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Why Yesterday's Optimism Wasn't Warranted

by: Gary Kramer April 02, 2008 | about stocks: BAC / C / DB / GS / JPM / MER / UBS

Gary Kramer

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It’s been done to death already, but a quick scan of yesterday's headlines made you think everyone was in on a huge April Fool prank. UBS (UBS) wrote down $19 billion and Deutsche Bank (DB) wrote down $4 bilion, so investors bought everything in sight, sending the market up almost 400 points to close at 12,654.

Everyone is once again saying that the worst is over, that they’ve finally accounted for all the losses, and that things are going up from here. I hate to be the bearer of bad news, but they’re wrong - and it’s not the first time.

Most people probably remember the Bear Stearns meltdown, the AMBAC and MBIA fiascos, the comments from Standard and Poors about the worst of the writedowns being over - and the subsequent surges in the markets after each of them. But you may not remember that this started last year. A quick refresher….

Here’s a NY Times story from October 2nd, 2007

The country’s biggest bank, Citigroup, will write off $5.9 billion in the third quarter, causing its profit to drop 60 percent from a year earlier. Europe’s biggest bank, UBS, said it had written down $3.4 billion in the value of mortgage-backed securities and would suffer a loss in the quarter. Other banks, including Merrill Lynch and Bank of America, have issued similar warnings.

Investors took the disclosures as a sign that the worst may be over for the banks and that any losses may be contained.

The Dow closed at 14,087, and the S&P 500 closed at 1546 on October 2nd. The Dow close was a record high.

Here’s another NY Times story from November 14th, 2007. According to the story:

Investors were buoyed by comforting words from top executives at Goldman Sachs and JP Morgan Chase, who said they were confident their companies would emerge relatively unscathed from the subprime mess. Lloyd C. Blankfein, Goldman’s president, said his bank would not take more write-downs on mortgage-backed securities, sending the bank’s stock up 8.5 percent to $233.04 a share. Shares in JPMorgan rose 6.3 percent.

The Dow closed at 13,231, and the S&P 500 closed at 1470 on November 14th.

Now comes yesterday's news. Stocks Surge on Hopes Financial Woes Are Easing was the NY Times headline. Another big surge in stocks with everyone thinking that the worst is over….

It’s not over. I don’t think it’s even halfway over. All those ARMs and Option ARMs that were taken out in 2005 through 2007 have yet to reset from their teaser rates.

When they do (throughout the next 2-1/2 years) there will be more losses. Many more losses. Much bigger losses. And stocks will need to fall to reflect those losses.

Disclosure: Author holds no positions in any of the stocks mentioned.

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Mortgage Cramdowns: A Disaster in the Making Jan 09, 2009

Related Stocks:

BAC, C, DB, GS, JPM, MER, UBS

This article has 27 comments:

Apr 02 01:09 PM
so your point is don't trust NY Times?
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Apr 02 01:13 PM
Yesterday: the most perverse response to awful news I've ever witnessed....
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Apr 02 01:14 PM
don't trust market optimism.

if loan performance is worsening worldwide, only about 25% of the estimated losses have been written down (292B out of 1.2T), and industry is slumping (auto sales down more than 15% yoy), how do markets go up?

how does any of this represent a bottom?
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Apr 02 01:16 PM
I don't understand all of the worry about resets on the 2005-2007 vintage of hybrid mortgage paper. Most of the teasers are at 150 - 200 b.p. Because of Fed easings, LIBOR has moved down 300 b.p. Most of the resets will be LOWER, not higher in rate yet people keep bringing up resets as a negative. DO YOUR HOMEWORK.
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Apr 02 01:17 PM
otoh,

people are tired of negative nominal returns from managed treasury accounts, don't trust or understand commodities, and won't put more money into real estate right now.

if every other investment option is worse, the stock market is comparatively attractive.
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Apr 02 01:30 PM
Well, you're definitely part of the "lunatic fringe". What you're not taking into consideration is that during the coming months/years, every effort will be made to refinance all those teasers before or as they reset. The financial companies and the government don't want foreclosures or losses. So lots of hoops will be jumped through to protect everyone, including the stock market.
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Apr 02 01:50 PM
Ya - i've been having a hard time understanding how losses make stock prices go up.
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Apr 02 01:50 PM
Ya- banks will be doing whatever they can to make sure that they dont have to foreclose on real estate that is worth less than the loans that are being secured by it. Very costly process - workout situations. Taking lower than market interest rate on rewritten loans, writing down interest and principal, not to mention the huge cost in labor to do it. Hey but one bright side, give the banks something to do, -they aren't going to be writing any new loans.
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Apr 02 01:53 PM
The stock market is a discounting mechanism and forward looking. Today's headlines are already factored in. Buy straw hats in winter.
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Apr 02 01:56 PM
the stock market is insanely inefficient
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Apr 02 02:29 PM
The main problem is the market (fueled by the bubbleheads at CNBC, and permabulls like Cramer) being driven by only one piece of news at a time. They can manipulate it to make it sound great, when viewed one piece at a time. But they are ignoring the forest fire to admire a single piece of grass growing. When taken together, there is no justifiable reason for the market to keep moving up. NONE.

As far as the market being a forward-looking discount mechanism, that is true, but the timing for us to be forward looking is not yet here. That should begin once things have settled and growth has flattened out...not when it is plummeting. There is still to much nebulous action ahead. Going ahead and calling bottom when you are still falling and reaching up instead of bracing for impact is called speculation.

The problem there is, and the root problem of all of these messes is pure, unadulterated greed. No one can fathom losing any money so they keep buying to fulfill their own feelings of supremacy. They won't allow the market to fall because they have been fed/told all their life that they are perfect and wonderful and they can do no wrong, and they actually believe it. This type of person will grasp at any shred of silver lining just to keep their fragile sense of self alive. Many of these people are analysts, who feed us their bs lines such as how Lehman severely diluting their EPS is a "good thing". Or how a manufacturing number that is horrible is actually "good" because it is better than their intentionally grossly lowballed estimate. tHey want to be the one to say in 5 years, "See how great I am? I called the bottom!" So they keep making predictions, because 99% of the population will only remember the one that finally came true.

I know this all sounds crazy, but investor psychology drives the market much more than fundamentals these days. This is what fuels excessive exuberance.
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Apr 02 02:48 PM
I'm a real bear at this point. I can't see how the stock market can keep going up in any short term horizon. What's the good news? But I'm stymied by this, the old saying: "Don't fight the Fed" when it comes to investing. To me, Wall St. is mainly a confidence/shell game. And yet it seems that the Wall St. Wunderboyz keep pulling crap out of their hats and we're all buying it. But once again, I come to the oft prudent warning about fighting the Fed. What do you all think?
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Apr 02 03:22 PM
I've never seen such a ridiculous market in all my life. What happens when the Fed is out of ammo. They must be sitting around every day saying Hmmm what BS can we pull out of our pockets now. Propaganda and a manipulation by our government has been a growing problem here in USA. These guys actually think that 600 dollars through our stimulus package will help us? Sure I can go to the supermarket 6 extra times and buy next to nothing. Common folks take a good look your all feeling this one. And Its just going to get worse. All these companies have to out do the last quarter or else they get beaten up in their stock prices. How they going to do that? Well their going raise their prices thats how. So your going to be spending more and more. But your not going to be making more and more. How upside down can you get before you finally say I cant do it any more. How are they going to do it when you cant buy their hyped up price products. This is one big Merry Go round. Prices have to fall everywhere or else we'll find ourselves crumbling under the pressure.
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Apr 02 03:48 PM
look, your money is not where you think it is:
March 31
Fiscal Year 2007: Capital/Assets
US
Bear Stearns 3,0%
Morgan Stanley 3,0%
Merril Lynch 3,1%
Lehman 3,3%
Goldman Sachs 4,5%
Citigroup 5,2%
JP Morgan 7,9%
Wells Fargo 8,3%
Bank of America 8,6%
Wachovia 10,2%

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Apr 02 04:15 PM
Finally! Im not an idiot!! These banks are going to get hammered! Im glad to see someone else feels the same!!!
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Apr 02 04:36 PM
I love it! UBS and DB write off ANOTHER $23 billion, and the idiots in the market go nuts. Did everyone forget that the banks have only written down about 30% of the total projected losses? How bout home builders? Another great play right now. Their stock is up huge, but the companies are in the toilet. What gives???
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Apr 02 05:03 PM
MER will announce at least 6 Billion in losses and it wont be over. Till the govt. does something big about subprime/ CDOs/Housing, the bleeding wont stop.

A couple of Investment banks need to go down - just like BSC did. That will cleanse the market and the true value of securities will be revealed. Remember how BSC ( and other inv. firms)was telling it was difficult to evaluate their securities due to the complex nature?? Well, overnight how did they (JPM and the Fed) decide that BSC was worth $2.00 - where was the complexity hidden, and unmasked just like that ??

Time to take a haircut - or should I say, completely shave the head?
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Apr 02 06:21 PM
Don't fight the Fed? All the Fed is doing is allowing the economy to fall with a parachute instead of smashing its guts out against the ground. Descend yet survive is the objective. The only choices we have on the way down are to shut our eyes or enjoy the view.
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Apr 02 09:08 PM
TOTALLY PREPOSTEROUS. I HOPE THE BANKS TANK BIGTIME AND I WAS NOT SHORT EVER BEFORE.
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Apr 03 12:53 AM
"I don't understand all of the worry about resets on the 2005-2007 vintage of hybrid mortgage paper. Most of the teasers are at 150 - 200 b.p. Because of Fed easings, LIBOR has moved down 300 b.p. Most of the resets will be LOWER, not higher in rate yet people keep bringing up resets as a negative. DO YOUR HOMEWORK."

I've done my homework - do yours....

I have a brother who took out a 3/1 Option ARM in 2005 (I told him not to do it) at a 3.785% rate. He put 5% down. His mortgage will be resetting in August, and his payments will almost double when his loan resets - because he's been paying the minimum.

He will not be able to keep the house, and he is NOT alone. The headlines are full of people like him (read a post from last week at
www.effor.com/blog/ind...
who will owe more than their house is worth. He will default on his loan - alond with thousands of others.

Your argurment would be correct if we were talking about people who took out traditional ARM's, but millions didn't. Interest only and Option ARM's made up close to half of all mortgages in 2005 through the first half of 2007. The majority of these home squatters will default when rates reset.

Do your homework.

Any questions?
gk

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Apr 03 01:17 AM
"so your point is don't trust NY Times?"

I used the NY Times as a source because evryone knows who they are, and their stories are normally factually correct. You are welcome to Google other sources for the dates above and pick your favorite source - they all say pretty much the same thing, and they all quote pretty much the same sources.

As I've said over and over - I don't know what prices will be next week or next month - but financial stocks (and the broad market) are not at the bottom yet. My best guess (and it's only a guess) is that we won't see a true bottom until late this year at the earliest.

As long as stocks skyrocket when more losses are taken, we're not at the botton. It'll take one or two quarters of no writedowns before people will trust the statements made by the financial sector.

They've lied for the past 6 months about the extent of the potential and real losses, so they've cried wolf too many times. At some point these lies will be reflected in stock prices. When the "forward looking statements" start to match the actual quarterly results, I'll move back into the market.

Until then, I'm looking at bear market rally's just like 2001 through 2003.

Of course I'm not a pro at this, and I don't know what's going to happen - but my money is 90% in cash at this point. I may be right about the stock market, and I may be wrong - but I'm not going to sit by and watch my portfolio lose 50% like so many people did from 2000 through 2003.

As Will Rogers once said "I'm more interested in the return OF my investment than I am the return ON my investment."

But there are two sides to every trade.... Which side are you betting on?

gk
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Apr 03 05:12 AM
the arm-reset is discounted and a moot point these days. what is not yet discounted and will ratlle markets over the coming 3-4 quarters are writedowns, losses and ultimately bankruptcies for several banks related to the falling value of land. foreclosures have just started to hit the banks' loan püortfolios. much more damage is ahead when those guys find the time to assess their loan portfolio and the land-collateral. homebuilders such as centex and lennar sold land at 20-30cents on the dollar. some regional banks will go under and counterparty risk will be a hot topic again. municipalities will face possible bk as well due to interest rate swaps that turned sour, lower tax revenues and escalating costs. good luck to those buying into leh, mer, ms, gs, wb, bac and jpm - you will likely find out that you could buy into most of them another 50-70% lower
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Apr 03 06:02 AM
Great letters! You've said it all.

I had a great five years of investing but I exited the market in August because it was obvious to me that this market has no credibility whatsoever. And it just gets worse and worse.
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Apr 03 07:33 AM
gary, wouldn't the banks have priced in the defaults that are as inevitable as you make the seem?
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Apr 03 08:17 AM
After reading all of the comments on EVERY site on Every Financial Co. Not one comment or article reflected a positive outlook. April 1, 2008 was a great day indeed. It carried a 400 point DOW move on the WORST news I have ever heard. UBS writing 19 billion off the books and having to Dilute the company with 15 billion stock sales..... and they SOAR 15%.... LEH did the same thing and MER moved up 12% on the news... The only way to look at that as a positive is it gave me a better place to enter a short position on all of the financials.... other than that, Ill just let Market gravity over come the small rallies.... Thank you all of you for your insight and thoughts and taking the time to comment.
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Apr 03 04:02 PM
Gary
I think the Administration is pulling strings to avoid a crash because they know that a market crash would kill their chances of staying in the White House. Why else would all these crazy things be happening? One problem that most of you seem to be forgetting is the high price of energy. No matter what happens to the banks the high price of gasoline is going to scuttle the consumer's ability to fill up the Tahoe and chug on down to the mall to pick up those Victoria's Secrets, flat screen TVs and Cheese Doodles. Since consumer spending constitutes 70% of the GDP I don't think there is any way we can avoid a serious recession. Have you read about the truckers blocking the Parkway to protest he desiel prices? The price of crude is not going to come down because demand is coming from worldwide sources.
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Apr 03 07:08 PM
Gale, Bush's chance of staying in the white house is over soon. He doesn't have enough power to offset the term limits, and he doesn't have enough power for this. Politics doesn't have anything to do with this so get back to reality. Dump the Tahoe. You'll have more money to pay your mortgage...
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