Back in July, I caught quite a bit of flak for singling out Ambac Financial
"I totally disagree with your views on Ambac. Ambac has taken a beating because of bearish views based on extreme situations," one reader commented. Bingo! What was probably overlooked is whether those "extreme situations" were justified or not.
Turns out, they were. Ambac plunged 33% yesterday, leaving shares down over 90% just since September, after yet another credit downgrade threatened its ability to survive. Rival MBIA
Ah, but the fat lady hasn't sung just yet. Bank of America
What the heck is going on here? Beyond the obvious -- banks lent money to people who can't pay them back -- one of the big factors hurting financial stocks is that there's a massive slug of both risk and uncertainty.
What's the difference? Risk has a measurable outcome, while uncertainty doesn't. And right now, the problem is that evaluating the investment potential of banks takes so much more than just predicting what real estate default rates will be, when unemployment will level out, or when the black-box of credit default swaps and collateralized debt obligations will stop imploding. Those factors merely make up the risk part of the equation. The big wild card is the uncertainty that comes along with these companies.
Now you see me, now you don't
Take Citigroup, for example. Its market cap of $35 billion as of yesterday's close is just 1.6 times what the company earned in 2006. From that standpoint alone, it's probably easy to want to tag the stock as an unbelievable value (which, in fairness, it might be).
But using those past figures is quite literally useless. Citigroup is in the middle of a massive deleveraging process that'll leave the company a fraction of the size it was in 2006, perhaps for good. Back in May, when things were "stable," Citi announced it would shed at least $400 billion in assets. Now that things are, uh, not so stable, it's realistic to think that number may surge even higher before things mellow out. Bottom line: It's crazy to think Citigroup will revert to previous earnings levels anytime soon, for many, many, many years. Investor, meet uncertainty.
Or take Goldman Sachs. In 2007, trading and principal investments made up 67% of net revenue. Sure, Goldman is home to some of the best-and-brightest. But that revenue is almost guaranteed to be a fraction of what it used to be, if only because it's now a bank holding company and will therefore have to face up to stringent leverage regulations. Ditto for Morgan Stanley
Or how about Merrill Lynch, soon to be part of Bank of America. Sure, it might look like BofA bought the embattled brokerage on the cheap, but how much of Merrill's revenue depended on the fact that it was the world's largest underwriter of collateralized debt obligations during the boom period from 2004 to 2006? Too much to allow anyone to make more than a wild guess at its future earnings potential, that's for sure. Welcome to the world of uncertainty, Fools.
Honey, I shrunk the bank
That's what's causing so much panic in financial stocks right now; Not only do they have ominous clouds hovering over head due to disturbingly tainted books, but even if those assets start to turn a corner, the paradigm shift in how the financial world will operate in the future reminds investors all too well what the term "value trap" means.
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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. JPMorgan Chase and Bank of America are Motley Fool Income Investor recommendations. The Fool has a disclosure policy.