Michael Durante Western Reserve research compilation
Western Reserve Capital Management, LP
July 2008 – January 2010
2009 Review & 2010 Outlook January 2010
“The Error of Pessimism is born the Size of a Full-Grown Man…”
- James Grant (via Pigou)
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
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
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
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
“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
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
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!
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
Stated book plus loan loss reserve drawn down to 1% of loans w/ excess taxed at 40% income tax rate and 2010 EPS.
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
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!
1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09
Loan Loss Reserve
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.
of Loan Loss
Net Interest Margin
2. Release of
of Loan Loss
Net Interest Margin
2. Release of
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 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.
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.
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.
“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
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?
3Q98 3Q99 3Q00 3Q01 3Q02 3Q03 3Q04 3Q05 3Q06 3Q07 3Q08 3Q09
Source: BofA Merrill Lynch, CEIC and Western Reserve compilation
To power its supposedly miraculous economy, Chinese state-controlled banks shelled out
more loans in 2009 than the entire country’s GDP ($3-4 trillion USD per the leverage
inherent in the Renminbi). In terms of a credit bubble, this would make Americans blush.
Chinese banks already are running-up against capital constraints in support of such heady
loan growth and this should concern investors about how sustainable a trend this really
can be. China has great long-term promise, but at present it’s ‘window dressing’ it’s
economy purely on credit overdrive. This excess credit has caused a stockpile of raw
materials (largely commodities), which has driven-up prices but has no end-market
demand. Many fund managers in the west are chasing these trends believing them to be
sustainable and therefore have drained the domestic equity markets to fund this
“performance chase”. We see a sharp reversal brewing which will benefit domestic
markets, the U.S. dollar and especially local financial stocks. The winds are ripe for this
reversal as it is supported firmly by the fundamentals. Many fund managers are not
positioned for this correctly.
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.
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
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
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.
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.
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
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”
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.
No other form of credit more closely mirrors unemployment trends (initially in recession)
than unsecured consumer lines of credit, yet it is an imperfect relationship. The one area
where SCAP has been very accurate is in unemployment which is now hovering around
10%. And no other form of credit (save commercial real estate) befuddled bank stock
shorts in 2009 as much as credit cards. Hum?
Solely using the unemployment rate as a barometer of credit card losses misses the
flexibility that banks have to change terms and adjust their underwriting in near real-time
based on changing economic and employment conditions. This is why some of our
favorite credit card-related holdings such as Capital One (COF), American Express
(AXP) and Alliance Data (ADS) as well as several money center banks (which have
large credit card portfolios) are seeing their credit costs abate faster than anticipated and
start to detach from the singular unemployment variable. Put simply, their underwriting
has adjusted to credit conditions. Amazingly, investors have not recognized this yet.
Trends in Credit Card Migration show Credit Improvement
The accompanying charts from Discover (Card) and American Express illustrate that
credit migration trends have definitively turned despite the stubbornly poor job
environment. Credit card issuers have adjusted accordingly and losses (NCO’s) are
falling now on both a dollar and percentage basis. And early stage delinquency rates are
now rolling over.
This data below charts American Express’ delinquency and net charge-offs adjusted for
seasonality. This indicates that the improving migration trend is even stronger than the
absolute seasonally unadjusted migration that most investors identify. So, 2010 will be a
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.
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
Formation 10,869 26,295 23,254 33,385 32,154
Formation 3,490 26,183 74,881 16,812 <8,388>
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
Nonperforming assets includes past due >90 days plus foreclosed property under FAS 114
Delinquent loans 30 to 90 days
Troubled debt restructurings under FAS 114
Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods
[remainder of page intentionally left blank]
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!
• 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
• 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
• 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
• 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)
• Net liquid assets make-up 66% of the stock’s market cap…enough said
CAMEL – 1 3 2 3 1 Overall 2
This is a franchise in stable condition which is under managed for potential. The 3 for
asset quality could be a 2 in short order and it is unlikely that it would decline… The 2
for management is our opinion that this management team, while solid, is not getting
enough out of this quality franchise. The 3 for earnings will be a 2 in no time as the
reserve build has peaked. For example, we would suggest selling the bank to US
Bancorp in the next up cycle (this may be likely). The valuation is materially below
intrinsic value with both credit cost abatement as a driver in 2010 and take-over premium
potential in the future. 2x book = $20. Stock is under $6. KEY is a BUY!
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!
Michael P. Durante
Bank Earnings “Power” v. GAAP
Source: Rochdale Research; Western Reserve
Appendix – Historical Fund Performance
Performance vs. the Financial IndexPerformance vs. the Financial Index
2004 2005 2006 2007 2008 2009 Cumulative
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)
Western Reserve Gross
Western Reserve Net (Class A)
SMID Cap Services Composite
Financial Services Composite
Specious Bank Proposals from the White House
January 22, 2010
“Desperation is sometimes as powerful
an inspirer as genius.”
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;
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
• 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
So, what’s up? Even the most veneer review of the facts suggests none of this makes
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
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
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
Buy the big, diversified and well capitalized banks. This may be the last great entry
point of the crisis.
Michael P. Durante
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.
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”
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.
Western Reserve Capital Management
July 30, 2009
One on One with Bob McTeer – How “Tight” is the Fed Really?
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
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
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 www.bobmcteer.com).
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.
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
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
Large Bank Liquidity is Astonishingly High
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%
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.
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
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.
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
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
"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?"
"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
"It would appear so."
About that time I woke up in a cold sweat and said a little prayer:
"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 www.bobmcteer.com, 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!
Michael P. Durante
Credit Update July 28, 2009
‘Reserve Builds’ Peaking; Shift to Earnings Power;
Are Shorts Now Just Outright “Gambling”?
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
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
Consumer Discretionary Consumer Staples Energy Financials
Health Care Industrials Information Technology Materials
Telecommunication Services Utilities
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”
19 Largest banks “Stress Tested” by the Federal Reserve
Fed’s 24 Month
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%
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
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.
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
Pre-Tax, Pre-Provision based on 1Q09 annualized
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.
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%
1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation
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.
Michael P. Durante
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
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