Book Value Can Be Deceiving for Financials

One of the reasons cited in support of the argument that now is a good time to invest in financials, and especially the investment banks, is their very low ratio price to book value (P/B), especially when compared to historic norms. However, at least for some of these firms, it is not yet time to rush out and buy.

Anyone reading this site probably already knows the meaning of book value and the P/B ratio. However, how sure are we of the book value for a specific firm? For financials, the P/B ratio has generally been considered a good indicator of relative value; yet, in this environment, things have become a little more difficult -- basing one's investment decisions on this ratio may produce unfortunate results.

For example, let us examine Merrill Lynch (MER), using its last quarterly report. In September 2007, its current book value stood at $39.60 per common share. At the current price of $54.69 (11 January 08), this produces a quite respectable price to book of 1.38. A screaming buy? Maybe, maybe not... Despite write-offs, Level 3 assets still on Merrill's books last September totaled $43.1 billion. Of these, $16.6 billion were mortgage-related and asset-based security (ABS) CDO positions. Specifically, total net exposure to subprime and ADS CDO assets, even after the $7.9 billion write-down, was approximately $21.5 billion (which included some Level 2 assets and off-balance sheets exposures). Just under $5.7 billion of this total represented net exposure to subprime, while $15.8 billion was their exposure to ABS CDOs, which are backed primarily by residential mortgage loans. Additionally, for investment purposes, through bank subsidiaries and off-balance sheet conduits, Merrill Lynch had a further net exposure of $5.7 billion to subprime mortgage-related assets.

At the end of September, common stockholders' equity was $33.9 billion. Several more billion in write-offs and the book value drops sharply -- at that point, the price to book ratio would become much less attractive. Not too long ago, Goldman Sachs' analysts predicted additional write-offs totaling $11.5 billion for the fourth quarter -- more than 33% of stockholders' equity (as it stood in September)! Just last week, after I had begun to write this note, the New York Times reported from one of their sources that these write-offs could reach $15 billion. Investors seemed cheered by the news, hoping this would be the end of it... (Sound familiar?)

In the growing shadow of this threat, Merrill Lynch has gone looking for additional capital. In addition to the investment from Temasek already announced, it is rumored that management will announce a new deal very soon. Though these infusions of capital increase overall stockholders' equity, they are also dilutive and will not result in an improvement in the P/B ratio.

Merrill Lynch, of course, is not alone in this situation.

As I have stated in other posts, I do not doubt that the financials will eventually turn around, but I do not expect it to happen until investors get a true understanding of the value of the assets on their books. With the worst of the mortgage crisis yet to come, and its full impact on the credit markets yet to be determined, we do not yet have that understanding.

So, what seems like a value play may actually be a value trap. Though I am watching the investment banks closely, I am not think current P/B statistics provide an encouraging picture. Merrill Lynch will report its fourth quarter results this week (17 January); I will be watching closely.

Comments

[Manifestor]

Can you (the author) explain why you think "the worst of the mortgage crisis is yet to come". Are you referring to the adjustable mortgage rate resets and the coming quarterly write-downs or do you foresee additional factors that trigger more crises.

[Bottom Line]

This "subprime" crisis is nothing of the sort anymore. The consumer is tapped out after living well beyond their means for the past few years and the Housing Bubble is going to be largely responsible.

When prices ran to historically high and absurd levels consumers not only overextended themselves by buying homes they couldn't historically afford through traditional means, but current homeowners also refi'd their existing homes to the max in order to spend this new found wealth.

Why not max out that HELOC? My house will be worth 20% more next year!

People are just starting to talk about credit card defaults and just realizing that other things like car loans are probably next...

People are just so anxious to find that bottom after 2 tough weeks that there probably will be a bounce, but I don't think a bottom will be close until 3Q 2008.

[Aidis Zunde]

In response to the first comment, Manifestor is correct, I was referring primarily to the subprime mortgage resets, which are estimated to peak this year (though quite a few will not reset until 2009). The government-sponsored, but voluntary, "bail out" plan may postpone the bad news on some of these, but that will only be a drop in the bucket (and may only serve to distribute that bad news over a longer timeframe).

Having said this, some will then argue that all this information should already be priced into the derivative instruments built upon these mortgage loans and, consequently, into the share prices of the firms holding those derivatives. However, if the crisis of recent months has shown us anything, it is that even the "experts" do not have a handle on the full financial impacts of impending defaults.

This, in turn, will continue to affect overall willingness to extend credit, with all the associated second level effects on the business environment. Though I am not at all predicting the end of the financial world (far from it!), this is enough of a crisis for me.

Therefore, I agree with the second comment that this has gone beyond subprime; the "bursting" of the housing bubble, coupled with concerns about the quality of other credit sectors, will continue to exert a bearish influence for a while. I agree that the market has further to go before reaching a bottom...

For more of my perspectives, I encourage you to visit my blog at vestopia.com at your convenience.