Wall Street's sickness
Another day, another big puppy coughs up something ugly as a result of its Wall Street dog food diet.
Wachovia's October dump is for a mere $1.1 billion in losses. Hey, that's pretty good news! It means it's only got some $680 million left to lose on these crummy loans! (Well, if you don't count the couple billion in subprime backed bonds.) Unfortunately, the underlying weakness in housing that's killing those CDOs will also force the bank to up its loan loss reserves by some half billion -- on top of charge-offs it will take for bad loans.
The dog food recipe
A quick refresher: These "CDOs" consist of non-choice financial cuts, risky loans, chopped, mixed, then doled out into "tranches" that allegedly separated risk and connected it to yield, with the rottenest bits paying best, but absorbing potential losses first. The top level of this dog food was often deemed triple-A, prime-cut, and this is the stuff that Wall Street heavies went ahead and bought, believing in their own financial butchery.
Trouble is, the "models" that the Wall Street wizards at Bear Stearns
When defaults got worse than Wall Streets' brainiacs expected, the rot spread from the grade D dog food up to the prime cuts very quickly, with the result that no one wants to buy those supposed triple-A tranches anymore, for fear they're even worse than current suspicions.
Rotten dog food spreads beyond the dish
As I said earlier this week, there's a lot of temptation out there to buy these banks now, on the theory that the worst of the news is now out. Don't count on it. More balance sheet horrors will reveal themselves as new waves of mortgages (including allegedly higher-quality Alt-A and primes) reset in the coming months. Moreover, there's a real danger that the gravy train is gone for these banks. These mortgage-backed securities were not a world unto themselves. They also formed one leg of even more complex financial products, like highly leveraged CDO-squared products. (To make these, you borrow a bunch of money to collect tons of that already chopped-up and mixed dog food, and you chop it up and mix it again, then dole out tranches according to your models.)
They infest all kinds of "commercial paper," the very stuff that was being swapped in off-balance-sheet "conduits" and "Structured Investment Vehicles." I say "was" because this market has seized up again, owing to the fear that there are unknown stink bombs hiding in all those opaque derivatives.
Foolish final thought
As a result, these money-making opportunities may be hobbled forever. That would not only mean the disappearance of what were easy cash flows. It could also mean that banks will need to take these lousy loans back onto their balance sheets, reducing the amount of money they have available for lending. In other words, be careful with those "cheap" looking P/E ratios on big banks. The E may continue to dwindle for some time to come, making the P look far too pricey.
For more on Wall Street's dog food diet:
At the time of publication, Seth Jayson, a top-10 CAPS player, had no positions in any company mentioned here. See his latest CAPS blog commentary here. View his stock holdings and Fool profile here. Fool rules are here.