Mammoth Short Squeeze in Countrywide

Countrywide posted an enormous $1.2 billion loss but Mozilo's statement that Countrywide projects return to profit sent shorts scrambling for cover.

Countrywide's quarterly net loss, its first in 25 years, totaled $2.85 per share and reflected about $2.9 billion of write-downs and credit losses. A year earlier, profit was $647.6 million, or $1.03 per share. Analysts on average expected a loss of $1.65 per share, according to Reuters Estimates.

The company wrote down $1 billion related to capital market disruptions. It set aside $934.3 million for credit losses, up from $38 million a year earlier, as more borrowers fell behind on payments, particularly on adjustable-rate and prime home equity loans. Other credit costs totaled $981 million.

'PERFECT STORM'

Countrywide said the third quarter represented an "earnings trough." It forecast fourth-quarter profit of 25 cents to 75 cents per share, and a profitable 2008, with a 10 percent to 15 percent return on equity. It also said it has negotiated $18 billion of "highly reliable" new liquidity.

Countrywide said borrowers were behind in payments on 29.08 percent of subprime loans it services as of September 30, up from 23.71 percent in June. The delinquency rate rose to 5.76 percent from 4.56 percent on prime home equity loans, and to 4.41 percent from 3.35 percent on conventional first mortgages.

"We've seen the perfect storm," Chief Operating Officer David Sambol said on the conference call.

It appears that Countrywide attempted to throw in everything but the kitchen sink into those "one time losses". But even with that strategy it is premature for Countrywide to be acting as if the "perfect storm" is over. Those increases in delinquencies are going to translate into increased foreclosures and increased REOs (Real Estate Owned) sometime down the line.

One has to laugh at the statement that the third quarter represented an "earnings trough." After all, a $2.85 per share loss is quite a "trough". The estimate was a loss of $1.65 per share. It's quite amazing to see a $1.20 per share earnings miss be treated as such magnificent news.

In addition, Countrywide appears to be bragging about securing another $18 billion in "highly reliable" credit lines. Instead investors ought to be worried about the possibility that Countrywide will again need those credit lines.

Finally I am noting that S&P credit analysts downgraded Countrywide one notch to "BBB-plus", the third lowest investment grade. Why it is investment grade at all remains a mystery.

However, the market as spoken and those issues are now "tomorrow's business".

Today the market has responded as if it believes those "one time" charges are a thing of the past and the perfect storm is now over. We will see.

Meanwhile, practical investors are wondering if there is a practical way to look at earnings. Indeed there is. In case you missed it, here it is, from Mr. Practical himself.

Practical Earnings

Back in the 1960s stock analysts began to compute operating earnings. Companies were regularly reporting gains from activities separate from their core business, so analysts began subtracting gains and losses from earnings that they did not expect to repeat. In those days operating earnings were almost always less than net earnings so analysts were being more conservative by computing price to earnings ratios in this manner.

Since 1990 this relationship between operating earnings and net earnings has completely reversed: operating earnings are almost always higher than net earnings because companies regularly show losses that they say are not recurring. Yet for anyone who cares to open their eyes, those losses seem to recur very frequently.

If you really study today’s PE ratios and compare them to yesterday’s methods, stocks are at least 20% higher in valuation.

As today’s banks take “write-off” after write-off, some as large as last years total earnings, the market seems to be finally catching on that these losses are not one time and are the direct result of core business activities gone bad.

But don’t forget the manufacturing companies that are doing the same thing. We long ago gave up as archaic looking at dividend yields and book value as tools to value stocks.

Perhaps as a measure of risk, you should check your favorite stocks for these. Maybe it has a lot more downside than you guessed.

Mr. Practical

The bulls won today with a Microsoft (MSFT) and Countrywide Financial (CFC) sponsored love fest. Let's see how long it lasts.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/