'US Subprime â Has the Correction Gone Too Far ?' Sep 24/07 Benjamin Tal senior economist CIBC http://www.research.cibcwm.com/res/Eco/EcoResearch.html
Look at all those billion dollar subprime write-offs, yet the market has NOT sold off dramatically; no crash or correction. This only means the economy is still strong, perhaps not as strong as it used to be, but still enough to survive.
Yes, but bigpicture makes a good argument that the bull of the market was an illusion because financials make such a big % of the total. These billions of dollars of writeoffs will remove months and even years of profits. This has to seriously break the market's momentum, doesn't it? He points out that we can't even trust overall P/E ratios because earnings have just vaporized. http://bigpicture.typepad.com/ 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. 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 . . .
Jim Rogers says we are experiencing the worst credit bubble in our history and that it will take not months, but years to recover: http://www.bloomberg.com/apps/news?pid=20601103&sid=aGCtO0cv4EAY
Btw, the big problem is that it's not just subprime loans that were the problem! The issues are much larger which explains the massive writeoffs: http://macroblog.typepad.com/macroblog/ So now the dissecting of today's market jitters begins, and there is no shortage of diagnoses. Today's data releases -- described here, here, and here, for example -- were certainly not great, but the most popular explanation seems to be that market players have developed a newly found sense that the world is a risky place. Barry Ritholtz sums it up nicely: The Dow is off 395 points as I type this. There will be some short covering shortly, and a rally attempt. But what I want to address is the change that has taken place: What has changed? What is different today than yesterday? Are the prospects of the economy and/or corporate profits so different today than they were merely a week ago? What has changed is Credit: Risk appetite for anything less than AAA -- and that includes the ABX stretched definition of AAA (see WTF is going on in the ABX Markets?) -- has waned considerably. The tinder, if not the spark, for the flare-up of credit concerns was this week's revelation from the mortgage lender Countrywide Financial that loan problems extend well beyond the subprime borrower. From the Wall Street Journal (page C1 of the July 25 print edition): By laying the blame for its earnings shortfall on rising defaults of prime home-equity loans -- many taken out by people who were straining to afford a house and didn't fully document their income -- Countrywide undermined the popular notion that only subprime borrowers are falling behind. And that could have a broad, negative impact on lenders' stocks. And from from Joanna Ossinger's column at the WSJ Online: Credit-market woes are partially rooted in the subprime-mortgage sector, which has been a source of market angst for months. But recently the problems have become more acute, as hedge funds invested in mortgage-backed securities have struggled and as default rates have risen, even among prime borrowers. Banks have been hurt by having to take loans onto their balance sheets instead of passing them on to outside investors. And major private-equity acquisitions have struggled to find financing, possibly removing one long-standing support for the market. It "all goes back to weakness in the mortgages," said Larry Peruzzi, equity trader at Boston Company Asset Management. But a closer look at the Countrywide development is instructive, as it reveals that the source of the problem is, not surprisingly, non-conventional types of loans. Again from the WSJ article: Many of the home-equity loans that are going bad are "piggyback" loans to borrowers who took out a second mortgage because they couldn't afford a large down payment and didn't want to pay for mortgage insurance. Now, with home prices falling in many areas, some borrowers owe more than their houses are worth. That is forcing Countrywide and others to increase provisions against losses. Another concern is the $27.78 billion of pay option adjustable-rate mortgages held on the books of Countrywide's banking arm. These loans allow borrowers to pay no principal or less than full interest each month. If they choose that option, their loan balance grows. Payments are now overdue on 5.7% of these loans held by Countrywide, up from 1.6% a year earlier. But here's the thing -- we surely have known for a while now that the building stress in mortgage markets is not a prime vs. subprime thing, but conventional-loan vs. non-conventional loan thing:
GS bought stakes in some hedge funds in the last couple of weeks. Means : IB´s always looking for "new" business thus broadening revenue stream...Recommending other IB´s and commercial banks to think about it, too.