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Whitney: Credit crunch far from over

The star analyst tells Fortune magazine that housing woes will force banks to keep taking writedowns.

By Jon Birger, senior writer
Last Updated: August 5, 2008: 3:12 PM EDT

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Oppenheimer & Co. analyst Meredith Whitney thinks the credit crisis is far from over.

NEW YORK (Fortune) -- The credit crisis is far from over, star analyst Meredith Whitney tells Fortune magazine in its upcoming issue.

Whitney, who audaciously - and correctly - predicted last October that Citigroup (C, Fortune 500) would have to cut its dividend, tells the magazine that banks in general today are still facing much bigger credit losses than what they've reported so far.

The Oppenheimer & Co. analyst warned last year - and continues to warn today - that the "incestuous" relationship between the banks and the credit-rating agencies during the real estate bubble will have a long-lasting impact on banks' ability to recover.

For years the ratings agencies, which are paid by the issuers of bonds, gave high marks to securities backed by subprime mortgages. Many of those bonds, of course, turned out to be anything but safe.

With Moody's (MCO) and Standard & Poor's (MHP, Fortune 500) now trying to make up for past wrongs, the pace of downgrades on mortgage securities is quickening.

This is a problem, because every time their portfolios are hit by significant credit downgrades, banks are forced to improve their capital ratios. Often that means issuing reams of new stock, which leads to serious dilution, as shareholders at Citi, Merrill Lynch (MER, Fortune 500), and Washington Mutual (WM, Fortune 500) now know.

"You're going to have this stealth pressure on bank balance sheets until you start to see the ratio of downgrades to upgrades change," Whitney tells the magazine. (This is an excerpt from "The Woman Who Called Wall Street's Meltdown and What She Sees Next" in the August 18 issue of Fortune. Read the complete story.)

Modern-day Cassandra

Whitney's bearishness has deep roots. In fact, she was the first analyst to sound the alarm loudly about subprime mortgages, predicting back in October 2005 that there would be "unprecedented credit losses" for subprime lenders. The problem, as she saw it, was that loose lending standards and the proliferation of teaser-rate mortgage products had artificially inflated the U.S. home-ownership rate.

A lot of the new homeowners were in over their heads, she believed, and would have trouble making their monthly payments when home prices started to fall and their teaser rates got bumped up.

Whitney's current concern is that banks aren't slashing costs and cutting losses in their loan portfolios fast enough. On the cost side, she says, banks have yet to come to terms with the disappearance of the securitization market, which she believes will stay in hibernation for the next three years.

Why does this matter? From 2001 through 2005, for every dollar of bank capital used to make mortgage loans, ten were supplied via investors in mortgage securities. All that secondary-market capital is now sidelined, but the staffing levels of bank lending departments don't yet reflect it.

By Whitney's reckoning, banks have laid off about 7% of their employees; she thinks the cuts need to reach 25%.

Time to get real

She also argues that banks need to "get real" about how they're valuing their problem mortgage-related debt, much as Merrill Lynch has now done. Merrill recently sold a large package of toxic mortgage debt for just 22 cents on the dollar.

Whitney's idea of "real" is pretty drastic. Whereas most banks are estimating 20% to 25% peak-to-trough declines in housing prices, the Case-Shiller housing futures traded on the Chicago Mercantile Exchange portend a much steeper 33% decline, she points out.

In fact, Whitney thinks the actual declines will be worse - closer to 40% - because of the loss of the securitization market and the paucity of mortgage credit available. And that means more defaults: "The consumer's ability to refinance his way out of trouble has diminished greatly."

Whitney's critics, and there are many among bankers and analysts, contend her bearishness at this point shows she simply doesn't know how to measure the remaining downside risk.

Her response: If she has no idea how to properly value bank stocks now, it's because the metrics don't work. Price-to-earnings ratios are useless when earnings are nonexistent. And valuing banks on price-to-book ratios is just as futile. Those book values - which reflect underlying assets and liabilities - are moving targets.

"Citibank has lost 50% of its book value since last year," says Whitney, who is married to pro wrestler John Layfield.

"I do not think we are near the end of write-downs," she tells Fortune, "so I continue to see capital levels going lower, capital raises diluting existing shares further, and stocks going lower."  To top of page