Friday, July 18, 2008

What About Those Banks & Mortgage Loans?

My friend B is a banker and mortgage banker of many years and great wisdom. A few days ago, he sent me the following email, as part of an exchange regarding the turmoil at Freddie and Fannie, and my recent post about them,

"I don't know what a "best option" is in the longer-term. Too much is unknown and seen through a political fog. We have not dealt with the consequences of moving towards the "financial utility" (or "supermarket" take your choice) dominated banking system without the constraints of a Glass-Steagle-like control for the transition. Some of the consequences of this are playing themselves out, e.g. the placing of investment banking under the sway of the Fed. The problems at Fannie and Freddie resulted at least in part from the excesses of firms controlled by incompetent and management and regulators, the blur between banking and investment banking, greed, housing policy, real estate cycles, ignorance and huge, highly concentrated risky holdings and murky politics, not securitization, standardization , etc.

In the short-run the U.S. government needs to assure bond (mortgage-backed and debentures) holders that the credits in the holdings are secure (I am far less concerned about share holders). Too much is at risk in pension funds, banks (commercial and thrifts), governments (foreign and domestic) , insurance companies, etc. The current means being adopted are probably OK in the short-run but should not be a surrogate for a longer-term solution. In the longer-run we need to come to grips with the world of the financial utility and its mechanisms.

As to the Indy Mac's (arguably a creature of the housing bubble) of the world, it seems that the market and the regulators are properly handling things.

I believe we are into a very long process of "hunt & peck" solutions, driven at least as much by political as economic motives. Giving Americans a piece of the rock has been a core philosophy of our society for quite some time. It is a bedrock (no pun intended) of an enlightened capitalism and a protective edifice against unsettled populaces. The governments at the Federal and local levels have been intimately involved in facilitating home ownership and Fannie and Freddie are just pieces of this environment.

Perhaps the inertia resident in the world of banking has been impacted by a outside forces great enough to change things, but to what end?"

B makes a great point as to why our government has the goal of home ownership. It tends to keep citizens viewing society as owners and participants with something to protect, rather than a mobile rabble prone to discontent. And it fosters healthy values along the lines of community welfare.

But the much, much larger picture seems to me to be, as always, B's focus on 'financial utilities.' B is the guy who, to my knowledge, first used the term in a phone call with me back in 1996, when I was the (first) Director of Research for the then-independent financial consultancy, Oliver, Wyman & Co.

Today's Wall Street Journal added perspective to this mess when it reported on Chase posting losses for last quarter that were 'not as bad as expected.'

It then went on to note that PNC's net income actually rose for the quarter, because it had never strayed from its simple, regional focus on traditional commercial banking.

Therein, I believe, lies the lesson regarding B's 'financial utilities.'

Banking is a derivative business. Unlike, say, Google or Intel, banks don't really 'create' value, beyond some simple, liquidity- and time-shifting aspects of financial management. And, if done properly, by some risk-sharing which diminishes overall financial risks of lending, a/k/a diversification of portfolios.

That being said, how can banking ever really be, as a sector, a long-term, consistent growth business?

It cannot. Pure and simple. It cannot.

Thus, B's comment that regulators have some good short-term fixes working, but a long term solution is, as yet, undetermined.

I believe this is because of human nature and the effects of technology on banking. As I wrote late last year, regarding Henry Kaufman's comments on financial services sector regulation in this post,

"In the process of their evolution, various financial systems came to increasingly on technology. This reliance, as it has in other industries, drove two important structural changes. First, the rising costs of technology made size profitable, driving consolidation in businesses such as credit card issuance and processing, as well as mortgage loan origination and servicing. Second, concurrent with this consolidation came lower fees for the same services.
In business after business, save, perhaps, for boutique services such as high-end private banking and investment banking M&A activities, scale has become important for driving costs down and making financial services ubiquitous to those who need them, be they retail consumers, investors, or institutional investors or credit customers.

In the decade since, commercial banks, contrary to accepted financial theory that an investor can diversify his/her own holdings better than a company can do it for him/her, sought these types of businesses to attenuate variation in their reported earnings, as well as pursue the mythical 'cross sell' opportunity amongst various retail businesses.

The results have not been impressive, as I noted in this post two months ago.

My point is that, over time, financial conglomeration does not, in fact, lead to consistently superior shareholder total returns. In fact, the only currently, or, for that matter, historically frequently-appearing large financial institution in my equity portfolio is Goldman Sachs. It's not a widely-diversified financial services company. Rather, it tends to specialize in two areas- institutional businesses, such as underwriting and trading, in which superior knowledge, modeling and risk management matter, and asset management, which shares the same salient characteristics.

The price that US consumers have paid for financial services innovation and cost reductions over the past five decades has been the concentration of many financial services into fewer, larger entities, which concentration has increased risks to the banking and credit system.

In fact, one of the few benefits, besides technological innovation, that recent consolidation affords is larger capital bases with which to absorb the effects of mistakes.

Looking back over nearly 50 years of US financial system innovation and evolution, I think one could fairly say that the benefits we have enjoyed have far outweighed the realized risks that have accompanied such changes. "

But what we now face is the problem of name CEOs of very large banks- Chase, BofA, Wachovia, Citi, Lehman, Morgan Stanley, Merrill Lynch- who wanted to attain star status through asset and profit growth way beyond the natural limits of the financing needs of the population.

My proprietary research on what factors drive consistently superior total returns in companies vary markedly between higher-growth and lower-growth companies.

The former group, to which banks, over longer terms than, say, three years, belong, succeed by managing ROE and expenses, not by investment in growth.

I hate to say it, but Jamie Dimon is probably the right kind of CEO for Chase. He is not very skilled in anything but taking out expenses and micro-managing his managers. A chip off of his old mentor Sandy Weill's now-discredited block.

But ironically, whereas Sandy came a cropper trying to gun for growth with a hybrid of insurance, investment banking, brokerage and commercial banking, Dimon has only to squeeze down on businesses at the typically-staid and slow-moving Chase.

I'm not saying Dimon will ever make Chase a consistently superior total return company. But I do think he has the potential to manage the financial utility, now, according to the Journal, the largest US commercial bank by assets, in a manner that avoids catastrophic losses.

And that, frankly, is just about what my friend B prophesied to me back in 1996. A few very large financial behmoths which would be incapable of fast growth or nimbleness, but would dominate share in the conventional, everlasting banking businesses of: deposits, revolving credit, mortgage finance, various service/processing businesses and basic asset management.

Which brings me to my conclusion for this post.

What about those banks and mortgage loans?

Well, the loans were made by inept bankers, allowed by their CEOs, in hopes of attaining unattainable consistent long-term revenue, profit growth and total returns. Eventually, the shareholders of the companies which made those loans must foot the bill.

And the banks?

Well, this morning's Wall Street Journal announced that Freddie is contemplating selling new equity.

Who, honestly, would be so stupid as to buy any, short of a pure political/regulatory play?

I believe that the financial utilities will rarely be investments that can consistently outperform the S&P500. As such, they won't be candidates for my equity or options portfolios. The nearby, two-year price chart for Wells Fargo, Chase, Citi, Wachovia, BofA and the S&P500 Index clearly demonstrates my point.
Not one of these banks beat the index.

I suppose if you want a bond-like return in a necessary enterprise, you could do worse than owning a less-ineptly-managed large financial services conglomerate.
But why would any intelligent person hold a money-center or large publicly-owned investment bank as a long term asset anymore?

Thursday, July 17, 2008

More Evidence of Economic Strength 'From the Road'

In this recent post, I discussed the economic evidence I've seen on my road trip that argues against a widespread recession.

In the last week, further evidence reinforces my belief that any recession currently underway in the US is either fairly stealthy, or not occurring in parts of the country that would seem to be candidates for it.

On the drive back from southern West Virginia, we stopped in Morgantown again, for lunch. Quizzing the staff of the restaurant, we learned that traffic this year is no different from last year. No difference due to gasoline prices.

In fact, the hostess remarked that spending was, if anything, up. People are filling restaurants and spending normally. The woman remarked,

'If they want to travel, they're going to travel.'

The major amusement park at which my daughter and I spent a day was as crowded as always. Hotels were full. Upon trying to find a room for an additional night's stay, we had to drive 45 miles away to get a room.

The parking lot of the park was as full as in past years.

Taking a slightly longer perspective, the people I spent time with in West Virginia told me that real estate foreclosures were not abnormally high. Down there, nobody had gotten carried away to begin with.

Two of the guides rather proudly announced that as of next year, they will be totally debt-free. Their purchases of electronics- computers, music players, etc.- have been strong this past year.

What's interesting to me is that these people, who represent a fair chunk of the American economy, simply behave far differently than the highly-leveraged consumers on both coasts.

Do the people who guided us raft fishing in West Virginia work several jobs each year? Yes. They always have. And they are not badly off.

Do they have health care? I doubt it- at least, not provided. They are entrepreneurs. Their sense of self-responsibility for their economic welfare is notable. Not one of them complained that some local or state agency wasn't finding them work or providing for them.

Rather, they use their considerable skills to do jobs that pay well, if are not always attractive to others. One guide has laid gas pipelines through the southern US swamps and donned "Gamma jammies" to clean up nuclear sites.

It's just a completely different picture of human economic behavior than you see in the major media. Self-reliance, restraint in consumption, a strong sense of saving for planned activities, and moderation in all things.

None of these people bought and flipped houses recently. But one of the guides, who works several jobs throughout the year, owns at least two rental properties, plus 7 acres on which he plans to build his last, largest home. Substantially by himself, of course. His child goes to private school and has a horse.

Does this sound economically disadvantaged or like an economic recession?

Not to me.

If you think stereotypically and assume that states with less income/capita and lower educational levels are therefore in economic trouble right now, think again.

Could it be that the better-educated, socially upwardly-mobil members of our economy are the ones in trouble, because they simply have lost their moorings regarding prudent personal economic behavior?

I'll write some thoughts about that in conjunction with the banking/real estate mess tomorrow.

Wednesday, July 16, 2008

Irresponsible Investment Advice On CNBC

A few days ago, I saw an unbelievable segment on CNBC concerning investing in financial service company equities.

CNBC on-air personality Dennis Kneale was discussing how badly the valuations of commercial and investment banks have slipped, thanks to their owning untold numbers and types of 'mark to market' securities.

These, Kneale remarked, make the equities of these firms equivalent to 'blind pools.'

That's a pretty harsh comment, but, I think, absolutely true. It certainly would prevent me from owning any of these equities.

My large-cap equity selection process, thankfully, measures and evaluates equities based on factors which basically rule out financial equities at this time.

The amazing part of the CNBC segment was that, following Kneale's comment, a guest bank analyst repeated her assertion that now was the time to look for bargains by bottom fishing the sector.

Her only cautionary remark was something like 'you have to evaluate each one individually, and be careful!'

I suppose in a roomful of professional analysts and investors, her words might be appropriate. But to retail viewers/investors, I think it bordered on, or was, completely irresponsible.

I'm sure you can find, right now, a lot of institutional investors who wrongly believed they could safely hold financial service equities, other than Goldman Sachs, with impunity. And even Goldman has suffered.

How, then, are garden-variety occasional, non-professional investors supposed to decipher and correctly guess at how much 'mark to market' junk is on the balance sheet of each and every financial service firm, and how much more it needs to be discounted?

Simply unbelievable that CNBC actually airs nonsense like this.

I'll have more to write about the financial service mortgage-related mess later this week, as well as my concluding 'from the road' piece about whether we are actually in a broad-based recession.

Tuesday, July 15, 2008

Updates on Anheuser-Busch & InBev, Yahoo, Icahn & Microsoft

Last month I wrote this post concerning what I believe the term "shareholder democracy" does not mean.

In that post, I discussed current examples of interest, including: Lehman, Yahoo-Microsoft-Icahn, Citigroup-Rubin, and Anheuser-Busch & Inbev.

Yesterday's Wall Street Journal reported on two of these stories. And the silver lining is that at least one situation actually turned in shareholders' favor.

Anheuser-Busch's board is to be congratulated for doing the right thing. That is, they played somewhat harder to get, and coaxed another $5/share out of InBev before acceding to the acquisition by the larger Belgian brewer.

Despite August Busch IV's silly whinings, the board correctly understood that Busch's lackluster performance. I wrote about it here.

Chalk one up for a board that actually did its job.

Then, in contrast, we turn to this week's news out of Jerry Chang's Yahoo. I wrote here about Carl Icahn's move into Yahoo two months ago.

Despite the obvious long-term problems at Yahoo,Chang and his board's chairman, Roy Bostock, have some idiotic notion that what Terry Semel didn't do, and Jerry Yang hasn't done in a year, somehow, Yahoo will accomplish for shareholders in the future.

Meanwhile, Icahn has correctly taken advantage of Microsoft's Ballmer's wrong-headed belief that his company can somehow benefit from Yahoo's search business, and already prospectively split up the firm, once his board slate is elected.

It is truly difficult to see how, if you still own Yahoo, or bought it after Icahn did, you'd do anything but vote for Icahn's slate.

Yang and Bostock will, hopefully, be sued by some shareholders for malfeasance in this whole mess.

We see pride and obstinacy getting in the way of what is a fairly obvious and simple decision- break Yahoo up or at least let someone else try to wring some value out of it.

Of course, if you had owned Yahoo, you really should have been out of it years ago, when its performance had underrun the S&P's for a few years. To me, as I noted in my earlier post, that is the real meaning of shareholder democracy.

Sell what you don't want, inexpensively.

Monday, July 14, 2008

Fannie And Freddie's Mess

I'm on the road, and not enjoying access to daily print versions of the Wall Street Journal. Reading it online is not as practical an option as I'd like it to be.

However, I had a chance to read the headline stories of the weekend edition of the paper. What I read about the developments in the mess involving US mortgage markets, Fannie and Freddie are scary.

I think my overall view of the situation is that it is a mistake to give more capital access to the same crew that got into this mess.

The implicit Federal Government guarantee clearly led to an imbalanced strategy over the last decade. Both institutions enriched employees, especially senior management, while failing to pay careful attention to the growing risks on their own balance sheets.

For this, we have Congress to thank, since it tends to view Fannie and Freddie as a large real estate finance cookie jar for their own pet agendas.

Of the choices which the Journal's article suggests, I think I would go with the Bush administration's desire to replace the current boards with members whose stated objective would be to clean up the balance sheets of the two firms and gradually shrink their role in the housing markets.

In this day and age, if a government-affiliated lender can't do a decent job securitizing housing loans, why allow it to exist?

We'll always get better performance from the private sector, assuming adequate regulation. Now, we have the worst of both worlds- shareholders losing value due to entrenched, incompetent management, and the Federal Government picking up the tab.

Shareholders chose to own the companies' stocks (I have owned equity in both firms in the past), so they deserve to lose their capital.

But to prevent a replay of this fiasco, I think it's time to remove the governmental connection to the two mortgage securitization firms as soon as it is possible.

Perhaps the most unfortunate aspect of this mess is its timing. Coming at the end of one US Presidential administration, it's unlikely that the clear, sensible and quick action required to begin cleaning up the problem will occur as it should. Instead, everyone except Secretary Paulson will look for reasons to delay until next calendar year.

That could be a fatal mistake for credit markets and the economy.