The biggest stories from last week’s stock market were the earnings reports of major financials including Bank of America (BAC), JP Morgan (JPM), and Citigroup (C). The results from these once lauded names were altogether uninspiring. Citi announced a major reorganization that will split the business into two separate entities, not to mention the $8 billion in losses for the quarter. JP Morgan, long thought the strongest out of all the financials, reported less than stellar earnings and lowered guidance going forward. However, Bank of America took the cake, reporting a $1.79 billion loss, which did not include the astounding $15 billion loss incurred as a result of the Merrill Lynch acquisition. The losses were so steep that BofA ended up needing another bailout from the TARP pool, this time to the tune of $25 billion.
This latest round of bad news should put to rest those that are claiming that the financial sector got us into this mess and it will rally the market to pull us out as well. These results show that banks are still deeply flawed and do not even know how to value the assets on their books. Further compounding the problem is the fact that many of the most important decisions are being made very hastily. No one knows exactly what was said as the deals were negotiated for Merrill Lynch and other distressed financial firms, but there is no way that Bank of America was able to do a thorough due diligence on the purchase of Merrill Lynch in the 24 hour period that was allotted for such action. It seems that the moral hazard overtook these banks’ aversion to risk in such a case as this. I mean, the government has showed who it believes is “Too Big to Fail” and the well from which the rescue plans are drawn seems anything but dry. If you were Ken Lewis, Bank of America’s CEO, wouldn’t it be worth the risk to take on a Merrill Lynch or a Countrywide, as long as you had the Treasury guarantee that you cannot fail because of it?
We could potentially only be seeing the tip of the iceberg as no one really knows what the troubled assets are worth now. There will probably be more rough quarters ahead for the banks, and more bailouts too. The latest ideas being thrown about are to target the assets themselves (thought we had heard that before) or an “aggregator bank” to shoulder the load of these toxic assets. Neither one of these proposals is getting much praise as a workable solution now anyway.
So, this is all to say that it is extremely difficult to arrive on a good reason to invest in banks right now. There is too much yet unknown, and while valuations may look compelling on some levels, the assets underlying these valuations could be subject to further write-downs. It may very well be true that in 2 years, each of these stocks could be priced higher potentially many times higher. However, with the current environment in financials being dominated by government intervention rather than revenue and earnings, we find speculating rather than investing to be a more appropriate term for buying these stocks at the current juncture.