Citigroup Management Looks Overmatched

From the WSJ:

“The selloff in Citigroup shares has led executives to start laying out possible contingency plans. In addition to pondering a move to sell the entire company to another bank, executives have started exploring the possibility of selling off parts of the firm, including the Smith Barney retail brokerage, the global credit-card division and the transaction-services unit, which is one of Citigroup’s most lucrative and fast-growing businesses, the people said.”

Sound familiar? Lehman Brothers was stunned by their tremendous stock price decline and considered selling off Neuberger Berman, its most prized and valuable unit. Citi executives are obviously clueless right now. After all, their CEO is a former hedge fund manager and has no banking experience whatsoever. Conversely, the top brass at the other major banks are all seasoned bankers.

Selling off their valuable assets to raise money to burn in their worst units is not a good strategy. It is hard enough to operate Citi if you are a great CEO, due to its immense size, but the situation nowadays only further reinforces the notion that Citi should be broken up. Nobody with a clear head would argue that Citi’s breakup value is worth less than the current $4.71 share quote. That said, when management looks incapable and nobody can really get a clear view of what exactly Citi’s financial picture looks like with everything lumped together, it is hard to have confidence that the underlying value of the firm’s assets will be realized anytime soon. Hence, people just sell the stock.

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

Down 45%, Warren Buffett & Berkshire Hathaway Are On Sale

About a year ago, I commented on an article that appeared in Barron’s which argued that Warren Buffett’s Berkshire Hathaway (BRKA) was overvalued. In my post, entitled Barron’s Pans Buffett’s Berkshire, I agreed with the article that Berkshire Hathaway stock looked overvalued. A lot has changed since then. Berkshire shares have fallen 45% from their high and hit a fresh yearly low on Wednesday at $84,000 per share. At that price, the stock looks cheap.

As I discussed in my 2007 post, the best way to value Berkshire Hathaway looks to be on a price-to-book basis. Berkshire’s core business is insurance (which is valued with price-to-book) and the company’s assets are largely in publicly traded securities, whether it be common stocks or various types of debt instruments. Going a bit further, I would use tangible book value, rather than total shareholder’s equity, because Berkshire has more than $30 billion of goodwill on its books.

The essential question is, at what price would Berkshire Hathaway be cheap? I would love to purchase the stock at tangible book value of $56,000 per share, but that appears to be a long shot, as one might expect given Buffett’s track record and the strong management team he has assembled there.

Accordingly, wouldn’t you agree that even 1.5 times tangible book would be a solid entry point for a long term investment in Berkshire Hathaway? I certainly think so. Well, guess what? Today the stock closed at $84,000 per share, which just happens to be both a new 52-week low and exactly 1.5 times tangible book value of $86.6 billion. Not only does that look cheap, but all of us non-billionaires can buy the class “B” shares for only $2,783 each.

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

Maybe I Should Apply For Bank Holding Company Status

I mean, everybody else is, right? Now that many short-term funding sources have dried up it is amazing to see how many different types of companies are applying to become banks. First it was the investment banks (Goldman Sachs and Morgan Stanley), then credit card companies (American Express), and today we can add insurance companies (Hartford) to the mix. Who knew?

Well, Capital One (COF) for one. You may remember that COF bought Hibernia Bank of Louisiana right after Hurricane Katrina hit the Gulf Coast (and North Fork Bank of New York after that). Many analysts questioned the move, even before the storm forced COF to renegotiate the purchase lower, citing the riskiness of a pure credit card company venturing out into waters it was less familiar with (retail banking). Capital One management insisted, though, that deposits were a less risky and cheaper funding source that would allow them to more easily expand their financial service product offerings nationwide. And these conversations were taking place way back in 2005.

Now I am talking my own book here, as Peridot owns shares of COF in client accounts, but I think the company deserves kudos for being years ahead of this trend. Rather than needing to become a bank out of necessity, they did it because they saw the need to sure up their funding sources in a world awash in structured products.

Not surprisingly, Capital One has weathered the credit crisis far better than most. COF’s earnings should come in around $4 per share in 2008, on par with 2007 levels. Tangible book value per share has risen from $28 in 2006 to $30 in 2007 and to $32 today. COF shares have fallen along with the entire sector, but that has been due to multiple compression (they now trade slightly below tangible book value) not a deterioration in shareholder value.

The consumer credit environment will undoubtedly be rough in 2009 as the unemployment peaks for this cycle, but with a strong management team, there is little doubt that COF will be a long term winner when the storm passes.

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

Readers Were Right, Paulson Nixes Asset Auctions

Has anyone else noticed that whenever Treasury Secretary Henry Paulson speaks the market goes down? Today is no exception, as we learned that Paulson has abandoned the idea of using the TARP funds to buy bad assets from banks using a reverse auction process. When the idea of auctions first came to light I was very keen on the idea, but others preferred direct capital injections into the banks, in return for preferred shares as well as common stock warrants. Readers pointed out that there was no assurance that an auction would actually happen. They were right.

Instead, TARP money was used to buy stakes in banks and now Paulson says the auctions are no longer a priority. I still believe that auctions address the core problem far better than direct capital injections. As we have seen, the financial institutions can do whatever they want with money if you just hand it to them. Heck, they might even use it to buy other banks or invite their top salespeople on expensive resort getaways. That wouldn’t go over too well, would it?

The root cause of the problem, huge losses resulting from bad loans (and the need to raise more capital after losing much of what they had), could be addressed by buying the assets from the banks for pennies on the dollar. Future bank losses would be reduced because the assets causing the largest losses would be jettisoned, and the banks would have cash to make new, hopefully better, loans. The direct capital injections have done nothing to reduce bank losses or help the housing market.

At this point, the remaining TARP money would be best-served by tackling the problem directly. If the Treasury prefers not to go the auction route, then you have to do something to address the home foreclosure problem. On that front, why don’t we just use the money to pay mortgage servicers a fixed amount for each loan they modify for borrowers who are struggling to make their monthly payment? Such a move would incentivize the lenders to work with their customers and stem the housing downturn, which is a major impediment to financial stability in the system.

It is in the best interest of everyone involved if the banks agree to take a little less money back on their loans rather than become a real estate developer by foreclosing on properties. If home supply and demand imbalances are corrected, and home prices stabilize, the economy would benefit tremendously.

Part of TARP Finally Ready To Go

In recent weeks there has been plenty of talk about the Treasury’s TARP initiative, but little progress on its actual implementation. On Friday we got news that PNC Financial (PNC) was the first bank to get a capital infusion from the TARP, and would use much of the cash to help fund its acquisition of troubled banking competitor National City (NCC).

I have previously written highly of PNC stock and this deal only furthers my bullish long-term view on the company. They are paying about $2 per share for a bank that traded at nearly $40 last year and fits their geographical footprint very well. PNC’s track record on successful acquisition integration is outstanding. As with the other strong banks buying weaker ones, loan losses will rise with the deals and that trend will continue for a while, but long term the buyers will only enhance their competitive positions in a marketplace that will have far fewer players overall when the dust settles.

Today we are learning about more banks raising capital through the TARP, Capital One (COF) and SunTrust (STI) among them. Don’t be surprised if Capital One makes an acquisition in coming months as well. They have indicated they are looking at potential deals and have raised money twice in recent weeks.

Hopefully the equity market can begin to gain some traction as some of these plans are not just announced, but more importantly, actually implemented.

Full Disclosure: Peridot was long shares of COF and PNC at the time of writing, but positions may change at any time

After Dropping Out, Wells Fargo Reconsiders & Outbids Citi for Wachovia

As was widely reported, Citigroup (C) and Wells Fargo (WFC) were the two top bidders for Wachovia (WB). After Wells dropped out, Citi got some help from the FDIC and a sweetheart deal. For about $2 billion in stock they landed Wachovia’s banking operations. Evidently, Wells Fargo management was pretty stunned at the deal Citi got and decided it could do better and still not overpay. Wells will now buy the entire company for $15 billion in stock, without any assistance from the government.

This a big deal for Wells Fargo. Despite heavy exposure to mortgages in the most problematic states in the U.S. (notably California, where of course Wachovia has a huge stake), Wells has weathered the storm well so far as their underwriting standards have proven tighter than most competitors. Wells has made money every quarter since this crisis began. Now they are issuing $20 billion in new stock (nearly 20% dilution to current shareholders) to pay for this deal and raise a little extra capital.

Investors clearly think it is a great deal for Wells, as the stock is trading up 8%. As with most of these bank deals, the long term benefits for strong deposit institutions will likely far exceed the short term losses incurred by taking on even more bad mortgage debt. The trend continues… the strong are getting even stronger as the weak die off. The problem, of course, might be that we wind up with a few even larger big banks that are perceived as “too big to fail.”

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

The Strong Banks Survive, Get Even Stronger

It appears the FDIC has decided that in order to protect taxpayers and customers of the weaker banking institutions, it needs to coordinate private deals to boost confidence and limit the government’s deposit insurance losses. So far they are doing a pretty good job given the current turmoil in the banking industry.

So who are the winners and losers? Well, it’s not rocket science. Poorly run banks are paying the price and the strong banks are getting really sweet deals to take over deposit bases, bank branches, ATM networks, etc for pennies on the dollar or are simply gaining market share as customers find new banks to use.

As for investment strategy, those people who have avoided the bombshells and focused their financial services allocations on those perceived as the stronger players have done relatively well if their analysis proved accurate.

From Peridot Capital’s perspective, I have thus far avoided the disasters (knock on wood). Rather than avoiding banks altogether, however, Peridot is invested in four institutions with strong deposit bases and manageable bad loan exposures. I have mentioned all of these names on the blog over the last couple of years, but below is a recap of the banks that Peridot owns along with their stock performance in the current quarter (Q3 2008):

*Bank of America (BAC) +57%
*Capital One Financial (COF) +45%
*PNC Financial (PNC) +34%
*U.S. Bancorp (USB) +30%

Now, am I piling into these names at current prices? No. They have had huge runs this quarter because they are the stronger players and capital has flocked to the likely survivors. However, strong banks should be on investors’ radars because there will be more financial shocks and during widespread financial share price weakness, everyone gets hit hard, presenting opportunities for those who want to separate the baby from the bath water.

Full Disclosure: Peridot was long all of the companies mentioned at the time of writing

Thoughts on the “Bailout”

A reader asks:

“Curious what your thoughts on the bailout are. Is it necessary and what do you think of its presented form?”

I definitely think something is necessary. The biggest problem I have with the plan is not the concept itself, but rather how Paulson and Bernanke have sold it to Congress and the public. The conventional wisdom on Main Street and in Congress is that we are simply writing a $700 billion check to bailout Wall Street and the rich executives who helped get us into this mess in the first place, at the taxpayers’ expense. I am puzzled as to why nobody has tried very hard to explain how that is largely inaccurate.

We are not writing a check for $700 billion and getting nothing in return. That would be a bailout. Instead, we are buying distressed assets at a fraction of their notional (typo, corrected and replaced “nominal” with “notional” -CB) value. By doing so, we are converting unrealized losses on the banks’ balance sheets to realized losses. How is that a bailout? The banks are going to book billions of dollars of losses by selling their assets to the government.

The whole point of the plan is to determine prices for assets where the market isn’t functioning, so we know what exactly the ultimate losses on this crap are going to be. Without a market for these assets, uncertainty as to actual losses is causing worry and panic in the marketplace. If we bought assets at par, then yes, that would be a bailout because we would protect the banks from losses. All we are trying to do is quantify the losses, which is extraordinarily important.

In return, the government is getting assets that are producing real cash flow. There will be plenty of defaults, but that is reflected in the price being paid (10, 20, 30 cents on the dollar in many cases). The taxpayers are not going to lose $700 billion from this plan. We could lose some, or make some, depending on a variety of factors, but by buying assets when nobody else is willing to, the odds are high that the price paid will be very, very fair, if not a bargain.

As for plan specifics, I like the idea of a reverse auction as a price discovery mechanism. It integrates a market-based system into government intervention. The only thing I am worried about is the incentive system for banks to participate. Very few firms have sold these assets at low prices so far, and I am not sure why they would be more likely to sell to the government. With a reverse auction in place, it is not like the government can bid unreasonably high prices to coax sellers, and they wouldn’t want to do that anyway since they are acting with taxpayer funds.

All in all, I like the idea but not the sales pitch. Too many people either don’t understand why anything needs to be done or are misguided in their belief that all we are doing is “bailing out Wall Street.” The middle class would be among the worst affected should the economy deteriorate significantly further. And anyone who thinks the government needs to leave the market alone simply is not well versed in exactly what started to happen last week, how dysfunctional the markets have become, and what could occur as a result should we just sit back and let the free market figure it out. The free market (and the greed and unethical behavior it promoted) got us into trouble in the first place.

Buffett Treads Lightly With Goldman Sachs Investment

If one of your first reactions upon hearing of Warren Buffett’s $5 billion investment in Goldman Sachs (GS) was, “Wow, I didn’t think Goldman was a Buffett-type company,” you are probably not alone. Warren has typically preferred consumer-related businesses with wide moats (high competitive advantage and barriers to entry). He often tells people that he would feel perfectly fine owning Coca Cola (KO) or Wrigley (WWY) if the stock market closed down for five or ten years. It would be hard to have the same level of confidence with Goldman Sachs.

So before you go out and load up on GS common stock on this news, let’s review exactly what Buffett is getting, and more importantly, the price he is paying. The $5 billion deal involves two parts:

1) $5 billion in preferred stock

These preferred shares are senior to common stock and pay a 10% annual dividend. Think of them as unsecured bonds paying 10% interest. He is not buying common shares with the initial $5 billion. In addition, if Goldman ever wants to retire these preferred shares (companies typically “call” preferred shares when they have excess cash), they have to pay Buffett a 10% premium to their face value. The vast majority of normal preferreds are callable at par, not at a premium.

2) Warrants to buy $5 billion of common stock at $115 per share

Buffett has the option to buy $5 billion of common stock at $115 per share at any time over the next five years. Keep in mind that while this part is common stock, there is absolutely no risk for Buffett on these warrants. Five years from now, Buffett earns a profit of $43 million for every dollar GS stock trades above $115 per share. If the stock is below $115, he does not lose a dime, as there is no risk on his part. These warrants are essentially call options he is getting free of charge.

From the terms of this investment, we can see why Buffett has decided to invest in an investment bank even though he typically goes for much safer and predictable operating businesses. Goldman does have a superior management team and great talent, but investment banking is not a business I would expect Berkshire to expand into anytime soon.

While he is taking a bit more risk by banking on Goldman’s survival, consider how the landscape has changed for Goldman in recent days. Not only has the government indicated they are willing to take dramatic action to help these firms survive, but it also has allowed Goldman to become a bank holding company. Goldman may very well use this new capital to build out their commercial banking operation.

With this deal, Buffett is banking on government intervention succeeding in greatly lowering the risk that Goldman Sachs gets into deep trouble. For such a bet, I’d say Buffett got a great deal by waiting things out and not investing until he figured the odds were stacked strongly in his favor.

Full Disclosure: No positions in the companies mentioned at the time of writing

Morgan Stanley Becomes A Bank, Gets Overseas Investment

Thanks to the Fed’s actions last week, Morgan Stanley (MS) has averted an emergency sale to Wachovia (WB), received permission to become a bank holding company, and has sold a minority stake to Japan’s Mitsubishi. The company is going to try to remain independent, for now anyway.

With the competitive landscape having changed in recent days, namely fewer competitors in the investment banking marketplace, the stronger players who can whether this liquidity storm will clearly be in a great position to take market share in this volatile environment.

It will be interesting to see if Goldman Sachs (GS) seeks a partner of some kind, or simply builds its bank holding company on its own. Outright mergers with banks are less likely now with the Fed’s intervention, but leverage ratios and funding sources still need to be refined to protect against future shocks to the financial system, which are certain to occur.

Given the uncertainty of how all of these things play out, my view on the investment banks has not changed (see my piece entitled Investment Banks Nothing More Than Black Boxes). I still prefer commercial banks due to more transparency of how they make their money, as well as far lower leverage ratios. If leverage falls meaningfully and investment banks disclose more in the future about what they hold, that opinion could potentially shift, just not yet.

Full Disclosure: No position in GS, MS, or WB at the time of writing