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Generational Dynamics Web Log for 28-Mar-08
Meredith Whitney lays out the template for financial crisis

Web Log - March, 2008

Meredith Whitney lays out the template for financial crisis

The Oppenheimer analyst says to expect reduced earnings expectations next week.


Meredith Whitney <font face=Arial size=-2>(Source: CNBC)</font>
Meredith Whitney (Source: CNBC)

Meredith Whitney is executive director of equity research at Oppenheimer and Co. She's also a Cassandra, predicting very troubled times ahead, but unlike most Cassandras, she's actually believed by some people.

I last quoted Whitney in an article last month, an article that's worth reading just for the pictures - she's a real babe.

But she's also just about the only analyst who ever appears on CNBC who tells exactly what's going on, which makes her very unusual. She made some calls last year about Citibank that got her a great deal of verbal abuse -- until they came true. So she's respected by a lot of people, albeit reluctantly.

Appearing again on CNBC on Thursday, she was interviewed by anchor Maria Bartiromo. In her interview, she essentially accused many banks of (a) fraud and (b) unmitigated stupidity -- although those words weren't used.

She also provides an explanation for why estimated earnings keep falling. I recently posted this table:

  Date    1Q Earnings estimate as of that date
  ------- ------------------------------------
  Oct 23:             +10.0%
  Jan  1:              +5.7%
  Feb  6:              +2.6%
  Feb 29:              -1.1%
  Mar  7:              -4.3%
  Mar 14:              -7.8%
  Mar 21:              -7.9%

And earlier I posted a similar table for the fourth quarter. In both cases, the corporate earnings estimates kept falling, week after week. As we'll see below, Whitney expects a big drop in earnings estimates next week.

Bartiromo began by asking her about a report that she published on November 11, 2007, on the ratings agencies:

"From my perspective, that was the single most important report that we wrote last year. This was two weeks after I downgraded Citigroup, and the focus of this report was on the interconnected relationship between the rating agencies and the bank regulators.


Meredith Whitney often closes her eyes when she talks, as if she doesn't want to see other people's reactions to the bad news <font face=Arial size=-2>(Source: CNBC)</font>
Meredith Whitney often closes her eyes when she talks, as if she doesn't want to see other people's reactions to the bad news (Source: CNBC)

What I basically said was, after $100 billion in securities had been downgraded in the month of October, that would impact what the regulators would require the banks to maintain on their balance sheets, with respect to those downgraded securities.

So that the capital ratios would look far worse than anyone had imagined, worse expectations than anyone had. And as a result, there would be more of a broad-based round of capital raised, and that's in fact what's happened. ...

The point of my note today was that in the month of February, 3 times, or $370 billion in securities were downgraded in the month of February. So first quarter earnings are going to put even more pressure on capital ratios, beyond all these charges that I expect."

So here's what's going on. Regular readers of this web site know that banks and financial institutions have been forced to write down billions of dollars in assets that they have in their portfolios. These are CDOs and other mortgage-backed securities that are nominally worth one value, but may be almost worthless on the open market.

So that's bad enough, but it causes another big problem for the banks: Regulators require banks to keep certain amounts of cash (or cash-equivalent securities) on hand to handle emergencies. These amounts of cash are called "capital ratios." What Whitney is saying is that once these writedowns occurred, they no longer had enough cash on hand, and had to go out and raise capital, thus affecting their earnings significantly.

She concludes by pointing out that the size of the writedowns was 3 times as large in February as it was in October, so banks are in an even worse situation today.

Whitney goes on to explain what banks are doing wrong:

"Well, the fact that I've spoken about this a lot. If you are truly marking assets to market, then just sell them - you should be indifferent. But these banks have got themselves into trouble, are going to get themselves into trouble prospectively, because they refuse to sell these assets, because they think the market is bid too low.

Well the problem is that each month that they wait, the asset values go lower, and then when the ratings agencies downgrade these assets, they're required to carry even more capital against those assets.

And capital clearly in short supply in the financials right now. ...

There are a couple of things that go on. So you have people that refuse to sell assets.... So if banks don't want to sell these assets, the longer they wait to sell these assets, the values decline.

But then when, all of a sudden, banks decide TO sell all these assets, there'll be a supply jam on the market driving prices down even lower, so there'll be more write downs. And ultimately, I think these financials will sell assets at well below today's market prices. ...

So I am playing catch-up with the banks that are playing catch-up with the credit markets, and I think if everyone just took their poison -- or their medicine, so to speak -- it would be easier on all of us analysts."


Maria Bartiromo interviews Meredith Whitney <font face=Arial size=-2>(Source: CNBC)</font>
Maria Bartiromo interviews Meredith Whitney (Source: CNBC)

This is actually very explosive stuff -- although neither of the women indicated that it was.

What Whitney is saying is that banks are trying to avoid having to write down their assets for as long as they can avoid it. But the longer they wait, the worse it is, because the mortgage-backed assets keep falling as time goes on.

But Whitney goes much farther -- she's predicting a full-scale panic when banks finally are forced to mark these assets down. Because the market will be loaded down with these securities from all sorts of financial institutions, they really will be almost worthless.

Just to provide context, as I've said before, the stock market panic of 1929 was caused when investors, who had purchased stocks on credit (margin), were forced to sell their good stocks to meet margin calls on their bad stocks. That forced selling caused share prices to fall even further, resulting in more margin calls to investors, resulting in more forced selling, until there was a full-scale panic.

Bartiromo has no clue about this, of course, but it's disturbing that Whitney doesn't seem to realize the full impact of what she's saying either.

She says that the banks should just "take their medicine," to which my response is, be careful what you wish for.

By the way, when she says that banks are stalling, she's essentially accusing them of defrauding the public, by pretending that their assets are worth more than they really are.

Bartiromo asks Whitney whether earnings estimates will come down next week:

"Not a doubt in my mind. Analysts typically like to wait until the end of the quarter -- [Monday, March 31] -- to put their estimate revisions out. I think it's pretty clear what's going on with this quarter, so why wait?

In February I cut [my earnings estimates] aggressively because I thought that the loss expectations for on-balance-sheet loans would be far higher than anyone expected. And at that time, I was 30% below the street. Going into yesterday, I was the HIGH on the street.

So these earnings estimates are being revised down dramatically on a consistent basis. So I don't think we're anywhere close."

This reflects the "earnings estimates" tables that I keep posting. She points out that earnings estimates have been falling steadily, and they'll fall even more next week.

Bartiromo asks whether the stock market will decline further:

"When the Bear Stearns news went down, I believe it was the 17th of March, I hoped that the stocks would go down to the levels where you could start getting interested in long term values. But the stocks didn't go down that much.

And what I had said at the time, what I had believed is -- this is an agony of incrementalism, where we have all these write downs are ultimately going to be, so we'll have a protracted environment where you have to continue to bolster up reserves."

Here's where Whitney is wrong. She thinks that all these writedowns will occur over a period of months, everyone will "take their medicine," and then things will be back to "normal." What she doesn't understand is that she's laid out a very explosive panicked selling scenario.

Finally, Bartiromo asks Whitney whether she'd buy financial stocks (like banks) right now:

"Even the financials that I like, I don't like. There are some great companies out there, but they're all going to get cheaper."

So the net of all this is that next week is going to be a very rocky week, after the first quarter ends, and actual earnings start pouring in.

Whether this results in panic selling at some point, as Whitney indicates it will, remains to be seen.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (28-Mar-08) Permanent Link
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