via: Dataroma

The new position in Bank of New York is really interesting to me. I have had this theory for a while now that asset management/trust banks would become attractive going forward because of their large fee income businesses.

See, for a long time, most banks operated on this 80/20 model where 80% of revenues came from interest activities (loans) and 20% came from fees (overdraft, credit card interchange, debit card interchange). But that’s changed a bit with the Durbin Amendment which is scrapping the debit card interchange fee from banks. Most bankers have publicly said that they will be figuring out new ways to make up the lost income — most likely by charging customers for things that they take for granted (free checking).

The other model though, might be to acquire financial institutions that are driven primarily by fees. There are a few ways to do this. A bank could acquire wealth management firms that are within their geography — BBVA did this when they came to Houston. Or they could acquire a trust bank, which typically has the income structure split closer to 65/35 than 80/20. We saw one of these acquisitions when M&T Bank (another Berkshire Hathaway holding) acquired Wilmington Trust in an immediately accretive deal.

So where exactly does Bank of New York fit into all of this?

Bank of New York is regulated as a bank but actually derives most of its income via fees. It acts as a custodian for financial assets. As a result, Bank of New York can charge asset management fees to clients, typically at a percentage of AUM. Plus, it can also charge clients on a per transaction basis – so if you expect an increased level of volatility going forward, then the bank should do quite well. This is a great business to be in and throws off a lot of free cash flow when times are good.

The only thing that concerns me about Bank of New York is the company itself. The business they are in is great and should have excellent prospects for the future, but historically the bank’s own results have been less than spectacular. To illustrate, look at BoNY’s EPS since 2000 versus Wells Fargo:

Those earnings seem pretty weak, which makes me wonder about BoNY. At the same time, they have engaged in M&A over the last 10 years, which might have hurt earnings growth — especially if there were integration costs and dilution. Maybe Buffett is expecting some kind of shift in operations, much like what happened with Coca-Cola when he invested.

I’d suggest taking a deeper look at trust banks and banks that have some kind of non-interest fee stream that makes up a greater than 20% portion of their business. This looks like a really fruitful area for some of the bigger banks to do deals and might be beneficial to investors.

In a recent article Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

Reports Of The Death Of Mean Reversion Are Premature (Behavioural Investing)

Anne-Louise Fogtmann has a good take down of what Montier said at the conference. Montier outlined his own views which I thought were interesting, particularly on cash:

Seven “immutable laws of investing” apply, Montier argued, as they have in the past:

-Always insist on a margin of safety.
-This time is never different.
-Be patient and wait for the fat pitch.
-Be contrarian.
-Risk is the permanent loss of capital, never a number.
-Be leery of leverage.
-Never invest in something you don’t understand.

With these rules in mind, Montier noted, somewhat bleakly, that “not very many assets have any margin of safety.” A few of his specific calls: Government bonds have no return potential; emerging markets look overvalued; and in a world where both bonds and equities could be too expensive, cash becomes a much more attractive investment, even when the yield is near zero. Not only is cash a better inflation hedge than bonds (it’s a zero duration asset), it can act as a store of value during periods of deflation.

GMO’s James Montier Says Rumors of the Death of Mean Reversion Are Greatly Exaggerated

The market’s had a pretty good run lately, making most equities more expensive for value investors. The dynamic between cash and equities is a really interesting one for us because we tend to hold portfolios that are more concentrated. Other investors might have the kind of allocations which allow them to replicate the movements of your typical indicies, but value guys tend to take a 5% to 10% position approach. This makes our allocation decision a bit more difficult. There’s a big difference between re-creating an index versus putting on 10% positions in full value/expensive stocks. This is why, for concentrated investors, it makes sense to shift to cash rather than equities. At the same time, there are pockets of value scattered throughout the market. While no one sector seems to offer compelling valuations, I have been spending most of my time analyzing select companies in industries ranging from energy to insurance.

Montier’s point about emerging markets being expensive is one that resonates with me. Take the case of Brazilian banks Bradesco (NYSE:BBD) and Itau (NYSE:ITUB). Both are priced richly at over 4x book value, but are generating high returns on equity (32% and 40%) implying an 8-10% return. If we dive deeper into the financials and analyst estimates, we can see that much of this is being driven on the prospect of loan growth. Brazil has a rapidly growing middle class and most people expect that financial services firms will be able to profit from that growth.

I agree that a developing middle class should be able to help the banks. In theory, as the banking sector in Brazil becomes more formalized, citizens should be depositing more money into banks and using them for payment transfers. That should lower the cost of funding for Brazilian banks. Plus, Bradesco and Itau are targeting for insurance income to make up 25% of their earnings in a few years. These are truly financial services supermarkets and I could see that part of the equation working out. But analysts are modeling loan growth at rates of 30% annually. I just don’t know if Brazil can sustain such growth levels. You could make the argument that much of the growth could be going to consumers, not commercial enterprises, but to me that kind of lending is much more difficult. At least when a bank loans to a business, the credit analysts can give a business a good scrubbing and have the business’ assets used as collateral. Consumer lending is an entirely different beast. They could try to increase the amount of mortgages on their books, but the problem there is consumer demand might not match up with supply, you might end up creating a mini-housing bubble.

To me, emerging markets at this point have a lot of things going for them. I do expect the BRIC countries to do well over the long term. But as a value investor I just don’t think you will get the margin of safety that you are looking for. Everything has to go right for them to warrant such high valuations. Buying right now is akin to being a trend follower or momentum investor. I have a list of great companies in BRIC countries that I usually check every other day. The way I figure it, given the way the global economy is going — any heightened level of volatility might trigger a pull back and make some of these companies a bargain. For now, you might be better off analyzing large caps with emerging market growth exposure. Those businesses still seem to be trading at attractive valuations.

After parsing through bank earnings one thing that sticks out is non-performing loans (NPL) remain high. Tracking NPLs and more particuarly NPL inflow rates will help you determine the amount of problematic loans coming into the pipeline. In any recovery you should see this number decline sequentially and from 4Q09-2Q10 that’s exactly what you’ve seen across most banks. But results from 3Q paint a different picture particularly in one region.

A closer look and you’ll find that Southeastern banks or banks with heavy exposure in the Southeast are starting to see the rate of inflows increase. On surface you may not be able to spot the NPL trends as a majority of these banks have disposed NPLs through sales or a transfer to held for sale which skew the inflow calculation.

Let’s take a look at some of the Southeastern banks that have reported 3Q results:

Regions Financial (NYSE:RF) which has $133 billion in assets and banks in the southeast saw NPL inflows of $1.4 billion compared to $900 million last quarter. The inflows were primarily due to income producing commercial real estate (CRE) and land/condo/single family loans. A quick glance shows at the end of 9/30/10, RF had $3.372 billion in NPLs, down from $3.473 billion last quarter. Taking the difference plus adding back charge-offs of $759 millions gives you $658 million in NPL inflows and implies a solid deceleration given last quarter’s NPL inflows of $900 million. But RF also transferred to held for sale $1 billion in troubled assets which they marked down $233 million skewing the inflow calculation. The actual inflow rate is closer to $1.4 billion when you consider the $658 million inflows + $1 billion in troubled assets – $233 million mark.

SunTrust (NYSE:STI) with $175 billion in assets saw NPL inflows increase to $296 million from $188 million in 2Q.

BB&T (NYSE:BBT) which has $157 billion in assets saw NPL inflows increase to $693 million from $505 million in 2Q excluding troubled asset sales which would make the inflows worse. 50% of BBT’s loan portfolio are comprised of commercial loans.

All three of the banks above saw NPL inflows decelerate from 4Q09-2Q10.

Synovus (NYSE:SNV) mainly a Georgia bank with $31 billion in assets saw NPL inflows increase to $422 million from $339 million after adjusting for the disposition of $172 million in trouble assets. This was the first increase in 5 quarters.

BancorpSouth (NYSE:BXS) with $13.6 billion in assets and banks around the Gulf had NPL inflows increase to $133 million compared to $115 million. BXS had no troubled asset sales.

Whitney Holding (NASDAQ:WTNY) a Louisiana bank with $11.5 billion assets saw NPL inflows improve but announced that it will sell $180 million in troubled loans and reclassify $100 million in additional NPLs to held for sale in 4Q10.

You are seeing inflows pick up in a few banks in the mid-west as well but it is not as widespread as it seems to be in the Southeast region. There could be a few reasons:

1. A slowdown relative to the rest of the US

2.Inflows continue to improve at the bigger banks(ex-C as numbers remain skewed due to their asset disposition strategy) most likely due to having a diversified footprint and loan portfolio. A good amount of improvement is also coming from card portfolios which most regionals tend to avoid. Typically regionals have higher concentrations of commercial, CRE, and mortgage loans which continue to struggle.

3. Banks are finally owning up to their losses.

I am not implying this is a trend and that we’ll see NPLs skyrocket but I do believe NPLs will remain relatively high and we’ll continue to ebb and flow from these levels for quite sometime. It’s a metric worth monitoring.

The billionaire financier, who has been beating the drum that private-equity dollars can save the troubled banking industry, bought a nearly 25% stake for $100 million in Vineland, N.J.-based Sun Bancorp. And, he’s making no secret of the fact that he wants to be involved in consolidating the nearly 120 Garden State banks with deposits of less than $3 billion apiece.

Becoming a mogul in New Jersey banking shouldn’t be too difficult: Ross has a lot of dented merchandise to choose from. Given Ross’s penchant for finding distressed gems, he might look at nine banks in the state that regulators have slapped with enforcement actions that order lenders to meet more stringent capital requirements — or else.

For example, privately-held Amboy Bank, based in Old Bridge with $2 billion of deposits, would jibe well with Ross’ latest acquisition. It is the biggest bank that is being asked by the Federal Reserve Bank of New York and the New Jersey Department of Banking and Insurance to boost capital within the next three years, and could benefit from a well-capitalized partner.

Some smaller names on the list under the watch of regulators include Delanco Federal Savings Bank, BNB Bank, City National Bank, Grand Bank NA, Millennium BCP, First Bank, ISN Bank, and Sterling Bank. The state’s publicly-traded banks have also gotten a lift after the Sun Bancorp deal. Moving higher in morning trading are Lakeland Bancorp, which has about $2.2 billion in deposits; Kearny Financial, with $1.5 billion of deposits; and OceanFirst Financial Corp; with $1.4 billion of deposits.

Wilbur Ross: The King of NJ Banking (WSJ Deal Journal)

I’ve actually spent the last few months analyzing banks in New Jersey and believe that there is indeed some great value to be found over there. New Jersey banks have benefited from largely being unscathed by a lot of the credit issues you saw in other parts of the country. With some of the wealthiest communities in the nation, banks can compete for some high quality deposits.

From speaking to management teams in the region, the consensus is that while they would love to do deals, there aren’t many depressed banks in the region. Deals are going to have to be done at a premium or in the form of a merger of equals. I’m not sure how that will jive with the idea of Ross doing rollups in New Jersey. What we might see are mergers of equals to get some size.

I think that there could be some incentive to do mergers. New Jersey banks face fierce competition for deposits from money center banks. In a number of counties like Bergen, Hudson, Essex, Middelsex, and Union: Bank of America or Wells Fargo leads the pack in deposit market share. More broadly, the largest competitors for deposits tend to be Bank of America, Citibank, Hudson City Savings Bank, JP Morgan Chase Bank, PNC Bank, TD Bank, and Wells Fargo Bank. That puts smaller, regionally/community focused banks at a big disadvantage. They are often left competing with each other for a spot outside of the top 10 in deposits. For a bank, that’s not good. You end up having to market CDs and interest bearing deposits which cut into your NIM. A great bank is able to rely more on savings accounts or low/non-interest deposits.

As a result, there might be some logic for a rolling up banks. It would help ease the competition between New Jersey banks and give the larger money center banks a run for their money. New Jersey is home to a number of mutuals that have excess capital too. Those banks would be very attractive to larger acquirers that are hoping to recapture equity after doing a wave of deals. I’m quite familiar (and bullish) with one of the banks listed in Bruno’s list excerpted above, so I recommend you check it out.

The play here looks familiar to other theses that I’m seeing from hedge funds. Namely, that after TARP and the government’s intervention, the worst is over for a company like Citi. It does not have to worry about failing and now, an investor just has to look at their prospects for income generation from newer loans to pay for loan losses:

Michael Breen: Speaking of mulligans, you just bought a firm that probably wish it had one for the past couple of years: Citigroup. Maybe you can let us know how you got comfortable with that, because a few years back, you were speaking about how you couldn’t get transparency on the big banks and the financials.

So is it a case of the blind now being able to see, or have things been shored up to a point that anybody can get comfortable with it? Why don’t you give us the thesis for Citigroup?

Bruce Berkowitz: I think it’s a bit of both. In the U.S., this was not a bankruptcy, but it’s gone through a scrubbing process, very similar to a bankruptcy, by the U.S. Treasury. Citigroup has spent a good amount of time with the U.S. government and many of its financial regulators, going through every liability and asset in the books.

After such a period of time, you normally are able to count the cockroaches. That is, the liabilities have been under a microscope for quite a period of time. There’s been huge capital injections by the government. There’s been a massive amount of dilution to old shareholders. And you’re starting to see some stability, the beginnings.

It’s very much what I call now the pig in the python. You have to look at their liabilities. So you have to look at their bad debt, and you have to continue to watch how the company is digesting its bad debt.

At the same time, you have to see the new debt that’s coming in, the new loans that they’re giving out. It’s fascinating. It amazes me, with financial institutions, the extent, the amount of new loans that are being created in relation to the total loan portfolio.

So it’s just now, in my opinion, a question of time, an ingestion period, where how many more quarters is it going to take before the new loans start to outweigh the old, existing loans?

…

Breen: And so for Citigroup, it’s safe to say they are far enough out of the woods that you’re comfortable with the equity, where, with the real-estate debt, with the bankruptcy, it’s a different situation, and you’re taking a different spot on the capital structure.

Berkowitz: Right. We’re in there. Our major partner is the U.S. government. I mean, Citigroup is woven into the fabric of the United States. Citigroup will be around. I hope it will be around in a smaller form. It will be around in a better form, it most likely will be around with different management, and Citigroup will move on.

How Berkowitz Got Comfortable with Citi (Morningstar)

Quick Notes:

-Wells Fargo has done exactly what they said they could do. Their $40B of pre-provision earnings could handle large losses of $20B.
-The government did the right thing in acting fast in the financial system

Q: Why the share split?
A: We wanted to give a cash and stock option for the shareholders of Burlington Northern. It was an easy decision.

Q: Berkshire Hathaway a member of the S&P 500?
A: Never talked to S&P about it. It would be a plus for shareholders.

-Wells runs a terrific bank. A very customer oriented bank. Their revenues will come through. When the stress test was done, the people evaluating them were way off on the revenues. Wells felt that people did not understand their revenue ability. Wells will never disappoint on revenue.

Q: The Bank tax?
A: I don’t understand that. Some banks like Wells were forced to take it. The government made a lot of money off of banks with TARP, where they will lose money is with the automakers.

Q: What about the AIG bailout?
A: The banks got paid but so did millions of other contract holders.

Q: Should the banks be backstopping commercial and investment banks?
A: I don’t think the government should be backstopping Morgan Stanley or Goldman Sachs.

Q: How do you get around the idea where the commercial bank is with the investment bank? This notion of too big to fail.
A: The banks that were too big to fail had management problems at the top. The board of directors should have something where if the bank has to go to the federal government to be saved, the CEO and CEO before of two years should sign something where they get wiped out. The CEO should say: If this place goes down, I’m busted.

Q: You are saying guys like Chuck Prince?
A: Yeah.

Q: Should there be a split forced by Congress? Or the director plan like you said?
A: I would like what I just suggested. I think banks should be reigned in on leverage and activities they can’t engage in.

-Buffett trusts the Fed. to do more financial regulation on banks.
-Congressional elections are a reflection of voters, they don’t feel good about the health bill and the economy. Those feelings converged with feelings on the candidates.
-American people’s expectations were probably too high on the economy. To President Obama’s credit, he tried to dampen their feelings too. When it grinds along, they unreasonably expected better things by this point and that wasn’t in the cards.
-The stimulus bill could have been used in a way that has a faster more immediate impact.
-Some of the benefits of the stimulus bill were wasted because they were Washington as usual.

Q: Does legislative uncertainty affect corporate hiring?
A: At Berkshire, we are down 25,000 in employment off of base in the last year–year and a half. Our carpet business is down to 6,500 people. That is concentrated to a small area in Georgia. We will hire people when the orders come in. We have 1,000 people down from the peak in our Acme Brick business. We hire based on what is happening in our order book. We aren’t getting orders yet so we aren’t hiring. Unemployment will be a tough figure.
-Until things improve for the economy, the American people will remain unhappy. The Christmas tree approach to legislation where you add on earmarks is not encouraging to the American people.

Q: What do you think about the Kraft deal?
A: I feel poor. They sold a fine pizza business – Kraft sold it for what they said was $3.7B for it but because it had practically no tax basis they really got $2.5B when Nestle is willing to pay $3.7B. That business earned $280M pretax last year, they sold it 9X pretax but then paid 13X EBITDA for Cadbury. They are paying more than that, EBITDA is not earnings, depreciation is a very real expense. Then on top of that they are spending $1.3B on rearrangements at Cadbury, $390M of deal expenses, they are using 260M of stock that their own directors are saying is significantly undervalued, when they calculate the 13 they are using market price not what they think it is worth. So, the actual multiple is 16 or 17 and they are selling earnings at 9X.

Now, it appears as if other investors (including J.C. Flowers, Paulson & Co, MSD Capital, and Soros) are seeing the attractiveness in acquiring failed banks:

Of the 140 banks closed by the government this year, private investors have acquired only two outright—IndyMac and Florida’s BankUnited. Private equity investors argue that they should play a bigger role, as their funds’ billions in unspent capital could bolster the banking system.

Part of the test will be how well OneWest works with financially troubled homeowners, especially under the Obama administration’s loan-modification programs.

OneWest is already generating hefty profits. For the six months ended Sept. 30th, it posted net operating income of about $700 million, according to filings with the FDIC. In 2007 IndyMac, saddled by troubled mortgages, posted a $614 million loss.

During the FDIC’s roughly eight-month control of IndyMac before selling it, the agency cleansed the bank of some of its bad loans through asset sales and write-downs, shrinking it by about 27%, according to filings. It also reduced the bank’s headcount by about 45%.

The FDIC also agreed to share in losses with the ownership group in both the IndyMac and First Federal deals.

OneWest’s improved performance allowed it to bid aggressively for First Federal. The owners didn’t invest additional money to acquire the bank’s assets; rather, the money came from cash on OneWest’s balance sheet.

OneWest paid $401 million, or a 6.6% premium, for First Federal’s assets, according to FDIC documents. That makes it among the first FDIC-arranged deals in which a premium was paid for a failed bank’s assets—many are sold at a discount to their assets.

Investors Reshape IndyMac (WSJ)

It is difficult to throw a dart at the board and scoop up good banks, especially smaller, more regional banks. Many of these banks have not properly written down the value of CRE loans on their books. Still, some banks are poised to do well. The ones that are now overcapitalized and acquiring the assets of failed banks should offer opportunity for investors. A lot of this depends on good stock picking, you need to look at the quality of their loans, what they are acquiring (and the deal terms), and also the quality of their management teams. You need to seek out bankers who are disciplined but enterprising enough to enter the fray and take market share. This requires more effort than simply picking up an ETF, but it should be rewarding.