High (or low) Finance

Story Highlights:

• Financials' earnings have fallen dramatically, taking share prices down 25% since their peak in May of 2007.
• Most other sectors were up in 2007, and have continued to do well this year.
• Financials may face a long road to recovery, but they're unlikely to keep down broader markets.

___________________________________________________________________________________________

Today's axing of more big bank CEOs and rumors of more asset write-downs ahead has the spotlight back on embattled Financials. And because the Financial sector is a big one, folks are worried Financial ills will form a spreading contagion.

Wachovia Ousts Thompson, Smith Will Be Interim CEO
By Valerie Bauerlein, The Wall Street Journal
https://online.wsj.com/article/SB121240774837437279.html?mod=hps_us_whats_news

First the bad news—the Financial sector may take some time to heal. Historically, whenever a large sector sells off, it can spend a long time in rehab.

Even so, in our view it's unlikely Financials drag down everything else today. What about all those losses for big banks? Many of the big Financials hold Collateralized Debt Obligations (CDOs) in the securitized debt markets—the ones affected by subprime and other problem loans. These securities have been written down by hundreds of billions of dollars—and the write-downs come directly from earnings. But CDOs have always been difficult to price because they don't trade as regularly as stocks—complicated models or esoteric indexes are often used to estimate their value. Today's write-downs are more a reflection of the weak market for these investment vehicles than a severe deterioration in their underlying value.

Regardless, its key to recognize these write-downs won't continue in perpetuity. Operating earnings, which measure the ongoing revenue and expenses of a firms' core business (and not non-recurring items like write-downs) have been strong all along. For example, Citigroup, a company which took a $10 billion net loss in the fourth quarter and more than $22 billion in write-downs for the year, still managed to earn $3.6 billion in 2007. That implies operating earnings somewhere in the $25 billion dollar range. It's a similar story for many of the big US banks and financial institutions. This isn't to say write-downs don't count. Of course they do. But it's important to recognize the ongoing core business remains healthy and thriving for most Financials. After all, despite all the caterwauling, Bear Stearns is the only major bank that's ceased to be, and even it went quietly into the dark night, snapped up by a bargain-seeking JP Morgan who'll likely benefit greatly down the line. See our 5/30/08 cover story, Bye-Bye Bear Stearns, for more. Unless things worsen significantly at the core level for Financials, it's hard to see them performing worse than already exceedingly dour expectations—a necessary ingredient for a sector to truly become a systemic infection.

As for the spate of CEO's being shown the door—it's classic regret shunning. Folks hate dealing with the pain of a bad investment decision (see subprime loans). To avoid it, and keep their self esteem intact to fight another day, they seek someone else to pin the blame on. Like say, a CEO. CEOs are easy to blame!

Is there good news in any of this? We think so. Whenever a selloff like the one in Financials occurs, like it or not, a scapegoat must be rounded up. Until one is found, folks don't feel the problem has been rooted out, and a rebound is unlikely. Finding a scapegoat might not help Financials much, which likely won't have much of a dead cat bounce, but it does help folks past their correction psychology—and should keep Financial woes from infecting the rest of the markets.