Michael Durante Western Reserve research analysis- camel example

1. Select Position Research May 2010
Citigroup (C) - Long
The Fund made its first investment (ever) in Citigroup (C) in the spring of 2009 at prices
as low as $1.50. While C is a liquid, widely-held and followed stock, our research
identified some very unique things in this investment which we believe the rest of the
investment community was not taking into account.
First, Fair Value Accounting (SFAS 157, 133 etc or “MTM”) was proving inaccurate and
we believed the capital raised and losses taken on C’s “bad bank” were significantly over
done. The result would be material recapture of loss provisions from the “run-off”
portfolio and the ability of Citigroup to re-invest the excess capital from TARP not yet
converted to common stock into more productive investments over time. This would
include stock repurchases and other accretive acquisitions and business realignments
elsewhere in the company’s continuing operations or “good bank”.
Losses on Bank-held Securitized Loans were Artificial High
-$20bn
$0bn
$20bn
$40bn
$60bn
$80bn
$100bn
Oct-96
Sep-97
Aug-98
Jul-99
Jun-00
May-01
Apr-02
Mar-03
Feb-04
Jan-05
Dec-05
Nov-06
Oct-07
Sep-08
Aug-09
USBanksUnrealizedSecuritiesLosses
Source: Federal Reserve, Goldman Sachs Research.
The chart above illustrates the inaccuracies of MTM accounting. No other large US
financial institution, save perhaps Bank of America (BAC) (which the fund began
purchasing at $4.50) was going to benefit more than Citigroup from the accounting
applications primary flaw known as an “observable input.” The “inputs” were based on

2. 2
illiquid insurance derivative contracts which proved to be inaccurate when compared to
their discounted cash flow.
It appears (to us) that few have recognized that the stock market bottomed at the precise
moment when the Congress announced hearings into the impact of MTM early last
spring. (Western Reserve began calling for MTM reform in 2007.)
Secondly, as a former Federal Reserve bank regulator, I was assigned to Mellon Bank
Corporation (now BK) during the S&L Crisis, when they attempted the “good bank; bad
bank” strategy also know as the “Grant Street (Pittsburgh) Bank” experiment which was
only a partial success. Based on my experience in that endeavor, the bank regulators have
learned from the lessons of “Grant Street Bank” and improved upon them in the
restructuring of Citigroup. In our view, investors overly focused on the “bad bank” run-
off and thus clearly over reserved and capitalized for this while ignoring the highly
valuable remaining assets and businesses of Citigroup. As a result, the franchise was
selling for well below its break-up value.
One such business was the AAdvantage credit card business. As analysts that once
focused on monoline credit card firms and credit card transaction processing stocks, we
had a unique view of AAdvantage. This is the world’s most profitable credit card
program….and a very reasonable multiple of ebitda, shares of C were trading BELOW
the intrinsic value of just this one product line of the company.
Third, as former regulators, we noticed early stage credit migrations were starting to
improve as early as the spring of 2009 which ultimately would take pressure off earnings.
While many analysts believed C wouldn’t return to profitability until as early as 2012-
2013, we believed 2010 was more likely based on our credit migration analysis. In 1Q10,
we were proved correct. The chart below depicts the “good bank” improving credit
position since 1Q09… something few other investors took note of given the share price.
Citigroup is Over-Reserved Now!
2.00%
2.50%
3.00%
3.50%
4.00%
4.50%
5.00%
5.50%
6.00%
6.50%
7.00%
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09
Loan Loss Reserve
Net Charge-offs

3. 3
Finally, in both a deteriorating and then improving credit migration environment, we look
out into the future at the bank’s “earnings power” as opposed to simply looking at the
present. The lowest risk (for an investor) way to get through a credit crisis is to evaluate
the bank’s ability to “earn” through the peak of the credit losses. The method we espouse
is the use of adjusted pre-tax, pre provision income (cash flow) and adjusted book value
(account for excess reserve build). The Federal Reserve used a similar strategy in their
SCAP analysis of the largest banks more commonly known as the “stress test”. We
believe bank accounting (particularly loss reserve build analysis) confuses most investors
and is a key advantage to our approach to the early detection of sea-changes.
The table below illustrates just how “cheap” large US financial institutions became
(especially Citigroup) and why the risk of owning the stock versus the reward started to
reverse – the evidence is in their ability to “earn” through problem loans.
Valuations Became Absurd!
Price
Book
Value
Adj.
Book
1
PTPP
2
Price/
Book
Price/
Adj. BV
Price/
PTPP
JP Morgan $41 $41 $50 $12 100% 82% 3.3x
Wells Fargo 26 24 29 7 107 88 3.5
Citigroup 3 7 8 2 53 44 2.2
PNC 52 63 73 15 83 72 3.5
Bank of Amer. 15 27 31 6 57 50 2.8
Capital One 40 57 62 16 71 65 2.6
US Bank 22 13 17 5 171 135 4.7
Average 92% 77% 3.2x
1
Stated book plus loan loss reserve drawn down to 1% of loans w/ excess taxed at 40% income tax rate and 2010 EPS.
2
Pre-tax, pre-provision at normalized annualized provision rate.
For Citigroup, a reasonable valuation would be to take the recent adjusted PTPP multiple
of just 2.2x, tax effect it up to 3.1x and quadruple that to 12x for a reasonable P/E of
about $14-$16. This is before including the assumption that at some point the economy
will start growing again….and C has one of the best global growth franchises anywhere.

4. 4
Wells Fargo (WFC) - Long
As mentioned above, pre-tax, pre-provision (PTPP) income is a more accurate gage of
where the industry’s cash flow strength stands. Valuations remain ludicrously cheap on
this cash flow-oriented basis as investors are still “hooked” on book value, reserve builds
and GAAP. Never before in history has the financial industry produced so much more
cash flow than reported earnings. The recognition and closure of this historic “gap” is
inevitable... the seeds of recovery in financial stocks is already underway.
30 Western Reserve Capital Management, LP © 2009Confidential
Pre-Tax Pre-Provision Profits: “Look Thru Earnings”
$0
$5
$10
$15
$20
$25
$30
$35
$40
2003 2004 2005 2006 2007 2008 2009E
Pre-Tax Pre-Provision Profits
Wells Fargo – Consistent Growth
Source: Wells Fargo & Company; 2009 estimated based on actual 1Q09 PTPP annualized.
We keep going back to Warren Buffett’s favorite bank stock –Wells Fargo (WFC) (one
of our favorites as well). Buffett refers to PTPP as “look through” earnings power (a.k.a.
cash flow). In the first quarter 2009, Wells posted record “look through” earnings
“power” as expressed by PTPP. This was driven by record double-digit organic fee-based
revenue growth. The very low dilution related to the purchase of Wachovia is also of
note. We continue to believe this is perhaps the most accretive acquisition in U.S.
banking history? Time will tell of course…
For WFC, a reasonable valuation would be the recent adjusted PTPP multiple of just
3.5x, tax effect it up to 5.2x and triple that to 15x. This multiple produces about $70-$75
before incorporating any assumptions regarding eventual growth in the economy.

5. 5
The chart illustrates the closing of the gap between (PTPP) and pre-tax GAAP which is
inevitable and which will continue. We believe this gap will become increasingly more
evident in reported or “GAAP earnings” in 2010 and consequently bank valuations will
rise steadily. Financial stock valuations are NOT reflecting just how wide of a disparity
still remains. This is why the Fund is over weighted traditional financials at present and
expects to be so for some protracted period of time.
How to Ride a CAMEL
We wrote in early 2009 –
The valuations that Buffett recognized and took advantage of in 1990 via purchasing
Wells Fargo; are very similar to the opportunities that we are seeing today in JP Morgan
(JPM) and Capital One (COF). As former bank regulators, we methodically analyze
banks under strict regulatory accounting practices (we ignore GAAP as it is flawed on
many levels) and evaluate the safety and soundness of banks based on the classic bank
examiner’s CAMEL rating methodology. CAMEL being an acronym for Capital
Adequacy, Asset Quality, Management Strength, Earnings Power and Liquidity. Each of
these factors are critical in determining which banks are in position to not only survive
but to determine which are in an optimum position to gain tremendous market share in a
recovery.
$0
$50
$100
$150
$200
$250
Pre-Tax, Pre-Provision
Pre-Tax GAAP
Bank Earnings “Power” v. GAAP
Mark-to-Market
Accounting
Overstatement of
Losses

6. 6
CAMEL is best illustrated by example:
JP Morgan (JPM)
Capital Adequacy
• Tier 1 RBC 11% is >200% of the regulatory minimum for “well capitalized”
• Total RBC 15% is off the regulatory chart strong
• Total RBC plus Loss Reserve 18% is off the regulatory chart strong
• Tangible Common Equity is >250% above the old 1.5% minimum regulatory standard
Asset Quality
• Nonperforming Assets are a low 0.6% of total assets
• Nonperforming loans are well below industry average at 1%
• Loan loss reserve is 3% or well in excess (> 250%) of nonperforming loans
Management
• Jamie Dimon and team are considered among the best in the industry and the Federal
Reserve has referred to JPM as the “second Fed”. Federal Reserve’s #1 “go to” bank.
The government chose JPM to aid in the liquidation of Bear Stearns and the take-over or
clean-up of Washington Mutual, a huge vote of confidence in management.
Earnings
• JPM’s core cash earnings were quite positive in 4Q excluding excess reserve build
• The “look through” earnings power is >$3.50 EPS and we believe WaMu accretion
exceeds $1 EPS
• So, JPM is trading at roughly 5x recovery EPS
Liquidity
• Loans-to-Deposits at roughly 70% indicate unheard of liquidity to manage any deposit
withdrawals and/or accelerate loan growth as economic conditions improve
• Current assets less current liabilities is an amazing $1 trillion or 10x the stock’s market
value and 40x the TARP monies they were asked to take
• Cash and equivalents less total debt is $556 billion or nearly 6x the stock’s market value
and 22x the TARP they were asked to take
Conclusion – JPM is an extremely valuable franchise trading at panic level
valuations. The balance sheet is extraordinarily liquid, capital levels extremely high
and asset quality well contained if not remarkably strong relative the economic
environment. The stock is priced at 50% of book value; 5x “look through” earnings
power and the bank has no less than 6x net cash to market value. This is the bargain
of a lifetime.

7. 7
Capital One Financial (COF)
Capital Adequacy
• Tier 1 RBC 14% is almost 300% of the regulatory minimum for “well capitalized”
• Total RBC 17% is well off the regulatory chart strong
• Total RBC plus Loss Reserve 21% is well off the regulatory chart strong
• Tangible Common Equity is >500% above the old 1.5% minimum regulatory standard
Asset Quality
• Nonperforming Assets are a low 0.6% of total assets
• Nonperforming loans are well below industry average at 1%
• Loan loss reserve is 4.5% or well in excess (> 450%) of nonperforming loans
Management
• Rich Fairbank and team are considered consumer finance stalwarts and were instrumental
in forever altering the credit card industry, which now is controlled by an oligopoly of
only the strongest underwriters. Their current credit statistics are the lowest in the
industry despite these troubled times. The government turned to COF’s management to
help them deal with troubled Chevy Chase Bank, a huge vote of confidence from the
regulators.
Earnings
• COF’s core cash earnings were positive in 4Q despite a massive excess reserve build
• The “look through” earnings power is >$7+ EPS and we believe Chevy Case will be
accretive in the years to come while further shoring-up deposit funding strength
• So, COF is trading at roughly 2x recovery EPS
Liquidity
• Loans-to-Deposits at roughly 90% indicate strong liquidity to manage any deposit
withdrawals and/or accelerate loan growth as economic conditions improve
• Current assets less current liabilities is $38 billion or 6x the stock’s market value and 10x
the TARP monies they were asked to take RE: Chevy Chase
• Cash and equivalents less total debt is $15 billion or 3x the stock’s market value and 5x
the TARP they took-down
Conclusion – COF is an irreplaceable consumer credit franchise trading at panic level
valuations. The balance sheet is highly liquid, capital levels incredibly high and asset
quality far stronger than its peers. The stock is priced at 25% of book value; 2x “look
through” earnings power and the bank has no less than 3x net cash to market value. This
too is the bargain of a lifetime.

8. 8
Bubble Alert (Short Opportunities)
What speculators are chasing in China is what we like to call “authoritarian staged
economics.” Fund managers keep misreading this as organic growth. This is a ruse. We
see this as nothing more than an inevitable pile of bad debt. In fact, Beijing, which
controls its banks, recently extended terms on many very large credits an additional ten
years. This is something that U.S. banks cannot currently do legally and have not done
since the 1980’s. The Japanese still employ this denial practice and we all know how that
has turned out. What we don’t know is how long the Chinese can sustain this loan
stimulus binge before real-end market demand returns from the West. We doubt they will
make it and a substantial correction may be inevitable.
China's Loan Stimulus Plan
Pile of Bad Debt Coming?
0%
5%
10%
15%
20%
25%
30%
3Q98 3Q99 3Q00 3Q01 3Q02 3Q03 3Q04 3Q05 3Q06 3Q07 3Q08 3Q09
Real GDP
Loan Growth
Source: BofA Merrill Lynch, CEIC and Western Reserve compilation
To power its supposedly miraculous economy, Chinese state-controlled banks shelled out
more loans in 2009 than the entire country’s GDP ($3-4 trillion USD per the leverage
inherent in the Renminbi). In terms of a credit bubble, this would make Americans blush.
Chinese banks already are running-up against capital constraints in support of such heady
loan growth and this should concern investors about how sustainable a trend this really
can be. China has great long-term promise, but at present it’s “window dressing” it’s
economy purely on credit overdrive. This excess credit has caused a stockpile of raw
materials (largely commodities), which has driven-up prices but has no end-market
demand. Many fund managers in the West are chasing these trends believing them to be
sustainable and therefore have drained the domestic equity markets to fund this
“performance chase”. We see a sharp reversal brewing which will benefit domestic
markets, the U.S. dollar and especially local financial stocks. The winds are ripe for this
reversal as it is supported firmly by the fundamentals. Many fund managers are not
positioned for this correctly.

9. 9
We suspect emerging markets like Dubai and Greece are just an appetizer; and this at a
time when more domestic investors are allocating their capital abroad than at any other
time in history. Consequently, we are finding many short ideas amid “back-door’ China
plays. The near ubiquitous confidence in China by western portfolio managers has
resulted in the gross over allocation to industrials and commodities in most portfolios.
Meanwhile, excessive pessimism in the U.S. economy and especially in our financial
system has created material under allocation to the U.S. financial sector.
So, strictly speaking, the odds fantastically favor U.S. financial stocks. Fundamentally,
our financial system is in repair mode while China’s system is fragile, bloated and has yet
to deal with their credit excesses. Strangely, a strong domestic bank can be had for
less than 1x book value while its Chinese counterpart trades at 5x book value. A
lay-up in our view…
Regional Banks – CRE isn’t what it seems – Long Selectively via
CAMEL analysis
Although some significant “clean-up” work remains, our financial industry has stared
into the abyss (with some serious help from non cash-based loss recognition accounting)
and has survived. Actually, the recovery has been text book. As we noted in our research
late in 2008, liquidity must be restored first and it was. Then capital replenished and it
has. Now asset quality is back to “manageable” and has continued to improve. And
finally, earnings restoration will follow. And it is here…
Credit migration trends tell the story now…
Residential Real Estate
The result of a study of residential mortgages (by origination year or “vintage”) by the
Federal Reserve Bank of Atlanta delineates the current setting. Put simply, we are past
the peak in the residential mortgage crisis although very few investors would believe us.
(remainder of page intentionally left blank)

10. 10
Residential Mortgages Are Behind the System
Source: Federal Reserve Bank of Atlanta
How to interpret this chart: People who bought homes in 2002 experienced much better
price gains than those who bought in 2005. At the same time, the credit worthiness of
borrowers declined between 2002 and 2005 due to the federal government’s “affordable
housing” mandates. These mandates legitimized and subsidized weak underwriting on
sub prime e.g. via Fannie Mae and Freddie Mac despite the steady warnings and higher
rate targets from the Federal Reserve. The Fed began raising rates in early 2004 and
accelerated the process through early 2007.
The blue dotted line shows what would have happened if people who bought homes in
2002 actually experienced 2005 price changes. If foreclosure levels were high, then that
would imply that declining standards were the main driver, but that's not what one
observes. Quite the opposite actually happened. 2002 underwriting standards were still
quite strong. So, the only “updraft” in the analysis came from potential home price
changes and those were minimal. So, this “easy money” theory that “economic
populists” charge with the cause of the mortgage crisis has no empirical foundation. The
Fed had nothing to do with high foreclosure rates. Conversely, the dotted red line shows
what would have happened if the better credit quality borrowers from 2002 had actually
bought homes in 2005. The fact that foreclosures are much lower in this scenario
suggests that while home price changes are a factor, it is overwhelmingly poor lending
standards that cause foreclosure risks to “go rogue”.
This should end the debate on the whether the Fed’s perceived “easy money” versus
mortgage industry lust (led by the Government Sponsored Enterprises) caused the

11. 11
mortgage bubble. The lesson is obvious – don’t make bad loans and then blame it on
monetary policy. Blame it on bad loans and unintended consequences of ill-conceived
government subsidies.
In 2009, we have seen home price declines moderate to low single digits per the Case-
Shiller Indexes. This is materially below the Fed’s “stress test” metrics as mentioned
previously. The residential mortgage crisis has peaked with the worst vintage of any
magnitude being 2005. This vintage is seeing foreclosure hazard steadily decline while
better underwritten older vintages are at less risk to home price erosion. We actually look
to invest in some of the very best mortgage underwriters taking market share, namely
Wells Fargo and Bank of America.
Mortgage “Reset” Risks are Abating Quickly
For investors, the forward looking observation here is that all vintages of residential
mortgage credit have seen peak foreclosure incidence and we are now in recovery. It will
be a long recovery and we will not see another “housing boom” for some time…maybe
decades. But, residential real estate no longer poses systemic risk to the broad financial
system. Although some “reset” risks remain in 2010, they drop-off in 2011 and beyond.
They also are higher quality mortgages and mortgage rates (for refinancing) remain low,
which are material mitigating factors.
As one can quickly discern (table below), residential mortgages are materially out
performing the “adverse” scenarios presented by the Fed’s “stress test”. So far, realized
losses on residential mortgages are running at 1/3 what banks have “reserved” for
already. Reserve releases are inevitable. This is one reason why Citigroup has recently

12. 12
paid-off its insurance coverage of their large mortgage-backed securities portfolio. The
upside is clearly evident.
Credit Quality is Materially Outperforming the “Stress Test”
19 Largest Banks “Stress Tested” by the Federal Reserve
YTD09
Charge-Offs
Times 24
Months
Fed’s 24 Month
“Adverse” Stress
Commercial Industrial 1.9% 3.7% 8%
Commercial Real Estate 0.6% 1.2% 10%
Construction 4.2% 8.4% 18%
Residential Mortgage 1.2% 2.4% 8%
Home Equity 3.1% 6.2% 16%
Credit Card 9.1% 18.2% 20%
Source: Federal Reserve and Western Reserve compilations
Commercial Real Estate
Financials, especially banks, continue to be the most shorted stocks by hedge funds and
speculators. Commercial real estate (CRE) is their target. They are taking too broad a
stroke and they simply are wrong.
Commercial Real Estate: A Tale of Two Types of Nomenclature
19 Western Reserve Capital Management, LP © 2009Confidential
Why Financials present the greatest
risk-reward opportunity
Credit Costs Have Peaked:
Commercial Real Estate Over Billed as the “Next Shoe”
19
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
Construction loans
CRE loans
Source: Federal Deposit Insurance Corporation
NetCharge-Offs,USBanks(annualized)
1991 - 2009
Source: Federal Deposit Insurance Corporation

13. 13
The accompanying chart (previous page) from the FDIC clearly details that “commercial
real estate” problems remain largely a residential problem resulting from excessive
construction and land development credit. This is not traditional CRE. It is without
controversy that traditional CRE is deteriorating amid the weak economy; however this
pales in comparison to what we saw as bank regulators during the S&L Crisis.
Nevertheless, the Fed’s “stress test” assumed an S&L Crisis-like outcome for traditional
CRE and this has forced banks to over reserve for this often referenced “second shoe to
drop”. JP Morgan already has had to “release” reserves for traditional CRE due to
“stress test” aberrant assumptions.
Banks which made a habit of loading their balance sheets with construction and land
development credits are another story altogether. They either are gone, absorbed by
stronger banks that averted the excess or remain penny stocks. They now are a mute
point to the current state of affairs in the financial system…an ugly, yet meaningless data
point now for public stock investors. The remaining depositories which are failing are all
very small and non public. These will be paid for with ease via higher FDIC insurance
premiums over the near term. The crisis effectively is over.
Current Bank Failures are Immaterial Institutions
Bank Name City State CERT # Closing Date
Columbia River Bank The Dalles OR 22469 January 22, 2010
Evergreen Bank Seattle WA 20501 January 22, 2010
Charter Bank Santa Fe NM 32498 January 22, 2010
Bank of Leeton Leeton MO 8265 January 22, 2010
Premier American Bank Miami FL 57147 January 22, 2010
Barnes Banking Company Kaysville UT 1252 January 15, 2010
St. Stephen State Bank St. Stephen MN 17522 January 15, 2010
Town Community Bank & Trust Antioch IL 34705 January 15, 2010
Horizon Bank Bellingham WA 22977 January 8, 2010
First Federal Bank of California, F.S.B. Santa Monica CA 28536 December 18, 2009
Imperial Capital Bank La Jolla CA 26348 December 18, 2009
Independent Bankers' Bank Springfield IL 26820 December 18, 2009
New South Federal Savings Bank Irondale AL 32276 December 18, 2009
Citizens State Bank New Baltimore MI 1006 December 18, 2009
Source: Federal Deposit Insurance Corporation
In reviewing the banking regulators’ mid year Shared National Credit Review (sometimes
referred to as the “SNIC Review”), most construction and land development loans were
concentrated in savings banks (thrifts) and smaller regional banks. The “leveraged loans”
component in all this (many backed by commercial real estate) were held by non banks
(largely hedge funds, private equity firms, bond funds, and insurers).
What happened in the 1980’s was not called the “Savings & Loan Crisis” without reason.
It was a result of very poor underwriting standards and lax regulating of smaller federal
and state government depositories, almost all outside the Federal Reserve System.

14. 14
It appears to have been overlooked by many that these types of poorly regulated
institutions again are a problem and were NOT allowed to participate in TARP.
Bank examiners we have spoken with in late 2009 have made it abundantly clear that
their focus in recent exams has been on commercial real estate. One district Fed Banking
Supervision & Regulation head told us that he was “pleasantly surprised” at the
underwriting quality of his district member bank’s CRE. This was post the completion of
their swat team-like exams.
Traditional CRE is the last leg of this credit crisis. This brand of exposure is far more
prevalent in regional banks than in money center institutions. And as illustrated below,
traditional CRE lacks the speculative risk that we witnessed in construction and land
development. This is nowhere close to the excesses of the S&L Crisis. Our analysis
concludes that this is a very manageable issue for the banking industry and will serve
merely to delay earnings recovery for some regional banks relative to their larger peers.
Traditional CRE Losses Tracking Better than Expected
0.0%
0.1%
0.2%
0.3%
0.4%
0.5%
0.6%
0.7%
0.8%
0.9%
2006 2007 2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E
GS CRE estimates (old)
CRE loans (US banks)
Source: Goldman Sachs & Co.
For this cycle, traditional commercial mortgages will be a drag on smaller bank earnings
recovery relative to larger banks. Thus, we have positioned the Fund accordingly. We
remain overweight large, diversified bank holding companies although we had started to
build positions in some recovering regional banks late in 2009. KeyCorp (KEY),
Huntington (HBAN); ZIONS Bancorporation (ZION); Marshal & Ilsley and BB&T
(BBT) are among those analyzed carefully and chosen for the Fund based on our
CAMEL analysis-based insights.
The Fed’s stress test used very high commercial real estate loss assumptions in assessing
capital adequacy. The 2009 losses across all insured depositories on traditional
commercial real estate loans were running 1.2% or approximately 1/8th
of the “stress test”

15. 15
formula for adverse outcome through the third quarter. And we actually see delinquency
abatement in the early reports of fourth quarter results at banks.
We believed there was a great opportunity in regional bank stocks in 2010. The
valuations of these banks are being maliciously maligned via the misperceptions over
commercial real estate. In particular, we believe Wells Fargo (WFC), US Bancorp
(USB), and PNC Financial (PNC) are well positioned for value expansion as well.
Credit Cards
No other form of credit more closely mirrors unemployment trends (initially in recession)
than unsecured consumer lines of credit, yet it is an imperfect relationship. The one area
where SCAP has been very accurate is in unemployment which is now hovering around
10%. And no other form of credit (save commercial real estate) befuddled bank stock
shorts in 2009 as much as credit cards. Hum?
Solely using the unemployment rate as a barometer of credit card losses misses the
flexibility that banks have to change terms and adjust their underwriting in near real-time
based on changing economic and employment conditions. This is why some of our
favorite credit card-related holdings such as Capital One (COF), American Express
(AXP) and Alliance Data (ADS) as well as several money center banks (which have
large credit card portfolios) are seeing their credit costs abate faster than anticipated and
start to detach from the singular unemployment variable. Put simply, their underwriting
has adjusted to credit conditions. Amazingly, investors have not recognized this yet.
Trends in Credit Card Migration show Credit Improvement
The accompanying charts from Discover (Card) and American Express illustrate that
credit migration trends have definitively turned despite the stubbornly poor job
environment. Credit card issuers have adjusted accordingly and losses (NCO’s) are

16. 16
falling now on both a dollar and percentage basis. And early stage delinquency rates are
now rolling over.
This data below charts American Express’ delinquency and net charge-offs adjusted for
seasonality. This indicates that the improving migration trend is even stronger than the
absolute seasonally unadjusted migration that most investors identify. So, 2010 will be a

17. 17
strong year for earnings recovery in credit card portfolios and banks with high exposure
to credit cards. The Fund is very well positioned in this credit class.
Four areas we would note from the current credit migration trends in credit card data…
1. We are in the seasonally high period for NCO’s (typically they begin to fall in
February as tax refunds come-in) however they already are falling sequentially.
2. Excess spreads remain at 8% to 10% making credit cards uber profitable despite
high unemployment and this is befuddling the perma-bears.
3. Early-stage delinquency is a more accurate leading indicator of NCO’s. These
continue to stabilize (flatten) despite being in the high season; this indicates card
issuers have already sufficiently adjusted for the current environment and will be
even more profitable in 2010 than analysts expect. Capital One’s huge fourth
quarter blow-out profits are only the beginning.
4. Payment rates (the % of balances paid-off each month by consumers) remain
elevated proving that the consumer is well behaved. They are not the spendthrifts
often portrayed by many pundits, intellectuals and academics. When consumers
feel more confident in their employer, they will begin to spend again. Overall
credit card loan balances declined over 20% in 2009, so there is plenty of “dry
powder” in consumer credit for an eventual economic recovery.

18. 18
Overall Bank Credit Trends have Turned Positive
Overall, credit migration continues to improve across most credit categories and on
balance have begun to DECLINE (see table below). Thus, the recent pull-back in the
financials appears to be the best entry point since the depths of despair last March.
Nonperforming Loan (NPL) Formation
Credit Migration Indicates a Peak has Arrived ($Billions)
Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009
NPA
1
Formation 10,869 26,295 23,254 33,385 32,154
Past Due
2
Formation 3,490 26,183 74,881 16,812 <8,388>
TDR
3
Formation 19,509 <7,179> 5,233 8,009 9,480
Net Charge-offs 16,774 19,247 27,931 30,577 39,168
Total 50,541 64,547 131,299 88,783 72,414
1
Nonperforming assets includes past due >90 days plus foreclosed property under FAS 114
2
Delinquent loans 30 to 90 days
3
Troubled debt restructurings under FAS 114
Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods
CAMEL analysis of the quarter - KeyCorp (KEY)
Observers of our method of picking financial stocks are used to our regulatory approach
or “safety and soundness.” Bank accounting is far simpler than most realize. Once a bank
has recognized its bad loans and reserves for them, the bank immediately returns to
profitability and eventually retained earnings increases, driving up capital ratios and book
value.
KeyCorp was not “there” last summer in our analysis. However, we now believe they are
very close and thus became a recent addition to the Fund’s long positions late in 2009.
Liquid assets have tripled in the past year and KEY has made NO overt underwriting
blunders in the downturn (unlike cross town rival National City now part of PNC).
KEY’s rising NPL’s are due to the recession (actuarial) and thus pose zero risk to
permanent impairment to the franchise (CAMEL analysis expanded below). As one
veteran regional bank analyst said recently of KEY – “The loan loss provision, which is
currently running 4.5%, is expected to decline to 1% as we enter 2011.” This means
KEY is currently trading at about 5x 2011 EPS power. Extraordinary value!

19. 19
CAMEL
Capital Adequacy
• Tangible equity 11% high among regional peers
• Tangible common 8% solid
• T1 RBC 13% high
• Tot RBC 17% extraordinary
• Primary capital 21% off the charts
• Prime cap/NPL’s 538% silly; reserve release/stock buy-back coming
Asset Quality
• NPA’s 3.0% below peer average
• NPL’s 3.9% below peer average
• Noncurrent loan migration decelerated materially @ 3.0% in 2Q and 3.2% in 3Q
• 90 day past dues dropped to 0.6% in 3Q from 0.8% 2Q; migration signaling peak
• LLR/NPL 101% suggests reserve build has peaked
Management
• Low risk management, but not to be confused with Wells, JP Morgan or US Bank
• We think they should sell this bank in the next up cycle to a stronger management
team and get a better ROE out of this quality franchise
Earnings
• KEY has never met its potential due to mediocre management (see above)
• However, the balance sheet is under loaned and EPS power is $1+ in 2011
(Street way too low at 27c)
• ROA should get back to 1.4% or $3 in EPS (regardless of management team)
Liquidity
• Net liquid assets make-up 66% of the stock’s market cap…enough said
CAMEL – 1 3 2 3 1 Overall 2
This is a franchise in stable condition which is under managed for potential. The 3 for
asset quality could be a 2 in short order and it is unlikely that it would decline… The 2
for management is our opinion that this management team, while solid, is not getting
enough out of this quality franchise. The 3 for earnings will be a 2 in no time as the
reserve build has peaked. For example, we would suggest selling the bank to US
Bancorp in the next up cycle (this may be likely). The valuation is materially below
intrinsic value with both credit cost abatement as a driver in 2010 and take-over premium
potential in the future. 2x book = $20. Stock is under $6. KEY is a BUY! Opportunity
of a career!