4/2/2008

Financial Stocks: A General Perspective
By David Urani

As we all know, the financial industry is trudging through a mess of defunct debt products, and the question on everybody’s mind is how much further do we have to go? With about $6 trillion of mortgage securities outstanding, there presents the potential for an immense amount of investment losses from mortgages that go bad. The good news is a substantial portion of these losses have been written down already, but the bad news is our nation’s financial businesses are nowhere near finished. The unfortunate part of trying to figure out this mess is that nobody, not even the companies themselves, knows exactly what these businesses the holding in their portfolios are worth. The financial system’s trillions of dollars worth of mortgage-backed securities and Collateralized Debt Obligations (CDOs) is like a big box of chocolates; you never know what you’re going to get.  The complicated structure of these investments is precisely the problem that started the credit market breakdown. Despite not knowing what these investments are currently worth, we can get an accurate idea of how much companies have already written them down; the figure stands at approximately $250 billion. 

Several institutions have attempted to estimate the eventual total investment losses to be recorded by U.S. banks, hedge funds, brokers, and other investment entities. Here are some estimates from a number of credible sources: S&P expects $285 billion, Goldman Sachs expects $460 billion, Ben Bernanke expects $500 billion, Merrill Lynch expects $600 billion, and Bank of New York expects $800 billion. As you can see, this is a very wide range, so, roughly speaking the average expected total write down is about $530 billion. Even according to the most optimistic estimate, given it took the majority of a year to write down $250 billion, it would take at least the rest of this year to clear the remaining write-offs from the books.

From a stock trading standpoint, investors should assume that financial stocks will appreciate before the end of the write-down cycle, as investors begin to look to the future once the end of write-downs is in sight. One important idea to realize is that when institutions calculate their investment write-downs, they match their portfolios of mortgage securities and CDOs to benchmarks, which include estimates that are often overly pessimistic about the future state of the economy. In that sense, much of the write-downs that have been recorded have built in somewhat of a worst-case scenario. Of course, some businesses are surely understating their losses in order to keep their image intact, but in the end, it is more beneficial for banks to be conservative with their estimates, both to be fair to investors as well as to give themselves a chance to clear their books more quickly and rebound strongly on a market turnaround. Therefore, at the end of the write-down cycle it is likely that we will see value added back into some investments, which should accelerate stocks’ gains.

On April 1, UBS sent the stock market soaring with its announcement that it would write down $19 billion in its next earnings report, and would raise approximately $15billion in capital to keep itself afloat. What was good about this news is the fact that many investors assumed that this would be the last straw, signaling that UBS and the rest of the financial system would throw in everything, including the kitchen sink. We may very well be more than half way through this ordeal, and that means that in quarters to come, write-downs should become less potent and banks should be relatively more profitable. One thing that investors can be confident in, nonetheless, is that the remaining downside for financials is limited, and the risk/reward ratio has become quite compelling.