Serious Money:Horace Lee Hogan was the little known music promoter who, more than half a century ago, declared that "Elvis has left the building" to the king's growing number of diehard fans. Hogan's words have since been enshrined in the annals of music history, writes Charlie Fell
More than three decades following Elvis's final exit, the words are an appropriate description of recent events on Wall Street as, one by one, the kings of investment banking from Citigroup, America's largest bank, to Merrill Lynch, the world's biggest brokerage firm, have been toppled from their thrones.
The crème de la crème have opted to leave office following disappointing third-quarter earnings numbers but their departure has not soothed the nerves of investors who fear that worse is yet to come. The summer's credit crisis is far from over and recent market turbulence suggests that its second phase has just begun.
The world's largest investment banks failed to meet the earnings guidance given to investors just weeks before third-quarter reports were released. If that was not enough to undermine confidence, Citigroup's disclosure just days after it posted disappointing quarterly figures that it planned to write-down its exposure to subprime mortgages by a further $8 to $11 billion on top of the $3 billion-plus hit previously announced certainly did the job. Financial stocks plummeted on both sides of the Atlantic and have registered a bear market decline of more than 20 per cent from their highs in February when subprime problems first surfaced.
Market turbulence has returned as investors have finally woken up to the fact that initial estimates of the cumulative losses resulting from the irrational lending practices of recent years were ludicrously low.
It was said initially that the subprime fall-out would cost no more than $100 billion. Realistic projections of cumulative losses, combined with the inevitable contagion that is now apparent across the credit arena, have since reached $500 billion. Investors are right to believe that worse is yet to come.
The scale of the damage arising from the re-pricing of risk is no longer in doubt and new accounting regulations combined with uncompromising auditing in a post-Enron world ensure that the banking sector has nowhere to hide. The Financial Accounting Standard Board (FASB) rule 157 took effect yesterday, making it far more difficult for the banking community to apply in-house mark-to-model pricing to esoteric illiquid securities in preference to more realistic indicative market prices.
The inevitable write-downs could be substantial. The big six American investment banks currently hold roughly $400 billion in such so-called level three assets as against equity of less than $300 billion. The exposure of Bear Stearns, Goldman Sachs, Lehman Brothers and Morgan Stanley relative to their respective equity bases is disturbing and true estimates of the value of level three assets will undoubtedly cause a serious deterioration in balance sheet strength.
The summer's credit crisis persists and normal market conditions are unlikely to be restored any time soon. The Federal Reserve's recent monetary easing has been ineffective so far and, though the printing presses will inevitably be put on full throttle, there is no escaping the fact that more than $500 billion in adjustable rate mortgages are on course to be re-priced upward by roughly three percentage points during the first six months of next year, an eventuality that easy money alone cannot solve.
Meanwhile, the evidence from the Federal Reserve's most recent survey of senior loan officers shows that lending standards continue to tighten. All told, investors can no longer discount the possibility that a full-blown credit crunch lies in wait.
Financial stocks have been in freefall in recent weeks and have lagged broader indices by the widest margin in more than seven years. The omens for equity investors are not good as similar periods of underperformance preceded a bull market peak in July 1990 and once again in March 2000. Could it be different this time? The performance differential could well be narrowed by an upward move in financial stocks, but dead cats don't bounce and investors would be unwise to bank on such a move being sustained. Bear market probabilities continue to climb.
