posted by: Byno | Nov 6, 2007 10:41:29 PM

Vega, gaius marius, BR.

You are correct in your points. It's refresing to find 3 other people on this planet that don't have their head up their ass and who can think for themselves. This is why I have argued for deflation. We are already in the liquidty trap and the jaws of that trap will close tighter and tighter on us over the next 15 months. The Fed is powerless to stop it.

Posted by: Gamma | Nov 7, 2007 9:00:58 AM

regarding the validity of abx pricing -- read the note out from creditsights today. i fear credit destruction is going to become the dominant feature of the american economy very soon.

Posted by: gaius marius | Nov 7, 2007 11:58:53 AM