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Banks Are Coming Clean, And Investors Love It

At least to the casual observer, Citigroup posted earnings Friday that weren't just bad, they were horrendous: A $5.1 billion loss, some $16 billion in writedowns from bad loans and layoffs to the tune of 9,000 workers.

But in throwing in the kitchen sink--and everything else laying around the house--Citigroup saw its shares soar 7 percent, taking the rest of the stock market along with it.

Call it the 'T' word: Transparency.

Even those bracing for more losses from financial firms see the logic of bad news translating into good news. Investors just want to know what's on their plate, even if they don't like the taste, and that's what Citigroup provided, along with a plan for recovery.

"The kitchen sink has gone in, but not necessarily all of the plumbing in the basement has been examined," said Diane de Vries Ashley, managing partner of Zenith Capital Partners in Florida. "There's no question that the earnings from the major houses have all been pretty spectacular in their negativism."

Will this continue? "To a degree, I think so," Ashley said. "Why is the stock market going up? It's beginning to look identified. It has a quantitative quality to it. It's not just rumors, it's not just speculation as to what it might be."

Ashley is one money manager bullish on financials now that the sector has suffered through months of plummeting share prices. Most market pros, however, think it's still too early for investors to jump in.

Like Citicorp on Friday, Merrill Lynch faced a similar reception from the market on Thursday, when it reported $6.5 billion in fresh writedowns and announced an additional 3,000 layoffs. Its stock gained a stunning 7 percent.

But despite this kitchen-sink mentality, some think traders are deluding themselves into thinking that the worst is over for the beaten-down big financials.

"These banks are such black boxes that even the people running them don't know what their writeoffs are going to be quarter to quarter," said Chris Mayer, banking analyst and author of the newly released "Invest Like a Dealmaker." "I think there are a lot of eager bottom-pickers still trying to snatch up financials, which tells me that the bear market in these things is not over."

Mayer and others believe the complex instruments the banks used to finance subprime loans make a clear picture on the extent of the fallout unclear, at least to this point. Only time, they say, will allow the damage to unwind and the institutions to regain Wall Street's faith.

A "Wonderful Opportunity"

But there's little arguing with results, and they've been fairly clear so far. Banks that have shown the willingness to clear up their balance sheets as well as the ability to recapitalize themselves for the damage done are getting richly rewarded by investors.

"I believe they're getting their arms around the problems, as are the regulators," said Bill Isaac, managing director at LECG in Vienna, Va., and chairman of the Federal Deposit Insurance Corp. during the banking collapse of the 1980s. "I would be very surprised if we haven't at this point gone so far with the markdowns that there will almost certainly be recoveries as things start to pick up."

Some worry, though, that even though banks may want to be in full-disclosure mode regarding the troubles ahead, it's almost impossible at this point until the collateralized debt obligations used to back subprime loans unwind. Banks are required to mark-to-market many of the assets involved in the instruments, meaning that they must assign current value to assets which may have drastically different values in the future, especially in light of the way homeowners have been walking away from their subprime-financed houses.

"There are just so many moving parts here," said Michael Kresh, president of M.D. Kresh Financial Services in New York. "I'm concerned that we still have a scenario where even the people in charge at the banks don't know exactly what they have going on."

Because of that uncertainty, experts are cautious about entering the financials.

"You want to stick with things you understand, things that are financially strong," Mayer said. "The problem with a lot of these things is you could wake up one day and they could be virtually out of business because of some accident in their loan portfolio."

Kresh takes a similar position, wondering if total transparency has been achieved or if more writedowns loom.

"I'm not ready to get into the financials yet because I'm still not 100 percent convinced that everything that has been designed to be opaque is completely on the surface," he said. "I'm not even sure that many of the people in the financial institutions themselves, except for the people who designed these products, understand what they are."

Ashley, though, is one of those willing to take a bullish stand on financials, attracted by their low prices and solid capital positions. Still, even she advises being creative when investing in them, advising smart options plays as well as common stock buys and to have carefully planned exit strategies.

"I think it's a wonderful opportunity to get into what is essentially a number of quality names at a very low price," she said. "Pick them with some care, make sure they are general dividend-paying and relatively solid institutions, that they actually take measures when they've committed boo-boos."

The sector also isn't likely to be affected much by a controversy earlier this week when the Wall Street Journal reported concern that some banks might be fudging the rates banks charge to each other for overnight lending, also known as Libor. The article suggested that banks were reporting low London Interbank Offered Rate numbers to hide weakness in their institutions. High interest rates would be suggestive of financial trouble.

"Banks in general, because Libor is priced market to market, always have a little bit of room for what is known in the markets as a tick or two," Ashley said. "There's no absolute Libor rate. There's always a smidge of negotiation to it."

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