The market is cheap on earnings.

The subprime issue is contained.

That’s been the mantra. I think the mantra is wrong. While the overall market is not expensive on earnings, certain parts are a lot more expensive than they look. Why? Well the earnings growth estimates are a hoax right now, specifically in the financial sector. Do they really know what’s on their books? Do they really know their exposure? How would they know? Can some of these mortgage companies look into the hearts and minds of their newfound (2005/2006) borrowers and tell who is going to default? I know they exported much of these risks in CDOs to hedge funds, but their is still exposure – but no one knows how much. So their earnings are at serious risk.

Let’s look at today’s problem child, Washington Mutual (WM)

Per Reuters:
Washington Mutual Inc (WM) , the largest U.S. savings and loan, may set aside $500 million more than it had previously forecast for loan losses in 2007, amid what Chief Executive Kerry Killinger on Monday called a “near perfect storm” in U.S. housing.

The thrift in July had projected setting aside $1.5 billion to $1.7 billion for loan losses. Any increase would be Washington Mutual’s fourth this year.

“Most housing markets appear to be weakening,” Killinger said at a Lehman Brothers Inc. financial services conference. “We would not be surprised to see declines in housing prices in many regions of the country … for the next few quarters.”

Seattle-based Washington Mutual cut nearly 11,000 jobs, or 18 percent of its work force, last year, and has fallen to sixth in U.S. mortgage lending from third in 2005 as it reduced risk.

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Takeaway: Fourth increase in loss provision this year. And you think these companies have any visibility on their issues? Do you want to know the last time they increased the loss provision. WAAAAAAy back in…. July. So we are talking on average every 60 days this type of financial institution is needing to increase its loss provision. And we are to trust earnings estimates in this sector? Anything in the financial spectrum? I don’t think so.

So yes they look ‘cheap’ on forward earnings – but can we believe any of these numbers? We are going to see a lot more interesting number coming in the next 10 days as many of the investment banks report. We already know what they are going to do – either miss or drop guidance. I might say, its possible some rescind near term guidance. Why throw up a number that you are clueless about? Major parts of their businesses the past 3-5 years have essentially ‘ceased’ to be in past month. How do you forecast that forward? Also will we start seeing the next round of layoffs for our economy during these announcements?

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Here is a must read article from CBSMarketwatch article dovetailing with this issue that I’ve been mentioning since the blog started – the ‘blindness’ to what is really going on in these major institutions.

Some highlights:

• - Will firms have to cut the value of assets they’re holding, resulting in charges that will cut into earnings?
• - How much did the slowdown in fixed-income markets eat into the revenue that investment banks generate from selling and securitizing assets such as mortgage-backed securities?
• - How deeply has the credit crunch cut the number of M&A deals that investment banks work on, especially those involving private-equity firms?
• - Wall Street’s titans dominate trading and sales of securities in equity, bond and other markets, while advising on and helping to finance some of the biggest mergers and acquisitions. They’ve also been at the center of a surge in financial innovation in recent years that’s created a huge credit derivatives market and rampant securitization, in which assets like mortgages and other loans are sliced into asset-backed securities and sold to investors. But many of these trends, which just a few months ago produced record earnings on Wall Street, have abruptly halted and even gone into reverse as problems in the subprime corner of the U.S. mortgage business spread across most of the credit market.
• - The credit crunch has increased concerns about how well investment banks value some of their assets. The firms hold some complicated securities that don’t trade much, making them more difficult to value than things like stocks and government bonds. “The more important, broader question is whether they can truly value the assets that they hold,” Bove said. “And the answer is that they cannot. They’ve overstated their assets and therefore their book values, so the stocks should go lower.”
• - When investment banks arrange financing for LBOs, they usually provide a bridge loan to help the deal close quickly. They then sell the debt in the market. When LBO financing stalls or fails, these banks are left with so-called hung loans. Such hung loans on the balance sheets of investment banks may have to be valued lower, cutting into earnings, Hecht and other analysts say.
• - The credit crunch has also disrupted several markets in which investment banks have generated lucrative fees recently. Sales of asset-backed securities are down 28% in the third quarter versus the second quarter and MBS issuance is off 24%, according to Banc of America Securities. Sales of high-yield debt are down almost 32% in the quarter, versus the previous quarter, the bank also estimated.

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Now the timing of all this is sooooo interesting. Fed announces their decision on the 18th mid afternoon, and these firms report on the 18th – 20th. So if we get the anticipated bounce from the 25 basis point cut, and then within next 2-3 days a slew of bad news from this sector – how will the market react? Assume its all a 1x charge and these banks took care of all their bad news in 1 quarter, or will they see this as the 1st shoe drop of an ongoing issue. I think the reality is the latter, but who knows how the market will view it.

Last 5 posts by Trader Mark

• Weekly Mortgage Applications Of Interest Today; Fed Already Loses $5 Billion on Mortgages - June 3rd, 2009
• CBSMarketwatch: Can Sequenom (SQNM) Make it Back into Investors's Good Graces? - June 2nd, 2009
• Jim Rogers Agrees with Marc Faber - May 20th, 2009
• Update on my American Idol Trade - May 13th, 2009
• HAL9000 Friends Did Not Enjoy the Rally; Hedge Fund Performance 4.2% YTD - May 12th, 2009