CNBC Documentary by David Faber, “House of Cards,” Is Worth Your Time

One of CNBC’s finest, David Faber, recently completed a two hour documentary about the housing bubble and the credit crisis. I had the chance to watch it on Sunday and it is very well done. For those of you who are interested in how the combination of mortgage brokers, Wall Street, and consumers led to the dire financial predicament we find ourselves in right now. Faber really hits on all of the major culprits and explains them well along with his superb guests.

CNBC replays House of Cards in prime time during the week and over the weekends. According to my Comcast program guide, the next airing is Wednesday from 8-10pm ET but check your local listings and set your VCR or Tivo.

Strong Arguments Can Be Made Against Mark-to-Market Accounting

One can make the case pretty easily that mark-to-market accounting has played a huge role in the deterioration of the nation’s leading banking franchises. Essentially, many banks across the country are being forced to write down the value of investment securities even if little or no loss has been, or is expected to be, incurred. Such writedowns are forcing banks to raise capital to cover losses that in many cases are never going to occur. Does that make any sense, or should banks report losses when they actually lose money? That is the key question surrounding the mark-to-market debate.

Consider the following example. Bank of New York Mellon (BK) presented at the Citi Financial Services Conference on January 28th and included the following slide in their presentation:

As you can see, the company wrote down its securities portfolio by more than $1.2 billion in the fourth quarter but based on the principal and interest payments these securities are producing, they only expect to lose about $200 million. Mark-to-market accounting rules are forcing them to take more than $1 billion in writedowns in excess of what they they believe will really be lost. Practices like this are undoubtedly putting more stress on the banking system than is necessary.

I have no problem requiring firms to write down assets before a loss is actually taken if they believe they will actually have a loss in the future. But to require them to take losses based on wildly volatile market prices (which are often inefficient in turbulent times like today) rather than the actual cash flows being generated from the securities seems like a poor way of disclosing the financial position of our banking system.

Full Disclosure: No position in BK at the time of writing, but positions may change at any time

Obama Team Discussing Bad Asset Purchase Program, But It May Be Too Late

I have written here previously that I didn’t understand why former Treasury Secretary Henry Paulson abandoned the original plan for the Troubled Asset Relief Program (TARP); buying troubled assets from banks to free them up to have more lending flexibility. CNBC reported Tuesday evening that the Obama economic team is preparing a plan to do just that. While it is the better idea, it is also a shame that we have already plowed through $350 billion in preferred stock investments in the banking sector.

The preferred capital injection idea was doomed from the start because it did two things that hampered the banks. First, the preferred stock carried interest rates of 5%-10%. A bank taking $10 billion from TARP might have to pay out $1 billion in annual interest to the government. Sure, that helps the government get its money back sooner, but it requires the banks to hoard capital to ensure they can pay out the interest on time. When capital is so scarce, making the banks pay out more in interest is not going to help them.

But the banks can lend out the vast majority of the TARP money they receive, right? Not really, which brings us to the second problem; with the troubled assets still on the banks’ books, they need to hoard capital to cover future losses that will be incurred on those assets. Without helping to relieve the banks of the sub-prime assets that are causing most of their losses, the new capital is just going to be eroded away as further losses mount. If someone comes into the emergency room with a dislocated shoulder, you don’t just give the patient painkillers, you pop it back in place to help relieve the source of the pain!

The first part of TARP simply treated the symptoms of the problem, not the source. As a result, we have blown through $350 billion already and don’t have much to show for it. It is encouraging that the Obama team is trying to find a solution for the troubled assets even though it is a complicated idea, but it just might be too late. We’ll have to see what the plan looks like (if it even comes to fruition), and more importantly, how receptive the nation’s largest banks are to participating in it.

Capital One: Book Value Down 3% in 2008, Stock Down 60%

When I construct an equity portfolio, I focus on individual companies rather than sector allocations. My thought process is that if I can pick the winners and avoid the losers in any given sector, I don’t have to predict which sector will do well and which won’t.

Now, I could go out on a limb and avoid all energy stocks, for instance, if I thought demand for oil (and therefore prices) would decline. But what if I was wrong? Energy stocks could soar and I would have no exposure whatsoever. Personally, I find it far easier to identify strong energy companies than to predict where energy prices will go.

If the energy stocks I choose to invest in are better than average, then the energy portion of the portfolio will outperform the S&P 500. If I can replicate that in more sectors than not over the long term, then I can outperform the benchmark index. In a nutshell, that is how I try to beat the market over the long term.

It sounds simple enough, but in unique times (such as today) rationality completely goes out the window, and that makes my job as a long term investment manager very difficult. I will use Capital One (COF) as an example. If you believe in efficient markets, this will serve as some evidence against that hypothesis.

I have followed Capital One for a long time and have written about it extensively on this blog over the years. In my view, it is one of the best managed and financially strong banking companies around. As a result, when faced with a choice of paying 10 times earnings for Citigroup (C) or the same price for COF, I chose COF.

My analysis has been mostly correct. Capital One has avoided huge losses on packaged securities of sub-prime loans and purchased various deposit banks before the credit crisis hit, which allowed it to maintain appropriate capital levels without begging the government for cash. As a result, the company’s tangible book value per share in 2008 dropped from $29.00 to $28.24, a loss of 2.6% in a year when many banks went out of business or were bailed out by the government and larger competitors.

As you can see from the chart below, however, Capital One’s stock price has fared far worse than their book value deterioration would suggest. It has dropped 60%, from over $50 to under $20 as of this morning. Fundamental analysis has gone completely out the window lately.

Sellers of Capital One will tell you that as the unemployment rate rises, Capital One’s loan losses will increase throughout 2009 and their earnings will decline, if not turn negative. I completely agree! Everybody knows this, including the company (management is forecasting $8.6 billion of loan losses in 2009, a dramatic increase from 2008).

Still, that does not justify a 60% drop in share price coinciding with a 2.6% drop in tangible book value. Let’s say book value falls 10% in 2009 (nearly four times the 2008 rate), reflecting an even worse year. At the same rate (20% decline in stock price for each 1% loss in book value), COF shares would drop 200% in 2009. Fortunately, a stock can’t go down more than 100%!

The market is behaving as if larger loan losses and a temporary disappearance of earnings threatens the survival of Capital One, although the company has a very strong balance sheet and can withstand these recession-related shocks, unlike many of their weaker competitors. Because such an assumption is off base, it makes very little sense for a long term investor to shun strong bank stocks in the current market environment.

Capital One may trade at two-thirds of book value today (how that figure is justified, I don’t know), but when the recession ends and the unemployment rate begins to drop, the odds are very good that the stock trades at two times tangible book value or more, which means the stock could triple in value, even ignoring any increases in book value which would certainly result as time went on.

Until then, the market will continue to only focus on the short term and conclude that a bad 2009 means companies like Capital One somehow have bad business models or are broken in some way. In actuality, they are simply riding the economic cycle. Finance companies make good money when times are good and do poorly when they aren’t. Fortunately, the good times far outlast the bad times.

Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time

The Market Now Believes All Banks Are The Same

For months I have been in the camp of investors arguing that there are distinctions between U.S. banks. The comparisons have been made for a long time. JPMorgan Chase (JPM) is better than Citigroup (C). Wells Fargo (WFC) is better than Wachovia. The market seemed to agree with this premise until recently, and Tuesday’s market action in the banking sector was startling. Once again we have fierce and indiscriminate selling of all banks.

The drops in these stocks in recent days signals than many market players believe that all of these banks are in serious trouble, regardless of whether they have or have not done things such as loaned to sub-prime borrowers, accumulated lots of structured products on their balance sheets, maintained strong underwriting standards, or focused more on businesses rather than consumers.

The fear now is that the stronger banks who bought up the troubled institutions for pennies on the dollar actually did not get a good deal. Instead, the bad assets they took on will cripple them. The government will be forced to bail them out, common stock dividends will be eliminated, equity holders diluted, share price values decimated, and the companies eventually nationalized.

While this may be true in certain instances, I still do not believe that every large U.S. bank is on the brink. The market though, disagrees right now. After all, people thought State Street (STT) was safe because its main business was not lending, but rather back office and custodian services. And yet somehow they have managed to amass an $80 billion investment portfolio with $6 billion of unrealized mark-to-market losses so far. Maybe it isn’t safer.

Fourth quarter earnings reports released in coming days and weeks will shed more light on whether banks that have been able to post relatively better financial results this far in the cycle can continue that trend. Maybe all of the number-crunching people like me have done in recent quarters, trying to identify the better banks, was a worthless endeavor. I sure hope not.

If last quarter marks the end of that relative out-performance, there might not be a single bank stock that qualifies as quality. That would be a sad day, but the market is losing patience and is spooked by that possibility, as Tuesday’s trading brought with it 20, 30, even 40 percent losses for some banks on relatively little or no news.

One of the better banks in the eyes of many, U.S. Bancorp (USB), released earnings today and recorded a fourth quarter profit of $330 million. The market has greeted the news by sending the stock down 12% today, bringing the year-to-date loss to -46 percent. The culprits appear to be worries over increasing credit losses and the possibility of a dividend cut.

These two issues are interesting because many of us believe that increasing credit losses and dividend cuts are to be expected. As the economy worsens, credit losses rise and in order to cover those losses and reserve for future ones, earnings will drop below dividend rates and dividends will be cut. These things should be obvious by now.

For a company like U.S. Bancorp though, it appears manageable and investors should not own the stock just for the dividend. USB is an excellent franchise and the long-term earnings power of the company is what should drive the share price. As a shareholder, I don’t mind if USB has to cut or eliminate their dividend for a year or two in order to cover credit losses from loans made during the boom.

Looking at USB’s losses and reserves, I don’t see a reason to be panicky. Charged off loans in Q4 were $632 million. The company covered those, set aside another $635 million for future losses, and still earned a profit of $330 million for the quarter. Total allowance set aside for future credit losses sits at more than $3.6 billion. USB’s gross earnings (before credit losses) was $1.66 billion for Q4, so between that and the $3.6 billion already set aside, the bank has plenty of capital to cover increased losses throughout 2009.

While there are no banks, strong or weak, that are going to be able to avoid increased credit losses over the course of 2009, there are certainly banks that are better positioned to withstand the losses than others. Although the market is no longer giving them credit for being one of the stronger institutions, companies like U.S. Bancorp are the favorites to survive the current economic downturn and be stronger on the other side of it with fewer competitors. Investors looking at bank stocks need to take that kind of longer term view. If you are looking to make a killing over the next three or six months, bank stocks are not the place to look.

Full Disclosure: Peridot was long USB at the time of writing, but positions may change at any time.

The Idea That Banks Aren’t Lending Anymore Is Ridiculous

One of the worst parts of being a money manager is that in order to stay on top of financial news one should really have CNBC on in the office constantly. There are many people on CNBC that I thoroughly enjoy (David Faber and Erin Burnett, to name a couple), but I say this because you also have to hear a bunch of garbage that people continually spew out of their mouths.

One of the things you constantly here nowadays is that “banks aren’t lending anymore.” Whether it is a politician who is upset about how the government’s money is being spent, or an economic doomsayer, this statement is simply untrue based on actual reported data (sorry, I’m a stickler for actual data). Depending on how strong a bank is right now, lending for the most part has either been increasing modestly, staying flat, or dropping modestly. Claiming that banks aren’t lending anymore implies that loan volumes have simply fallen off a cliff, but nobody making these accusations ever can back it up with any facts when pressed.

Take the fourth quarter earnings report from JPMorgan Chase (JPM) released today. Despite an economy that shrunk during the quarter, JPM’s total consumer loans rose by 2% or $10 billion, to $483 billion, between September 30th and December 31st. This is not an aberration. As we will see (and I will add more data to this post as it comes in) most banks will show similar numbers for the latest quarter.

Given that economic growth is negative and unemployment is rising, one could easily understand if lending dropped during a recession. After all, if the core problem was lax lending standards and those standards are being revised upward, lending should be going down, not up. Evidence of increases or simply a stagnation in loan levels goes against exactly what many are claiming (that the banks are hoarding capital).

It is certainly true that someone with a FICO score of 500 or 600 (sub-prime) might not get a loan in today’s environment, but that does not mean that banks aren’t lending. Instead, it means that banks are not giving money to people who likely won’t be able to pay it back. Isn’t that exactly what we want, given that the sub-prime mortgage crisis is what got us here in the first place?

Remember, numbers don’t lie but people do. For some reason too many people seem to want to blame the banks for more than their fair share, and that is saying a lot given that these institutions don’t exactly have impressive operating track records recently.

Full Disclosure: No position in JPM at the time of writing, but positions may change at any time

Update (1/16/09):

Consumer Loans Q4 2008 vs Q3 2008

Bank of America -2%, Citigroup -4% vs JPMorgan +2%

Makes sense given the relative strengths of each bank. In all three cases, loan growth is rising faster than GDP. Banks are lending, you just need to be a prime borrower to qualify (and the majority of U.S. consumers are in prime territory).

Despite Capital Infusions, U.S. Government Should Not Dictate Bank Behavior

With at least a mini Citigroup (C) break-up plan coming to fruition, there is chatter that the U.S. government has a hand in some of these decisions. The justification is that the TARP program has resulted in the government directly injecting capital into banks like Citigroup, and as a result they are shareholders and have a large influence on guiding future operational decisions.

This is an interesting assumption because the government does not own common shares in Citigroup or any other U.S. bank, and therefore has no controlling rights like other shareholders do. The preferred shares the government bought carry no voting rights, as that is a core characteristic of preferred stock. The government does have warrants to buy common stock in the future, but those warrants are under water and as long as they are not exercised, they don’t bring with them any rights of control.

If the government really is behind much of Citigroup’s decision making, it may signal that the bank knows it will need more financial assistance down the road and therefore feels it must comply with government requests. If not, I would tell them to buzz off.

As for the break-up plan itself, does it make me bullish on Citigroup stock? Not really. While it is a step in the right direction, Citi still has one of the weakest balance sheets in the industry. It is practically impossible to know what their assets are worth and how high future losses will be. As a result, trying to accurately value the company is extremely difficult. The stock is cheap, but that alone is not enough of a reason to buy it.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

Brokerage Joint Venture With Morgan Stanley Is Positive Step For Citigroup

I have written previously, as have numerous other investment managers, that in order for Citigroup (C) to have the best chance of being nimble enough to grow and be managed efficiently it needed to be broken up. The vast number of businesses they have, coupled with the dozens of countries they conduct business in, would make it extremely difficult for anyone, including current CEO Vikram Pandit, to successfully manage the company.

It now appears we are a day or two away from hearing from Citigroup that they are contributing their Smith Barney retail brokerage division to form a joint venture with Morgan Stanley’s retail business. The combination would have more than 21,000 brokers, making it the largest brokerage firm in the world.

Although a dramatic shift from prior assurances from Citigroup CEO Vikram Pandit that he would not break up the company, I think this joint venture makes a lot of sense from their perspective. Under the rumored terms of the deal, Morgan Stanley would own 51% and manage the joint venture. Citigroup would own 49% and receive a ~$2.5 billion equalization fee (to account for the fact that Smith Barney has more brokers than Morgan Stanley).

Initial press reports had Citigroup selling 51% for $2.5 billion, which made little sense since it would only value the unit at about $5 billion. However, it appears they are getting $2.5 billion in cash and a 49% stake, which sounds more like it. In addition to the cash, Pandit downsizes Citigroup and makes his job of managing it a whole lot easier.

While this deal does not put an exact dollar value on Smith Barney (the joint venture will not trade publicly), which would have helped Citigroup shareholders more easily justify the current $6 stock price, it does give Morgan Stanley the option to buy out Citi’s 49% stake in the future. While I would not suggest Citigroup sell the entire thing (it is doing far better than their banking businesses), this deal does manage to raise capital and make the large bank more manageable.

While not a life saver, this deal does make some sense, which is more than we can say about Citigroup’s business decisions in recent memory.

Full Disclosure: No position in Citigroup or Morgan Stanley at the time of writing, but positions may change at any time

Financial, Retail Weakness Mask Underlying Core Profitability

Simply judging from the stock market’s performance over the last couple of months, you might think the entire U.S. economy is teetering on the brink of disaster. In reality though, the sheer ugliness of the financial services and retail sectors is masking the other eight sectors of the market that, while certainly weaker than they once were, are actually holding up okay given the economic backdrop. The easiest way to illustrate this is to show earnings by sector for the last three years; 2006, 2007, and 2008. Keep in mind the 2008 are estimates based on nine months of actual reported profits and estimates of fourth quarter numbers.

As you can see from this graph, earnings in areas like telecom, healthcare, staples, or utilities are doing just fine and can withstand further weakness in 2009 and still more than justify some of the share price declines we have seen in recent months.

The selling has been indiscriminate but the business fundamentals are quite differentiated, depending on sector, which is one of the reasons that the U.S. equity market has not been this cheap relative to earnings, interest rates, and inflation since the early 1980’s. It is a gift for long term investors.

Citigroup: A Sell At $3.00?

I really thought we would finally see a less negative view on Citigroup (C) from Meredith Whitney a couple weeks back when the stock hit three bucks. Whitney, you may recall, is the Oppenheimer & Co banking analyst who downgraded Citigroup to “underperform” last year when the shares traded for around $40 each. Last month, Citigroup hit a fresh intra-day low of $3.05, capping a stunning 13 month 92% drop in the shares of what once was one of the most valuable U.S. companies.

What a perfect time that was to remove a “sell” rating. At $3.05, Citigroup stock likely had two possible long term outcomes; go bust or go a lot higher. Whitney could have closed the book on what would have been one of the best analyst calls of all time. It would be easy to justify upgrading Citi to “neutral” at $3 per share. After all, after a 92% drop, the risk-reward trade off is far less compelling unless you really think the company won’t survive. Whitney has never indicated she thinks Citigroup will go under, so I have to think recommending investors sell the stock at $3 makes little sense, unless she wants to remain the most bearish analyst on Wall Street and an upgrade of a large bank stock wouldn’t fit that mold.

In the past two weeks, Citigroup stock has surged by more than 150% from the ridiculously low $3 quote to $7.70 per share as I write this. If that $3 print turns out to be the low (I am not predicting that necessarily, as I have no idea where bank stocks could trade in the short term), Whitney might have to remove her “underperform” rating at much higher prices, which tarnishes the call because she would have that rating on the stock as it doubled, tripled, or even quadrupled in value.

If the stock goes back down in the coming weeks or months, I think Whitney would be well-served to put a neutral rating on the stock, claim victory, and cement her Citigroup call as perhaps the best sell side recommendation of all time.

It would not be an easy decision given the banking sector still has not overcome its problems, but moving on would signal to investors and her clients that she has not resorted to simply being the most bearish banking analyst on Wall Street. Just because that is what put her on the map, it does not mean staying bearish for too long could not take her off of it just as quickly.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time