The news on the financial front is bad.  Period.  It doesn’t matter how many times some analyst, CEO, Fed Chairman, or the President says the economy is robust or the “subprime” problem is contained, the news is bad.  From all of the research I’ve been able to do on the financial debacle, I could write a proper horror novel.  For anyone who thinks the financial problems have already been priced in the market, here are a few observations:

Corporate profits are going down.  Prices companies pay for materials are increasing (same for individuals) and their margins are shrinking.  We’ve written before about all of those share buy-backs being an ominous sign.  The reason is this:  A company has 2 million shares and earns .10 per share in year one, then buys back 1 million shares.  In year two the company reports they earned .12 per share.  Did they have a good year?  No.  They actually earned less, but in year two they just don’t have as many shares.  Yes, I made this simplistic, but keep it in mind the next time you simply scan the headlines of an earnings report.  Be sure to dig a little deeper, see if you can find their year-over-year revenues and profit margins.  And right now, expect any company to project a rosy outlook for their sector, unless it is a sector that feels it needs an interest rate cut to survive.  Then you will be hearing wailing and gnashing of teeth.  But, that’s OK, you say, because at least they aren’t involved in this credit crunch thing, right? Do you know how many companies are actually involved in financing activities?  Would you be surprised to learn that Caterpillar (CAT) and Deere (DE) and Pitney Bowes (PBI) derive 12% of their earnings from financing activities? And what about all those store credit cards?  No big deal because people are paying their debt?  Think again.

Loan repayments are defaulting at an increasing rate, and it’s not just subprime, but all loan types.  Construction and industrial (commercial) loans, credit card loans and personal  loans defaults are on the rise.  Why is this happening?  All of this credit was a house of cards.  The following scenario starts with the fact that housing was overbuilt and overpriced. And the more complicated financial schemes and relaxing of financial rules to continue expanding credit are not accounted for, but only makes it worse. 

Bank A loans Fred $1,000, with interest, for a house. The hope of Fred being able to repay, is the risk that Bank A is taking, and if Fred can’t repay it, Bank A will take the house.  Joe finds he needs $2,000 to buy a house.  So, he goes to Bank B and borrows the money, with the same deal as Fred.  Bank A and Bank B sell those mortgages to Bank C, thereby ridding themselves of the risk if Fred or Joe can’t pay the loans.  Bank C doesn’t really want the risk, even though it is making money from the servicing of those loans and collecting the interest.  So, Bank C bundles those loans, calls them an investment vehicle and sells them to Investor A and Bank D.  Why does Investor A and Bank D buy this debt?  Because it’s value should go up as home prices appreciate.  Bank D wants to use it as collateral to borrow money and Investor A expects to make a nice return, since real estate only goes up.  Until it doesn’t.

When the housing prices drop, the collateral supporting the price of those loans drops as well.  Investor A wants to sell these loans now and take his cash out of the market.  But, the problem is that suddenly everyone figures out that housing is in a slump and doesn’t want to pay Investor A’s or Bank D’s asking price.  So they have two choices.  Hang on to the loans (debt) and wait/hope that real estate prices go back up, or sell at a loss. 

Ok, that’s the simple version of what’s going on.  Banks are losing money, broker/banks are losing money, other’s involved in finance are losing money.  And they are all pinning their hopes on real estate values rising.   

Bloomberg article on U.S. Profits  

Forbes Magazine article on corporate financing

Article on mortgage meltdown, not just sub prime