Don't trust the Wall St rally

Don't trust the Wall St rally

Divining future profitability of the nation's financial firms tells us stock market valuations are still too high.
By Bethany McLean, Editor at Large

Up until now, all eyes have been on the losses that are hitting the financial sector from the acronym soup of new instruments such as CDOs and SIVs. Everyone is scared, and rightly so, of the MUB (Monster Under the Bed) that might be lurking in supposedly safe havens. Still, financial stocks staged a big rally on the last trading day before the weekend, and again Monday, due to the belief that the worst is past, and that the government will step in to save the Street should that MUB pop out from under the bed.
But even once the current crisis is past, there's another issue facing the financial sector: Will it look like it used to? "I think it is important to step back and ask some broader questions about our financial system," wrote Ben Inker, the chief investment officer for quantitative equities in global developed markets at money management firm GMO, in a recent paper. "What it does, how big it should be; and what its sustainable level of profitability might be."
These questions are obviously important for financial services firms. At its recent peak stock price in December 2006, Citigroup (C, Fortune 500), for instance, sold for $53.34, or over 2 times its reported book value (and over 4 times if you exclude goodwill and intangibles) and almost 13 times its reported 2006 earnings. Do those numbers represent a baseline to which we'll return when this crisis has passed, or are they anomalies?
And the size of the financial sector may also matter for the rest of the market. In a piece last summer, credit rating agency Moody's opined that the market was safe from systemic risk in part because the $45 billion in profits reported by a group of financial firms including Citi and Merrill Lynch (MER, Fortune 500) were "considerable and significantly larger than in 1998," when those same firms reported profits of $12 billion. As the events surrounding Bear Stearns show all too clearly, the market isn't safe from systemic risk. Was Moody's wrong partly because that $45 billion isn't sustainable - or wasn't real in the first place?
One way to think about this is to look at the profits of the U.S. financial sector versus GDP. Inker did this, and the result was what he describes as a "truly striking chart." From 1947 to 1997, financial profits were stable at around 0.75% of GDP. But over the last ten years, the share of GDP represented by financial profits began to shoot higher. In the last few years - before the Street began to report massive writeoffs - financial profits represented roughly 2.25% of GDP. Inker says that it is too simplistic to say that the right number should be 0.75%. But when you think about what financial profits consisted of at the height of the boom, 2.25% seems unsustainable too.
The last decade saw the explosion of securitization - the carving up and redistributing of risk - the boom in hedge funds, and the private equity mania. It's apparent now that Wall Street can't transform a sub prime mortgage into a triple A credit, and that the redistribution of risk doesn't get rid of it. Unless (or until) we forget that simple lesson, it's hard to see the securitization game being played again. As for hedge funds, some commentators, such as Pimco's Bill Gross, predict the demise of broad swaths of them. With that goes the rich profits Wall Street has earned on prime brokerage. And fees from private equity, which at the height made up huge chunks of the Street's investment banking revenues? That won't come back roaring without cheap credit.
We are going to have to create whole new ways of securitizing and funding debt of all types, but especially mortgages and consumer credit. While I have confidence that those intrepid bankers on Wall Street will figure out something, as their future bonuses depend on it, it is going to take time to replace a system that took decades to build.
You also have to consider the massive writeoffs that the Street has taken. Thus far, Citigroup has taken $32 billion in writedowns related to the subprime crisis. Merrill Lynch's writedowns have totaled $22 billion. So were Citi's 2006 profits really the reported $21.2 billion, and were Merrill's the reported $7.5 billion? Or was some percentage of that an illusion? If Bear can be sold for $2 or $10 a share, then how solid was Bear Stearns' $84 per share in reported book value?
Thought about more broadly, if commentators are right that mortgage losses alone will total $300 billion to $500 billion, then, as Inker writes, "profits that look like they have been 2.25% of GDP in the past several years have actually been more like 1.75%, if we smooth the losses over the last 3 years and into next year as rough justice." And of course, mortgage losses are only a subset of the total losses.
Think back to what Ken Lewis, the CEO of Bank of America (BAC, Fortune 500), said last fall when his company announced its first round of writedowns: "Making money for several years, only to give most of it back in one year, is not a brilliant business model."
Inker says that the data doesn't point to any firm conclusions about what the level of financial profits should be. His best guess, though, is that a "normal" level of profits would be about half the amount that the financial sector reported in 2006.
Then, you also have to think about the multiple of those earnings that investors should be willing to pay. In a paper published in the fall of 2005, risk management gurus Leslie Rahl and Barbara Lucas of Capital Markets Risk Advisors, noted that in the past decade, a lot of things have happened that aren't supposed to happen, from the interest rate hikes of 1994 to the 1998 collapse of LTCM to the 2001 terrorist attacks. Or as the authors put it, "once-in-a-lifetime events seem to occur every few years."
If that's the case and if such events now mean that Bear Stearns (BSC, Fortune 500) can go from seemingly viable to threatening to bring down the entire financial system in the space of a week - then what sort of multiple should investors pay for Bear, or for any financial firm? Maybe investors shouldn't pay 12 times earnings, and maybe they should pay a discount to, rather than a multiple of, reported book value.
Of course, trying to guess how this will play out is just that - guessing. But if you say, for instance, that Merrill's normalized profits would be half the 2006 level, you get to about $4 billion. If you think that we should be willing to pay a smaller multiple for those earnings than we did in the past - let's be generous and say 10 times - then you get to a total market value for Merrill Lynch of $40 billion. That's still a 10% discount from today's valuation.

The Time vs. Task Dilemma: Why You Could Be Working Too Much

The Time vs. Task Dilemma: Why You Could Be Working Too MuchSkellie
One of the reasons many of us choose to start a freelance business is the option of largely escaping time-based payment. If a task only takes an hour, it takes an hour. People like us get paid the same whether we fill a day with it or not.
While freelancers who’ve made efforts to escape time-based pay get some pretty neat perks, there’s a trade-off: a heightened risk of over-work.
Unless they’re being given more work than they can feasibly do in the time, 20, or 40, or 70-hour per week workers don’t necessarily need to be more productive. For project-paid freelancers, the speed with which we can fly through tasks will dictate how financially successful we are.
And there’s the rub. There’s nobody telling us to go home at the end of the day, there’s no point beyond which our work is unpaid simply because it’s late in the evening, no time when the office lights start to go out, no pre-paid hours. We complete a task, we get paid, and we can complete most tasks at any time of the day or night, on any day of the week. It’s no surprise that many freelancers are overworked. The lure of “one more project, one more invoice” can be hard to resist.
The danger of overwork is compounded because project-paid freelancers have a habit of not keeping accurate tabs on the hours we work. If you enjoy what you do, working out exactly what to track can be a puzzle. Does feed reading count as play, or work-related research? What about answering emails — not all of which are strictly business related? The work-life divide is often a blur.
The problem
The only thing standing between 80 hour weeks is either a) a lack of projects or b) will-power. If you’re feeling overworked, you’ve probably got enough clients. The only variable left is self-control: the ability to say “I’ve worked enough today,” and stop. If you don’t yet have it, how do you get it?
The first question to answer is: do I feel overworked? It’s a gut feeling you get. Not necessarily all the time, but it will rear its head occasionally, maybe at the end of a day when you’ve worked from when you woke up until when you tumbled back into bed, or when you realize that you haven’t seen your best friend in a while. The next variable is how you react to that gut feeling. It’s all too easy to say: “But I need to be working this much right now, because of this, this and that.” In other words, if we overwork now, we can relax later. That ‘relaxed later’ is usually postponed ad-infinitum. Sound familiar?
One solution
This isn’t the only solution and I don’t claim that it will work for everyone. All I can say is that it worked for me, and my freelance routine probably isn’t much different to yours (liaise with clients, do work, invoice, get paid… eventually). Even if this solution won’t work right out of the box for you, it might be made workable with a few adaptations.
The process starts with a calculation: what’s the minimum amount you need to earn in a week in order to live? In other words, to pay rent, bills, buy food and have a little extra spending money left over — let’s say, $50. That’s not your ideal income, of course, but it’s the benchmark for your absolute Minimum Weekly Income (MWI) — the amount you must make to keep your affairs in order. You should only allow yourself to overwork in order to meet your MWI.
The next calculation is your cap: your Target Weekly Income (TWI). The formula is this: your average hourly rate multiplied by the number of hours you’re willing to work. Let’s say you’ve worked out your average hourly rate to be $30 and you want to spend 30 hours a week on paid tasks. Your TWI is $900. When working out the hours you want to work each week, I’d always suggest subtracting roughly 5 hours (or 2 hours for part-timers) to account for non-paid, work-related tasks (like managing accounts, answering email and liaising with clients). In this example, the person would be working 35 hours, and get paid for 30.
If you’re not sure of your average hourly rate, take the last month’s worth of jobs (or the last two-weeks worth if your memory is as bad as mine) and divide how much you got paid for each job by roughly how many hours the job took. Then add up the average hourly incomes for each job and divide by the total number of jobs over the time period. The result is a rough estimate of how much you earned per hour of work last month.
The purpose of the TWI is to establish a ceiling: the point where you stop working or accepting new jobs, even if you haven’t reached the maximum amount of hours you want to work in a week. Sometimes you will work less than full-time hours, but this is to balance out those weeks where you have to struggle and over-work just to meet your Minimum Weekly Income. Alternately, you can keep working past your TWI until your reach your work-cap for the week, but you should claim the time back as earned vacation time, or raise your TWI if you over-earn consistently.
To show you a working model, here’s my overwork safety net:
MWI = $300 (If I have to, I’ll exceed my work-cap to meet this minimum earn).
Work-cap = 10 hours (I’m finishing a communications degree and have a lot of other projects going on — I don’t want to do more than ten hours freelancing a week).
TWI = $500 (The weekly earn I aim for — I can stop working once I reach it even if I haven’t reached my work-cap).
Average hourly rate: $50 (I work fast, and I won’t accept jobs with a lower estimated hourly rate unless my MWI is in danger).
If you feel like you’re regularly exceeding your TWI while staying within your work-cap, it’s time to raise your TWI by increments.
As you can probably guess, this model does require some rough time-keeping but your career is still defined by income rather than hours. If we’re to be honest, we can’t avoid overworking unless we define what overwork means for us.
If you want to get started now and don’t mind sharing, you’re welcome to list your MWI, Work-cap, TWI and rough hourly rate in the comments section. I’d also be interested to hear your experiences with over-work. If you’ve conquered it, what was your strategy?