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Michael Durante Western Reserve research compilation


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Michael Durante Western Reserve research compilation

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Michael Durante Western Reserve research compilation

  1. 1. Western Reserve Capital Management, LP Published Research July 2008 – January 2010 Confidential Materials
  2. 2. 2009 Review & 2010 Outlook January 2010 “The Error of Pessimism is born the Size of a Full-Grown Man…” - James Grant (via Pigou) Dear Partners, A year ago amid the throws of the financial crisis, we referred to the then existing market opportunity as “once in a career.” It was. The transition to new leadership in Washington created a historic valuation opportunity. This was a function of both procrastination and politicizing on several fronts which exaggerated and magnified uncertainty. We will address just two. First, the Congress having delayed taking action to deal with the absurdity of mark-to- market accounting (MTM) until the spring of 2009 escalated the financial crisis (crisis NOT to be confused with recession). The devastation of MTM on the financial industry and the stock market resulted in trillions of dollars of “unintended” loss as an apparent consequence of necessary delay until after an election. TARP was a direct necessity and function of this delay. The legislature finally took-up the matter in a congressional hearing on March 12, 2009. The stock market bottomed on March 9…the day the House Financial Services Committee announced the hearing. Western Reserve senior advisor Bob McTeer, former President of the Federal Reserve Bank of Dallas, provided key expert testimony to the March 12th event. Secondly, TARP rules were highly politicized in early 2009 and resulted in the “stress test” for larger banks, most of whom, were coerced to take TARP. A market panic ensued immediately over concern that TARP was being abused by the new administration as a “back-door” ploy to nationalize the U.S. financial system. The independent Federal Reserve Board stepped-in and defended it’s “turf” under the Bank Holding Company Act of 1956. The Fed completed the “stress test” and today bank TARP is a smashing success. Other, non bank uses of TARP well… not so much. Financial markets stabilized and now slowly and steadily are convalescing. The architect of TARP has rightfully been named TIME’s Person-of-the-Year, but the psychological damage to the market and the economy (including record cash hoarding economy wide) has left wide open the window of opportunity still. Investment flows into domestic equities remain deficient at best and U.S. financial services stocks remain
  3. 3. 2 widely under owned and heavily shorted despite their fundamentals recovering strongly and their valuations remaining compelling. Western Reserve Master Fund (“Fund”) since inception has produced over 20% annualized alpha when compared with any financial services index and has produced profits both long and short. We believe the Fund’s best years lie ahead. The opportunity of a career remains clear and present. For a comprehensive performance summary…See – appendix at the end of this letter. The approach which has dominated our stock selection in 2009 and continues as we enter 2010 incorporates using both strict regulatory analyses (CAMEL e.g.) in assessing which financial firms to invest in as well as good ole fashioned deep value investing. We believe market participants will shift from the liquidity and capital worries that plagued much of 2009 towards earnings power and profit recovery discounting in 2010 and beyond… Our own fundamental research has identified for some time now a consistent escalation in underlying profit power (cash flow) across the financial services sector, while erosion remains far more endemic in more widely owned sectors of the market including manufacturing, commodities and durables. So, high quality U.S. finance and services stocks remain the cheapest stocks found anywhere in the world. There are outstanding opportunities both long and short for fundamentally driven investors as price disparity relative to valuations and fundamentals remain very wide across disparate industries. Financial Crisis Update Miss-priced credit, particularly in the areas of housing and private equity/leveraged loans (LBO’s), fostered our current state of economic malaise. However, it was poorly designed new credit accounting (MTM) and the irrational application therein which created the actual “financial crisis” and with it the multi-decade buying opportunity that we opined was developing over the past year. To the surprise of most investors, the intentionally concentrated home price index – the Case-Schiller 20 City Composite – declined only a modest 3% in 2009. The base-case of the Federal Reserve’s “stress test” called for a 14% decline and the adverse case a 25% decline by comparison. Thus, the current environment is not nearly as bad as the worst- case scenario which was discounted into financial stocks at their lows. Therefore, it is no surprise that financial services stocks have led the rally since the March 2009 lows. The current breather that financial stocks are taking stems mostly from the second wave of TARP repayments and the renewed attacks from the current administration (“banker’s tax” e.g.). This just provides yet another buying opportunity. Credit, on balance, is unquestionably outperforming the once awful assumptions, in large part, because expectations were artificially grim due to MTM. To the Fed’s credit, they told investors that the assumptions in the “stress test” were set too high purposely and few believed them. So, investors should not be shocked at the faster-than-anticipated recovery in credit costs and earnings for banks. If the White House has noticed the
  4. 4. 3 “obscene” profits recovery at banks, then why haven’t more investors? We find that curious to say the least. 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. 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 started calling for MTM reform in 2007. As the chart above suggests, the accounting magnified fear (liquidity) much more so than predicted credit (cash flow). So - Yes Virginia, the accountants were wrong. The dramatic decline in unrealized securities losses essentially makes our long-standing point about MTM. It was ill-advised legislation which was materially inaccurate due to its being highly pro-cyclical. This essentially caused the financial crisis and thus necessitated TARP! The table below starts in early 2007 as MTM becomes “effective” and shows an updated progression of the trend in asset value recovery at U.S. banks. We predict values could again be positive by the end of 2010. Quarterly Progression in Unrealized Securities Losses at Banks Qtr Unreal Sec Losses QoQ ∆ 1Q07 -$5 31% 2Q07 -$16 213% 3Q07 -$14 -13% 4Q07 -$10 -25% 1Q08 -$17 64% 2Q08 -$31 86% 3Q08 -$45 44% 4Q08 -$77 73% 1Q09 -$63 -18% 2Q09 -$48 -25% 3Q09 -$26 -45% 4Q09E -$12 -53% 4Q10E +$11 -92% Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods Research; Western Reserve MTM was inaccurate. The Federal Reserve understood this and Bernanke called for “mark-to-maturity” (the far more accurate accounting alternative) and he used the Fed’s
  5. 5. 4 emergency lending authorities to quell the panic. (Think – cooler heads at the Fed prevailed over CYA CPA’s and “CDO Cowboys” speculating). What really happened last year? MTM caused most to start carrying golf sized umbrellas in 2009 – the kind that covers you, your bag, the golf cart and half the cart path. Naturally, the problem with umbrellas is that it’s hard to see around them when you’re hunkered down underneath. Consequently, too few saw any signs of recovery on the horizon…many still don’t. Goodbye TARP, We Hardly Knew You With all due respect to Massachusetts, the biggest story since our last report has to be the last of the larger banks exiting TARP in December – Bank of America, Wells Fargo and Citigroup. Strangely enough, the market met the news with a thud as the “perceived” overhang of stock translated into a “buyer’s strike” which left the financials vulnerable to a sharp pull-back. The current “war on banks” offered-up by the administration in response to Massachusetts has obliged such vulnerability. The current pull-back is identical in scope to the TARP repayment overhangs of last May-June. Consequently, this likely is the best entry point into financials since the late spring’s “stress test” release and first bevy of TARP repayments. The accompanying valuation table illustrates how some of the nation’s larger banks stack up on a price-to-adjusted book basis and on a pre-tax, pre-provision basis (P/E power) as of the latest reported data (per share basis). Think of pre-tax, pre-provision or “PTPP” as EBITDA where the D&A are not a permanent expense (loan loss provisions fall back by 90% in economic recovery periods). Large US financials are the cheapest stocks in the world, especially on a risk-to-reward basis. They trade hands at just 77% of adjusted book value (to include excess loss reserves) and about 3x free cash flow (to exclude excess loan loss provisions). Valuations Remain 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. Bank accounting seems to bewilder many a pundit that we hear blasting the sector and valuations suggest that apathetic investors remain conspicuously in the dark. Once a bank has recognized its bad loans and “reserves” (expenses) for them, they immediately return
  6. 6. 5 to profitability. They begin to “cash flow” their losses on a continuum again, thus maintaining their reserve (no more non cash reserve building eating into reported profit). At that point in the cycle, the reserve itself is no longer a “real” expense, but de facto retained earnings or “capital”. It is, after-all, “parked” in “reserve” as a contra asset instead of held in the bank’s capital account, a mere accounting convenience during a crisis. Over the past decade, changes to GAAP require that this reserve must be drawn back down so the IRS can claim its rightful piece of the bank’s actual profits. We are at this point in the credit cycle already. We saw our first “reserve releases” from Capital One and JP Morgan as the fourth quarter earnings season is now underway. 2009’s “reserve build” mantra is quickly advancing into a “reserve release” chorus line in 2010 and at a much faster pace than investors have yet to recognize. 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 Western Reserve outlined and forecast this recovery process early in 2009 and witnessed it’s progression in Q2 and Q3 of the past year. The chart below is a repeat from mid 2009 and outlines the major succession of events. 1. Reduction of Loan Loss Reserves Record Levels of Capital and Liquidity 5. Transitional Increase in Net Interest Margin Spreads 2. Release of Excess Loss Provisions Into Earnings 3. Transaction -related Earnings as “Money Flows” Return 1. Reduction of Loan Loss Reserves Record Levels of Capital and Liquidity 5. Transitional Increase in Net Interest Margin Spreads 2. Release of Excess Loss Provisions Into Earnings 3. Transaction -related Earnings as “Money Flows” Return
  7. 7. 6 Large bank reserve builds have peaked and regional banks are inching closer. Therefore, their book values now MUST be adjusted to include the contra asset account more commonly known as the “loan loss reserve” as real capital again (tax adjusted of course). This is the analysis that we have outlined in our arguably non-consensus, but forward looking adjusted book value and PTPP summation. TARP was the “walk-off” home run that we predicted Western Reserve wrote about TARP in September 2008 and predicted it would work to stave-off a depression and that the taxpayer would make a profit (see our letter – Paulson Plan Response, September 2008). People thought we were “Cuckoo for Cocoa Puffs” and subsequently went out and resumed shelling bank stocks in sheer panic. That was of course until MTM was dealt with directly in early 2009 as opposed to indirectly via TARP. TARP was primarily used to sop-up troubled banks by providing cheap acquisition capital for the strongest banks like JP Morgan, Wells Fargo, PNC and US Bancorp e.g., to save the taxpayer from Washington Mutual, Wachovia, and National City et al. TARP also was utilized to provide financial systems cushion in strong services providers like Bank of New York Mellon, Northern Trust et al to bolster confidence. As a result, TARP served its purpose and was returned to the taxpayer and with a good profit. The public reaction is another story. Any bank receiving TARP, regardless of purpose or repayment, is made to be a villain by populist rant? A rather asinine response one might quarrel… however, we do enjoy the cheap stock valuations. The Fund still has a sizeable weight long banks that are benefiting from sweetheart deals to buy troubled banks. As we wrote in July 2009 – Wells Fargo’s deal for Wachovia is “perhaps the most accretive acquisition in the history of U.S. banking”. As fund managers still early in a recovery in both the economy and financial stocks, it is likely poor form to extol our analysis of TARP, the “stress test” or to take the apparent minority position that Chairman Bernanke is the hero of the crisis per se. TARP and Chairman Bernanke curiously remain “hot buttons” for many populists on and off of Wall Street. And financial stocks remain in most investor’s “doghouse”. Something that shrewd investors are destined to enjoy.
  8. 8. 7 We thought the Partners might appreciate the perspective of one of the Fund’s senior advisors – Bob McTeer on the matter. The following is a musing from Bob’s National Institute for Policy Analysis (NCPA) blogsite. If you don’t already follow Bob on CNBC or read his blog, we would highly recommend it. He is among the sharpest central banking minds our nation offers and a very “thoughtful” (non partisan) economist. TARP Thoughts Dec 17th, 2009 11:24:59 AM By Bob McTeer A couple of people have mentioned to me that the TARP repayments are all over the news and suggested that I write about it. My response has been that I didn’t know how to avoid saying I told you so. I’ve written and said often that TARP would produce a profit for taxpayers, or only a small loss. However, I could always feel eyes rolling. While I never bought the idea that TARP purchases of preferred stock was only from banks ALREADY in good condition, I do think it was limited to banks that WOULD BE expected to be in good condition AFTER the purchase. In many cases the government investment was conditional on the raising private capital as well. For the rest of President McTeer’s comments on the end of TARP see his blogsite home - Inflation - Fed’s Balance Sheet Misconstrued, Needlessly Feared Investor concern about the monetary base is grossly overblown as McTeer and Western Reserve have consistently outlined (see – A Conversation with Bob McTeer, August 2009). Very few have come to this realization. As Bob reminds us, it’s the velocity of money that matters and not the size. We don’t see velocity being a serious problem anytime soon. This buys both the Fed and the economy time to recover naturally and pragmatically. And an environment of a steady unwind by the Fed will be a backdrop which is enormously beneficial to financial firms’ earnings. It is commonly overlooked that about half the Fed’s balance sheet is made-up of voluntary excess member bank reserves. This cash is “parked” there by banks unwilling to lend yet and de facto by the weak demand for loans. This is hardly inflationary. The remainder is in long-term assets and offsetting liabilities necessary for the Fed’s “unusual and exigent” initiatives during the crisis as required by law (see – Federal Reserve Act, Section 13-3). These measures are not monies in circulation and thus cannot be inflationary.
  9. 9. 8 “Inflation Protected” Treasury Strips Yield Just 1.32% Source: U.S. Treasury Department; Baseline Source: Seeking Alpha We are quite confident that the recent weakness in the dollar was NOT caused by inflation-fanning monetary policy as the velocity of money remains anemic. Case in point, the most recently issued ten-year Treasury inflation protected bonds or “TIPs” yield just 1.32% e.g. signaling that long-term inflation expectations are negligible and that the more likely risk is deflation. The legions of new-aged “gold bugs’ should be
  10. 10. 9 reminded that their leading indicator (the price of gold) of future events now finds itself sold via infomercials running 24/7 like the endless Viagra commercials. This smacks more of a speculative bubble than an inflation hedge. As we recall, many “hedged” inflation with $150 a barrel oil too. It predicated deflation. Needless to say, we are bearish on commodities. No, the dollar weakness is not the specter of inflation. Once again, this results from speculators chasing non-dollar denominated assets outside the United States in places like Brazil, India and China. The word for this is “disintermediation” and not “inflation”. Like other bubbles, this too will unwind and we gather could be painful for some. Fragile China Doll What speculators are chasing in China is what we like to call “authoritarian staged economics.” Fund managers keep misreading this as organic growth. It’s a ruse. We see it 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 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
  11. 11. 10 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. 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… Credit Quality - State of the Recovery in Our Financial System 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.
  12. 12. 11 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
  13. 13. 12 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.
  14. 14. 13 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 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
  15. 15. 14 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.
  16. 16. 15 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) and BB&T (BBT) are among those analyzed carefully and chosen for the Fund. 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”
  17. 17. 16 formula for adverse outcome through the third quarter. And we actually see delinquency abatement in the early reports of fourth quarter results at banks. (For a quick refresher on the Fed’s Supervisory Capital Assessment Program “SCAP” test which is more commonly known as the “stress test”… See the detailed discussion in our Credit Update letter dated July, 2009.) We believe there is 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. 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
  18. 18. 17 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 falling now on both a dollar and percentage basis. And early stage delinquency rates are now rolling over.
  19. 19. 18 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 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.
  20. 20. 19 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 [remainder of page intentionally left blank]
  21. 21. 20 Industry-Wide Credit has Turned! Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods Aggregate NPL Formation $M -$20,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 $140,000 Q208 Q308 Q408 Q109 Q209 NCO's TDR Past Due NPA Aggregate NPL Formation (Excluding NCO's) $M -$20,000 $0 $20,000 $40,000 $60,000 $80,000 $100,000 $120,000 Q208 Q308 Q408 Q109 Q209 TDR Past Due NPA
  22. 22. 21 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.’ As discussed earlier, 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! 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
  23. 23. 22 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! The chart above is a repeat with updated data. As we had forecast, the closing of the gap between (PTPP) and pre-tax GAAP was inevitable and will continue. We believe this gap will become increasingly more evident in reported or “GAAP earnings” in 2010 and bank valuations will rise steadily. Financial stock valuations are NOT reflecting just how wide of a disparity still remains. Opportunity of a career! Regards, Michael P. Durante Managing Partner $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 Source: Rochdale Research; Western Reserve
  24. 24. 23 Appendix – Historical Fund Performance Performance vs. the Financial IndexPerformance vs. the Financial Index -80.00% -60.00% -40.00% -20.00% 0.00% 20.00% 40.00% 60.00% 80.00% 100.00% 120.00% 2004 2005 2006 2007 2008 2009 Cumulative Rtn Since Incep. Cumulative Alpha Percentage Western Reserve Gross Western Reserve Net Financial Composite Index Western Reserve Gross Western Reserve Net Financial Composite Index 2004 27.10% 19.90% 12.04% 2005 -3.87% -4.20% -4.76% 2006 20.30% 14.70% 4.52% 2007 -14.70% -12.80% -32.45% 2008 -9.49% -9.13% -45.38% 2009 27.66% 21.71% -10.25% Cumulative Rtn Since Incep. 44.84% 29.86% -63.06% Cumulative Alpha 107.90% The chart above reflects cumulative performance data for each year illustrated. Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include BKX, SPFN and KRE. Performance Since InceptionPerformance Since Inception SMID Cap Services Composite consists of equally weighted long-only SMID Cap Growth Mutual Funds and Indexes. Components include WAAEX, WBSNX, BANK, DPSVS, IWM, SPFN and FINAN. Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include BANK, IWM and SPFN. Since inception, our average annual Alpha is 20.55% per year. Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross) -80% -70% -60% -50% -40% -30% -20% -10% 0% 10% 20% 30% 40% 50% 60% 70% Dec-03 Apr-04 Aug-04 Dec-04 Apr-05 Aug-05 Dec-05 Apr-06 Aug-06 Dec-06 Apr-07 Aug-07 Dec-07 Apr-08 Aug-08 Dec-08 Apr-09 Aug-09 Dec-09 Western Reserve Gross Western Reserve Net (Class A) SMID Cap Services Composite Financial Services Composite
  25. 25. Specious Bank Proposals from the White House January 22, 2010 “Desperation is sometimes as powerful an inspirer as genius.” -Benjamin Disraeli Dear Partners, We are busy putting the final touches on our 2009 wrap-up report to Partners and have been distracted this week by the antics out of Washington. The 2009 Review Report will be published next week. Meanwhile, this week should have been a great week for our fund. Our financials all reported great earnings recovery trends and many on Wall Street started to finally agree with us that credit costs have peaked (credit has turned). The cherry atop the earnings sundae should have been the out-of-touch progressive agenda in Washington taking a body blow in Massachusetts with the election of a fiscal conservative who disfavors unfair government taxing of bankers that have repaid TARP e.g. Instead, the markets are reeling and the country’s premiere financial firm’s are seeing their share prices distorted by a panic-stricken “buyer’s strike” following the suspicious timing of the specious new bank reforms from the White House. We all know the President badly needs a victory, but this is his “Hail Mary” pass? We have seen a 17% year-to-date gain in the hedge fund erode by about one-third since the Obama administration’s Malakoff cocktail press conference. First, let’s go over the fundamental facts: • Bringing parts of Glass-Steagall back would do nothing to prevent future financial crises like the one our country has endured. Rumors are circulating that the President chose to ignore his economics team in favor of his political strategy team on this issue. • Almost all the firms that blew up in the housing crisis would not have been averted by Glass-Steagall – they were home builders; mortgage companies;
  26. 26. investment banks; government sponsored enterprises; insurance companies; savings and loans; and mostly small community banks. • TARP worked “magnificently” as Warren Buffett said two days ago in lauding Chairman Bernanke. • The TARP losses that Mr. Obama’s “banker’s tax” is supposed to recover are virtually 100% General Motors, Chrysler and GMAC, none of which are banks and the likelihood of repayment seems quite a stretch. • Yet, the “banker’s tax” targets JP Morgan, Goldman Sachs, Wells Fargo et al, which all repaid TARP profitably for the taxpayer. So, the “banker’s tax” is an overt lie. If one wishes to “soft speak’ the term to avert offending anyone, it’s a non sequitur. If this is still too harsh, we apologize profusely and gladly would supply the term - “ruse” if this helps to soften the truth. • Stranger still is Mr. Obama’s sudden interest and discovery that proprietary trading, private equity firms and hedge funds caused the housing crisis and must be fixed before Fannie Mae. Very odd conclusion. Prohibiting or limiting these valuable sources of capital would certainly be harmful to the liquidity necessary in our capital markets and this ultimately would damage our economy’s recovery prospects. Long-term, such prohibitions make our most important financial institutions far less competitive on the world stage! Who thinks that this helps anyone? So, what’s up? Even the most veneer review of the facts suggests none of this makes fundamental sense. Did something happen on the way to the Forum? • The progressive tax and spend agenda has either been defeated or been minimized at every turn, in large part, due to the fiscal conservative populism that has swept the nation beginning last summer, largely over health care reform. • The progressive agenda suffered significant losses in both Virginia and New Jersey in November and it was massacred in Massachusetts this week. • Their agenda is lost – healthcare reform; global warming payola; union (card check) pay-offs and other nefarious slights-of-hand (and big cash movements we might add). Even the Cornhusker Kick-back is suddenly jeopardized. But wait – what about financial reform? • The White House’s apparent response to the Boston Massacre was to accept defeat on all other reform. So, all the President’s men (well, some of them) were mustered and the politicos hatched a plan for recovery (Not an economic plan, but a POLITICAL one). This plan MUST “capture Tea Party populism” the President demanded and simultaneously “trap” the fiscal conservatives by pitting
  27. 27. their free market capitalism ideals against the one and only major flaw in the Tea Party movement – Tea Partiers appear to hate big business almost as much as they despise big government. “Scott Brown is just like me” – Barack Obama • Voilá! Ignore your economics team and pull the ancient formaldehyde preserved Paul Volker and his antiquated ‘70’s style Glass-Steagall type reforms off the shelf, dust them off and sell them to the Tea Partiers as a way to “punish” big banks under the auspices that it also can reduce systematic risk in the economy – “Hurrah…we’re back!” Volcker’s plans, while stale, are workable if executed pragmatically, but he’s a mere “prop” in a political gambit. Make no mistake. The new progressive, anti-bank strategy will backfire and we believe bank stocks will return to leadership stocks very soon… • The voter post mortem from Massachusetts suggests that two things cost Mr. Obama “Mr. Kennedy’s” seat in the Senate – (i) the administrations’ soft stance on the terrorists and (ii) the excessive spending of his progressive government. • Distaste for “Wall Street” was NOT the cause of the Boston Massacre anymore than prop desks caused people to buy too much house or speculators to juggle three condos and foolish people to lend to them. • While many regular folks across America may not like individuals that make more money than they do…those folks are smart and they do understand that some jobs just pay more. • The public wants banks regulated but not dismantled and they do not believe “Wall Street” is refusing to lend to them either. After-all, they can walk into their local community bank and test this theory out and most have… • The counter evidence against Mr. Obama’s proposal is powerful and irrefutable on the merits – large banks have repaid TARP and Detroit has not. Detroit is Mr. Obama’s “baby”. “Wall Street” was the Fed’s problem and ….like the Fed, was a profitable venture for taxpayers! Chairman Bernanke saved us from a Depression. Just ask Warren Buffett. • The “banker’s tax” is wildly unpopular among the public as most Americans have a material distaste for unfair taxation. Just ask King George. Scott Brown said he disfavors the “banker’s tax” flat out and he partially campaigned on it. While we have yet to discover exactly who Mr. Brown is, we are quite sure he’s not just like Mr. Obama as the President has asserted. And we certainly don’t think the people see them in the same light either. • Finally, the current financial reform bills in the House and Senate are very different, quite convoluted and clearly contradictory on several fronts. For
  28. 28. example, some want to “End the Fed” while others in Congress wish to expand it. Mr. Obama further complicates the matter via his “timely” new round of added proposals this week thus causing further splintering throughout the Congress. • Yesterday, republicans questioned Obama’s “add-on proposals” and even House Finance Chairman Barney Frank (D-MA) announced his own reservations on the timing of such proposals and their impact on the economy. He appeared in our estimation to be “chapped” that he wasn’t consulted first. Senate Finance Committee member Dick Shelby (R-AL) said he first would demand hearings on the new proposals if they were to be considered at all. So, financial reform getting through the Congress will be sausage grinding that may make health care reform look legible and the folks at Jimmy Dean wince. Our conclusion is that this will backfire on Mr. Obama and blow over quickly. A mere excuse to take some chips off the table in a market that has made a good move. One buys this Obama swoon in bank stocks! This is perhaps your last chance at an “Obama discount.” It’s his last salvo. One deals with “populism” by ignoring the proposals that have no fundamental merit as the people eventually will figure out the facts. For example – “we need health care reform because we have an emergency where millions of Americans are not insured”. That didn’t work very well. So, how will “Wall Street must pay (even though they already have paid us back)” work with the populace? It will NOT sell. Buy the big, diversified and well capitalized banks. This may be the last great entry point of the crisis. Regards, Michael P. Durante Managing Partner
  29. 29. The Central Problem is NOT the Central Bank December 28, 2009 As a former Federal Reserve staffer; long-time Wall Street banking analyst (Salomon Bros., Prudential); and now hedge fund manager, I was astonished at just how puerile Messrs. Klein and Reisman’s essay was regarding the role our central bank plays in asset bubbles. I find it surprising so many investors are falling prey to such trivial and “populist” arguments. We do indeed reside amid the golden age of naive discourse. Clearly, facts and erstwhile gravitas appear optional both on Wall Street and on Capitol Hill. Objectivity has been lost. The authors claimed to have undertaken “a deeper examination” of the role the central bank plays in asset bubbles. Their assertion that the Fed is the causal effect is blatantly untrue and debased of certainty to even the most casual of observers of markets and the Federal Reserve. The Internet bubble; housing bubble and commodity bubble were not a monetary phenomena as asserted at all. They were speculative excesses by investors. To presume interest rate targets and the size of the monetary base automatically causes people to make poor loans and bad investment decisions is delusional. People’s own blind ambitions cause bubbles. The Fed’s role is to manage the excesses inherent in the human nature of market participants as their actions make their way through the capital markets. The Fed’s role does not include predicting bubbles and then preemptively taking action by talking investors off the ledge before they climb out the window. The Fed’s reluctant role is to manage the bust. To assist in cleaning up our messes in a manner not dissimilar to the way the Rule of Law stays ‘mob justice’. Blaming the Fed is a convenient deflection away from our own avarice. It is, as I said, a puerile argument. The child blaming the parent for not warning us enough as one Texas senator recently opined in casting her vote against the reappointment of Chairman Bernanke. The Internet bubble itself was not even debt related. It was driven by an insatiable equity investment bubble where endless operating losses at scores and scores of dot com companies were funded with evergreen stock issuance. It would seem absurd to assert that the Federal Reserve is to blame for “encouraging” investors to fund this ‘get rich quick’ scheme that was the Internet IPO boom as a function of the Federal Open Market Committee having left the Federal Funds Rate (the rate at which banks charge one another for overnight credit) too low as an alternative to equity capital allocation frivolity. The tech boom ended when investors realized their folly and not a moment beforehand. The Fed, however, was there to ease the fallout. Chairman Greenspan warned of irrational equity valuations several years in advance of the tech bust. Like the authors and our politicians, are we to argue the most salient argument is that the Fed “didn’t warn us enough”? Not credible. The authors were correct, in part. The housing bubble was encouraged by Washington policies – namely “affordable housing” mandates from HUD that were adopted at the insistence of an increasingly entitlement drunk Congress following the elections in 2004 and 2006. The real “money printing” was at Government Sponsored Enterprises (GSE’s) Fannie Mae and Freddie Mac. Their massive buying of sub prime and non conforming mortgages at the behest of Congress coupled with their implicit government guarantee all but legitimized perilous mortgage lending. If what the Congress unleashed was not satiable enough, the balance was accommodated by investor greed.
  30. 30. For its part, the Fed started to increase short term rate targets in early 2004. And for those that minded, they declared all out war on housing formation in August 2005 at the Fed’s annual summer meeting in Jackson Hole. Again, most investors took no heed to the Fed’s warnings. When mortgage rates started to rise, mortgage miscreants “hatched” teaser rates and other exotic structures to skirt more conventional underwriting to match abetting Congress accelerating asinine housing subsidies. To their own downfall, the financial institutions that championed the high risk mortgage origination orgy were not bank holding companies, but rather non bank financials outside the purview of the Federal Reserve’s regulatory staff. New Century, Bear Stearns, AIG, Countrywide, Washington Mutual, IndyMac and, of course, the GSE’s all were firms not regulated by the Fed, but rather by the federal government. Perhaps, it’s not surprising that the Congress finds the “Potomac Two- Step” befitting for the Federal Reserve with 2010’s mid term elections looming? The politicians may need a convenient deflection from their own shortcomings as the vast majority of “toxic” mortgages were originated after 2005 and therefore long post Fed applied restraint. Monetary policy, like regulatory oversight reach, has its limitations unfortunately. The commodity surge of the past decade has not resulted in any systemic inflation because it too is a speculative bubble. One borne of excessive non industrial demand or “investment” demand... Luckily, our economy is far less susceptible to such shocks, especially fictional ones, because of the modern monetarist Fed and our dominant services based economy. Sure, the Chinese are partly to blame as their “command and control” economy clearly is out of control and has resulted in unrealistic demand for raw inputs. However, an equally concerning issue is the “debt bomb” that is the commodities futures market, regulated by the Congress. While the cash markets for equity and debt, which are regulated by the Securities and Exchange Commission, have margin requirements of fifty-percent (50%); the derivatives markets, inclusive of commodity futures, require as little as a 5% margin requirement (twenty-to-one leverage). This has resulted in the disproportionate price escalation and volatility of almost all commodities relative fundamental supply and demand much the same way that low down payments and esoteric mortgages distorted housing market outcome. The Federal Reserve plays no role in derivatives regulation and needs to. Blaming the Fed for $150 oil is incongruous. The fact is that the commodity bubble is a function of a lack of prudent regulation by the Commodities Futures Trading Commission, which reports to the Senate Agriculture Committee. More unintended consequences of improvident government... The Federal Reserve is not “juicing the economy” as the authors would have one believe. Their argument is specious at best. It is quite the opposite actually. The Fed has been forced to “plug” holes in our credit markets created by impetuous lending now swinging the delicate pendulum of confidence too far the other way. Such actions have included the use of the Fed’s balance sheet in support dysfunctional securitization markets; ill-advised new accounting regulations imposed by the Congress on the Financial Accounting Standards Board (mark-to-market accounting); and a lack of regulation over derivatives by the CFTC (the AIG mess e.g.). So, the Fed has been busy stepping-up where unintended consequences of government and investors have left the economy more vulnerable that at any other time in the past seventy years. And the central bank has succeeded. The near full repayment of the Troubled Asset Relief Program or “TARP” far faster than anyone could have imagined is testament. Despite a roughly $2 trillion Fed balance sheet, which many a pundit complains about, the velocity of money remains anemic. Money itself isn’t inflationary and cannot cause irrational growth. Half the Fed’s balance sheet is tied-up in offsetting long-term assets and liabilities related to the “holes” that needed to be plugged to avert an out right depression. These “monies”
  31. 31. are not in circulation and thus cannot aid velocity-driven inflation per se. The other half of the Fed’s balance sheet is comprised of the voluntary excess bank reserves held on behalf of member banks and bank holding companies. Despite incredibly low rates of interest on these reserves, banks have been unwilling to put that capital to more productive use at this stage of the recovery. Certainly, a despotic White House and Congress towards the banking industry are playing a role therein. Hoarding cash we are. Afraid of big government, big deficits and big taxes come due. Record liquidity at corporations, banks and individual investors alike are epidemic and THIS is what is stifling the economic recovery. So, the Fed’s “plugs” remain necessary as a bridge over the mob until said pendulum finds its natural balance once again. The Federal Reserve appropriately and comfortably can continue to punish investors for hoarding cash by maintaining low short term rates for a protracted period. The make-up of the Fed’s balance sheet lacks velocity punch and there is little evidence the velocity of money in the private sector is picking-up much steam. The Fed can back out of current undesired capacity within the nation’s monetary base pragmatically as banks slowly begin to lend again, corporations start to invest again and investors regain their nerve once more. For now, that’s not happening. So, stop blaming the Fed. They didn’t choose your investments for you anymore than they chose the folks you voted for. Take responsibility. In contrast, the Fed is all that stood between us and ourselves during the crisis’ worst moments. Regards, Michael Durante Managing Partner Western Reserve Capital Management
  32. 32. July 30, 2009 One on One with Bob McTeer – How “Tight” is the Fed Really? Partners, The Western Reserve team was very fortunate to spend an extended lunch recently with Robert McTeer, the former President and Chief Executive Officer of the Federal Reserve Bank of Dallas. The insight shared with us was as ‘tasty’ as the dessert we all enjoyed as an excuse to extend our conversation. We are grateful for his valued time and timely observations. As many already know, Bob is an outspoken former member of the Federal Reserve’s Federal Open Market Committee (FOMC), which de facto sets global monetary policy. Bob currently serves as a Distinguished Fellow for the National Center for Policy Analysis. In addition, to the delight of Aggie aficionados everywhere, he is a recent Chancellor of Texas A&M University (sorry Horns fans). However, we did NOT talk football…as it’s a bit of a sore spot for Aggies in recent years. But, as Bob pointed out, all things are cyclical. An Aggie revival, like an economy, sometimes just sneaks up on a complacent Longhorn! Throughout his career, President McTeer spent thirty-seven years in the Federal Reserve System and is widely acknowledged as among the most experienced, respected and influential central bankers active or inactive the world over. Bob also is a contributor to CNBC, Bloomberg Television and FOX Business….and he also has a tremendous love for country music and cowboy poetry….(For more information and additional analysis, please visit Most investors and member of Congress alike seem to be obsessed these days with the extraordinary “power” of the Federal Reserve, the world’s ONLY independent central bank. I joined the Federal Reserve right out of Vanderbilt specifically because of the institution’s unique power to shape global economies. The independence of the Fed differentiates America from all other peers and, in large part, helped create the greatest economy the world has ever known. Americans have an aggregate net worth which is 17x that of any of our peers such as France, Germany, Great Britain and Japan. One of the greatest differences between America and her peers lies in the fact that our central bank operates largely independently of the central or federal government.
  33. 33. President McTeer relayed to us his pointed views on the Fed’s unique powers now being questioned by some in the media. He addressed what most investors and politicians seem to fear most – the Fed’s currently large balance sheet and the prospects for inflation in an economic recovery. President McTeer mentioned a recent presentation he was invited to attend where the speaker showcased a picture of ever rising and unfettered Fed balance sheet growth. The speaker contended that this balance sheet growth by necessity was certain to unleash a wave of vicious inflation. The presenter was absolutely certain that the Fed would be responsible for massive inflation in the imminent future merely by the anecdotal evidence of its balance sheet trend during this financial crisis…clearly an autocorrelation without empirical back-up. Runaway inflation in the offing? Bob doesn’t think so, nor does Western Reserve! As President McTeer described to us, inflation is never inevitable and hardly a result of the size of the Fed’s balance sheet per se. His first point was that the crux of the growth in the Fed’s balance sheet took place over nine months ago and there has been NO further expansion in the Fed’s balance sheet since early December 2008. Secondly, President McTeer made a keen and critical observation that many are overlooking. The composition of the Fed’s balance sheet is not inflationary. Qualifying the nature of the Fed’s balance sheet growth must be considered when determining its potential affect. In fact, much of the significant growth in the Fed’s balance sheet is paired-off by directly offsetting assets and liabilities (mainly loans to troubled financial firms), which are not monies in circulation. Money (assets that support direct liabilities) are not in circulation and thus not inflationary. He warned that one should ignore these offsetting factors when considering the inflationary affect. We believe President McTeer’s comments speak to the point that the aggregate total expansion of the Fed’s balance sheet itself was irrelevant. Only the expansion of true monetary base figures such as bank reserves and cash in circulation or the monetary items on the liability side of the Fed’s balance sheet were to be observed in relation to inflation risks. To this end, he quickly alerted us to the fact that the monetary base itself has not grown at all in several quarters now. And much of the monetary base is easily attributable NOT to the Fed’s actions to bolster troubled institutions last year (as assumed by mere balance sheet size observers), but rather to commercial banks “hoarding” excess reserves (cash) at the Fed as a shelter against the storm that gripped our financial system. Western Reserve made this specific observation in our own musings as bottom-up financial firm analysts in 2008. We echoed this analysis in nearly every correspondence over the past year. The accompanying table below is now a three-peat from our own research letters. The following data indicates just how LIQUID the largest US banks had become by the fourth quarter of 2008. President McTeer’s observation is correct. It agrees with our own fundamental research (driven from bottom-up analysis) when compared to President McTeer’s macro observation about the state of the Fed’s balance sheet.
  34. 34. Large Bank Liquidity is Astonishingly High Company Market Value Cash & Equivalents Short Term Debt Net Liquidity % Market Value JP Morgan $131 bil $489 bil $33 bil $456 bil 348% Wells Fargo $108 bil $200 bil $72 bil $128 bil 119% US Bancorp $31 bil $46 bil $26 bil $20 bil 65% Bank of America $103 bil $435 bil $186 bil $249 bil 241% PNC $17 bil $75 bil -0- $75 bil 1,071% Capital One $10 bil $40 bil -0- $40 bil 400% Average 374% 1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation President McTeer’s observation that much of the dramatic rise in the monetary base was not attributable to the Federal Reserve is evident on member bank balance sheets. As he wrote recently – “(member) banks voluntary holding excess reserves at the Fed….because given the stress and uncertainty facing the banks, banks don’t necessarily regard them as excess.” We would concur. The data table above references for analysis a small sample of large banks. On average, they hold a massive 374% of cash and equivalents (M2) relative to their market value and ALL are materially net liquid on both a short term and long term offsetting liability basis. In every way, these companies no longer resemble banks. They are deploying no leverage. How can that be inflationary? If anything, the return to normalcy for lenders will be protracted at best and “normal” leverage is not inflationary. The inflation hawks likely are simply wrong or premature alarmists to phrase that delicately. The Great Depression It was unlikely that we would have a lively discussion with Bob without the mistakes of the Great Depression coming-up. Western Reserve has opined for some time that the independent Fed saved the Republic last year as a bureaucracy would never have acted in an unbiased, apolitical and efficient manner to handle the financial crisis. As President McTeer noted, the Federal Reserve of the 1930’s, still partially bound (as we had noted) by direct reports to the President (the Treasurer and Comptroller of the Currency) on the Fed’s board, mistakenly believed the high levels of bank reserves were “excess” and thus the cause of the economic rise and bust. So, the Depression-era Fed made the awful choice to “mop up” (as Bob called it) the member bank reserves by dramatically increasing their reserve requirements (effectively locking-up the cash when the economy needed it most). This of course drained the economy of liquidity and deepened and prolonged the Depression. Bob opined that many of our leading politicians and even the talking heads on financial TV are not familiar with this history and, therefore say “strange and dangerous things about the presence of today’s excess reserves” on the Fed’s balance sheet.
  35. 35. President McTeer indicated his great respect and confidence in Chairman Bernanke and noted that of all people, he was a keen observer of Depression-era mistakes. How “Loose” is Monetary Policy Today? President McTeer discussed with us the inherent nature of the monetary base. As he noted, one cannot just “spend” the monetary base. It’s just a raw material. If left idle, it does very little if anything at all. This is the current state of our economy. We have learned the lessons of the Depression and now sit atop a very high level of liquidity in the system. However, for the monetary base to activate or “spur” spending, it requires velocity. Therefore, the size of the monetary base alone is not inflationary at all. President McTeer noted that the recent measures of the monetary base are very tepid after last year’s spurt as banks moved to hoard cash….currently, it is growing at a pace not consistent with inflation risk. As a result, the Fed’s monetary policy is actually a lot “tighter” today than widely accepted and inflation far less a risk. And while the Fed’s balance sheet indeed is large by historical standards at present, the composition “augers well” for Chairman Bernanke to ease back and shrink it as an economic recovery begins. Given the combination of expected low velocity of money and the composition of the Fed’s balance sheet, President McTeer foresees a solid, yet protracted economic recovery not likely to be accompanied by much inflation. He does not subscribe to the calls from academia for the Fed to shrink its balance sheet immediately. To illustrate, Western Reserve has noted record credit card pay-offs in master trust data from Citigroup to JP Morgan to Bank of America to Capital One. All of these credit card issuers are seeing record consumer pay- offs. In addition, the savings rate is at or near an all-time high as well. So, President McTeer is accurate in stating that now is not the time to shrink the Fed as the velocity of money is weak. McTeer’s conclusion was simple – “I don’t think a sharp increase in inflation is in the cards”. Report Card on Bernanke and Paulson TARP worked! Bernanke and Paulson stepped up and did it right. That was the short version of President McTeer’s comments on the subject. We agree. We have a nice spot picked out on the National Mall in Washington for their monuments. In addition, McTeer agreed with our long-standing call that the toxic asset repurchase program auction strategy known as the “PPIP” is an ‘empty gesture’ owing to the colossal inaccuracy of mark-to-market accounting (“MTM accounting”). Now that the banks have excess liquidity and have written down assets well below their intrinsic value, they have no incentive to sell them at auction. In fact, the opposite is likely to occur and already underway. Banks will hold these under priced assets (primarily mortgages) and as MTM accounting now makes its exit; the intrinsic value of these assets will start to be realized and capital levels at banks will rise even beyond their current “stress tested” excessive record levels.
  36. 36. We already have observed “mark-ups’ on assets subject to MTM accounting year-to-date. More to come… Mark-to-Market Accounting – A “Crusade” If there was one topic that ultimately drove a meeting with President McTeer and Western Reserve, it was the frustration we both felt over MTM accounting. McTeer called his campaign to eradicate the ills of MTM accounting a “crusade”. Western Reserve began writing about the inherent problems with MTM accounting as early as 2007. We are grateful President McTeer championed this cause as most investors and undoubtedly very few Americans have any clue how this arcane accounting brought our country’s financial system to its knees. President McTeer was asked to speak on the matter of MTM accounting before the Congress. You have read our musings on MTM accounting. These are from Bob’s own blogsite…. “During last Thursday's hearings by the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises on market to market accounting, the most impressive verbal and written testimony for my money was William Isaac's.” Both President’s McTeer’s assessment, former FDIC Chairman Bill Isaac’s presentation (See chart above) all agree. MTM accounting will end up being wrong by about 10x or 1,000%. The capital “hole” manufactured by the inaccurate loss assessments created the financial panic the country was dragged through from 2007 through March 2009. This crisis (and bear stock market) ended when the House Finance Committee held hearings on MTM accounting in early March of this year. House Finance Committee ranking member Spencer Bachus (R-AL) asked all of his Congressional colleagues to read one of McTeer’s writings regarding MTM accounting
  37. 37. titled “My Mark-to-Market Nightmare.” It may be the one single blog that saved the financial crisis and turned the tide of this awful recession and stock bear market. Here is President McTeer’s commentary in its original form and entirety. The blog rant that turned the tide… My Mark-to-Market Nightmare I couldn't sleep at all last night. It started with a dream-nay, a nightmare-that I had taken a three-week vacation in a remote part of the world where cell phone reception was happily non existent. There were zero bars. It was a good vacation. I came home refreshed, full of vim and vigor, and ready to re-join the rat race. All that changed when my accountant called with bad news. He said I was broke-flat broke. I thought he was kidding. "How can that be?" I asked. "I have my portfolio of Treasury bills and notes and a few mortgage-backed securities to fall back on if necessary." "Yes, but you've been gone three weeks, which is an eternity these days. During that time, your Treasuries declined in market value because interest rates increased, and your mortgage-backed securities became illiquid as trading in them virtually stopped. I had to mark them all down to market, which, in the case of the MBSs, was virtually zero. Sorry about that, but that's not the worst of it. Writing down the market value of your securities reduced their value by more than your net worth. So, you're now broke. You've gone from a high-net-worth individual to a no-net-worth individual." "Wait a minute! I don't have to sell these securities now. I can wait until their prices recover. I can even hold them to maturity if I have to. There's no credit risk. The Treasuries were issued by the federal government, which could print money to pay them off if it had to, and the MBS's were issued by Fannie Mae and Freddie Mac, which are quasi-government. They are obviously too big and important for the government to let them fail." "I'm afraid a lot happened during your vacation. Fannie and Freddie are government now; they, too, got marked to market and taken over by the government. So did AIG, the huge world-wide insurance company." "Well, there you are. All my securities are now government securities, and, if necessary, I can hold them all to maturity. There's no need, no rationale, to mark them to market. Besides how low could they go anyway?" "Your Treasuries are pretty short term, which is in your favor, but a flight into Treasuries still reduced their yield. Your Mortgage-backed securities took the biggest hit. Since the market for them has virtually dried up, I've had to mark them all the way down." "All the way down?"
  38. 38. "Yes, all the way down." "Well, I guess I could always sell my house." "I've already taken the liberty of putting a for-sale sign out front." "Thanks a lot. I'm glad I have a thoughtful accountant like you. I don't know what I would do without you." "Thanks. I do my best. I'm actually trying to get appointed to FASB, which is the Financial Accounting Standards Board. That's the outfit that makes up these accounting rules. It would be quite an honor for me. It is the most powerful organization in the country. Even their bosses at the SEC and Treasury are afraid to mess with them." "Do they have the power to change their rules or modify them a bit to help the country get through this housing crisis?" "Yes, of course. Or, the SEC could direct them to do it. In its big bailout bill, Congress reaffirmed the SEC's authority to do that in order to remove any doubt. I don't know why they are defying Congress." "Do you think it will get done eventually?" "I doubt it. Accountants take pride in their professionalism, and it just wouldn't look right for them to modify an accounting rule just to save the financial sector and the economy." "Speaking of that, I read on the plane that the Federal Reserve, probably the most conservative institution in America, if not the world, has been pulling out all the stops- taking unprecedented steps-to get the country through this national emergency. And I understand the Treasury has also taken extraordinary, unprecedented steps to save the economy. Am I right?" "You are right." "And I believe there is a provision in the Emergency Powers Act, or some such law, that gives the President the right to suspend even the Bill of Rights in a national emergency. Am I right about that too? "I believe so." "So the Bill of Rights may be suspended in a national emergency, but not mark to market accounting?" "It would appear so." About that time I woke up in a cold sweat and said a little prayer:
  39. 39. "Lord, please don't ever mark me to market, especially on one of my down days." - Robert D. McTeer, January 12, 2009 In sum, President McTeer is a national treasure and we were very fortunate to sit down with him to discuss meaningful issues of the day. We look forward to our future conversations with President McTeer. In the meantime, please spend some time at, where you will find similarly unbiased and pointed opinions on other essential issues such as the inner workings of our uniquely independent Federal Reserve System, how great central bankers think, and the banking industry and the economy at large. Thanks again Bob! Regards, Michael P. Durante Managing Partner
  40. 40. Credit Update July 28, 2009 ‘Reserve Builds’ Peaking; Shift to Earnings Power; Are Shorts Now Just Outright “Gambling”? Partners, Banks have begun to report second quarter earnings in earnest and there have been no surprises. The media and many investors (highly incited by record short interest – see Chart below) are focusing on the direction of problem loans without qualifying where we are in the normal credit migration cycle. The larger and predominantly untold story being the dramatically improved balance sheets and cash flows that we are seeing industry wide which reflect reserve builds peaking and new problem loan migration decelerating. Aggregate Short Interest in the S&P 100 Index RECORD Financial Stock Short Interest In the history of our markets, no one has ever witnessed the level of short interest that is now imbedded in domestic financial stocks. For lack of a better description, it’s a financial engineering powder keg; which very well may be the greatest mechanical lay-up “trade” in investing history. This level of short interest will have to be unwound and the 0 200 400 600 800 1000 1200 1400 1600 Feb-00 Aug-00 Feb-01 Aug-01 Feb-02 Aug-02 Feb-03 Aug-03 Feb-04 Aug-04 Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Millions Shares Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Information Technology Materials Telecommunication Services Utilities Financials Technology Consumer Discretionary
  41. 41. result will be skyrocketing financial stocks. This is only a matter of time… actually it’s a time bomb. Short squeezes are unpredictable and violent. We wouldn’t try to “time” it. Miss this one and you will, again for a lack of a professional investment term – “kick” yourself. The stock market rally, which began on March 9, is of great debate. Cyclical, secular? What is not in dispute is the rally’s leadership; the financial sector has led this rally by a wide margin. This has encouraged more and more short selling as a result. So, the consensus is that this is a cyclical bull. Fundamentally, we had been seeing sea-change improvement in financial industry capital and liquidity for more than two quarters now. This quarter, we are seeing definitive improvement in credit migration as well… This coupled with the consensus belief and the fact that we are in a cyclical bull (high short interest) and improving capital, liquidity and now asset quality (at the margin), we believe the more likely outcome is a secular bull. At this stage of an economic recession, one would normally expect problem loans and loan losses to be continuing to cumulate. However, what’s more interesting to us is where the granular data might suggest we are positioned along the credit migration trail. The result so far this quarter is that we see clear indications that the broader industry is well positioned to “absorb” expected losses. Bear in mind, losses are the tail-end of the credit migration trail. As an example, J.P. Morgan Chase & Co. (JPM) is a huge bank which canvasses much of the country and just about every type of loan imaginable (save the “pick-a-payment” lunacy). This provides a good cross study of the credit migration trend and where bank reserves stand. Western Reserve Capital Management, LP © 2009Confidential Why Financial Stocks Will Lead the Pending Recovery JP MorganChase – “Reserve “Build” Peaking $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 0% 50% 100% 150% 200% 250% 300% 350% Loan Loss Reserve (LLR) Nonperforming Loans (NPL) LLR/NPL
  42. 42. As the chart above illustrates, management at JPM (considered the best in the industry) has begun to allow their extraordinary high loan loss reserve “coverage ratio” of periodic losses (charge-offs) to begin to drift downward. Why? Simple. They see improving trends in early-stage credit migration at a moment in time when the consensus is focused on late stage migrations (charge-offs) already fully “stress tested” or reserved for. This is why the consensus will be proven wrong. In fact, some market players and pundits have resorted to calling for an all new Great Depression to support their bearish stance which can’t be justified in terms of the fundamentals. Your Fund started covering our financial shorts in January and February in earnest. In retrospect, we were slightly ahead of the March bottom as we saw capital and liquidity solved for ahead of the consensus. Now, we are getting more aggressive with our longs as we see positive credit migration shifts. This quarter has seen most banks reporting improvement or moderation in early-stage problem loans. This confirms our analysis that the industry will never come close to reaching the level of cumulative losses currently imbedded in capital and loss reserves by the Federal Reserve’s “stress test” completed in May. For such “adverse” losses to be reached, early-stage problem loans would need to be surging markedly higher now as opposed to decelerating, moderating and in some cases falling across some loan categories as actually is being reported. Reviewing the data below will assist in illustrating these points. Remember, the Federal Reserve required the nineteen (19) largest banks, encompassing roughly 75% of all US banking assets to “carry” capital and reserves high enough to absorb the test’s “adverse” outcome. 19 Largest banks “Stress Tested” by the Federal Reserve 1Q09 Charge-Offs Times 24 Months Fed’s 24 Month “Adverse” Stress Commercial Industrial 1.9% 3.7% 8% Commercial Real Estate 0.4% 0.8% 10% Construction 3.2% 6.4% 18% Residential Mortgage 1.0% 2.0% 8% Home Equity 2.9% 5.9% 16% Credit Card 8.1% 16.3% 20% 1 Source: Federal Reserve, Federal Deposit Insurance Corporation and Western Reserve compilations It doesn’t take long to identify the absurd assumptions of the “stress test” relative to the current reality in credit. In some loan categories like C&I lending e.g., the actual results are running <50% of the “adverse” stressed for. Even highly controversial loan categories such as commercial real estate and residential mortgage are outperforming the most draconian outcome of the”adverse stress test” by several country miles. Commercial real estate is <10% the stressed level; residential <25%. Home equity is <37%. Credit cards are easier to predict because they are very actuarial and correlate to unemployment, yet are running just fine relative the stress test. In fact, the companies
  43. 43. tested with very high credit card exposure – Capital One (COF) and American Express (AXP) - passed the “stress test.” Therefore, the extrapolated actual loss-run rates fall considerably short of what the industry’s regulators have required these institutions carry capital and reserves for. This combined with improving early-stage migrations seen in 2Q09, is why banks are beginning to indicate loan loss reserve builds have peaked or will peak within this calendar year as the chart of JPM indicates. We don’t expect this record bearish position pitted against the nation’s financial stocks to just roll-over one day and admit that this is “over”. We expect a nasty, grinding, blood- letting torturous short cover rally to last for the next several quarters. It should end up similar to the one I witnessed as a young banking analyst just leaving the Federal Reserve’s staff in 1992. That short squeeze annihilated the infamous Feshbach brothers, who liquidated in 1992 as a result. By the way, this occurred long before nonperforming bank loans had peaked. While the Feshbachs were professional short sellers; they merely misread the extent of the banking industry’s woes at the top of the credit migration cycle. Today, we believe much of the current short selling in financial stocks is being done by amateurs (courtesy of retail investor friendly reverse exchange traded mutual funds like the SKF) and grossly over subscribed and highly leveraged (capital structure arbitrage long) less liquid bank preferred. If one looks away from credit, here’s the underlying picture as we referenced in our last research letter. 15 Western Reserve Capital Management, LP © 2009Confidential Why Financial Stocks Will Lead the Pending Recovery Bank Profit Recovery Gap is a Record: $0 $50 $100 $150 $200 Pre-Tax, Pre-Provision Pre-Tax GAAP Bank Earnings “Power” v. GAAP Source: Rochdale Research Mark-to-Market Accounting Overstatement of Losses
  44. 44. As noted previously, the Federal Reserve’s “stress test” promoted pre-tax, pre-loan loss provision revenue as the first order of “absorption” for credit losses or cash flow (not book value). This caught Wall Street by surprise but not us. This is because loan loss provision expenses are non-cash redirections of equity capital from retained earnings to a contra asset loan loss reserve. Therefore, they are real expenses but are a more accurate reflection of past over statement of earnings power and far less a reflection of current and future earnings power. At this stage of the credit cycle, we are seeing massive reserve builds at banking companies or non-cash loss provision expense which is well in excess of actual periodic losses and this is distorting the reported earnings or “GAAP”. As we said before, pre-tax, pre-provision (PTPP) income is a more accurate gage of where the industry’s cash flow strength stands today. So, it’s time to switch valuation tools to be invested long in the best financials based upon earnings recovery potential relative to current “look through” earnings power. The values are quite compelling. Company Market Value PTPP1 MV/PTPP Recovery EPS2 P/E JP Morgan $131 bil $47 bil 2.8x $5.50 6.0x Wells Fargo $108 bil $37 bil 2.9x $4.00 5.8x US Bancorp $31 bil $8 bil 3.9x $2.80 5.7x Bank of America $103 bil $35 bil 2.9x $3.75 3.0x PNC $17 bil $6 bil 2.8x $5.75 6.3x Capital One $10 bil $5 bil 2.0x $7.00 3.0x Average 2.3x 4.9x 1 Pre-Tax, Pre-Provision based on 1Q09 annualized 2 2011 estimates by Western Reserve Capital Management, LP We also find it odd that we have record short interest against some of the most liquid companies in the marketplace. Company Market Value Cash & Equivalents Short Term Debt Net Liquidity % Market Value JP Morgan $131 bil $489 bil $33 bil $456 bil 348% Wells Fargo $108 bil $200 bil $72 bil $128 bil 119% US Bancorp $31 bil $46 bil $26 bil $20 bil 65% Bank of America $103 bil $435 bil $186 bil $249 bil 241% PNC $17 bil $75 bil -0- $75 bil 1,071% Capital One $10 bil $40 bil -0- $40 bil 400% Average 374% 1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation
  45. 45. Case-Schiller 20 Market Home Price Index – Through May 2009     The opportunity set between the high mechanical “trade” against the enormous consensus short interest in financials amid improving balance sheets and now stabilizing credit migration across the industry is hard to lay-off in our humble view. The above chart is the Case-Shiller 20 (large) market home price index through May. Home prices are stabilizing now and could indicate the recession is ebbing more quickly than the consensus (or short interest in the financials) believes is possible. In fact, the Case-Shiller 10 and 20 market composite indexes both improved on a month-over-month basis in May. Admittedly the gains were only 0.4% and 0.5%, respectively, but it’s the first positive month since July 2006. Regards, Michael P. Durante Managing Partner
  46. 46. Second Quarter Earnings Outlook July 12, 2009 Focus on Pre-Tax, Pre-Provision… Not ‘Reserve Builds’ Partners, Western Reserve Master Fund (the “Fund”) closed the second quarter positive in the low double digits on the year. The fund now has produced nearly 100% of alpha (excess return) since inception relative our financial benchmarks. We are getting a nice price “break” (retrace) in June and July heading into earnings season-based nervousness just as we saw in April. We thought it timely to share our thoughts on where we think second quarter earnings will shake-out for the financials and where they are from a valuation standpoint. There is no argument where the economy is… However, stocks and the economy are never coincident at great deep value points. They are coincident ONLY at overbought conditions. 15 Western Reserve Capital Management, LP © 2009Confidential Why Financial Stocks Will Lead the Pending Recovery Bank Profit Recovery Gap is a Record: $0 $50 $100 $150 $200 Pre-Tax, Pre-Provision Pre-Tax GAAP Bank Earnings “Power” v. GAAP Source: Rochdale Research Mark-to-Market Accounting Overstatement of Losses
  47. 47. As noted previously, the Federal Reserve’s “stress test” promoted pre-tax, pre-loan loss provision revenue as the first order of “absorption” for credit losses or cash flow (not book value). This caught Wall Street by surprise but not us. This is because loan loss provision expenses are non cash redirections of equity capital from retained earnings to a contra asset loan loss reserve. Therefore, they are real expenses but are a more accurate reflection of past over statement of earnings power and far less a reflection of current and future earnings power. At this stage of the credit cycle, we are seeing massive reserve builds at banking companies or non cash loss provision expense which is well in excess of actual periodic losses and this is distorting the reported earnings or “GAAP”. Therefore, current earnings power should largely be qualified (though not entirely ignored) as a function of the aforementioned. This is especially true in light of the massive equity capital raises at banks at the behest of the Federal Reserve’s stringent ‘stress test’; which the Fed has now verbalized overstates their expectation for credit losses. As we said before, pre-tax, pre-provision (PTPP) income is a clearer gage of where the industry’s cash flow strength stands today. Valuations remain ludicrously cheap on this cash flow-oriented basis as investors are still “hooked” on book value, reserve builds and GAAP. As the chart on page 1 illustrates, 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” are the seeds of the recovery in financial stocks that we believe have already begun. 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.
  48. 48. We keep going back to Warren Buffett’s favorite bank stock –Wells Fargo (WFC) (as it’s also one of our favorites). Buffett refers to PTPP in a far more easy to understand term. He refers to this as “look through” earnings power (a.k.a. cash flow). In the first quarter, 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 of note. We continue to believe that this was perhaps the most accretive acquisition in the history of U.S. banking. Time will tell of course… JP Morgan (JPM), US Bancorp (USB), Capital One (COF) and PNC Financial (PNC) all closed highly accretive TARP funded acquisitions as well. However, the market has not yet recognized this because investors remain unfocused on CASH FLOW! So, what do we expect to see in the second quarter earnings season? We anticipate more positive surprises than negative… big will trump small • More loan loss ‘reserve builds’ in excess of periodic losses; however, we believe the level of excess reserve builds has peaked (JP Morgan’s Jamie Dimon concurred on this recently in a meeting) and this will not go unnoticed for highly focused banking observers and astute investors in the sector. • Investors still remain overly focused on balance sheet capital and not cash flow and liquidity. How one gets through troubled waters in business is through cash flow and liquidity. This is how the Federal Reserve first ranked ordered banks via capital adequacy in their “stress test”. We believe the recent capital raises; increased liquidity and improving cash flows at banks will dominate the earnings season and will trump periodic credit despite our expectations for continued weakness in the latter. • Higher non-performing loans, especially in more traditional commercial and industrial (C&I) and commercial real estate credits. However, the cumulative loss potential on these traditionally more consistently underwritten “garden variety” bank loans will be relatively low and will lead to the lower relative ‘reserve builds’ we are calling for. A subtlety to some perhaps, but not to all. Most banks are in excellent capital and liquidity shape now and most are very good at traditional commercial lending or their “bread and butter”. There is no new “shoe to drop” per se. By contrast, expect to see actuarial-based deterioration in the industry’s underwriting strength wheel-house due to the economy. There was no “bubble” in traditional commercial bank lending. • The vast majority of residential mortgage, land development and multi-family conversion “bubble” credit problems have passed through the system now. They are post peak. Let’s stop obsessing about them. The housing collapse is over. It’s collapsed completely now. In fact, recent housing data suggests we are somewhere in the early 1960’s in terms of new supply and prices having begun to stabilize in most parts of the country. We expect no quick recovery. But, we no longer have “Dick Nixon to kick around anymore”. • Consumer loan charge-offs will continue to escalate alongside the substantial rise in unemployment claims since the beginning of the year. Now, more than 80% of this cycle’s job losses have occurred since last November with most in the past five months. The rise in claims has tapered-off, but job losses are still losses. As a result, heavy