Dan Gross tackles the write-down paradox today: how come the share price of
[Citigroup/Merrill Lynch/Bear Stearns/Whoever] rises when the bank announces
massive losses? After all, he
writes,
Write-downs should be especially worrisome when taken by banks, since they
are in the business of valuing financial instruments.
Gross’s response is, basically, "investors are idiots".
Egged on by bank executives, investors have come to believe this is the extent
of the damage. We’ll take these write-downs and no more! The credit problems
are over! Let’s move on!
Investment bank CEOs and their shareholders clearly believe that the worst
is over. But a fine line separates belief from credulity, and the large investment
banks are blurring it.
I don’t believe that investors are idiots. In fact, I don’t believe that investors
are bidding up the stocks of the banks declaring large write-downs. Citi is
down 17% from its highs, while Merrill and Bear are both down more than 25%
– even as the stock market more generally is hitting new highs. If a share
price reflects expectations of future earnings, then clearly investors are much
less bullish on these banks than they were a few months ago.
What’s more, investors are perfectly cognisant of the amount of turmoil in
the credit markets. It’s worth remembering that a write-down does not actually
change the value of a bank, which is the thing measured by the share price.
If a bank’s assets are impaired, then the value of the bank has gone down whether
or not it takes a charge to earnings this quarter.
So the way I see it, the stock price of these banks started falling dramatically
as their balance sheets declined in value. In fact, the stocks fell particularly
hard and fast because at the time there was relatively little indication that
senior management at the banks was taking the turmoil in the credit markets
seriously, preferring instead to simply keep on dancing.
Now, however, fixed-income executives have been fired, charges have been taken,
and the banks are clearly aware that there has been a fundamental change in
the way that credit markets operate. Given that a clear-eyed bank is worth more
than one in denial, it makes sense to bid the shares up a little bit –
although not to anywhere near their old highs.
There are degrees of denial, of course. Gross might well be right that there
are more write-downs in these banks’ futures, which investors may or may not
be pricing in to the share price. But I think he’d be hard-pressed to find a
real, flesh-and-blood institutional invetor who really believes that the credit
problems are over. Rather, those investors think that the people who were digging
the banks into big holes have largely been fired, and that the attitude of the
banks to the credit markets more generally is one of sensible caution rather
than reckless abandon.
In other words, a write-down means a chastened executive, and investors, right
now, like their executives to be chastened. Investors might be delusional, but,
on the other hand, they might not. I prefer to give them the benefit of the
doubt, since the market generally is more reliable than any one pundit.