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Pop! Went the profit bubble

In an era of boom-and-bust cycles, this was one for the history books. How the Fortune 500's earnings went from record gains to a shocking fall as revenues collapsed faster than companies could cut costs.

By Shawn Tully, senior editor at large
Last Updated: April 21, 2009: 1:02 PM ET

(Fortune Magazine) -- America is getting used to the sound of bubbles bursting - the collapse of tech stocks in 2000, the blowup in corporate bonds that rumbled late last year, the housing debacle that's still resonating. Now it's official: The sumptuous profits America posted over the past few years weren't part of a new world order, but a bubble that, like the others, went out with a bang. And what a bang.

It was just recently, in 2006, that Fortune 500 earnings reached an incredible, historic pinnacle that dwarfed all previous peaks. This year the group established another record, but in the opposite direction: It suffered by far the largest two-year fall in profits in the 55-year history of the list.

Of course, corporate earnings always retreat after years of strong growth. That's the nature of the business cycle. As Fortune noted in its 500 issue in April 2007, "Sad to say, the historic rise won't continue." What's extraordinary is how quickly and brutally plenty turned to hardship, and how many idols of the boom saw their record earnings dissolve into staggering losses.

Why so fast? The economy's fall was precipitous, leaving companies little time to adjust and pushing the 500 from the summit to something resembling an earnings depression. "We've never seen such a sudden, severe decline in profit performance," says John Lonski, chief economist for Moody's Investor Service.

The numbers tell the story. From the all-time high of $785 billion in 2006, Fortune 500 earnings slipped to a robust, even bubble-level, $645 billion in 2007. The real damage came last year, when profits plunged to $98.9 billion for 2008, a decline of 87% from 2006. (In general, we'll compare 2008 results with 2006, since it was the previous profit peak.)

For every dollar in profits the 500 garnered two years ago, its members made 13 in 2008. In fact it was in the last four months of 2008 that forces converged to sweep away the profits of corporate America. It would be difficult to invent the full range of vicious currents that came together in that period, from a free fall in U.S. demand to collapsing exports to falling prices. Especially damaging was a jump in labor costs, a big surprise given the rise in joblessness. The onset of trouble was so sudden that despite millions of layoffs, managers couldn't cut labor costs fast enough to match cascading revenues.

The plunge is hitting industries from banking to gaming to mining, but it has a common theme: It mirrors the fading fortunes of the American consumer. The problem is that households are heavily, often ruinously, in debt - at the same time their major assets, their homes and investment portfolios, are shrinking in value. Many are so stretched that they're defaulting on mortgages and credit card lines, especially the rising ranks of jobless; most are sharply reducing their spending to cover monthly interest and pay down their debt. The radical retrenchment, after golden years when Americans spent lavishly and reliably paid their loans, is hammering profits with special savagery in two broad areas: financial services and discretionary consumer goods and services, from hotels to toys to cars.

Where the storm hit hardest

Banks and securities firms that bet recklessly on the housing boom suffered epic losses as their assets turned toxic, most notably the packages of risky mortgages known as collateralized debt obligations (CDOs) that have collapsed in value as millions of Americans default on their home loans. The losses from those toxic instruments, which take the form of massive write-downs, have been overwhelming. During 2008 the companies most affected by toxic-asset fallout rang up five of the 11 biggest deficits posted on Fortune 500 lists since 1994: AIG (-$99 billion), Fannie Mae (-$58.7 billion), Freddie Mac (-$50.1 billion), Citigroup (-$27.7 billion), and Merrill Lynch (-$27.6 billion).

Major consumer banks have suffered from another kind of consumer crisis, one that has yet to play out: a meltdown in their staple businesses of providing mortgages and credit card and auto loans. They were forced to pile on ever-rising credit costs as 2008 progressed. Those costs came in two parts: charge-offs for the loans customers defaulted on today, and ever-increasing reserves on loans likely to go bad in the future. Bank of America, J.P. Morgan Chase, and US Bancorp didn't suffer the huge losses that hobbled the players consumed by toxic securities, but their profits dropped from towering to puny. And in the harsh fourth quarter, Bank of America and Wells took substantial losses.

The whirlpool sinking financial services is one of the most shocking events in Fortune 500 history. Banks, securities firms, and insurers were the biggest winners in the fat years, posting $257 billion in profits in 2006, about a third of the 500's total. Last year the financial sector suffered a loss of $213.4 billion. The $470 billion swing in profits explains almost 70% of the total dollar fall since the heights of 2006.

Our color-coded damage report
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