2007 marked one of the worst years for financial stocks in recent memory. Everything from megabanks like Citigroup (NYSE: C) and Bank of America (NYSE: BAC) to brokerage firms such as Merrill Lynch (NYSE: MER) and Bear Stearns (NYSE: BSC) took massive hits, as the subprime bonanza that, in part, fueled their run-up in the past few years came ceremoniously crashing down. And that doesn't even begin to describe the graveyard of subprime mortgage stocks that met their quick demise as their once-prosperous business model became not much more than a cooperate Ponzi scheme. After all the carnage, investors look toward 2008 with a simple question; Is the worst behind us, and will 2008 be a rebound year for financials?
This Fool's opinion: Don't count on it.
Sure, the best time to invest is often when a sector has been knocked down, dragged across the street, kicked in the face and left for dead -- that's often where the bargains are found. With many financials trading at multiyear lows, it may be tempting to call a bottom and hop on the contrarian express train, hoping to cash in as financials make a rebound. Add in a Federal Reserve that's all but certain to continue cutting interest rates throughout 2008 and, heck, we might be in for a banner year! Right?
Not so fast. There may indeed be plenty more suffering before the dust clears over these battered stocks.
Get ready to rumble
As Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) Chief Warren Buffett is often quoted as saying, "Be greedy when others are fearful, and fearful when others greedy." While financial stocks certainly meet the criteria of an industry with blood in the streets, several factors can be clearly seen today that point to further falls in what has been a lucrative industry.
Just last week, banking behemoth Citigroup sprung chatter of shedding assets -- to the tune of some $12 billion -- in an attempt to shore up its balance sheet. Not long before that, Merrill Lynch publicly disclosed a $1.3 billion sale of its commercial lending unit to General Electric (NYSE: GE). While these sales will certainly patch up holes created by a roiled debt market, when some of the largest and most respected financial institutions in the world put out a yard sale in their front drive, you don't exactly get the sense that rosy times are ahead.
Clean up on aisle 4
Another reason tough times may still lie ahead stems from the root of the current problem: bad debt. In the next 12 months, more than 1/2 of a trillion (with a T!) dollars of mortgages -- most of them subprime -- are due to reset, sending monthly mortgage payments for millions of Americans uncomfortably higher. As this happens, it doesn't seem too far-fetched to assume that home foreclosures will continue at breakneck speed and the CDOs that serve as their de facto parents will follow up with more defaults. More defaults could mean more write-offs for banks.
Not only might the current debt go sour, but the fees that were generated from packaging and selling these CDOs in recent years is sure to slow to a trickle, if not dry up completely. In the past decade, the financial system underwent a paradigm shift in which banking gurus conjured up new ways to package, slice, and sell debt to other investors -- all while collecting lucrative fees for doing so. With a schizophrenic debt market in place, it doesn't seem likely this avenue of revenue will return to banks for quite some time. Bottom line: Don't expect the record profitability banks achieved in recent years to make its way back in 2008.
Black sheeps emerge from the fog
If you happen to be a bankaholic and insist on putting money in the financial sector, all hope might not be lost. There are certain banks that have proven resilient to the mess their brethren have gotten into by avoiding the credit hoopla in the first place. Goldman Sachs has been the standout investment bank to steer clear of writedowns that have plagued many other firms. While Morgan Stanley and Merrill Lynch have had to take drastic measures by raising billions of dollars of equity -- eroding existing shareholders' ownership -- Goldman seems to be holding tight, a prospect that could bode well in such a notoriously competitive industry.
Another standout star has been Bank of New York Mellon (NYSE: BK). Formed this past year when Bank of New York merged with Mellon Financial, the new organization has largely avoided servicing subprime debt in recent years. While this was undoubtedly a cause for the underperformance compared to its peers over the past years, it will certainly pay off now that lending returns to more modest levels. On top of that, a continued focus on wealth management, clearing, and custody management rather than traditional bank lending should put the company in a prime position as its peers continue to tread water.
Will the big banks ever rebound? Yes, of course. Investors were rewarded over the past years with large dividend yields and handsome returns from what was once considered a ho-hum industry. Like many investments, cyclicality in the sector demands that, from time to time, excess is taken out to make way for future leaders. Time will tell when, but don't bet on it to happen in 2008.
For related Foolishness:
