Stick That In Your Pipe and Smoke It

In an obvious reference to Alan Greenspan's loose monetary policy in 2002 and the mis-management of the money center banks and brokers, TCF Financial's (Symbol – TCB – "Takin' Care of Business") Chairman writes this pointed paragraph in his earnings release today:

 “TCF did not engage in the activities that have created so many problems in the financial industry,” said William A. Cooper, Chairman and CEO. “TCF has not made subprime, broker purchased, Option ARM, teaser rate, out of market, low doc or other risky mortgage loans. TCF kept on its balance  sheet all the loans it originated. TCF has no auto or credit card portfolios or asset backed commercial paper. We have never owned Fannie Mae or Freddie Mac preferreds, trust preferred securities or bank owned  life insurance (BOLI). TCF does not have any derivative contracts. Higher charge-offs at TCF have been primarily due to the imprudent behavior of our competitors and an ill-advised monetary policy that created the unprecedented rise and fall of the housing markets. TCF remains profitable, solidly capitalized and ready to take advantage of prudent growth opportunities. TCF declared a $0.25 quarterly dividend payable to stockholders on February 27, 2009. We expect to continue our dividend in future periods subject to maintaining solid profits and strong capital.

In accordance with our compensation programs, TCF Executive Management  received no bonuses for 2008. As Chairman and Chief Executive Officer, I receive neither a salary nor a bonus.”

I don't own TCF, nor have I ever done research on the stock.  However, based on that one paragraph, I'm going to dig in a bit further.  A 10% dividend, if it can be maintained, makes me very interested.  Oh, and I nominate TCF Chairman William Cooper for Treasury Secretary. 

Don’t Let The Door Hit You

Tim Knight over at the Slope of Hope posted this last night but it was so good, I had to post it, too. This was written eight years ago by the Onion, America's Finest News Source.  If it weren't so sad, it would be funny.  It just goes to show how weird the last eight years have been and how far the Republicans strayed when a satirical news site basically predicted the future.

Bush: 'Our Long National Nightmare Of Peace And Prosperity Is Finally Over'
January 17, 2001 | Issue 37•01

WASHINGTON, DC–Mere days from assuming the presidency and closing the door on eight years of Bill Clinton, president-elect George W. Bush assured the nation in a televised address Tuesday that "our long national nightmare of peace and prosperity is finally over."

"My fellow Americans," Bush said, "at long last, we have reached the end of the dark period in American history that will come to be known as the Clinton Era, eight long years characterized by unprecedented economic expansion, a sharp decrease in crime, and sustained peace overseas. The time has come to put all of that behind us."

Bush swore to do "everything in [his] power" to undo the damage wrought by Clinton's two terms in office, including selling off the national parks to developers, going into massive debt to develop expensive and impractical weapons technologies, and passing sweeping budget cuts that drive the mentally ill out of hospitals and onto the street.

During the 40-minute speech, Bush also promised to bring an end to the severe war drought that plagued the nation under Clinton, assuring citizens that the U.S. will engage in at least one Gulf War-level armed conflict in the next four years.

"You better believe we're going to mix it up with somebody at some point during my administration," said Bush, who plans a 250 percent boost in military spending. "Unlike my predecessor, I am fully committed to putting soldiers in battle situations. Otherwise, what is the point of even having a military?"

On the economic side, Bush vowed to bring back economic stagnation by implementing substantial tax cuts, which would lead to a recession, which would necessitate a tax hike, which would lead to a drop in consumer spending, which would lead to layoffs, which would deepen the recession even further.

Wall Street responded strongly to the Bush speech, with the Dow Jones industrial fluctuating wildly before closing at an 18-month low. The NASDAQ composite index, rattled by a gloomy outlook for tech stocks in 2001, also fell sharply, losing 4.4 percent of its total value between 3 p.m. and the closing bell.

Asked for comment about the cooling technology sector, Bush said: "That's hardly my area of expertise."

Turning to the subject of the environment, Bush said he will do whatever it takes to undo the tremendous damage not done by the Clinton Administration to the Arctic National Wildlife Refuge. He assured citizens that he will follow through on his campaign promise to open the 1.5 million acre refuge's coastal plain to oil drilling. As a sign of his commitment to bringing about a change in the environment, he pointed to his choice of Gale Norton for Secretary of the Interior. Norton, Bush noted, has "extensive experience" fighting environmental causes, working as a lobbyist for lead-paint manufacturers and as an attorney for loggers and miners, in addition to suing the EPA to overturn clean-air standards.

Bush had equally high praise for Attorney General nominee John Ashcroft, whom he praised as "a tireless champion in the battle to protect a woman's right to give birth."

"Soon, with John Ashcroft's help, we will move out of the Dark Ages and into a more enlightened time when a woman will be free to think long and hard before trying to fight her way past throngs of protesters blocking her entrance to an abortion clinic," Bush said. "We as a nation can look forward to lots and lots of babies."

Continued Bush: "John Ashcroft will be invaluable in healing the terrible wedge President Clinton drove between church and state."

The speech was met with overwhelming approval from Republican leaders.

"Finally, the horrific misrule of the Democrats has been brought to a close," House Majority Leader Dennis Hastert (R-IL) told reporters. "Under Bush, we can all look forward to military aggression, deregulation of dangerous, greedy industries, and the defunding of vital domestic social-service programs upon which millions depend. Mercifully, we can now say goodbye to the awful nightmare that was Clinton's America."

"For years, I tirelessly preached the message that Clinton must be stopped," conservative talk-radio host Rush Limbaugh said. "And yet, in 1996, the American public failed to heed my urgent warnings, re-electing Clinton despite the fact that the nation was prosperous and at peace under his regime. But now, thank God, that's all done with. Once again, we will enjoy mounting debt, jingoism, nuclear paranoia, mass deficit, and a massive military build-up."

An overwhelming 49.9 percent of Americans responded enthusiastically to the Bush speech.

"After eight years of relatively sane fiscal policy under the Democrats, we have reached a point where, just a few weeks ago, President Clinton said that the national debt could be paid off by as early as 2012," Rahway, NJ, machinist and father of three Bud Crandall said. "That's not the kind of world I want my children to grow up in."

"You have no idea what it's like to be black and enfranchised," said Marlon Hastings, one of thousands of Miami-Dade County residents whose votes were not counted in the 2000 presidential election. "George W. Bush understands the pain of enfranchisement, and ever since Election Day, he has fought tirelessly to make sure it never happens to my people again."

Bush concluded his speech on a note of healing and redemption.

"We as a people must stand united, banding together to tear this nation in two," Bush said. "Much work lies ahead of us: The gap between the rich and the poor may be wide, be there's much more widening left to do. We must squander our nation's hard-won budget surplus on tax breaks for the wealthiest 15 percent. And, on the foreign front, we must find an enemy and defeat it."

"The insanity is over," Bush said. "After a long, dark night of peace and stability, the sun is finally rising again over America. We look forward to a bright new dawn not seen since the glory days of my dad."

Premium Multiple Being Drained Out Of Wells Fargo

The premium earnings and book value multiples that Wells Fargo (WFC) has enjoyed for the past decade are being drained from Wells Fargo. Wells Fargo's stock has always traded at approximately a 20% premium to the banking group because of its higher than average earnings growth, higher returns on equity, and low level of non-performing assets. However, that premium multiple relative to the group is beginning to erode in a phenomenon known as "multiple compression."  Wells Fargo has underperformed the other bank stocks since the beginning of the year. Wells is down 37% vs 23% for the group since December 31st.

WFC Comparable Returns Since Jan 1st  

Source: Bloomberg

Click Image To Enlarge

Several events in the past two weeks account for investors deciding that the premium multiple was no longer worth paying for Wells Fargo.   First, the company has a very low tangible common equity-to-assets ratio after the Wachovia deal.  My estimate is about 2.6% – 2.7% vs the average bank of around 5.0% – 6.0%. This raises the probability that Wells will be tapping the TARP II for a second time to consummate the Wachovia deal.  Even though most refer to this as a bailout (i.e. free money) tapping the TARP is anything but free because the government's preferred shares sit higher in the capital structure than the common shareholders.   In addition, the TARP II money seems to be coming with many more onerous terms from Hank Paulson and company including reducing or limiting dividend growth. This makes the common stock much less attractive.

Second, Bank of America increased the loss ratio of the Merrill subprime CDOs to over 30%. This is higher than the "worst-case" 20% loss ratio Wachovia had assumed in some of its subprime mortgage portfolio.  Most likely, loss estimates will be going up significantly for the bad loans at Wachovia.  Increasing loss estimates will require additional capital.  It's hard to see how the combined Wells Fargo/Wachovia can be considered a premiere institutions given the rising level of losses and need for additional capital.  

Third, the sentiment toward bank managements has soured significantly since Ken Lewis was exposed as a liarregarding the Merrill Lynch merger. Wells' CEO John Stumpf and CFO Harold Atkins have, on numerous occasions, touted Wells' strong capital ratios and outperforming mortgage portfolio. However, after the Bank of America announcement, investor skepticism is high.  Wells Fargo has been magically impervious to the California real estate collapse despite it being their home market. Many short sellers believe that Wells is simply taking their time recognizing losses in their mortgage portfolio rather than taking their medicine as the the losses occur. Management is delaying taking the losses under their accrual accounting basis rather than taking mark-to-market losses like the investment banks. And who knows how many troubled loans Wells Fargo will "discover" now that it has consummated the merger with Wachovia? John Stumpf might yet turn out to be the next Ken Lewis.

The premium multiple is being drained out of Wells Fargo as investors anticipate increased government investment because of these issues. Yet some of the premium still exists. The following charts show that even relative to other high quality banking companies, Wells still trades at a high multiple. As late as December, Wells traded over 4.0x tangible book value and over 2.0x stated book value. This was a significant premium to the other national banks, which traded around 1.5x tangible book value and 0.9x stated book value. Impaired companies such as Citigroup and Bank of America currently trade around 0.3x stated book value.

WFC Book Relative To Industry


Source: Baseline

Click Image To Enlarge

If the consensus view becomes that Wells Fargo is no longer a premiere institution, then the premium multiple could disappear all together. This indicates to me that Wells could see further downside from these levels. At 0.9x book value, which is the current median multiple of the banking group, Wells Fargo stock would be trading at approximately $12 – $13.

The rapid decline in Wells Fargo shares will also have a negative effect on the broader market. Wells Fargo is one of the most widely held financial stocks by insitutional investors. Every fund looking to maintain some financial exposure has been hiding in Wells Fargo. The 37% decline in this "safe" stock will weigh on the performance of most every large cap mutual fund. Even Warren Buffett has taken a $4 billion hit on the stock in the past two weeks.

A list of the top 25 fund holders is a who's who of large cap stock managers who are now underperforming their indexes.

WFC Institutional Holders

Click on Image To Enlarge

The decline in Wells Fargo stock is certainly weighing on its holders but could also have negative implications for the future performance of the market as a whole.  If the once impervious Wells Fargo turns out to be worse than expected, the confidence in the overall securities markets will erode further.  And that could lead to further multiple compression for the entire market.

Absurd Bailouts

"Anyone else have their hand out?

– Lewis Black 

With the announcement this morning that Bank of America is getting an additional $138 billion, the bailouts have reached a level beyond absurdity. Has anyone at the Treasury noticed that the market value of Bank of America is only $41 billion right now? With $138 billion you could essentially let BAC go under and start three new BAC's.

I've stopped crying. All you can do now is laugh. The only person you can turn to in a case like this Lewis Black

The Government Is Pouring Money Into A Bottomless Citi Pit

"There is nothing more difficult, more frustrating and more expensive than to keep a corpse from sinking"

Peter Drucker

In bailing out Citigroup a second time (as you recall, Citigroup just received $25 billion from the TARP in October), the government has started the process of creating a bigger problem than the one it is trying to solve.  What problem could be bigger than the complete meltdown of the United States' financial system?   The complete bankruptcy of the United States. 

I thought the TARP was actually being implemented correctly at first.  The TARP capital was essentially being used to re-capitalize relatively strong banks.  This capital was being used to help good banks take over weak ones, which accelerated the process of moving assets into strong hands without a complete melt-down in the system.  However, from the start, Citigroup should have gone on the "weak bank" list, rather than the "strong bank" list. 

Unless the government stops backing up failed institutions such as AIG and Citigroup, I don't see how any money will be left over for stronger institutions. Among the many things the government is terrible at doing is cutting its losses.  Once it begins a program or a course of action, it continues it indefinitely no matter how stupid or costly.  

This lack of government risk management is a problem because Citigroup is a bottomless financial pit.  Rather than being bailed out, Citi needs to be broken up and sold.  Rather than buying its stock and giving it more capital, the government needs to act as an investment banker by separating the parts that buyers want – the branches, Salomon Smith Barney, the money management arm - then spliting off the parts hardly anyone wants.  Rather than guaranteeing the toxic assets currently on Citigroup's balance sheet, the assets need to be placed into a separate entity that can be sold to private equity investors at a steep discount (with some government financed money, if necessary).   

Right now, the government is actually backing up a company with absolutely no real capital.  The government is trying to keep a corpse from sinking.  Jonathan Weil explains Citigroup's capital situation clearly in his article "Citigroup’s ‘Capital’ Was All Casing, No Meat" on Bloomberg today… 

There’s something very wrong with the way Citigroup and the government measure capital.

To see why, let’s dig into just one portion of Citigroup’s capital that has been soaring in value this year. It’s called deferred-tax assets, or DTAs, which now make up a big part of Citigroup’s book value and Tier 1 regulatory capital.You won’t see anything about these assets’ values in Citigroup’s third-quarter report to shareholders. The bank buried them on its balance sheet in a line called “other,” and it discloses them in its financial-statement footnotes only once a year. You can piece together how much the values had grown, though, from Citigroup’s filings with the Federal Reserve Board.

Deferred-tax assets typically consist of tax-deductible losses carried forward from prior periods, which companies can use to offset future tax bills. Under generally accepted accounting principles, such carryforwards are valuable only to companies that are profitable and paying income taxes.

To the extent a company doesn’t expect to use these assets, it’s supposed to record an offsetting valuation allowance to reduce their value. DTAs also can take the form of carrybacks, which let companies claim refunds of past taxes paid.

As of Sept. 30, Citigroup’s net DTAs were about $28.5 billion, after subtracting deferred-tax liabilities. That represented 29 percent of the bank’s common shareholder equity and a whopping 80 percent of tangible equity, which excludes goodwill and other intangible assets. On a gross basis, DTAs were even bigger; the bank hasn’t disclosed how much.

By comparison, Citigroup’s stock-market value finished last week at $20.5 billion. The longer Citigroup goes without chopping its DTAs, the more investors should be wary of any of its numbers.

Now look at some of the other fluff in Citigroup’s $96.3 billion of Tier 1 capital, as of Sept. 30.

— The Tier 1 figure included $23.7 billion of so-called trust preferred securities issued by Citigroup, which are treated as debt under GAAP.

— About $27.4 billion was preferred stock, which is debt from a common shareholder’s standpoint. (Citigroup raised an additional $25 billion from the government last month in exchange for preferred stock.)

— The Tier 1 measure excluded $10.8 billion of paper losses on various securities and derivatives, even though these reduced GAAP equity. It also included $12.7 billion of intangibles.

So, in truth, Citigroup had little, if any, real capital, even if the values for all its toxic loans and mortgage-related investments had been accurate. Most of the above-listed items won’t help the bank absorb losses. Rather, they are the kinds of things that cry out for more capital.

What we need from America’s banks is for their leaders and regulators to start speaking with credibility.

We’ve had enough funny numbers

Giving government money to healthy banks and "encouraging" them to consolidate the bad banks is a reasonable course of action.  However, Citigroup probably still has over $1 trillion of toxic assets "off balance sheet" and no capital to back up those "assets".  The entire company is insolvent.  For Citigroup to be fully rescued, it alone would need the entire $700 billion TARP to bail it out.  The current round of $305 million of loan guarantees are not going to save the company any more than the first $25 billion of TARP money did.  All the current bail out does is buy time for someone else to take over the problem.  Get your hard hat on, Timothy Geithner.     

And if the government continues with it's current plan,the United States government's cost of borrowing will eventually rise.  Currently, the cost is low – Treasury bills yield 0.3%.  However, as the financial contagion spreads across the world, fewer and fewer other governments will be able or willing to purchase our debt.  That will be a problem when the United States government asks for another $1 billion for TARP II. 

Eventually, our country's creditors will realize that the United States government is insolvent.  Short of selling Alaska to Russia, there's no hope for the United States to pay back an $11 trillion loan.  If our creditors refuse to loan us money at reasonable rates for TARP II,  the United States will have to go to the International Monetary Fund (IMF) for help.  Of course the IMF will tell us what it tells all its borrowers…devalue the currency and implement austerity measures.  That inevitably leads to a depression.  

I think this second Citigroup bailout is the beginning of the end for the United States.  The only course of action that will stop this inevitable slide into insolvency is for Citigroup to be broken up and sold in pieces.  Otherwise, Citigroup and AIG  will suck up the rest of the TARP money designed for healthy institutions. And after that, I believe the jig will be up for additional bailout money.

One Hundred Companies That Can Take Themselves Private

In past years, I have successfully used a screen that identifies companies that can take themselves private by levering up their balance sheet and using their cash flow to pay the interest payments.  The screen assumes companies could get financing at 9% and could cover the tax adjusted interest payments if they stopped expanding and just spent a minimum in capital expenditures to continue operating.  

If you assume that we don't enter a depression and the companies could actually get financing right now, a stunning number of high quality companies – companies with high cash flow and relatively low debt – could take themselves private at today's prices.  Obviously, the assumptions of the screen are unrealistic currently.  If General Electric is paying Warren "Loan Shark" Buffett ten percent interest rates, then most other companies won't be able to find financing.  But that's beside the point.  At these prices, many quality companies are cheaper than they have been in history.  Money is still available - it's just scared and sitting on the sidelines.  If we see any return to stability in the financial system, many of the stocks on the list could see 25% – 50% upside just by a return to median multiple.        

My original screen included over 200 companies that could take themselves private but I have filtered it to only include companies with relatively low debt to equity ratios.  As a caveat, several of the companies on the list are coming off of cyclical peak earnings and won't be able to sustain the levels of cash flow they have generated in the past year.  However, many others are very steady cash generators with strong balance sheets.  Some of the large cap stocks on the list, like Disney (DIS), Applied Materials (AMAT), and Exxon Mobile (XOM) are unbelievable bargains.  Many of the mid cap stocks are solid companies that have almost become small caps such as Federated Investors (FII), MSC Industrial (MSM) and Manpower (MAN).  And many of the small caps are now cheap, undiscovered gems such as Advanced Energy (AEIS), Darling International (DAR) and JDA Software (JDAS).  


DeMark Readings Finally Signaling A Potential Bottom

It's been a painful month for investors but the markets could finally be finding a bottom.  The DeMark Weekly indicators have reached 12 and 13s across the board and stocks are as oversold as they have ever been.

The Weekly DeMark Combo on the S&P 500 paints the most compelling picture for a bottom.  It is currently registering both a 9 and a 13.  A 13 buy countdown signal is an extremely rare event on an index because indexes do not typically sustain such straight down moves for long periods of time.  The only other 13 buy countdown signal on an index that I recall was during the 2002 market bottom.  

SPX Weekly 102808

Likewise, the NASDAQ has registered a 9 buy setup on the weekly DeMark Sequential.

NASDAQ Weekly Seq 102808

Given that we finally hit buy signals on the DeMark indicators, I think we're due for a massive snap back rally.  Stocks are as oversold as I have ever seen them.  The number of stocks above their 50 day moving average for both the NASDAQ and the NYSE is almost at zero. 

NASDAQ Stocks Above 50 Day Moving Average 102808  

NYA Stocks Above 50 Day 102808

And the volatility of volatility (a measure of the 20 day standard deviation of the VIX) is off the charts high, but starting to turn down.  That's typically the sign a turnaround is close at hand.

Volatility of Volatility 102808

While none of these signals tell me the bear market is over, the evidence finally points to a rally that should take the indexes up 10% – 20% from current levels. 

How AIG Took Down Europe

I have been trying to understand why the typically conservative European banks such as ING have been in dire need of capital.  The real estate bubbles in Europe were significantly smaller than the ones in the US and many of the European banks never bought much of the toxic mortgage paper churned out by Wall Street. 

Well, according to Business Week, it turns out they didn't avoid the risk, they just thought they had hedged it with credit default swaps. Credit default swaps (CDS) are a great way to protect investments provided that the counterparty you entered in contract with is able to honor its obligations. However, most of the CDS' were written by AIG. 

The counterparties to AIG simply relied on Moody's and S&P for an accurate picture of the credit worthiness of AIG.  AIG, however, never disclosed the extent of it's exposure, so the rating agencies never fully understood the risks.  When AIG went bankrupt, in part due to its agreements with counterparties that required collateral in case of a ratings downgrade, these counterparties were left high and dry.

As a result, the European banks suddenly realized they are highly leveraged and needed additional capital.  The following article from Business Week tries to explain:

How AIG's Credit Loophole Squeezed Europe's Banks

European banks didn't gorge on subprime assets as much as their U.S. counterparts did. So why do foreign lenders suddenly need a bailout? Their deals with insurer American International Group (AIG) may offer a clue.

Before the financial crisis hit, AIG did a booming business in credit default swaps, complex instruments originally designed to protect lenders if borrowers fail to make debt payments. The biggest buyers were European banks, whose deals last year with AIG totaled a staggering $426 billion. But the banks didn't always buy the swaps as insurance against defaults—they often used them to skirt capital requirements. AIG declined to comment.

Under international regulations known as the Basel Accords, European lenders have to set aside a certain amount of money to cover potential losses. By owning credit default swaps, banks could make it appear as if they had off-loaded most of the risk of a loan to AIG or another firm, thereby reducing their capital needs. The perfectly legal ploy allowed banks across the Continent to free up money to make more loans. It was part of the game taking place across the global financial system. During the boom, firms seemingly created money out of nothing, propelling the markets to unsustainable heights.

Such excessive risk- taking has brought down several European lenders. Consider Dexia, which received an $8.7 billion bailout from regulators in late September. The Brussels bank boasted about its credit default swaps in a press release last year, saying that the deals "freed up regulatory capital." A Dexia spokesman now says the firm made little use of such swaps.

Another busted bank, Fortis, noted in a May 2007 investor presentation that it planned to use "capital relief transactions" to help fund its purchase of ABN AMRO assets. A Fortis spokesman says the bank didn't buy swaps to improve its capital position.

Until late 2007, AIG gave its deals with European banks cursory mention in filings. Then the insurer got smacked by subprime losses on unrelated transactions. After that, investors pressured AIG to come clean about all of its sophisticated deals. AIG officials said in a Dec. 5 conference call that banks using credit default swaps could set aside capital that amounted to only 1.6% of a loan's value, vs. 8% without.

European banks didn't tap only AIG. Bermuda's Primus Guaranty (PRS), a firm that sprang up during the boom, targeted European banks looking to game regulations. Philadelphia bond insurer Radian Group (RDN) marketed "Basel-friendly" swaps. Says Daniel Gros, director of the Centre for European Policy Studies in Brussels: "Through adjustments, [banks] could convince regulators that there was low or no risk."

AIG's credit default swaps, though, delivered an extra dose of leverage to the financial system. Given its high credit rating, AIG could make deals that required it to put up a meager amount of collateral, or cushion, against losses. The upshot: AIG boosted lending with little money.

But the gambit worked only as long as AIG maintained its credit rating. If the insurer were downgraded, AIG would have to pony up more cash. Otherwise the deals would fail—and banks would have to raise capital or dump assets.

That very scenario started to unfold on Sept. 15 when AIG got downgraded. Within 24 hours, the Federal Reserve stepped in with an $85 billion bailout to save the company. These days, AIG no longer makes such deals. It's just another way credit is contracting as the financial system pays for the excesses of the past.