Choosing Financial Stocks in a Time of SIVs and Credit Crunches

Many large commercial and investment banks announced painful writedowns and large losses for the third quarter of 2007. Some other banks, though, have announced relatively moderate writedowns and continued earnings strength. Are the latter a good buy?

One lesson from the high tech boom of the 1990s is that when you have a distressed industry, think carefully before investing in the apparent winners. Recall the telecom industry circa 2000 and 2001. Company after company was announcing writedowns and losses from aggressive expansion and industry overcapacity. Some companies folded. But WorldCom kept announcing strong financial results. You might have thought WorldCom would be a good investment.

Fastforward to June 2002. WorldCom publicly admitted to having engaged in an accounting fraud involving billions of dollars. Those glowing earnings reports were bunk. Shareholders were hung out to dry. The biggest difference between WorldCom and the losing telecom companies was that WorldCom was willing to lie about its performance.

The financial services industry is currently living in a world of turmoil, with much of the turmoil stemming from CDOs and other mortgage-related derivatives that are traded only by appointment and often have no open market price (especially not after the credit crunch began). These “assets” are the source of a lot of the recently announced losses. Valuing them is often a matter of judgment. The bank can use a mathematical model for valuation, but there’s wiggle room in the models and they haven’t been exactly spot on when it came to predicting cash prices (see http://blogger.uncleleosden.com/2007/08/how-computers-did-in-financial-markets.html).

Only the banks and their auditors know what actually happened with this past quarter’s accounting. But here are a couple of thoughts. A bank that wanted to avoid a bad third quarter this year could have given itself the benefit of the doubt at every turn and come up with results that didn’t look bad. This would have been a dangerous tack. If the real estate sector continues to decline (as many predict), circumstances in the fourth quarter may compel more writedowns at year end. And if a bank’s writedown this past quarter was relatively small, the writedown at year end may have to be relatively gargantuan (because those benefits of the doubt tend to evaporate as asset values slide).

Of course, there’s also the possibility that a bank with a serious CDO-subprime problem may have taken the opposite approach and been highly aggressive in writing down hinky assets. Then, at year end, it might report relatively positive results for the fourth quarter. Concerns have been aired that the banks reporting large writedowns may be creating "cookie jar reserves” that they could tap into in the future to smooth out more turmoil in their earnings. If such is the case, they are likely to have a problem with the authorities, since maintaining cookie jar reserves is considered bad accounting form.

Nevertheless, if you’re going to take a flyer on a stock in a volatile sector like financial services, do you want the one that might report improvement in the future, or the one that might have spent too much time primping in front of a mirror? Is it possible that the banks reporting strong results now simply are better managed and avoided riskier plays? Yes, that’s possible, and maybe it’s true. But WorldCom was considered a well-managed company until it blew up. Think and research carefully before plunging into stocks of banks and other companies holding volatile assets.

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