Wow, lots of stories Friday about the “shocking” earnings miss (and lowered forecast) by GE (NYSE:GE). MarketWatch said, “GE’s warning pokes hole in recent sentiment that credit crunch has passed” and “The rebound had been fueled by renewed sentiment on Wall Street that the worst of the credit crisis — including the threat of spiraling financial bankruptcies — was past.”
A story on CNN said, "'My guess is that earnings forecasts for 2008 are still pretty high relative to the economic reality,' Davidson said."
I have one word for Mr. Davidson - Duh!
As I posted just yesterday, I don’t think we’re anywhere close to a bottom yet, and the earnings estimates for 2008 and 2009 are way too high. Eventually, stock prices adjust to reflect earnings, and sometimes the adjustment process is long and painful - as we all learned in 2000 through 2003.
All the stories about Goldman Sachs’ (NYSE:GS) and Lehman's (LEH) CEOs saying that they can see the light at the end of the tunnel - while simultaneously upping their own writedowns - are crap. If the CEOs are so good at predicting the future, why couldn’t they tell us what losses their own companies were going to have?
Speaking of Goldman, I think the glitter is coming off. This past week it announced that the amount of “Level 3 assets” increased from $69 billion to $96 billion during the first quarter. If you haven’t been keeping score, “Level 3 assets" are those for which there’s basically no market, no one wants them, so Goldman is stuck with them.
It's kinda like having a house that’s “worth” $1 million, but no one will buy it, so you’re stuck with the mortgage payments - but you can say you have a $1 million house. That is, at least until you have to sell it because you can’t make the payments any longer - then it suddenly becomes a $500k house - and you just lost $500k.
It also means that the value of those assets is a 100% guess. In effect, Goldman is saying “we think we might have $96 billion in assets, but we really don’t know what they’d be worth if we tried to sell them. They might be worth $96 billion (but we’re almost certain that that’s not right) but they might be worth 3 cents on the dollar. We don’t have a clue, so we pulled that $96 billion number out of our butt.”
Level 3 assets are, by definition, “hard to value.” In fact, they are impossible to value, because no one will buy them. So companies use a “mark to model” method to come up with a number. Since “mark to model” varies depending on the model used, we’re back where we started - no one has any idea what these assets are worth.
You may be asking why it’s a bad thing that the value of the assets rose so much in one quarter, and that’s a good question. Wouldn’t it be a good thing if my $1 million house went up to $1.5 million in one quarter? The answer to why it’s bad is that it’s a made up number. I know that this is probably getting old but you need to understand it - NO ONE WILL BUY IT AT ANY PRICE RIGHT NOW!
Your next question is probably something like “Why would Goldman make up a higher number for these assets if that’s viewed as a negative?" Another good question, but the answer is easy. You see, if you claim that your assets are worth more, you can use them as collateral so you can borrow more money.
Kinda neat, isn’t it? Goldman increased its ability to borrow by $27 billion in just one quarter. But who would take these Level 3 assets as collateral you ask? You’re on your “A” game tonight dear reader - another good question.
The answer is that there’s only one place to go to borrow against these assets that no one will buy - the Fed. You and me (via the government) are loaning Goldman billions of dollars by allowing it to give (I’m going to make up some numbers here - let’s call them “Level 3″ numbers) the Fed $10 billion in Level 3 assets. In exchange, the Fed gives Goldman $10 billion in Treasuries.
So you and I are now on the hook for $10 billion of basically worthless assets, while Goldman now has $10 billion of nice safe Treasuries. Nice trick, ain’t it? That’s the Federal Reserve’s new Term Securities Lending Facility [TSLF] in a nutshell.
That’s one of the ways that the Fed is propping up the banks and brokerage houses right now - short of an indirect buyout like they did with Bear Stearns (NYSE:BSC) anyway. But sooner or later, the losses from these made up Level 3 assets need to be accounted for.
The only question remaining is who will pay for the losses - the banks who made the risky loans, the investment houses that took the risky loans and leveraged them, or the taxpayer. My best Level 3 guess is that we’ll see a combination of the above, but taxpayers will eat a significant chunk of the losses.
As a result, the Fed will have to print more money to pay the bills, so the dollar will continue to fall, and the stock market will drop in inflation adjusted terms - and quite probably in real terms as well. Within the next 12 months, Dow 9,000 is much more likely than Dow 15,000 in my opinion.