Bank Earnings: A Shot in the Dark

The finance sector is set to report, but mortgage entanglements are leaving analysts without a clue

Investors grimaced as stock prices plunged in the first days of January; it was one of the ugliest trading performances to kick off any year, with financial, technology, and consumer goods companies dropping to new lows. Yet the market may get knocked down another peg when big banks and Wall Street titans kick off their earnings announcements on Jan. 15.

Why? Those results are not only likely to be dramatically down but they're also shaping up to be the most confusing and unreliable set of profit figures this key sector of the market has ever produced. Investors will find themselves arguing whether financial firms over- or understated results for the fourth quarter. That's unfortunate news for those hoping for an early view of whether the credit crisis is abating. "There is going to be a lot of confusion and debate," says Frederick Cannon, managing director at Keefe, Bruyette & Woods, a broker specializing in the financial-services industry.

The root cause of all the murky numbers: housing. Many banks hold stakes in a dizzying array of financial instruments generated during the real estate boom. With that market in turmoil, bankers don't really know the value of their mortgage holdings or the complex securities based on home loans. That uncertainty has also spilled over to debt tied to corporate loans. "This situation is having a profound impact on the numbers," says Michael Thompson, director of research at earnings-tracker Thomson Financial (TOC).

And with financial outfits accounting for 22% of the Standard & Poor's 500-stock index, the doubts in the sector could feed pessimism about the broader market. Analysts believe earnings among financial companies will be down 62% for the fourth quarter from a year ago, according to Reuters Estimates (RTRSY). That's a big reason why the outlook for the S&P 500 has turned sour: Analysts now predict profits will drop 8.4%, compared with forecasted growth of 11.5% as recently as Oct. 1.

Expectations for the index changed dramatically after big banks, including Merrill Lynch (MER), Citigroup (C), and Morgan Stanley (MS), revealed massive losses this past fall stemming from the subprime meltdown. Their announcements exposed damaged assets that investors didn't know banks had. Merrill Lynch, for example, was forced to revise its results downward by $1.8 billion in October after rethinking the numbers it had announced only weeks earlier. The stream of bad news—and the fear of more—has pummeled stocks: Since the end of September financials have fallen 22% and the S&P 500 has lost 8%.


For a sign of just how subjective bank earnings are right now, look at the trouble pros have getting a fix on profits and losses. Normally, as an earnings announcement draws near, analysts' predictions move closer to a consensus. The exact opposite is taking place today, with the dispersal of forecasts widening, according to Thomson Financial. Just a week before Citigroup's scheduled Jan. 15 earnings announcement, the bulk of analysts' estimates were within 43 cents of the average prediction of a 93 cents per share loss. By contrast, on the eve of Citi's quarterly report a year ago, estimates were tightly clustered just 3 cents off the average $1-per-share profit. On Jan. 8 Merrill Lynch analyst Guy Moskowski changed his Citi estimate from a loss of 73 cents to a loss of $1.43, another sign of the slippery earnings situation.

A barrage of accounting changes are complicating matters. Not so long ago, banks kept most of the loans they made on their books, accounting for them in a standard fashion. But in recent years banks increasingly have packaged those loans into bundles and sold them into the markets, where their values fluctuate. At the same time, regulators have pressed the banks to reflect gains and losses on those assets right away in their quarterly earnings. And, as housing has tanked, auditors have pressured banks to look far and wide for prices to calculate values, even if that means using prices from thinly traded exotic securities. The result is that banks' earnings will be based less on facts and more on interpretations of the market's whims.

With so many debatable values, comparing the performance of different banks will be tricky. Some will play it safe and report the worst plausible results for this quarter. It's a strategy that could set the stage for a spectacular rebound a year from now. Others may want to window-dress their books so they don't have to seek more capital.

Don't expect clarity anytime soon. Many banks will probably revise their initial results after auditors have combed through their filings for the Securities & Exchange Commission. And if credit markets pick up later in the year, banks may have to sharply adjust their numbers—again.

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