Well, I certainly made a costly mistake and didn’t see the spring meltdown coming. I was certain that “healthy” financial firms wouldn’t see their stock prices fall to a small percentage of their net worth. Of course, I also didn’t see $3.3 Trillion in borrowing from the US government in my lifetime. Needless to say, the markets are not impressed with the direction of new President is taking us. And while he discounts the markets as simply pole taking, the real world US citizen is watching their savings shrivel.
Mr. Buffett says the US economy fell off a cliff but better times are to come. I’m actually a little more optimistic, go figure. I’m very disturbed by the governmental borrowing and wasteful spending. Unfortunately, I see an inflation hit in the coming years because of this, so prepare your finances for inflation risks. On the silver lining, however, I see a valuation opportunity that seems to be only mildly mentioned on various financial sites.
Let’s take one of my favorite large banks, Wells Fargo, for example. This company is currently trading at half of the balances sheet net worth. In other words, if I had $45 Billion lying around, I could buy Wells Fargo, sell all the assets, settle all the debts, and have $90 Billion left over. Such a move would be a handsome 100% profit for my trouble. There are two gotchas in this scenario. First, balance sheets rarely show the whole picture. Historically, however, the picture is not always bleak. Corporations are not allowed to determine income based on cash flow. If a company purchases a desk for an office it can’t write off the purchase amount against incomes. It is only allowed to write off approximately 20% of the purchase price each year. Interestingly, the desk will probably stay in service far beyond five years, so year six will show a balance sheet entry of zero for the desk when the desk still has some value remaining. In this example, the balance sheet is undervalued. However, sometimes companies don’t write off assets at all and carry them on the balance sheet for an amount that is actually higher than the asset could ever fetch from a fire sale situation. For example, Circuit City never achieved anything close to parity when it liquidated its inventory. Thus, we have an example of an overvalued balance sheet. When you take the good with the bad, you have to assume that balance sheets are at least somewhat “balanced”. (especially since the CEO and Board are now on the hook for lawsuits if they cook the books)
But there is still a missing element here. President Bush (W), enacted a lame provision with the best of intentions. (famous last words) FASB, the governing body for accounting rules, was instructed to create a mark to market provision. I’ve talked about this provision before, but the short version is this. If Countrywide has an average of 40% losses on their loans because they made bad loans they are required to write down their balance sheet to the amount they could actually sell the loans for, say 50%. If Wells Fargo had not made any bad loans and had a average loss of 1% on their loans, the new rules require that they, too, write down their loans to what Countrywide could get. In other words, Wells Fargo has to assume that their loans are as toxic as those of Countrywide even if the loans Wells Fargo holds are being serviced regularly. Wells Fargo recently wrote off $4 Billion and is considering another $28 Billion. But they aren’t selling the loans!!! In other words, this bank prefers to hang on to the loans and service them which means they earn approximately 4% after servicing costs on the loans. The write offs would only be realized if one of two things happened. First, Wells Fargo sells the loans. (good luck) Second, Wells Fargo experiences a huge increase in loan defaults. Now when I say huge, I don’t mean relative to past default levels. Unlike the press, I don’t consider a jump from 2% to 3% a huge increase. It is large relative to the figure but not relative to the lender’s portfolio. Nobody, short of the “bomb shelter wackos”, is suggesting that broad portfolios such as Wells Fargo is going to experience losses on their loans of anything over 3%. So their losses aren’t real!!! In contrast, when they earn interest on their loans, the interest income is cash in hand and very real. Real income, paper loss = stock hammered and opportunity.
This analogy doesn’t apply to all institutions. Some banks have stricter debt requirements. For example, one of my old favorites (may my portfolio rest in pieces) is MCG Capital. They, however, cannot allow their assets to drop to less than 200% of their debt. Because FASB requires the write down of their assets regardless of servicing record, the adjustment has a negative effect on their ability to maintain their own debt. In this example, they can be forced to sell off assets at a highly reduced rate which further pressures their capital position, which increases the supply of companies selling assets, which further pressures the asset price, which further reduces their capital position, etc, etc.
The cycle is spasmodic and can only be stopped by letting the FASB rules return to their previous reasonable state. Oh yeah, the government could simply buy all the banks at fire sale prices and then unwind the fabric of the US economy while increasing the size of government forever. Did I mention I was optimistic?
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