Why Forecasts For Financial Companies Are Too Optimistic

This morning, Freddie Mac (FRE) reported a $1.2 billion write-down for credit losses and total GAAP mark-to-market losses of $3.6 billion. The third-quarter losses from the government-chartered company added to the growing amount of recorded losses for multiple banks and financial firms.

These losses have greatly increased the uncertainty about 2008 profits.

For example, out of the approximate 400 banks and thrifts within the Zacks Rank universe, brokerage analysts have cut 2008 profit projections on 202 of them. At least 10 analysts have lowered their forecasts on BankAtlantic (BBX), Bank of America (BAC - Analyst Report), Citigroup (C - Analyst Report), National City (NCC), Prosperity Bancshares (PRSP), Synovus (SNV), TCF Financial (TCB - Analyst Report), Wachovia (WB) and Washington Mutual (WM).

Cumulatively, 110 earnings estimates have been revised up for next year and 568 have been cut, a Zacks Revision Ratio of 0.19. To put this number in perspective, the Revisions Ratio for the entire Zacks Rank universe is 1.11, meaning more earnings estimates have been raised than lowered.

The pessimism is not just limited to banks and thrifts. Earnings estimates for 2008 are being revised on credit card companies (eight analysts have slashed forecasts on Capital One (COF - Analyst Report)), mortgage lenders (seven analysts have cut forecasts on Countrywide Financial (CFC)) and investment banks (11 analysts have lowered forecasts on Merrill Lynch (MER)).

Bluntly stated, brokerage analysts are not sure how bad profits are going to be next year for the financial sector.

How did so many financial firms get themselves into such a mess?

The answer starts with the housing industry. Historically low interest rates and lax lending standards prompted many people to either become first-time homebuyers or trade up. As demand for housing rose, so did demand for mortgages. Seeing an opportunity to expand their profits, banks and other financial companies beefed up their mortgage teams.

There is nothing wrong with providing mortgages to qualified homebuyers, but there is a problem when lending standards are relaxed. As Paul McCulley, managing director at PIMCO puts it, lenders gave homebuyers a call option without requiring them to put any skin into the game. In other words, homebuyers were given interest only mortgages (a call option to buy the house at a set price) with no money down.

Compounding matters were mortgage calculations that approved borrowers for a more expensive house than they should purchase, real estate agents who encouraged non-traditional loans and consumers who didn’t bother to calculate whether or not they could afford the mortgage once it reset.

At the same time, financial professionals concocted new ways to package loans and provide funding.

When a loan is made, it is typically added to a portfolio and then resold to investors. This allows a bank to continuously loan more money. (By reselling loans, banks can loan more than a dollar for every dollar of assets they hold onto, though regulations limit the extent to which a bank can leverage its deposits.)

Traditionally, these loan portfolios could pay both principal and interest, principal only or interest only. Depending on the credit quality of the borrowers within the portfolio, analysts could reasonably calculate the risk of default and therefore price the portfolio accordingly.

Hedge funds and other financial intermediaries operating outside of the regulations governing banks saw the opportunity to take advantage of the lending boom and didn’t hold anything back. Using their ability to leverage themselves more than a traditional bank could, while simultaneously creating and trading derivative instruments based on the loan portfolios, these intermediaries added to the credit bubble.

At first, everything seemed to work pretty well. The number of mortgage originations rose and analysts felt pretty comfortable with their loan portfolio valuations. As long as homeowners could make their monthly payments, it was reasonable to expect the system to continue to function

The weak link in the system, however, was the reliance on homeowners to make their monthly payments. This link began to break apart as a rising number of adjustable rate mortgages began to reset earlier this year. At the same time, the economy began slowing and housing prices peaked. This, in turn, started putting many homebuyers in a position where they couldn’t make their money payments and couldn’t sell their house at a price high enough to pay off the loan - effectively throwing a wrench into the works.

Since the value of a loan portfolio is determined by the credit quality of its borrowers, rising default rates hurt returns. As returns fall, demand for the loan portfolio drops, leaving the portfolio owner holding a proverbial hot potato. Compounding matters are derivatives and leverage that intensify the decline in value.

Adding to the complexity of the problem is the manner in which loan portfolios are valued.

Companies can value their portfolios on a mark-to-market or a mark-to-model basis. Your stock portfolio is always valued at mark-to-market, because you can readily call up a quote. A good quality loan portfolio may not have a direct market quote, but in general, there are enough publicly-traded securities to use as a proxy for valuing the loan portfolio.

When a direct asset or a fairly reliable proxy does not exist, however, a mark-to-model valuation must be calculated.

A mark-to-model value involves determining what a willing buyer might offer for a portfolio using mathematical equations. As any mathematician will attest, an equation is only as valid as its inputs. Since loan portfolios are based on the credit quality of the borrowers, rising defaults make it difficult to properly assign a value.

A portfolio of underperforming loans is harder to sell, particularly in the current environment. Furthermore, if credit quality is deteriorating (e.g. more borrowers are defaulting on their loans), then assigning a value to a portfolio becomes even more difficult. The inclusion of derivatives only adds to the difficulty of assigning a value.

None of this even factors in the problem of housing prices. When a homeowner defaults, he is effectively forcing the lender to buy the house. Given that foreclosure laws prevent a house from being quickly sold, lenders are left with an asset that is temporarily illiquid (they cannot immediately sell it) and is depreciating in value (housing prices drop when a home goes into foreclosure).

This is a toxic combination for a financial firm. They cannot properly assess what their exposure to future losses will be, nor do they have the ability to quickly get rid of their nonperforming assets (e.g. loan portfolios, foreclosed homes). Given the very large margin of error that can exist in mark-to-model valuations, it seems likely that the losses incurred by financial firms will rise in the months to come.

This makes the job of a brokerage analyst difficult. Despite their efforts to "come clean", the CEOs and CFOs of many banking firms probably do not really know what their mortgage-related downside risk is. Not to mention the fact that if a homeowner can’t afford to make his housing payment, he is probably also struggling with his car payment and credit card debt. Given all of this uncertainty, the chances of a brokerage analyst making a correct assumption on 2008 earnings seem pretty remote. More importantly, it is probable that the reduced estimates are probably still too optimistic.

Charles Rotblut, CFA, is the senior market analyst for Zacks.com. He can be reached at crotblut@zacks.com

Zacks Premium and ZacksElite subscribers can view the Zacks Industry Rank List at http://www.zacks.com/zrank/zrank_inds.php. This interactive list allows you to see all of the companies, and their Zacks Rank, within more than 200 industries. Shown below is the Zacks Sector Rank List, which shows the trend in estimate revisions on a broader scale.