March 17th, 2008
It is always hardest to think clearly in the midst of a crisis, yet it is precisely when the noise seems deafening that rational analysis is most valuable. As we have been discussing, the market is being dominated by fear and panic, creating an extreme valuation opportunity in the financial sector for those willing to engage in thorough due diligence and apply an owner’s investment horizon. While the timing of the recovery from this crisis is still unknown, we believe its seeds are already being planted. History unequivocally illustrates that these moments of extreme fear are a primary source of long-term excess return. Thus, this commentary is intended to offer some initial reactions to the implications of the Bear Stearns sale.
- Our portfolios have limited exposure to the kind of liquidity risk seen in the sale of Bear Stearns. Our financials portfolio is diversified across a wide range of business models (i.e., P&C insurance, life insurance, consumer lending, deposit-taking, as well as capital markets). Our largest positions (the GSEs, Citigroup, Bank of America) are in businesses where investor doubt centers on capital and earnings – areas where we believe careful analysis and patience will be rewarded – rather than in businesses where day-to-day funding is in question and where to some extent negative sentiment is itself part of the risk. We believe that our large exposures avoid this kind of risk by the very nature of their business models (bank deposits and bank status, implicit government guarantee, etc.). From this standpoint, the sources of potential liquidity risk in the portfolio today are in the pure investment banks, Lehman Brothers and Morgan Stanley, which collectively constitute an exposure of 2-5% across the relevant domestic and global portfolios.
- With respect to liquidity, the Fed is on our side. As is its primary role, the Fed is acting responsibly and aggressively to enable the continued functioning of the U.S. financial system. It is following many of the traditional steps it has taken in the past as well as introducing some new additional steps. Its decision this past weekend to extend its role as “lender of last resort” to the investment banks (enabling them to use the Fed’s discount window for a broad range of investment grade collateral) means that the possibility of a liquidity run on the large investment banks due to a lack of confidence in their continued viability is meaningfully diminished.
- Even without the Fed as a backstop, Lehman and Morgan Stanley have deeper liquidity positions than did Bear Stearns. In the wake of its own funding “panic” in 1998, Lehman instituted a number of significant backstop measures. Among them is a large pool of unpledged liquid assets available to the parent of $98 billion, representing roughly 14% of its balance sheet assets and nearly 75% of its cash capital requirements. While Morgan Stanley’s number is smaller, its own liquidity pool is over half the size of its cash capital requirement, and its excess cash capital position at November 30th was more than 30% of its cash capital requirement, a very large cushion. It is also notable that Lehman and Morgan have far more diversified businesses (both by geography and line) than did Bear Stearns, whose dominant source of revenue and earnings stemmed from its leveraged exposure to the mortgage market.
- The long-term normal earnings power of our largest positions in financials has not been materially impaired by the subprime / credit crisis. We believe that Citigroup, Bank of America, Capital One, Fannie Mae, Freddie Mac all share a common trait: their earnings “engines” have not been permanently impacted by the current stresses. As we have described in some detail in past commentaries, spreads on new business for the GSEs are the widest in their history generating ROEs approaching 40%. Citigroup’s earnings are driven in large part by its global franchise of consumer businesses, wealth management and investment banking that should continue in the future. Structured debt was never a major source of earnings at Citigroup. Capital One enjoys the position of scale advantages and wide spreads in credit card lending. Worth noting is that these wide spreads and the pricing power benefits of its scale make the credit card business less susceptible to loss even during recessionary periods than most financial businesses. Bank of America enjoys its position as the largest deposit taking franchise in the U.S. We estimate that its normal earnings power has increased by as much as 10% (from mortgage origination and servicing) due to its soon-to-be completed acquisition of Countrywide.
Certainly there are questions that still remain: Is all the bad news out? Will these companies be required to raise additional (dilutive) equity capital? Since this is a global crisis and not just a U.S. phenomenon, is it different this time? While we believe the bulk of the bad news has been disclosed, are encouraged by the ease with which equity capital has been raised (only modestly dilutive at Citigroup), and believe that the spreading of the pain globally is actually a positive, we acknowledge that only time will tell the whole story. Still, the opportunity offered today is rare and our research suggests history is still our guide.
As always, please feel free to contact us with questions or for further discussion.
Disclosures
Past performance is no guarantee of future results. The historical returns of the specific portfolio securities mentioned in this commentary are not necessarily indicative of their future performance or the performance of any of our current or future investment strategies. The investment return and principal value of an investment will fluctuate over time.
The specific portfolio securities discussed in this commentary were selected for inclusion based on their ability to help you understand our investment process. They do not represent all of the securities purchased, sold or recommended for our client accounts during any particular period, and it should not be assumed that investments in such securities were, or will be, profitable.