Top executives of Goldman Sachs (GS) and Morgan Stanley (MS) now say respectively that the financials are in the fourth quarter or ninth inning of the credit mess.
Yes, and all of the financials' profit reports are as sweetly fresh as lilacs after rain, and their stock prices are really not careening around worse than the Jamaican bobsled team.
An admitted accounting geek, I have reported on quality of earnings for more than a decade. No way, no how am I an expert, when I hear that, it feels like my brain is starting to run out of my ears. I am just a journalist. But having researched this and talked to the pros as much as I can, my thinking on this is clear as a cold country creek.
There is still plenty enough voltage and not enough shock absorbers in the financials' balance sheets to leave any Wall Street executive feeling as withered as a salted snail.
Which is why you'll see the more circumspect Wall Streeters like Richard Fuld, chief executive of Lehman Brothers (LEH), and his chief financial officer Erin Callan carefully couch what's going on by saying that, while the current financial crisis may be past its nadir, problems remain.
And which is why it's passing strange that John Thain, chief executive of Merrill Lynch (MER), has been saying his beleaguered brokerage doesn't need more funds after raising nearly $12.8b, although the Wall Street Journal says you can expect to see $6b-$8b in writedowns when it reports earnings tomorrow.
I must get this out of the way first. What's really intolerable is the combination of finger wagging brimstone behavior and self righteous piety on what the world needs to do to fix the credit crisis coming from the likes of George Soros, a billionaire who has built his fortune on the backs of past crises, and a certain high level central banker instrumental in helping create this one, you know who I mean, weighing in like a self-serving cuckoo clock as well (as Abe Lincoln once said, "he can compress the most words into the smallest number of ideas of any man I ever met.")
We are not out of the woods just yet. Banks are rapidly recapitalizing with infusions from sovereign wealth funds (some SWFs have seen their stakes drop 20% or more), from private equity firms, and either by selling assets or issuing new shares. Suffice it to say investor pain remains. Not just pain in the form of shareholder dilution--the negative G-forces in the form of damaged credit on bank balance sheets have created a Black hole from which no dividend can (or should) escape.
Here are the statistics. Anywhere from $360b to $460b of adjustable-rate loans are scheduled to reset this year. About 9m borrowers are upside down in their mortgages. Auction notices rose 32% year over year, a sign that defaulting homeowners are just walking away, market watcher Richard Suttmeier says. A cold calculation--borrowers, even those with decent credit scores, find it easy to walk away from their houses when their loans are close to or surpass the market value of the property.
And as the value of securities tied to mortgages nosedives, banks and investment houses will face more writedowns, which so far have totaled at least $245b since the beginning of 2007. Some estimates put the eventual cost at $460b. The IMF puts the credit losses overall at $945b. It's anyone's guess now. UBS (UBS) still has ropey assets on its balance sheet, some $31b. Goldman Sachs (GS), $96.5b, Morgan Stanley (MS), $78.2b.
So no more talk of innings or basketball quarters. This feels more like a basketball game's shot clock.
But here's what should most concern you. Hedge fund Greenlight Capital's David Einhorn, as sharp a pencil as any when it comes to reading the financial statements, says investors may choke when they take a closer look at what's really sitting on the financials' balance sheet.
Remember how in the past couple of months how Carlyle Capital was on the brink of collapse, he asks? It used its balance sheet assets to do more borrowing, levering itself 30 to one against its assets. Same leverage ratio for Merrill. Same for Bear Stearns.
But Carlyle's portfolio had triple-A rated government securities, historically the safest paper around, Einhorn notes. Chilling.
What's even more perilous is what Einhorn found out that's really going on with a critically important valuation metric used to assess the health of banks and brokerages. It's called return on equity, the equity portion similar to what is an individual's net worth. Einhorn says that banks count things such as preferred stock and subordinated debt as equity when calculating their leverage ratios. That's like adding in, instead of subtracting out, your mortgages and auto loans to arrive at your own net worth.
If those items are knocked out as they should be, then the financials' leverage to common equity is even higher than thirty times, Einhorn says.
And the financials consciously levered themselves to eye-watering levels because that is what they were incentivized to do, to maximize executive compensation, Einhorn says. More leverage means more revenues which means more compensation, especially at investment banks which pay out 50% of their revenues as bonuses are backpay.
And Einhorn adds that the banks and brokerages' levered balance sheets hold items much dicier than government securities. They have stocks, bonds, various loans waiting to be securitized, pieces of structured finance transactions, derivative exposures of staggering notional amounts and related counter party risk, they have real estate, private equity.
Back to the IMF's $945b figure for expected losses. That's vs $750b in losses fm Japanese economic crises of 1990s. That $945b breaks down as follows: $556b for US residential loans and securities; $240b on commercial real estate securities. Corporate loans including leveraged loans are expected to account for $120b in losses, consumers add another $29b.
That $945b is about 8% of the US's GDP vs 15% of Japan's GDP. But whereas Japan's banks bore almost all the losses, now places as far afield as Norway, the Artic, and entities such as pension funds, insurance companies and hedge funds will bear most of the losses from the credit crunch. Spread the pain, right?
So how long will it take The Great Credit Crunch to unwind? One 2003 study of post war housing busts in rich countries indicates that housing crashes coupled with banking crises last about four years. The housing busts in Sweden and Norway in the early ‘90s acted like an anvil on their balance sheets for years.
A bright spot: the IMF expects global growth to slow to a 3.7% growth rate from 4.9% in 2007. Not so bad, given the five years of hectic growth the world has seen--and still coming off a huge base. Besides, any slowdown might be a good thing, as it would dampen inflation now coming a cropper (I like that term, coming a cropper) in emerging markets.