As part of Rule Maker Portfolio holding and FOOL 50 component American Express' (NYSE: AXP) earnings release this week, the company offered a shocking piece of information: its American Express Financial Advisors (AEFA) division had to write down more than $826 million, or more than a third of its junk-bond portfolio. This write-down (which essentially means that American Express is declaring those underlying assets to be worth nothing) resulted in a charge directly to earnings. If you are an AmEx shareholder, as the Rule Maker Portfolio is, that was a charge to YOUR earnings. I hope you're torqued, because I certainly would be.

In discussing this enormous loss, AmEx CEO Kenneth Chenault stated that the company "did not fully comprehend the risk" of the instruments that make up the majority of its portfolio losses. I find this hard to believe, as this is the third consecutive quarter in which AmEx has had to take a write-down on its junk-bond portfolio. Last quarter the company declared a loss of $182 million in junk bonds; the quarter previous it was $49 million. The loss this quarter was bigger by an order of magnitude, but any corporate management that is worth its paycheck should have damn well figured out the risks after, oh, the first six-month, $230 million loss.

This is one of a seemingly endless stream of mea culpas by AmEx in what now seems to be a weakness in every part of its operations. Over the last 12 months we have seen:

  • The three write-downs detailed above. In April the company assured investors that there would not be another write-down in the AEFA portfolio. Fool me once...
  • A few short months after the launch of its Online Brokerage that was heavily marketed as offering "free trades," last autumn AmEx had to significantly change its fee structure, instituting limits on the number of trades and adding fees. Fool me twice...
  • American Express offered a "free unlimited Internet service" to its cardholders earlier this year. Then it put a limit on free online time to 30 hours a month. Recently AmEx informed Internet customers that they would be charged a flat rate of $12.95 per month. Fool me three times...

In each of the three programs listed above, AmEx rushed headlong into a service, product, or instrument that it did not fully understand. This is an alarming trend, and it is, and should be, genuinely damaging to the American Express brand name. And the fact that AEFA has now had to take a bath on its high-yield options a quarter after it said there would be no more charges against its portfolio is inexcusable. American Express says that it will not take such risks again. Unfortunately, seeing as the CEO has admitted that the company failed to recognize the risks it was taking in the first place, it's going to have to excuse investors for the lack of confidence in this statement.

So what happened?
Starting in 1997, American Express began dealing in derivative products called collateralized debt obligations. These instruments are put together by a company, combining junk bonds and risky bank loans into a single package. The packager then sells these obligations as a single security. The instruments contain a carefully weighted combination of debt obligations ranging from the most risky, which is nearly guaranteed to default, to high-quality paper. The assumed default rate when these instruments were sold was around 2%. Horrendous debt loads have carried the current default rate above 8%, leaving the packagers -- in this case AmEx -- with insufficient collateral. The result? Earnings go poof!

The unforgivable part here is that AmEx entered into these instruments not by necessity, but by choice. American Express is not an investment bank, they do not deal in bond issues, nor do they have any greater financial reason for ensuring liquidity in debt instruments by one of their prize customers.

What is even more galling is that American Express' largest shareholder, holding more than 11% of the total outstanding shares of the company, is Berkshire Hathaway (NYSE: BRK.A), chaired by Warren Buffett, who is rumored to know a thing or two about complicated financial instruments. Certainly it occurred to the management of AmEx after the first two write-downs to consult Mr. Buffett about its derivative portfolio?

Question everything
Now that the big bath is out of the way, things should improve, right? Unfortunately, even absent of these myriad external events AmEx management is not instilling much confidence. In its second-quarter report, AmEx reported that its Travel Related Services (TRS) Division, which includes its charge card operations, grew revenues by only 3% over the previous year. TRS contributes more than two-thirds of total revenues to AmEx's top line.

AmEx also announced that it would eliminate up to 5,000 jobs, or 6% of its total workforce. Although I don't consider it to be couth to wish ill on anyone, one would hope those responsible for the $1 billion plus in write-downs would be high on the list, since the layoffs are a fairly obvious method for AmEx to maintain profitability.

There are two problems here -- the first of which is that all of the top AmEx brass received raises and bonuses WAY into the six figures this past year. Rather than lay off good people to achieve profitability, I'd suggest AmEx hit the pocketbooks of the people under whose watch these egregious operational losses have happened, and that starts at the top. So not only should the shareholders be angry, so should AmEx employees. I do not find it meritorious when a management fires workers simply to make short-term profits look better. A well-managed company hires judiciously when demand is high so that layoffs may truly be a last resort during a downturn. That is clearly not the case here.

AmEx refused to give any guidance for growth for the remainder of this year, and yet it maintains that it will grow at an annual rate of 12-15%. Seeing as its largest contributor to revenues, TRS, has had growth slow to a crawl due to a rapid downturn in the business travel market, one would be right to wonder where this growth is going to come from.

Two years ago, one of the former Rule Maker components, Gap Inc. (NYSE: GPS), went through a crisis of management from which it has yet to emerge. I have a deep respect for American Express as a brand and as a company, but its recent past does not inspire much confidence at all. I and the other Rule Maker managers will be watching closely for further degradation. We don't wish to watch another great company seemingly fall to pieces on our nickel.

When he was young, Bill Mann thought those "Question Authority" T-shirts were worn by people who knew a lot of stuff. Boy, was he wrong. At the time of publication, Bill owned shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.