Why Bank Shares Rise on Write-Downs

Dan Gross tackles the write-down paradox today: how come the share price of [Citigroup/Merrill Lynch/Bear Stearns/Whoever] rises when the bank announces massive losses? After all, he writes,

Write-downs should be especially worrisome when taken by banks, since they are in the business of valuing financial instruments.

Gross's response is, basically, "investors are idiots".

Egged on by bank executives, investors have come to believe this is the extent of the damage. We'll take these write-downs and no more! The credit problems are over! Let's move on!
Investment bank CEOs and their shareholders clearly believe that the worst is over. But a fine line separates belief from credulity, and the large investment banks are blurring it.

I don't believe that investors are idiots. In fact, I don't believe that investors are bidding up the stocks of the banks declaring large write-downs. Citi is down 17% from its highs, while Merrill and Bear are both down more than 25% – even as the stock market more generally is hitting new highs. If a share price reflects expectations of future earnings, then clearly investors are much less bullish on these banks than they were a few months ago.

What's more, investors are perfectly cognisant of the amount of turmoil in the credit markets. It's worth remembering that a write-down does not actually change the value of a bank, which is the thing measured by the share price. If a bank's assets are impaired, then the value of the bank has gone down whether or not it takes a charge to earnings this quarter.

So the way I see it, the stock price of these banks started falling dramatically as their balance sheets declined in value. In fact, the stocks fell particularly hard and fast because at the time there was relatively little indication that senior management at the banks was taking the turmoil in the credit markets seriously, preferring instead to simply keep on dancing.

Now, however, fixed-income executives have been fired, charges have been taken, and the banks are clearly aware that there has been a fundamental change in the way that credit markets operate. Given that a clear-eyed bank is worth more than one in denial, it makes sense to bid the shares up a little bit – although not to anywhere near their old highs.

There are degrees of denial, of course. Gross might well be right that there are more write-downs in these banks' futures, which investors may or may not be pricing in to the share price. But I think he'd be hard-pressed to find a real, flesh-and-blood institutional invetor who really believes that the credit problems are over. Rather, those investors think that the people who were digging the banks into big holes have largely been fired, and that the attitude of the banks to the credit markets more generally is one of sensible caution rather than reckless abandon.

In other words, a write-down means a chastened executive, and investors, right now, like their executives to be chastened. Investors might be delusional, but, on the other hand, they might not. I prefer to give them the benefit of the doubt, since the market generally is more reliable than any one pundit.