Q3 Earnings Season: Taking the Long View

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Includes: BAC, BSC, C, CFC, COF, ETFC, GS, JPM, LEH, MS, USB, WFC
by: Markham Lee

Q3 earnings season kicks off this week with four of the big brokers reporting first: Lehman Brothers (LEH) reporting on Tuesday, Morgan Stanley (NYSE:MS) on Wednesday, and Bear Stearns (NYSE:BSC) and Goldman Sachs (NYSE:GS) reporting on Thursday. The Lehman Brothers report also comes on the day that many expect the Fed to announce a rate cut, which means we financial scribes won’t be lacking for anything to write about Tuesday afternoon. With respect to the brokerage’s earnings reports, I’m most interested in understanding how they expect earnings to be impacted down the road from slowing LBOs, the credit crisis, etc. I would also look for any data around losses from CDOs, in addition to hoping to gain an understanding with respect to future ARM reset exposure and CDOs for each the broker has yet to realize the losses. However, considering the market events of the past 6-8 weeks, I think we need to take the long view with respect to looking at results from the financial sector. Don’t get me wrong, I’m not downplaying the significance of the results from the big brokers, however, keep in mind that there are a LOT of earnings reports and data releases related to the financial sector, coming out over the next month or so. In order to generate a solid understanding of the overall health of the financial sector, and assess the carnage from the credit and mortgage crises, we’ll need to a wide cross section of data in order to gain a holistic view.

In other words, this week’s data is just the tip of the iceberg.

Financial Sector Earnings

Over the next month or so, here are a few things to watch for as various financial companies report earnings for Q3 2007:

Capital One (NYSE:COF)

Capital One’s problems with GreenPoint Mortgage have been well publicized, and COF slashed their earnings forecast by 1/3 due to having to shut down that unit. However, there are a couple of other issues to deal with:

1) During Q2, earnings from COF’s auto lending business declined 60% on a YoY basis, if this rate of decline continues, it spells not only significant problems for COF, but for the auto lending (subprime in particular) sector as a whole.

2) Capital One’s exposure to the mortgage crisis didn’t die with the shuttering of GreenPoint, as they still originate a significant amount of mortgage loans outside of GreenPoint. In fact, their web site still advertises no/low documentation, ARMs, etc. It stands to reason that they still have significant exposure to the mortgage crisis.

3) First and foremost, Capital One is a credit card company and whilst their credit card business has been strong over the last two quarters, it remains to be seen if that trend can continue. U.S. credit card lenders reported a 30% increase in total defaults/charge-offs over the first half of 2007, this is on top of the fact that COF increased the number of direct mail credit card solicitations sent to subprime borrowers by 18%. Considering the overall industry trend and COF increasing its exposure to borrowers with the lowest credit ratings, it stands to reason that COF will see some weakness in its credit card unit before long.

Countrywide Financial (CFC)

The main question waiting to be answered is whether or not Countrywide is a money losing mortgage lender or a profitable lender that is just a victim of the credit crunch. If the question is the former, their future becomes rather murky, if it’s the latter the common prediction that Countrywide will emerge from their current problems as the dominant player in the mortgage market, may well be on their way to coming true. The following are some other things to watch for when Countrywide reports:

1) Liquidity: back in August, Countrywide issued a press release stating that they would be funding 100% of their mortgage volume through their retail banking arm by the end of September. They also stated that through the implementation of more rigorous underwriting standards, they now expect that “90 percent of the loans we originate will be GSE-eligible or will meet our Bank's investment criteria”. I’m not so much interested in the loans meeting the bank’s investment criteria here, just what % of their loans are now able to be (and have been) sold to the GSEs?

2) ARMs: In their last earnings report, Countrywide stated that they have $27.2 billion worth of ARMs on the books and 5.7% of these loans have late payments. It will be interesting to see if CFC has managed to refinance these loans, sell them, etc, in order to reduce their exposure to ARMs, as well as somehow reduce the number of these loans that are in arrears.

3) Delinquency Rates: the key here isn’t so much the actual rate it’s whether or not there is a trend indicating a DECLINE in the delinquency rate from Q2, or even when comparing August to September. I will note that subprime mortgages had a delinquency rate of almost 24% last quarter, and prime HELOCs were around 4.56%; consider it a positive sign if the rates stay positive, decline or only increase slightly.

E-Trade (NASDAQ:ETFC)

Justified righteous indignation or was the “discount broker protesting too much?”, is the question investors want answered when E-Trade reports its Q3 2007 earnings. After all, let’s not forget that during the initial stages of the mortgage crisis (back in March/April) both Thornburg Mortgage and Indy Mac Bank were protesting the declines of their stock price, releasing data on the quality of their mortgage portfolios, etc, well, look at where they are now.

Finally, the overall financial state of E-Trade has significant implications on a lot of the calls for further consolidation amongst online brokers. I’ve always felt that TD Ameritrade lagged behind E-Trade, let alone Schwab and Fidelity due to its dearth of banking services, lending, credit cards, etc, BUT, they may have the last laugh if E-Trade’s mortgage portfolio is as bad as some people think.

Bank of America (NYSE:BAC)

Due to the company’s avoidance of the subprime mortgage market, I look to BAC as an indicator of the health of the prime mortgage and consumer debt markets. During Q2 of ’07, BOA raised its reserve for bad loans by 80%, saw a 47% increase in net charge-offs and saw a 23% YoY decrease in the earnings from its consumer banking unit (retail banking, consumer loans and credit cards).The question for BAC will be simple: “During Q3 of ’07, did the company managed to slow down, maintain or decrease the negative trends we saw around consumer debt during Q2?”

Macro Data on the Economy & the Financial Sector

With regards to macro level data on both the economy and the state of the financial sector as a whole, it would be wise to keep an eye on the following:

Federal Reserve Statistical Release G.19: This report provides data on consumer debt levels for auto loans, personal loans and revolving lines of credit/credit cards. Starting last year and continuing throughout the current one, the rate of increase for revolving debt levels held by consumers has jumped substantially due to a combination of resetting ARMs, the closing of the housing ATM, etc. Unless the rate of increase slows down, it’s quite likely that we’ll see not only a consumer debt bubble, but bank earnings suffer when overextended consumers cause the bubble to burst.

FDIC’s Quarterly Banking Profile for Q3: this isn’t a report that always gets the press it deserves, which is a shame because it provides an excellent view into the overall health of the US Banking Sector. The last one had a lot of negative data in it with respect to increases in delinquent loans, the number of money losing banks, etc, however, that was for Q2, what do the numbers look like with the credit crisis and the rapid increase in the number of foreclosures are factored in?

Lately, there has been a trend of investors getting overly excited just because one piece of the puzzle looks positive, as opposed to looking at the big picture. This is true whether you’re looking at retail sales data, financial stocks or the market as a whole. There is an absolute ton of data coming out around the financial sector over the next month or so, be sure to review, evaluate and consider all of it before making your forecasts and assessments with regards to the financial sector, the mortgage crisis, credit crunch and the U.S. economy.

Here is the Q3 2007 reporting schedule for some of the major financial firms who’ve announced reporting dates as of 9/14/07:

- Lehman Brothers: 9/18/07

- Bear Stearns: 9/19/07

- Goldman Sachs: 9/20/07

- Morgan Stanley: 9/20/07

- U.S. Bank (NYSE:USB): 10/16/07

- JP Morgan Chase (NYSE:JPM): 10/17/07

- Bank of America: 10/18/07

- Citibank (NYSE:C): 10/19/07

- Wachovia (NASDAQ:WB): 10/19/07

Disclosure: as of the writing of this article, the only companies mentioned that the author holds a positions in, is U.S. Bank.

Sources:

  • The Financial Times: “Credit-card defaults on rise in US” – August 27, 2007
  • The Boston Globe: “Credit card companies woo struggling mortgage-holders” – September 4, 2007
  • PR Newswire: “Countrywide Supplements Funding Liquidity Position” – August 16, 2007