The Broyhill Letter (Q2-08)

7/29/2019 The Broyhill Letter (Q2-08)

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T H E B R O Y H I L L L E T T E R

In a few years, we shall look back at this time as one that redefined the landscape of the USfinancial system and, by association,the workings of global capital markets. - Mohamed El-Erian, PIMCO Co CEO and Co CIO

Executive Summary

The age of financial deregulation began in the early 1980s with the implementation of the Depository

Institutions Deregulation and Monetary Control Act, ushering in an age of financial mania that carried the

equity markets substantially higher over the next two decades. But around the turn of the millennium, financial

re-regulation began to trickle back into the capital markets after a series of corporate scandals shook the invest-

ment world.

The past 28 years of financial market deregulation has unmistakably begun to reverse. Something has changed,

and changed materially. Consequently, the tide is nowflowing out after nearly three decades of financialization,

which will no doubt crimp financial sector profitability for years to come, with a concurrent hit to valuation

multiples.

Too Big to Fail

It seems that with each passing month the estimates for losses in the global banking system keep rising. This time

last summer the largest estimates were around $400 billion. By the end of the year it was in the neighborhood of

twice that. Then last quarter we saw estimates approaching $1 trillion. Last week, the number being broached was

$1.6 trillion, by Bridgewater Associates, one of the top analytical firms in the world.

The latest FDIC Quarterly Banking Profile highlights

that Industry earnings for the fourth quarter of

2007 were previously reported as $5.8 billion, but

sizeable restatements caused fourth quarter net

income to decline to $646 million. The banking

industry reported $5.8 billion in earnings to its

investors, but restatements took that total down by

89%. While there are, in fact, more loss reserves per

dollar of total loans now, these reserves arent

keeping up with the proportion of loans that are

actually going bad. The industrys coverage ratio has

fallen for eight consecutive quarters and now stands

at the lowest level since the first quarter of 1993.

Given that mortgage resets remain heavy and will

continue well into 2010, it is likely that loan-loss

reserves will be forced up sharply, simply to prevent

further erosion in the coverage ratio. In order to actually raise the coverage ratio to normal levels, far more

massive write-downs will be required than weve observed to date.

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COMMITTED INVESTORS ALONGSIDE YOU

SECOND QUARTER 2008


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The financial system is at a crossroads. At current market prices, the system remains under-capitalized despite some

$350 billion of capital-raising over the past 12 months. Moreover, given the collapse in their equity prices, a growing

number of institutions are essentially unable to raise capital without government help. Accordingly, we look for the

official sector to encourage further capital-raising and work even harder to isolate the most vulnerable financial

institutions and limit the negative spillover effects. For some institutions, especially the systemically important ones,

this is likely to involve facilitated marriages similar to what occurred earlier this year in the cases of Bear Stearns and

Countrywide. Others face the risk of explicit failure (as occurred with IndyMac, the California-based bank). In all cases,

equity holders will experience additional pain.

Dead Cat Bounce

Freddie Mac owed $5.2 billion more than its assets were worth in the first quarter, making it insolvent under fair-valueaccounting rules. The fair value of Fannie Mae assets fell 66 percent to $12.2 billion and may be negative next quarter.

These institutions are on a short path to insolvency. The basic problem is that both Fannie and Freddie need more

capital, and perhaps far more than their current market capitalization. The problems with Fannie and Freddie have to

be solved. They are now handling 80% of the mortgages in the US. Without them the housing market would grind to

a halt quickly and housing prices would drop even beyond our pessimistic views.

We are told that there are 90 banks on the watch list of the FDIC. This is double the number that was on this list in

2006, the year before the financial crisis began. Note that IndyMac was NOT on this list at the end of the first quarter

of 2008. It was then called well-capitalized. The trend in bank failures does not give any comfort. IndyMac is one

of seven bank failures in 2008 and it is big.

There seems to be an additional problem that the notion of earnings for financials seems to be a somewhat more

fragile one than for industrial companies. Some may recall that New Century Financial was a mortgage lender

specializing in subprime loans. It was the second largest originator of such loans in 2006. The fact that it declared

bankruptcy is nothing particularly noteworthy. But what makes it reasonably unique was the fact that it managed to go

bankrupt without ever declaring a loss. The potential for a firm that appeared consistently profitable one moment to

wipe out years of declared profit the next moment, is hugely higher for financial firms than non-financials.


SECOND QUARTER 2008




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Where to from Here

This argues for using a higher discount rate on the expected future earnings offinancials, to make up for the fact

that the earnings, even once declared, may prove to have been illusory. And even after accounting for the recent

sharp decline in share prices,financials remain an exceptionally large component of the market itself. As the chart

below shows, todays 17% of market cap may be well off the high of nearly 25% but remains a long way above

the levels before this bubble started. Financials have already lost the distinction of having the largest weight in

the S&P 500.

Two historical cases of sector declines from major peaks are Energy in the 1980s and Technology earlier this

decade. Energys weight in the S&P 500 tumbled from 31% in November 1980 to 15% in December 1983 a

16 point drop over three years. Technologys weight fell from 35% in March 2000 to 13% in October 2002 a

22 point drop over two and one half years. Financials weight peaked at 22% as recently as last year and has only

dropped 8 points since then. Based on the previous cases, the sector has further downside in both time and price,

and the likelihood of a move toward the single digits, a level not seen since 1980, is increasingly likely.

Bottom Line

The powerful short-covering rally in the bank stocks since the mid-July lows has alleviated some of the fears of

imminent doom for the banking sector. But it remains clear that conditions are not yet in place for a period of

sustained financial sector outperformance. Rather than viewing the process as nearly complete, we believe the

first phase has now passed and we are now entering the most dangerous period of this adjustment process, as the

need to cleanse the system of bad debts and paper will be challenged by governments efforts to re-liquefy (i.e.

bailout) the system, producing additional stress and potential fracture points.

The combination of massive uncertainty as to the amount and distribution of near-term write-offs, another huge

uncertainty as to the likely level of industry profits in the aftermath, and disturbing questions as to the quality of

reported earnings in the sector suggest at the very least taking a deep breath before putting significant amounts

of capital in the financial sector. Almost all investments we make involve taking on significant risks, but few

investments seem to contain the level of unknowns that the US financial sector currently embodies. Buying them

today may turn out to be a very profitable speculation, but it seems harder to consider it a true investment.

- Christopher R. Pavese, CFA


SECOND QUARTER 2008



The Broyhill Letter (Q2-08)

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