Financial Sector Write-Downs: Don't Be Seduced Into Holding the Bag

Write-down. Such an innocuous word. Let’s take a look at the word of choice for the financial community and what it is really telling us. According to Investopdeia, the definition of write-down is to reduce the book value of an asset because it is overvalued compared to market. In other words, for quite some time now we’ve been lied to. Told that a company was worth much, much more than it was. None of us here are so naive that we believe these companies woke up this quarter and “suddenly” realized they had grossly overstated their value. The ongoing problems with the underlying assets, namely mortgages, have been a growing one for quite some time now and will likely not peak until mid to late 2008. Yet it was only a couple quarters ago when these same institutions were pointing the proverbial finger at their rivals while saying their own assets were solvent. Remember the rhetoric coming from the financial institutions and Washington alike as they told us “we don’t foresee significant spill over from the subprime problem into the general economy”?

Did financial institutions not see the problem? In April, Deutsche Bank Securities initiated coverage on Citigroup (C) with a Buy rating and a $62 target. One month before that both Bank of America and A.G. Edwards upgraded to buy based on “valuation”. In fact, you have to go back to 2002 to find a single sell rating on Citigroup. This is spite of the company’s model being publicly decried as one that is not tenable and in spite of regulatory problems and dismal performance. Merrill-Lynch was upgraded to buy in April by both Deutsche Bank and Goldman Sachs and again in August by UBS. Goldman cited “valuation” as the reason for the upgrade.

Speaking of “valuation”, I’m a bit confused at the markets current valuation of these financials. A couple of weeks ago, Cummins (CMI) reported. They met guidance and had a blowout quarter increasing profits and sales substantially. In addition they reaffirmed year end guidance, indicating that this year is going to be the most profitable one in the company’s history. Their share price fell over 20% when the market opened because some analysts from these recently written down financial institutions had decided they were collectively tired of CMI coming in above guidance. As such, they created their own estimates, in spite of being repeatedly told by management precisely where the company was coming in. To put this in perspective, to date Merrill Lynch has announced the loss of more than a full YEAR’S net income. Citigroup is estimated to have lost – they call it writing down – 3/4s of a years profit! Neither of these companies fell as much in one day as a company in the midst of its best year ever with increasing revenue, net and guidance!

Each “write-down” to date has been accompanied with assurances that this is the “kitchen sink” approach. Everything bad is now accounted for with no more bad news to come. I’m not sure if these guys are living in a home or a hotel, because by my count there have now been several “kitchen sinks” thrown in and I’m confident there are going to be several, if not many, more to come.

While it seems the financial industry has developed and inversely proportional model for valuation to recommendation, don’t let them seduce you into thinking there is value here. Rather than write-down the value of your portfolio I recommend staying clear of the financial sector for mid and long term investment. There will be better entry points once this debacle is in the rear-view. We are currently facing accelerating default rates on the underlying assets. Until that scenario is complete and we can take stock of the carnage, there will most definitely be more losses – whatever they choose to call them.

Disclosure: none