One month ago 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 (NYSE: C) 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, Citigroup 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 Citigroup. 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 Citigroup’s global consumer business. Of this figure, nearly $2 billion was an increase in Citigroup’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 Citigroup that the credit quality of its loans is deteriorating much faster than expected. To put Citigroup’s $2 billion allocation to loan losses in context, during the first and second quarters of 2007, Citigroup added just $646 million and $545 million, respectively, to its loan loss reserve account.
We should expect many, many more dismal pre-announcements from the banking industry over the next few months. Just yesterday, for example, Thornburg Mortgage (NYSE: TMA) said its subprime losses will be 27% higher than expected. As our colleagues at the 5-Minute Forecast explained, “Thornburg Mortgage will throw another $1.1 billion on the mortgage carcass pyre.”
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 writeoffs. 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 & Gunpowder 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.” Citigroup’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 are rallying 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 further Fed rate cuts, the financial markets are flashing many glaring signs that monetary inflation is spiraling out of control. So Fed Chairman Bernanke will receive ample opportunities to establish his credentials as an inflation fighter…or not.
With gold and commodities soaring, and most global stock markets either approaching or blasting through July peaks, he may decide to put further rate cuts on hold for the time being.
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.
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