Our Take: Contrarian - Or Simply Wrong?
As banks gird for an earnings season to be dominated by asset write-downs, a new debate touches on the industry's hiring outlook for later in 2008.
"Writedowns may be masking some good news," declared the headline on an item in the newsletter FierceFinance earlier this week. The item spotlighted a Fortune Magazine article touting the novel idea that further asset write-downs will make bank stocks attractive. Although its author didn't say so, such an assertion implies a belief the credit crisis will soon pass and business will return to "normal." In that case, the demand for bankers and other financial-market professionals, especially in the fixed-income area, would soon revive too... along with the chance that compensation for fixed-income bankers will recoup last year's damage.
The argument goes like this: Accounting rules force owners of out-of-favor debt instruments like CDOs and leveraged loans to revalue many of those assets at current market prices whenever they release financial statements. When an asset isn't actually trading, a market-based value is estimated from credit derivative indexes. Fluctuating market perceptions of default risk captured by these indexes mean that even credits that are fundamentally sound can be subject to heavy markdowns. "The writedowns generally don't reflect actual cash losses," Fortune observes. "The bonds underlying many illiquid securities such as CDOs continue to pay interest on time, even as related indexes show readings that would suggest widespread default."
Pain Today, Pleasure Tomorrow?
The supposed "good news" is that if a bank holds onto such an asset and it doesn't default, the owner will eventually recover the original higher value, either from uninterrupted interest and principal payments or from selling it at a higher price. Citing January write-downs by beleaguered bond insurers Ambac and MBIA, the article suggests they and other financial firms are "overstating potential losses out of a sense of diligence, (and) that could lead to increased profits once markets stabilize." In other words: Today's write-down is tomorrow's undervalued asset.
Or not. The only way bank executives can be proven right in refusing to dump their bad bets is if they know more than the market. And you don't have to believe in efficient markets to believe the market is more likely right than some of the players who are caught in what now looks like a losing trade. Remember: Even if the market is wrong, it could be wrong in the opposite direction - high-risk loans and structures could ultimately turn out to be worth less than the market is now paying.
The conventional view, which we share, is that multi-billion dollar write-downs are nothing but bad news for banks' current and future business prospects - and in turn, for the hiring and compensation outlook.
Recovery Requires 'A True Purging'
That view was expressed in crystalline form by Meredith Whitney, an equity analyst at CIBC World Markets who's long been bearish on the industry. "The massive disruption in the debt markets clearly is signaling that things are worse than people wanted to believe," she told Maria Bartiromo in an interview recently published in BusinessWeek. "The big disconnect is that there's no agreement between buyer and seller on any level. So sellers are holding on to aspirational valuations on securities."
As long as banks cling to illiquid debt, they'll be hampered from making new loans or buying new bonds. Thus, said Whitney, "What we need to see is a true purging to get the system back to a state of restored liquidity ...The financial institutions that hold most of these assets are in absolute denial."
That indicates how market crises most often get resolved: through an unrestrained, cathartic selloff that clears the decks for fresh business. So, when watching for signs that might herald a turnaround of lending and structuring activity, we'd be more encouraged to see the industry's players throw in the towel and sell discounted credit assets, rather than keep trying to ride out the storm.