Monday, September 29, 2008


Far right leaning conservatives in the house, noted investor Jim Rogers and my friend Joe say the best bail out option right now is to do nothing. This is a moot point as a deal has been struck that will be presented to the house for a vote tomorrow. This deal will pass. This deal will authorize initial purchases of $250 Billion of mortgage backed securities. It authorizes two more tranches: one of $100 Billion and another of $350 Billion, provided the President declares these additional purchases are necessary and provided the congress consents by up or down vote. Still, it is valuable to understand why the do nothing option is a bad choice.

Hundreds of thousands of careers of honorable people and the investments of hundreds of thousands of honorable investors is at stake. These people did nothing wrong, other than to believe the stories told by their government representatives. The bankers were required, under penalty of law, to make loans in the most risky communities to high risk customers. The US government threaten to jail any banker who discriminated against any customer. Furthermore, US Government backed corporations bought trillions of dollars of these mortgages. Furthermore, Wall Street INVESTMENT BANKS, sliced and diced the risky loans and backed them with specially designed "certificates". The rating agencies declared that these packages of paper were solid because they contained relatively small amounts of the risky stuff (they ignored the consequences of the run away market that resulted from easy credit). Furthermore, the US Government gave an implied full faith and credit backing to the process.

The prices of homes soared because of the easy credit dictated by the US Government. After a time, it became clear that the way for lenders to make reasonable returns was to turn out loans as fast as possible. Government policies made the lending a no lose proposition and the failure to comply a criminal violation.

However, during the middle of the process, the government changed the accounting rules. The new rules required, under severe penalty of law, the marking to market of securities. When the housing bubble broke, banks were left with no option other than to declare massive unrealized losses. My Myrtle Beach example tells the whole story. An oceanfront condo that sold for $155,000 in 1985 was foreclosed and resold for a net of $95,000 during the recession of 1991 (with extra special terms offered by the selling bank). The same condo sold for $535,000 in 2005 as a result of easy credit. It is now valued at $265,000 or less as there are no bidders. The mark to market price is not determinable, but it is very low relative to the 2005 high. Beach condos are a special category. They are more volatile than regular homes and there are special lending rules that apply, however, the example they provide is useful in understanding the situation.

Bankers who trusted the integrity of their government should not be punished for their honest work and owners of over priced homes should be allowed the opportunity to spread out their payments in order to eventually recoup their investment. Holders of bank stocks should not be forced to anti up the total loss caused by the policies of government.

Forcing banks to sell to bigger banks right at the bottom of the cycle is not ethical. Banks that operated in good faith should be granted a little capital flexibility and a little time to recover. One fair approach would be to allow the paper to be marked to cash flow value rather than "dead market value". All elements are in place for the real estate market to heal itself. Building has virtually stopped. New supply has ceased. The old supply is being reduced. New roads and new retail locations are replacing some houses. Demand for housing is growing. Hundreds of thousands of young couples will be married in the months ahead and many young couples with children have already outgrown the apartments where they currently live. The downward spiral of home prices has been exaggerated and it is all but over, especially if a few easy steps were taken.

There are many somethings that could be done. With money available near historic lows, banks are ready to offer very attractive mortgage terms, provided they get relief on capital ratio requirements or mark to market rules. Many a discouraged potential buyer would be encouraged to buy a home should the banks suddenly be able to advertise the availability of low rate loans. Many a buyer would be willing to take over the payments on a foreclosed loan if there was a small increase in confidence. A small tax break offered to any home buyer would further stimulate demand. The cost of such a program would be nothing! after taking into consideration the increased tax revenues generated by the return of a solid real estate market. It would only take the sale of only a small percentage of homes to "prime the pump" and make the housing market strong. Many a person selling their current home would buy a new one elsewhere. A lot of pent up transactions will occur as soon as a small amount of confidence is restored.

Again, the Paulson bill is not a bail out bill or a rescue bill. It is a bill designed to quicken the pace of bank consolidation. The biggest banks would like to buy huge amounts of assets while real estate prices are in deep recession.


Bank of America (BAC) was a 1.7 TRILLION DOLLAR BANK a couple of weeks ago. The purchase of Merrill will add another TRILLION DOLLARS OF ASSETS! We talk like the $700 Billion Paulson represents a lot of money but this one bank is about 4 times the size of the buy out proposed.

JPM (the combination of JP Morgan Investment Bank and Chase Manhattan Commercial Bank) was a 1.5 TRILLION DOLLAR BANK a few months ago. It became a 1.7 TRILLION DOLLAR BANK after it bought Bear Sterns. It actually jumped in size by much more than $200 Billion because the assets purchased were at rock bottom prices. Should the Bear Sterns assets recover to anywhere near the underlying mortgage values, JPM will make billions of dollars off this purchase. Last week, JPM picked up the largest savings and loan in the country, Washington Mutual (WM) for a song. JPM took on another huge pile of deeply discounted mortgages. Based on what is about to happen, when the government establishes a new, very low, mark to market price, JPM will have to report losses of perhaps as much as 30 Billion Dollars on this purchase. Here again JPM has added the potential for billions of dollars worth of profits. I submit that Jimmy Diamond knows more about the likely auction price than you or me. Maybe the write downs will not be as large as feared.

WM's shareholders got hosed due to the greed of others. WM was forced out of business by ridiculous accounting rules. How many other shareholders will lose out while the FOMC and the Treasurer keep the lid on capital ratios and mark to market rules?

In any event, investors should remember the famous seen in "Its a Wonderful Life" when Jimmy Stewart saved the savings and loan while "Mr. Potter" saved everything else. When others had lost their heads, the richest man in town was buying, just like Warren Buffet is today. BAC, Citi and JPM represent scores of other very rich men and they are also buying.


A regular reader wants to know what to do with her shares in WB. In the absence of a bail out bill, WB could have survived as an independent bank or have arranged a very solid merger, especially true had there been temporary relief from capital ratios, easily grantable by the FOMC. However, it looks like the bail out bill is going through. Thus, it looks like WB will be forced to write down paper right at the bottom of the market. WB is thus in a scramble to find one or more merger partners or buyers, one who can withstand the short term hit of writing down more paper.

The "news" is that a bidding war has broken out between Citibank and Wells Fargo. This does not necessarily mean that current shareholders will get a nickel. The rumor that went around when GS and MS became bank holding companies was that there would be a combination of Wells Fargo, WB and GS or MS in order to form a bank large enough to compete with C, JPM and BAC. So far, we have seen no indication that GS or MS are ready to start bidding, other than the fact that each has raised substantial new sums of capital. Now that the bail out bill is likely to force the weakest banks to fail, there will be plenty of food for the sharks to consume.

Citibank is a 2.1 TRILLION DOLLAR BANK. It already owns the remnants of several investment banks. Wells Fargo (WFC) is much smaller, about $600 Billion in assets, but apparently virtually untouched by the sub prime crisis (influenced certainly by one of the major holders, Warren Buffet). Again, to reach the scale and diversity of JPM, C and BAC, it seems likely that a WFC-WB combination would be accompanied or followed by a further deal with GS or MS. Since the new WB Chairman has close connections with GS, the persistent rumor is that GS will be involved in any three way deal involving WB.

There are many other players. For example, BBT has grown up fast, partly through its steady campaign of acquisitions. Even so, it has only $200 Billion is assets. BBT is most likely to buy another regional or to do a merger of equals with another regional, such as Sun Trust or First City? BBT could possibly buy a bank the size of WB, but, having been conservative enough (perhaps smart enough) to have avoided the sub prime slime, it seems unlikely that BBT would try to swallow so much.

One of my good friends who is an officer at BBT says that Goldman (GS) and Morgan (MS) are not going to like the regulations required of deposit bankers. He is right, they avoided these regulations as long as they could. Merrill Lynch, Lehman and Bear Stearns avoided them as long as they could. Ultimately, GS and MS had no real alternative, they could join the prospering commercial banks or they could follow Merrill Lynch, Lehman and Bear Sterns on the bought out for less list. The name Merrill Lynch will still be around for a very long time, but the firm did not give up its independence on a whim.


A 50/50 proposition! WB has the customer relationships that are desired by companies such as GS, JPM and MS. Ironically, democrats constantly talk about how the rich are getting richer while the reality is that a growing percentage of the worlds citizens can now afford 401-K and other investment accounts. In the old days, JPM dealt with only the very rich, those who controlled a very high percentage of the worlds assets. Today, big money is made off the trillions of relatively small transactions made by the billions of people who own savings and investment accounts.

When JPM picked up WM, it picked up 2,300 retail branches. What a switch for a firm that used to be 100% located in New York? Most interesting, it is not the real estate that was of great value to JPM. The account list was the prize.

As of February of 2009, TV signals of the past 60 years or so go dark. This huge super information highway will suddenly be available for 21st century banking. For decades, there has been the understanding that banking would one day become paperless and mobile. The infrastructure is just about in place. Millions of people already have their income directly deposited to their bank. Millions already make withdrawals with debit cards. Millions already check their balances and reconcile their statements online. Convert a small mobile computer (sophisticated cell phone) to a debit card and suddenly the need to visit a bank branch will be a rare event. Would it not be nice to easily check your bank balance immediately before and after buying your groceries?

The productivity produced as a result of mobile banking will be enormous. Small and large transactions will be completed in an instance. Call in a pizza order and hit the payment key to finish the transaction. No more allowing a waiter to take your credit card to a reader. No more trips to make deposits or to acquire cash. Eventually, no need to carry a wallet. No more copper pennies to steal your time or to wear holes in your pants pockets.


As I recall, it was in 1979 when the Credit Union, where I was General Manager, became the first financial intermediary in North Carolina to offer floating rate, Federally Insured, money market accounts. The next step in my plan was to offer extraordinary benefits to all credit union members. The caveat was that members must agree to direct deposit of their checks and to access their accounts primarily through debit cards. I lost that opportunity because I strongly disagreed with several board members who wanted our credit union to become a charity for low income earners. Twenty-nine years later, the movement toward direct deposit and debit card withdrawal is about to take a significant leap.

Back in 1979, my study of cost revealed that each time a member came to the credit union to make a withdrawal, the cost was in excess of $2.30. The cost of a debit card withdrawal would have been only a few pennies. Today, the cost of an over the counter withdrawal is undoubtedly much higher at a prime bank location staffed by people making today's wages and benefits. On the other hand, the cost to make withdrawals through electronic means is moving rapidly in the direction of ZERO!

The fixed cost to set up a computer system to account for trillions of transactions is considerable, but the marginal cost per transaction is truly a very tiny fraction of a penny. The business of online banking is a very different business than branch banking. For some time to come, there will be many individuals willing to accept slightly higher loan rates and slightly lower savings rates in order to deal with a live teller. In the long run, economics always wins. The fewer the people willing to pay extra, the higher the extra required. Old timers will be slower to convert than the young, but eventually, the attractive savings and transaction rates offered by the largest banks will result in fewer banks. Eventually, there will be world banks.


Friday, solid banks such as JPM, BBT and BAC jumped in value. The financial index is showing strong relative strength even while there are hand grenades going off at the weaker banks. The passage of the "out of business bill" is going to speed up the consolidation process. At some point, there will be the breakout of bidding wars that run the prices of the small fish up. Indeed, this morning, we are seeing a significant decline in resource prices in Australia, a soaring dollar against various currencies, and stronger financial prices. I would not be surprised by a 300 point jump in the Dow today.

Here again, the timing of this bill is not an accident. More aggressive actions could have been taken months ago if it was the plan that is to lead the market. If it is the market that leads, then the plan was timed in order to take advantage of the turn. It is very difficult for an individual investor to time a market, but the Chairman of the FOMC and the Treasury Secretary of the USA certainly have powers to influence that we do not have.

The time to buy whole banks is just before a dramatic turn in the price of real estate. It took many months for the unsold homes on the market to reach 11 months supply. The unsold supply peaked three months ago. The peak might be tested this month as potential home buyers and the rest of us have been slammed by the beat of the "pending crisis drum". It has been implied and even said by some that if we do not do something quickly, another Great Depression or even Armageddon will be upon us. Who is shopping for a house under the beat of such loud drums?

The bottom line is that it is time to buy bank stocks. Spread out your purchases, because there will be losers and winners, but buy bank stocks. If you own WB, you have a tough choice to make. WB is likely to be bought. My guess is that current shareholders will receive something. I am hopeful but doubtful that the price will be $10 or more. The market should pop on the news that agreement has been reached. Further more, when an auction takes place, there can be huge surprises. My friends at BBT were surprised that JPM took such a hit to own WM. The analysis at JPM is that the short term loss will lead to a very substantial long term gain, why take the risk if one does not expect extra high returns. Citi could easily buy WB if it wants.

By the way, while this consolidation plays out, long term treasury rates and commodity prices should continue to fall. Bank leading spreads may stay wide, while banks try to recover losses and because the cost to replenish the FDIC is substantial. The continued pressure on economic growth should continue to pound on the price of commodities. Ultimately, the FOMC is likely the follow the 90 day t-bill rate down and cut the Fed Funds rate, currently at 2.25%. The 90 day bill traded Friday at .67%. It is likely to meet the Fed Funds rate somewhere in between the .67 rate and the current 2.25% Fed Funds rate.

Once the "going out of business bill" is in place, the FOMC will be in a position where it can release pressure by lowering rates when it wants. Market rates are very distorted right now, but based on TIP spreads, inflation expectations have fallen dramatically. The average of "yield curve brakes" are no where near where they were in July of 2007. The dramatic decline in inflation expectations, should result in substantially lower short rates from Europe to Australia and back around; but, only to the extent accompanied by further declines in the price of energy.

Now is not the time to DO NOTHING! Now is the time to buy banks.