S&P500 ex-Risk ?

Here’s an issue I have been mulling over, without a satisfactory answer: 

There have been many investment thesis (thesii?) over the past few years about the market which supported the bullish side of the ledger: Earnings were high, stocks were cheap, risk was moderate, the Fed model favored stocks over bonds.

Regardless of whether you found these arguments persuasive or not, global markets have gone higher. While the U.S. indices may have lagged the rest of the world’s bourses, they too, have powered higher. 

Here’s the odd factor: It turns out that many of the arguments made in favor of U.S. domestic growth have been based on an assumption that turned out to be false. To wit: The Financials, the largest sector in the S&P500, had legitimate, sustainable, normalized risk-based earnings.

That basic premise turned out to be wrong.

Picture a race car driver, going way too fast in the first half of a track. He puts up record breaking lap times, only to crash and burn in the last turn. His driving coach would say his risk-adjusted speeds were irresponsible.

That’s how I perceive what has been going on with the Financial sector. It wasn’t Fraud, but rather a reckless disregard for Risk that led to outsized returns on many big cap stocks in the group.

Merrill Lynch (MER) just wrote down $8 billion dollars, erasing 5 years of profits. Citigroup (C) dinged  $11 billion. Washington Mutual, (WAMU) Countrywide Financial (CFC), Bear Stearns, GMAC — there seems to be an ongoing parade of mea culpas that are erasing not just quarters of profits, but years of earnings. And there are likely to be many more of these, as tier 3 assets get priced appropriately. (UPDATE: Morgan Stanley (MS) now rumored to take a $3-6B writedown)

What’s truly astounding is that we may only be seeing the tip of the iceberg. Its possible that the big brokers and banks have $1 trillion in toxic debt on their books to be written down. That would equal decades — not years — of profits to be wiped out.

To paraphrase the WSJ, "the financial crisis is becoming Shakespearean comedy."

So here’s the odd question that I have been wrestling with: Given what we now know about how the true nature of the S&P500 earnings in this group, what did the past few years of data actually look like? Now that the big Banks have erased nearly all of their earnings of the past few years, what should that data have looked like from 2003-2007 with most of the Fins as a goose egg?

I would like to see historical data adjusted for the S&P500 for the Financial sector’s losses. Specifically, if we back out the earnings that turned out to be based on a reckless disregard for risk, what does the following data look like?

• What were year-over-year Earnings? 

• How cheap were stocks really?

• What were the actual risk adjusted returns?

• Were stocks as undervalued as the Fed model suggested?

Consider our race car driver from before. If he fails to finish the lap, his time gets voided. Any Financial compan’s earnings are a function of measured risk versus potential reward. If earnings turn out to be based on far greater risk than assumed, and subsequent losses offset them — i.e., they are not sustainable — they too have been voided.    

Question for our mathematics wizard readers: Can we figure out an easy way to take the historical data, and adjust these reckless risk-based earnings, now that they have been wiped out?

I don’t know the answer to these questions — but they certainly are food for thought . . .


Markets fear banks have $1 trillion in toxic debt
Sean O’Grady
The Independent, 06 November 2007

Why Street Bankers Get Away With Repeating Old Mistakes
WSJ, November 6, 2007; Page C1

Fears intensify for prolonged turmoil
FT Reporters
November 5 2007 21:27 |

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  1. CR commented on Nov 6

    Stocks are set to rebound today, and the economy’s looking better than ever. I read that on the news this morning. What on earth are -you- talking about?

  2. rjrj commented on Nov 6

    The plural of thesis would be theses.

  3. Chad Brand commented on Nov 6

    Your post implies that an $8 billion accounting writedown is equivalent to $8 billion in profits, and thus they offset in your view of the situation. However, as was noted on the Citi call yesterday, these writedowns are not cash outflows, they are simply accounting adjustments. These ABS are still generating cash flow in-line with expectations (downward adjustments will occur, but not at the magnitude that an ABX index would imply).

    This is one reason why Citi doesn’t have to cut the dividend. The writedowns are simply accounting entries, not actual cash flow hits. As a result, I don’t think $1 of cash earnings would be equivalent to $1 in CDO writedowns, as in your example.

  4. dukes commented on Nov 6

    Barry, I do think what the financials have been doing is out and out fraud. I wish I could use Level 3 accounting to count the value of my assets…don’t you?

  5. Leisa commented on Nov 6

    BR, Is this really a useful exercise? Would you do the same thing for commodity driven stocks where their earnings were “inflated” due to commodity prices being high that subsequently collapsed?

    Also, the previously reported “income” that showed up in the income statements were due to fees. The losses experienced are asset valuation writedowns–balance sheet items. You’d have to do the same thing for homebuilders. A bit of apples/oranges.

  6. RichardN commented on Nov 6

    It erased 5 years of profits in the sense that most of those profits were also just accounting adjustments, not cash. The cash-flow citi has certainly does help them, but those “accounting adjustments” significantly affect their capital ratios and their ratings thereby jeopardizing their dividend. I don’t think you were listening to the same CC as I, because it was actually quite scary, and the market agreed.

  7. Gustav commented on Nov 6

    @chad brand: If you are marking your assets to market prices, these prices reflect the discounted value of their cashflows (if you beleive in financial theory of market values).
    this assumes the writedown is actually anticipating a future loss.
    however, one could say the ABS are UNDERVALUED at their current market value, then one should buy them (as one could argue, chinese equities are overvalued).

    So those writdowns anticipate the cash-flow losses in the future…..it’s just paper money, but if markets turn out to be right, the cash flows will be missing in the future…..

    thank you, IFRS mark to market, the greates bubble generating accounting sceme invented

  8. Marcus Aurelius commented on Nov 6

    As with the presumably dead driver, analysis of his recklessness will help neither him nor the spectators (other drivers might take heed – but then again, they apparently understood the risk before coming onto the track).

    P.S: Autopsy of the driver woud confirm that he had beeen smoking crack and drinking martinis prior to and during the race.

  9. shrek commented on Nov 6

    Very interesting Barry.

  10. Greg0658 commented on Nov 6

    Chad – I agree on your write down thesis. No money gone, just the ability to buy something with #’s in an account.

    BR – The Fed and the general system has been forcing folks to gamble in markets. Add pay to play. But IMO working class folks only have time to deposit in savings accounts for a guaranteed return for the later years when the body is worn out.

    Chad – What were they buying? Cheap labor in foreign lands. Domestic companies play’g the game and struggling. Consolidate then Break-up … for those #’s.

  11. Will G commented on Nov 6

    I have to agree. Since 1990 financials have moved from a 8% weighting as a percentage of the S&P 500 to a 21% weighting with profit margins in the sector jumping from 6% to 14%. I would give equal credit for the jumps to deregulation and increased risk appetite.

  12. Greg0658 commented on Nov 6

    ps – fast moving trade in this thread

    My personal conundrum – I was always hoping for Unity in the World and balanced living standards abroad, but home community 1st please.

  13. GST commented on Nov 6

    by: Chad Brand | Nov 6, 2007 7:48:41 AM

    – is absolutely correct.

    99 % of market participants don’t understand that these are non-cash charges that dramatically overestimate the risk to cash flow.

  14. Ironman commented on Nov 6


    I think that you’re describing an awful lot of work – it might seem do-able at first if you limit the analysis to the dedicated home lenders, investment banks, etc. but I think the problems scale substantially when you start expanding the “extraction” process into the holders of the debt (hedge funds, non-primary home lenders, etc.) How much of this kind of debt holding would be enough to exclude a company from the index? Worse, this is the kind of thing that you really have to mine the footnotes in dozens, if not hundreds, of annual reports to discover the full scope.

    There might be an easier way to do this. Over it’s history, there’s been a remarkably strong correlation between the S&P 500’s index price and dividends per share, particularly in the modern age (since 1952).

    If you accept that dividends represent the portion of earnings that the S&P component companies believe to be “sustainable”, there’s a pretty straightforward mathematical relationship between the two while the market is in what passes for an equilibrium growth phase:

    P = Po * D^R

    Here, Po is the effective value of the S&P 500 index with zero dividends per share, D is Dividends per Share (over the preceding 12 months) and R is the ratio of the average growth rate of index value to the average growth rate of dividends per share, which is fairly constant during these phases. P would be the average monthly price per share of the index (the index value).

    The current growth period that began in June 2003 with the end of the bubble. Po is 121.74, R is 0.7574 (being less than 1, this indicates that the dividend growth rate has been faster than the growth rate of stock prices), and through September 2007, dividends per share for the S&P 500 is 27.06.

    Assuming the growth phase for stocks is fairly broad-based, if you can anticipate how the financials might change their dividends (which affects both the dividends and dividend growth rate), you can use this relationship to anticipate where the S&P 500 index will go.

    Otherwise, expect the market to continue tracking on its current course, absent serious (and highly disruptive) disturbances.

  15. Werner Merthens commented on Nov 6

    I think going back and readjusting what were projected earnings before is an exercise in futility. It does not change anything. It is just psychologically comforting for the perennial pessimists, who can now claim that they were right all along.
    The entire return vs. risk scenario is basically very simple. In order to earn a return over the risk free rate you have to assume risk. There is no way around that. And risk means the possibility of a real tangible loss. In some cases the loss may be big enough that it really hurts.
    So the perennial bulls have to suck up one of those biting losses every now and again. It is just the nature of the financial markets.

  16. Philippe commented on Nov 6

    It may be difficult to restate past profits in accordance with level 2 level 3 abscond accounting from the banks (assets value are estimated in accordance with the banks management opinion please read “there is no market matching their prices”.
    As far as I am concerned the net assets value is the only method to assess the banks.
    It is to be read very often that central banks in their capacity of Banks supervisors are not able to assess the banks.It is harder to back value date their level 2/3 past profits and actual profits

  17. Vega commented on Nov 6

    To the unbelievably naive people who think Chad makes a good point and to Chad:

    There are two sides to the balance sheet. Clearly you do not understand this. When you write down assets, you are not miraculously able to write down your liabs, too. You cannot say, “Hey, I borrowed $100B to finance $100B of bullshit assets. Gee, now those assets are worth 10% less so I’m going to write them down. Awesome! I can write the liabs funding those assets down, too.” You cannot do that, folks. That is NOT how it works. You take a hit to equity. Why? Because A = L + OE. If your A’s get smoked, you better believe your OE is going to get smoked, too. That is a HUGE deal, folks, that is why people are puking their bank and b/d shares. In short, the assets on the balance sheet of MANY of these fins are totally mismarked. TOTALLY. And when I see Maria Bartiromo bullshitting on CNBS with a bunch of dumbass talking heads about “Gee, is it time to buy the fins yet?” I want to puke. Let me reiterate: the assets on these firm’s balance sheets are STILL mismarked. Ask yourself this: “Gee, Citi’s Level 3 assets jumped to $135B last quarter. How do I feel about that?” Mark-to-mystery assets are not a good thing, folks. Asset QUALITY will continue to erode as defaults on home mortgages continue to ramp up, and the ramp in write-offs (write-oofs?) will continue as all the b.s. borrowers have a come-to-Jesus moment and realize their ability to pay off their now-underwater home loan is ZERO.

    Want to know the best part? According to ISI, a significant portion of defaults in the mortgage space are NOT due to ARM resets (yet). That’s right, people are defaulting now because they cannot pay the TEASER rate. Think about that. Also, consider thinking about what the reset curve looks like for vanilla ARMs and option ARMs in 2008 and 2009. Just wait. The horror show for the banks is just beginning.

    P.S. BR, MER’s $8B writedown is equivalent to only FY06’s total PnL, not five year’s worth. I believe the “five year’s worth” we heard bandied about relates to 5 years of fixed-income PnL.

  18. Ross commented on Nov 6

    Citi takes a write down. I must pass thru the income statement and wind up as a charge against equity. Not a cash charge for sure. Perversly reducing equity increases the future return on equity. Value players, anyone anyone?
    Just follow Dick Bove’s lead. He is one smart cookie.

  19. s0mebody commented on Nov 6

    At least now the bulls are getting their “multiple expansion”

  20. Winston Munn commented on Nov 6

    If I understand the sentiment presented, the banks are marking these assets to a fair estimated value based on cash flow, while the markets that trades these assets are wrong?

    However, many of these products were financed and refinanced with short term loans.

    The problem it seems is twofold: first, the assets backing these products is falling in value, so the package itself was originally mispriced; second, the default/foreclosure rate is much higher than anticipated, meaning risk, too, was mispriced.

    The banks seem to be saying that if we can hold onto these assets long enough, we can reduce our losses, while the markets seem to say otherwise.

    With a home inventory glut continuing to plut downward pressure on home prices and ARM resets pressuring default rates, it doesn’t appear that these assets will recover anytime soon.

    So if you are depending on short term loans to refinance, who is going to lend on an asset whose value is doubtful? And if you can’t refinance….

    So I think the argument is right…up to a point. The real losses will occur when the products have to be liquidated in the markets.

  21. The Dirty Mac commented on Nov 6

    I have skimmed these posts, so I apologize if this point was made already.

    Citi and all banks are in the leverage business. When capital is decreased for any reason, the amount of assets the bank can support will decrease by the amount of capital times the equity multiplier. So, there is a substantial opportunity cost even though there may not be an immediate cash flow loss.

  22. Michael Donnelly commented on Nov 6

    I like the analogy, and to advance it one more step. All the bonus money paid during the time the car and driver were in the straight away are gone for good. There is no claw back as car and driver are crashed in the turn.

    Same happened during internet bubble, similiar happened with Enron.

    The good times aren’t that good and the insiders know it, so they cash out. This and NOT Martha Stewart type insider trading is a problem.

  23. Kp commented on Nov 6

    Umm, I thought the money was mostly made from the securitization and custodial fees, not from cash flows associated with HOLDING these bullshit derivatives. Income from the fees is REAL, and does count.

    Isn’t this the halmark of the IB business model? Find new and innovative ways of repackaging and reselling….never have to actually hold on to the toxic waste. What we are seeing IS the worst case scenario. The music stopped…the lights came on…and the IB’s crap conveyor belts grinded to a halt.

    Anyway I think it’s wrong to look at it as erasing past earnings. It only affects future earnings expectations, and I thought that what stock prices are supposed to mirror.

  24. Chad Brand commented on Nov 6

    I think my point would be to focus on whether or not the ABX index, at today’s quote, really reflects what will wind up being the true “present value of future cash flows from the MBS.” If you believe the markets are efficient right now, then yes, you would disagree with my prior point above.

    I would argue, however, that a subprime loan index like the ABX trading at 18 cents on the dollar when subprime delinquency rates are in the 30% range (this is just the last number I saw, it could be off) might indicate that writing assets down based on current market prices might proof inaccurate. Do we really think 88% of subprime will default? Even if we say 50% will, the ABX isn’t indicative of reality.

    Nobody knows where the numbers will wind up, but I can certainly understand why the banks aren’t rushing to mark everything they have down to zero or 18 cents on the dollar.

  25. Chad Brand commented on Nov 6

    I think my point would be to focus on whether or not the ABX index, at today’s quote, really reflects what will wind up being the true “present value of future cash flows from the MBS.” If you believe the markets are efficient right now, then yes, you would disagree with my prior point above.

    I would argue, however, that a subprime loan index like the ABX trading at 18 cents on the dollar when subprime delinquency rates are in the 30% range (this is just the last number I saw, it could be off) might indicate that writing assets down based on current market prices might proof inaccurate. Do we really think 88% of subprime will default? Even if we say 50% will, the ABX isn’t indicative of reality.

    Nobody knows where the numbers will wind up, but I can certainly understand why the banks aren’t rushing to mark everything they have down to zero or 18 cents on the dollar.

  26. Scott Frew commented on Nov 6


    The financials contributed x% (30+?) of S&P earnings, therefore, real S&P earnings were actually smaller by that percentage 9whatever it was — I’m estimating between 20-30%).

    Therefore, the real P/E of the index was much higher than actually claimed and stocks were not nearly as cheap as advertised.

    When you buy stocks when they’re expensive, you tend to not get good results over time. . . .

  27. GST commented on Nov 6

    To puker vega:

    Your analysis is as good as the totally erroneous “five year’s worth” in this post.

    You don’t understand Chad’s point, because you don’t understand the difference between cash flow and ‘asset marks’.

    Read the comment following yours.

  28. GST commented on Nov 6

    Posted by: Chad Brand | Nov 6, 2007 9:42:24 AM

    – again is exactly correct. The ABX is way off likely cash flow realizations.

  29. spcwby commented on Nov 6

    Here is the Level 3 assets to equity ratio summary:

    (Courtesy of Roubini’s Blog)

    Citigroup 105%

    Goldman Sachs 185%

    Morgan Stanley 251%

    Bear Stearns 154%

    Lehman Brothers 159%

    Merrill Lynch 38%

    This becomes very interesting now, doesn’t it?

    Looks to me like Goldman Sachs and Morgan Stanley are by far in the WORST situation among the investment banks.

    And yet the media is focusing all of their attention on Merrill Lynch—which actually has by far THE LEAST EXPOSURE of all of them. What a joke.

  30. michael schumacher commented on Nov 6

    Does’nt matter how you paraphrase it however the banks are increasingly using words that do not really equate to what they are doing.

    The bottom line is that a “write down”= some measurable and equity changing loss.

    No other way to look at it, you can parse it any way you like (the banks and brokers are spending millions of dollars just so YOU understand that a write down is “different” than a loss). And the best part about it is that they are trying, yet again, to put some gift wrap on it and present it to you as another opportunity…….

    Banks/Brokers are scumbags that lie at every opportunity they have. Because out country is financially ignorant they get away with telling you that a write down is not a loss and people actually (in this thread) believe it.

    But wait…this is only really starting. What happens in Q2 ’08 when Merrill can’t blame O’Neal for the continuing “write-downs” or Citigroup who can’t blame Prince for it either. These brokers get one qtr “free pass” so that they can blame the ex CEO’s. After that what do they do???

    A loss is a loss NO MATTER how you gift wrap it.


  31. joe commented on Nov 6

    Chad, you don’t understand how ABS works if you think 88% of subprime mortgages have to default to wipe out the BBB- tranche of a mortgage backed security.

    Further, you definitely don’t understand how CDO’s work. Once the BBB- tranche of MBS defaults, all the mezzanine CDO’s, which are collections of BBB- tranches of MBS repackaged magically into 80% AAA CDO securities, will start to face downgrades (or already have).

  32. MikeinMT commented on Nov 6

    I’m with Barry and Vega. If you retain your earnings to capital and then subsequently write down some other asset, it’s the same as if those earnings never occurred.

    What will really be interesting is when all this gets extrapolated to GDP.

  33. Lloyd commented on Nov 6

    Cash flow is king and I understand what is a non-cash charge (ex: write-offs and depreciation) but the bill does come due at some point if capital is vaporized, no? The Liability side of the B/S increases which will require more of the cash flow directed to pay off the cost of carrying those liabilities (higher interest expense). At the same time, the cash inflow from the overvalued assets will decrease. Therefore, a bank will have to tie up more capital in non-cash inflow generating activities so while these are non-cash charges, if they become sizable enough to cripple the capital base then we have a problem Houston. Also, dividends are paid out of retained earnings, so what do you think happens if a company has big write-downs and less capital to return to shareholders? Am I missing something here? I’m not saying Citi is going under but I think balance sheets are far from healthy across the sector at a time when loan growth is slowing (residential mortgages are just the start).

  34. drucev commented on Nov 6

    Don’t have to be a math wizard to generate a wild-assed guess:

    Losses per Bill Gross: $250 billion (others say $400 billion)

    NIPA annual corporate profits: ~$1,600 billion

    Can’t immediately find exact number, but S&P 500 profits are on the order of $600 billion.

    Banks are around 25% of the S&P.

    So as a WAG about 1-2 years’ bank profits got wiped out, about 1-2 quarters S&P profits.

    So if you go back 6 years to 2001 when the insanity kicked off, figure bank earnings could have been 15-30% too high, S&P 4-8%.

    Disregarding the losses they were able to fob off on MBS buyers.

  35. gaius marius commented on Nov 6

    Citi and all banks are in the leverage business. When capital is decreased for any reason, the amount of assets the bank can support will decrease by the amount of capital times the equity multiplier. So, there is a substantial opportunity cost even though there may not be an immediate cash flow loss.

    i think this is the critical point. if this were a capital-only business, i agree completely that writedowns on this scale would not be a big deal, and that cash flow in time — even if it doesn’t even approach previous expectations, which is guaranteed in the case of much of this level 3 cdo-squared trash — would repair their balance sheet and keep banks like citi in a tenable position.

    unfortunately, that is not the case. citi is levered after these writedowns something like 20:1. the five IB are collectively levered closer to 35:1. continued writedowns are going to force the banks to regurgitate assets in an effort to raise capital, even in an environment of regulatory forebearance. and because of liquidity issues, they will probably have to sell their better assets — the reliable cash flow generators — at a discount.

    THIS is the problem facing the banks, and why looking at their current cash flow as proof of concept is probably a fool’s game.

    the $64 question: given the extended condition of all the banks at once, who buys these assets? and if there aren’t enough capital-strong buyers — and it seems guaranteed that there are not, outside of governments — do the sales force a deflationary liquidation in which asset sales force prices down so quickly that further writedowns (this time on even strong assets) outpace capital building?

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