Here come more financiers' writedowns
Another day, another prediction of red ink for banks and financial firms. But some analysts caution against taking these numbers at face value.
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NEW YORK (Fortune) -- Another winter writedown storm hit Wall Street Monday. Shares in Citi, Fannie Mae and Freddie Mac sank after analysts predicted another round of multibillion-dollar losses at the struggling financial firms.
The expected writedowns, which reflect rising loan defaults and sharp declines in indexes tracking debt-related securities, come as falling house prices and a slow economy weigh on U.S. consumers. Shares in Citi (C, Fortune 500) dropped 2% after Oppenheimer analyst Meredith Whitney slashed her full-year earnings forecast to 75 cents a share from $2.70 previously.
Whitney, who made headlines late last year by being the first analyst to predict Citi would cut its dividend - which it soon did - said the bank's profits will be hammered by Citi's need to reduce the value of loans and bonds on its balance sheet. The analyst, who rates the stock the equivalent of sell, predicts "further writedowns to their carrying values of [collateralized debt obligations] related to sub-prime mortgages, further writedowns from leverage lending commitments, and further writedowns associated with on balance sheet consumer loans."
That's a lot of writedowns, but Citi isn't alone in facing big hits to its earnings. Goldman Sachs downgraded Fannie (FNM) and Freddie (FRE, Fortune 500) to sell from neutral, saying it expects $4.2 billion of writedowns at Freddie and $2.6 billion worth at Fannie when the government-sponsored enterprises report fourth-quarter earnings this week. The downgrade comes on the heels of a similar move Friday by analysts at Merrill Lynch. Goldman even recommended that investors short Freddie Mac shares ahead of Thursday morning's expected earnings release. And it also significantly reduced earnings predictions for other Wall Street giants, including Bear Stearns, Morgan Stanley, Merrill Lynch and Lehman Brothers.
By now, huge writedowns are old hat for investors in the financial sector. In just the past two months, Citi took an $8.1 billion writedown of its mortgage-securities holdings, UBS (UBS) took $13.7 billion in mortgage-related writedowns and AIG (AIG, Fortune 500) took a $4.9 billion hit to its credit derivatives portfolio. The river of red ink comes as no surprise, as banks and brokerage firms find themselves carrying billions of dollars of loans and mortgage-related securities whose value has declined along with a sharp slowdown in the debt markets.
But some skeptics say writedowns may in some cases overstate the extent of problems at financial firms. Many writedowns result from the need to "mark-to-market" the value of illiquid securities - such as CDOs and leveraged loans - or the debt that banks took on to finance the recent private equity buyout boom. Because many of these securities rarely trade, managers are left looking to market indexes for guidance on the size of the appropriate writedown - as Whitney noted Monday in a discussion of the recent 6% drop in the leveraged loan index, or LCDX.
"The decline of the price of the LCDX reflects the markets' priced perception of increased credit risk of leveraged loans, causing a sharp pullback in investors' demand for these types of loans and has caused a backup of the leveraged loan pipeline and assets to build up on balance sheets of banks," she wrote in Monday's report on Citi. "As banks and brokers are required to use these indexes and other market data to 'mark to market' their outstanding loan commitments, we expect banks to be forced to reflect such market declines in their 1st quarter 2008 results further hampering results already hampered from the most challenging market environment most have ever seen."
While no one doubts that the market environment is challenging, some observers say the mark-to-market writedowns don't always help investors seeking to accurately assess a firm's health. For one thing, the writedowns generally don't reflect actual cash losses. In the case of Fannie and Freddie, Goldman sees more writedowns ahead in part because declining interest rates reduce the value of the hedges the firms use to protect the value of their mortgage portfolios - even though the declining rates don't cause Fannie and Freddie to lose actual money during the period.
Similarly, many of the leveraged loans now trading at a discount continue to perform; the drop in the index partly reflects investors' fear that debt-burdened companies will go bankrupt if the economy heads into recession. Similarly, 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.
That's why Christopher Whalen, managing director of Institutional Risk Analytics, calls fair-value markdowns "madness," saying they tell investors nothing about the economic value of a business. Jeffrey Miller, CEO of investment adviser NewArc Investments in Naperville, Ill., tells investors to delve into the details of writedowns rather than being scared away from possibly attractive investing situations by scary headlines. He says the fact that the banks are keeping loans and bonds on their books rather than selling at fire-sale prices indicates the value of the underlying assets may well climb.
A case in point comes from bond insurers Ambac and MBIA. Back on Jan. 16, Ambac posted a fourth-quarter loss of more than $32 a share, reflecting a $5.4 billion writedown of its CDO holdings. Ambac said about $1.1 billion of the writedown reflected credit impairment, but the rest was a mark-to-market loss tied to the declining value of its bond insurance contracts. "Ambac continues to believe that the balance of the mark-to-market losses taken to date are not predictive of future claims," its press release read, "and that, in the absence of further credit impairment, the cumulative marks would be expected to reverse over the remaining life of the insured transactions."
Similarly, MBIA last month posted a fourth-quarter loss of more than $18 a share, after a $3.5 billion writedown of its CDO holdings. The actual credit loss reflected in that giant writedown, the company said, was $200 million. If other financial firms have been involved in overstating potential losses out of a sense of diligence, that could lead to increased profits once markets stabilize.
The financial guarantors' situation illustrates the questions confronting investors in writedown-riddled companies: Is it fair to believe the portfolio will avoid further credit losses even as the economy slides toward recession? Is it reasonable to assume that the company is presenting a full and fair accounting of its situation?
David Merkel, chief economist at broker-dealer Finacorp Securities, urges caution. "It comes down to assessing management," says Merkel, not referring to any particular company. Though most execs surely make what they believe to be appropriate judgments, he says, "some are prone to fear and greed."