Understanding and Profiting from the Next Banking Crisis

Understanding and Profiting from the Next Banking Crisis Comments by Christopher Whalen Third Annual Value Investing Conference Darden School of Business University of Virginia October 29, 2010

The American Dream • Since the turn of the 20th Century, the world has been confronted by the paradox of rising productivity. Innovation in the form of new technologies and processes creates opportunities every day, but also leads to overcapacity in legacy industries, and chronic under employment and deteriorating credit quality in banks. • Post‐WWII policy of allowing other nations to rebuild their economies via free access to the American market created structural imbalances in the U.S. Focus on housing as a substitute for productive industries is the root of the current U.S. malaise. • Decline of American industry and accumulation of public and private debt has led to a banking system with excessive exposure to real estate and government debt, and few alternatives for diversification of risk.

A Crisis or Metastasis? • First stage of the banking crisis involved stress on liquidity due to market contagion. TARP, the Fed, FDIC responded with liquidity and debt guarantees. • The second stage involved stress on capital via charge offs and loan loss reserves, both of which drove banks into record levels of loss. Profits for past several decades completely wiped out by crisis of 2008. • The third stage of the banking crisis involves degradation of bank operating efficiency as restructuring accelerates, loan servicing expenses rise and lenders involuntarily become non‐operating REITs.

Impact of QE/ZIRP on NIM • Many on Wall Street believe that net interest margin or NIM among U.S. banks is at record levels. They are right, but not in the way that many investors and analysts expect. • Unfortunately, measured in dollars, gross interest revenue of the banking industry has been cut by a third over the past three years due to the Fed’s zero interest rate policy. Banks, savers are literally dying from lack of yield on assets due to QE/ZIRP.

1984Q1 1984Q4 1985Q3 1986Q2 1987Q1 1987Q4 1988Q3 Source: FDIC Quarterly Bank Profile 1989Q2 1990Q1 Total interest income 1990Q4 1991Q3 1992Q2 1993Q1 1993Q4 1994Q3 1995Q2 1996Q1 Total interest expense 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 2009Q3 2010Q2 0 Net Interest Income ‐‐ Large Banks 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 200,000

Why is ZIRP/QE Not Working? • In the post WWII period, Fed interest rate cuts resulted in significant reduction in average mortgage borrowing costs for households ‐‐ until 2008, when mortgage rates implied by the bond market fell significantly but households were not able to refinance. • Fees charged by Fannie Mae and Freddie Mac, and a mortgage origination cartel led by the big four banks (BAC, WFC, JPM, C), are now 4‐5 points on new origination loans vs. less than 1 point during housing boom. Huge subsidy for largest zombie banks effectively blocks refinancing by millions of households. • These fees, which can add up to 7 to 10% of the face value of the loan, raise mortgage rates to borrowers by hundreds of basis points. Banks and the housing GSEs, however, saw significant benefits in declines in funding costs thanks to low Fed rates.

% 0 2 4 6 8 10 12 14 12/1/84 Source: Absalon 11/29/85 11/29/86 11/29/87 11/29/88 11/29/89 11/29/90 MTGEFNCL 11/29/91 11/29/92 11/29/93 11/29/94 11/29/95 USMIRATE 11/29/96 11/29/97 11/29/98 11/29/99 11/29/00 Fed Target 11/29/01 11/29/02 11/29/03 11/29/04 The Refinance Gap 11/29/05 11/29/06 Predicted MIRATE 11/29/07 11/29/08 11/29/09

Large Bank Risk vs. Return • The next chart shows the risk‐adjusted return on capital or “RAROC" metrics for the top 100 US banks from The IRA Bank Monitor. RAROC is simply net income/economic capital. • The chart suggests that the real, risk‐adjusted profitability of the US banking industry has been declining since the mid‐1990s, when securitization and other types of "innovation" really kicked into gear.

Large Bank RAROC (%) 300 RAROC Avg RAROC Stdev 250 200 150 100 50 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 Source: FDIC/The IRA Bank Monitor

Bank Stress Ratings: Banks (FDIC Insured Units) A+ A B C D F 2010 06 3,551 1,575 480 463 77 1,632 2010 03 3,676 1,592 504 480 93 1,534 2009 12 2,978 1,539 480 432 85 2,441 2009 09 3,308 1,481 410 429 77 2,337 2009 06 3,518 1,449 417 421 72 2,256 2009 03 3,959 1,431 452 437 88 1,820 2008 12 3,918 1,448 376 390 98 2,003 2008 09 4,498 1,293 315 356 63 1,793 2008 06 4,884 1,323 329 326 66 1,458 Source: FDIC/The IRA Bank Monitor

Bank Stress Ratings: Assets (Billions of $) A+ A B C D F 2010 06 $2,164 $2,837 $4,942 $1,337 $465 $1,458 2010 03 $2,109 $1,295 $6,622 $1,088 $381 $1,843 2009 12 $1,457 $1,826 $3,072 $1,839 $295 $4,601 2009 09 $1,756 $1,938 $4,316 $584 $94 $4,535 2009 06 $2,005 $2,097 $4,132 $518 $68 $4,458 2009 03 $3,202 $3,131 $3,587 $729 $86 $2,784 2008 12 $2,366 $5,398 $403 $694 $46 $4,033 2008 09 $2,907 $5,504 $525 $704 $144 $3,772 2008 06 $2,897 $5,256 $400 $695 $51 $3,983 Source: FDIC/The IRA Bank Monitor

Opportunities • For banks and investors, one of the biggest opportunities for gain is to invest in the stronger regional banks that are acquiring troubled or failed institutions. Resolution results in losses, but also creates value for investors and society. • Acquiring failed banks from the FDIC is extremely attractive for existing banks, which tend to get preference from regulators in failed bank sales. Attractive pricing, lack of legacy liabilities key positives for investment thesis.

Opportunities • Another way for investors to exploit the bank restructuring process is to purchase troubled assets. So far, Fed QE and ZIRP are enabling banks to resist selling bad assets. • In addition, the FDIC, NCUA and other agencies are issuing RMBS and CMBS securities with government guarantees that offer attractive yields compared with Treasury debt.

IRA Advisory Service Ticker Q3 09 Stress Q4 09 Stress Q1 10 Stress Q2 10 Stress Outlook** RAROC Symbol/ Name Rating* Rating* Rating Rating BBT "A" "B" "B" "B" Positive 0.8% BOH "A" "A" "A" "A" Positive 30.1% CFR "A+" "A+" "A+" "A+" Positive 23.9% HCBK "A+" "A+" "A+" "A+" Positive 8.86% IBKC "A+" "A+" "A+" "A" Positive 12.32% NTRS "A+" "A+" "A+" "A+" Positive - 8.56% PNC "A" "B" "A" "B" Positive 3.92% TD "C" "A" "C" "B" Positive 1.39% USB "B" "B" "B" "A+" Positive -4.83% WABC "A+" "A+" "A+" "A+" Positive 9.04% Source: FDIC/The IRA Bank Monitor Source: FDIC/The IRA Bank Monitor * Bank Stress Ratings ** Subjective outlook on forward operating results.

IRA Advisory Service Ticker Q3 09 Stress Q4 09 Stress Q1 10 Stress Q2 10 Stress Outlook** RAROC Symbol/ Name Rating* Rating* Rating Rating WFC "A" "A" "B" "B" Neutral 0.51% BAC "C" "C" "C" "C" Negative -1.04% FITB "B" "B" "C" "C" Negative -6.09% ALLY "F" "F" "A+" "A+" Negative 3.13% HSBC "F" "F" "C" "C" Negative -1.79% JPM "C" "C" "C" "C" Negative -1.04% KEY "F" "F" "F" "C" Negative -11.17% STI "F" "F" "F" "F" Negative -8.91% WBS "F" "F" "C" "C" Negative 1.13% Source: FDIC/The IRA Bank Monitor * Bank Stress Ratings ** Subjective outlook on forward operating results.

Conclusions • The U.S. banking industry entering a new period of crisis where operating costs are rising dramatically due to foreclosures and loan repurchase expenses. We are less than ¼ of the way through foreclosures. The issue is recognizing existing losses ‐‐ not if a loss occurred. • Failure by the Bush/Obama to restructure the largest banks during 2008‐ 2009 period only means that this process is going to occur over next three to five years – whether we like it or not. Lower growth, employment are the cost of this lack of courage and vision. • The largest U.S. banks remain insolvent and must continue to shrink until they are either restructured or the subsidies flowing from the Fed, Fannie Mae/Freddie Mac cover hidden losses. The latter course condemns Americans to years of economic malaise and further job losses.

Contact Information Corporate Offices For inquiries contact, Lord, Whalen LLC dba “Institutional Risk Analytics” R. Christopher Whalen 371 Van Ness Way, Suite 110 SVP/Sales and Business Development Torrance, California 90501 Tel. 914.827.9272 Tel. 310.676.3300 Cell. 914.645.5304 Fax. 310.943.1570 cwhalen@institutionalriskanalytics.com info@institutionalriskanalytics.com WEBSITE: www.institutionalriskanalytics.com

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Understanding and Profiting from the Next Banking Crisis

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