Our Take: Honey, I Shrunk the Balance Sheet
Did last quarter's earnings season mark the climax of the credit crunch's impact - or just the opening act? The period from now through mid-January should provide some answers.
In our inaugural column four weeks ago, we wrote that Wall Street's medium-term hiring and compensation outlook rests on the magnitude of future asset write-downs sparked by the sub-prime mortgage collapse. The reckoning's next phase will play out over the coming four weeks. For clues to 2008 hiring plans, we suggest looking past fourth-quarter results and paying special attention to anything banks say about write-downs they expect to record for the first quarter.
Many investment banks operate on a November fiscal year. So for Wall Street, year-end earnings season - otherwise known as "confession season" - is about to kick off. To be sure, last month saw a parade of confessions about losses from mortgage and other credit and derivatives exposures. So a considerable amount of looming bad news about the fourth quarter is likely already embedded in both market prices and banks' business plans.
Look For Recent History to Repeat
We at eFC are reporters, not analysts; we claim no special insight into the quality of banking assets, whether on-balance sheet or off. But in light of what has been reported about the financial sector's ongoing exposure to sub-prime loans packaged into a smorgasbord of structured bonds, derivatives and other vehicles with varying degrees of opaqueness, the simplest scenario is that the immediate future will repeat the recent past. In other words, where the credit crisis is concerned, the coming crop of announcements may look a lot like the third quarter's - if not worse. That's because the current period embraces the full fiscal year, whose numbers (unlike last quarter's) will have to pass muster with each firm's independent auditors before being filed with the SEC.
What did last quarter's reports look like? In a word, grim. Even though most banks had already published loss estimates before the third quarter ended, again and again the actual write-down amounts proved far larger than their initial estimates (with the notable exceptions of Goldman Sachs and Lehman Brothers). Worse yet, several institutions also disclosed that their remaining fixed-income holdings had depreciated still further - as much as $11 billion further in the case of Citigroup - from the end of the third quarter to the time the results were announced.
Since then, reported mortgage delinquency rates have soared to 20-year highs while foreclosure rates continue setting new records. The asset-backed commercial paper market remains moribund, while yield spreads between short-term government and bank paper remain historically wide, diminishing the impact of the Fed's rate cuts. Since early November, the ABX indexes - a broad, market-based gauge of default risk for various classes of home equity loans - have shown signs of stability , but not of a rebound.
Latest Events Show Asset Values Are as Cloudy as Ever
Meanwhile, the past 10 days produced a raft of important events. The most visible is the homeowner rescue package cobbled together by Treasury Secretary Paulson and an alliance of banks, loan servicers and investors. It aims to stabilize the overall U.S. housing market by blocking scheduled interest-rate adjustments for a subset of sub-prime borrowers, thereby preventing foreclosures and forced sales. The downside is that cash flows to structured bonds that hold these loans will be reduced. The impact on the bonds' value depends on the default rate assumptions that banks and bondholders use when valuing them. In weeks ahead, look for some analysts to question both the assumptions used and the resulting valuations.
That's not the only sign that asset values remain nebulous at best. First, E*Trade sold $3 billion of collateralized debt obligations and other mortgage-related assets to Citadel for a reported 27 percent of book value. Then, a Credit Suisse CDO deal called Adams Square I fetched such paltry prices when liquidated that even its most senior, AAA-rated tranche absorbed losses, while all other tranches paid out nothing at all. HSBC and two German banks bailed out their respective troubled structured investment vehicles (SIVs); HSBC brought $45 billion of SIV assets onto its balance sheet. Fortune Magazine reported that Fannie Mae is recording its sub-prime mortgage bond portfolio at about 98 percent of par, but the story claims similar bonds are quoted 10 - 20 percent below that. And bond insurer MBIA faces a threat of losing its AAA rating in two weeks unless it raises billions in new capital. Downgrades of MBIA and other bond guarantors would threaten the AAA ratings on up to $2.4 trillion of insured municipal and structured finance issues.
All in all, it promises to be an interesting few weeks. As events unfold, we'll do our best to keep you posted about the impact on your job and your career.