Inspirations and Aspirations

Willie Sutton at Eastern State Penitentiary

My dearest brother sent me a link to yesterday’s New York Times story detailing how hedge fund investors are circling the country’s small banks like raptors after particularly tasty chipmunks.

ERIC LIPTON
Published: May 5, 2009

CAINSVILLE, Mo. — No one seems to want to own a business in this dusty, windswept corner of rural America, population 370, with its crumbling sidewalks and boarded-up storefronts.

First National, with its boarded-up second story and $17 million in assets, is worth about a third of what its owner, a New York investor, paid for an Upper East Side town house in 2006. It is an unlikely launching pad for a new American banking empire. Except, that is, for J. Christopher Flowers, a media-shy New York billionaire who last year bought the First National Bank of Cainesville, one of the United States’ smallest national banks.

With that charter in hand, Mr. Flowers plans to take over a handful of large struggling banks, casualties of the economic crisis. In some cases, he hopes, the federal government will help.
Mr. Flowers, a private equity manager, has no particular love for rural Missouri; in fact, he has never set foot in Cainsville. Rather, he wants to use the national bank charter he picked up in this farm town to go on a nationwide buying spree.

My brother’s comment was telling:

Hello sucker— how the vulture capitalists will pick your pocket with the help of their lobby and the same connivers in the congress!!

M.C. Escher in Lego by Andrew Lipson and Daniel Shiu

And it’s hard to argue that he’s not right. Parties that hold “toxic assets” are going to unload them to other parties who also hold “toxic assets,” who in turn will unload their “toxic assets” to other parties who also hold “toxic assets” in a scheme to make would-be M.C. Escher’s the world over jealous. And all with underwriting from the government and the Fed.

The Who's Roger Daltry

And since this is a game that requires an enormous amount of money to play, why waste our time being aggrieved that the same Masters of the Universe who drove the bus off the cliff own the tow truck that’s come to drag us out? It’s American as Willie Sutton. Or in the words of the immortal poet, Roger Daltry: “Meet the new boss [baby]; same as the old boss.“

“It’s premature to conclude the economy has turned,” said CFO Howard Atkins in an interview with The Associated Press.
Atkins did say the bank was seeing a clear benefit from the government’s actions to bring interest rates down. “All I can tell you is, we’re seeing a lot of business.”

$3 billion buys a lot of bling. That’s the net revenue Wells Fargo expects to report for the first quarter. Suddenly, the debate on the economy is focused on whether Wells Fargo’s results are representative, or an anomaly. The President, understandably, is looking on the bright side:

President Obama emerged from a meeting with his senior economic advisers on Friday to say “what you’re starting to see is glimmers of hope across the economy.” But there were also signs of growing tensions between the White House and the nation’s banks over the next phase of the financial rescue.

Currency speculators the world over seem to share the President’s optimism.

April 11 (Bloomberg) — The dollar posted the biggest weekly gain versus the euro in more than two months on optimism the worst of the financial crisis in the U.S. is over.

Still, plenty of people are out there offering more dour assessments.

Wells Fargo announced today $3 Billion in profits. It was fantastic news and it sent the stock market soaring.

However, one thing that didn’t get talked about was why they made so much money.
Wells Fargo CFO Howard Atkins discusses the banks $3 billion reported first quarter 2009 earnings. Atkins hypes the impact of mortgages to the bottom line, due to low interest rates and foreclosure selling no doubt, but shockingly admits at the 7:45 mark that with the writedowns that would have been required by Mark to Market the bank actually lost money on the quarter.

To put it another way, Wells Fargo made money because the government allowed them to play “let’s pretend your assets are worth something”.

But what if that’s exactly what’s going on, and it’s working? What if instead of creating some toxic asset merry-go-round, banks are just allowed to hold toxic assets off their balance sheets long enough for rationality to return, and sensible valuations to emerge?

Just to be clear: I believe the market in mortgage backed securities and their derivatives, is as “undersold” today as it was “oversold” in the middle years of the decade. The herd mentality and “animal spirits”  are every bit as evident in this economic climate as they were in the giddiest days of the Internet, commodities and real estate bubbles. Only everybody’s running to the exits, blocking the aisles, so to speak.

Taking a quick look at “Unbossed’s” graphs of monthly default notices; yeah, sure there’s a spike coming, and defaults on both residential and commercial mortgages are going to double in the coming weeks and month. But double from what basis?

If the baseline rate of default a year ago was say somewhere in the neighborhood of 1% or 2% (which would have been historically typical), and is anticipated to double based on NODs, then the expected total rate of default will rise to between 2% and 4%. If defaults peak in this range, then portfolios of mortgages will still be worth 75 to 80 cents on the dollar, not the 25 to 30 cents the market values them at today.

Most banks will be able to “ride out” a 2% to 5% rate of default in either commercial or residential mortgages, especially with generous amounts of cheap cash available from the Fed to shore up balance sheets.

In short, everybody has an interest in “staying put” for as long as possible, then capitalizing their losses after the panic subsides. This includes property owners. If the “results” from Wells Fargo are representative – even if they were goosed by new leniency in mark-to-market accounting – it is a sign that the middle-ground bailout and TARP strategy adopted by the Administration is working, It may involve a bit of “accounting magic,” but doesn’t all banking? And in the circumstances, the pessimism that dominates the zeitgeist may in hindsight come to be seen as hysterial (in every sense of the word) as yesterday’s notion that no investment is as safe as real estate.

There’s another trend to look out for. Banks and other financial market makers understand that the current under-valuation of residential and commercial real estate, and the even greater discounts of mortgage portfolios, is the best opportunity for profit they’ve seen in years. They don’t want to partner with other investors or the government, or sell out their interests at all, if they don’t have to. Conditions have been created in which, if they can weather the storm, there is a quick, profitable path to a major windfall.

The bling at the end of the rainbow for many of these institutions is going to turn out to be the very same mortgage-backed securities and collateral debt obligations that got us into the crisis in the first place. When they finally do start trading, they are going to trade significantly below their true long-term asset values. And the smart money is going to snap them up. The Administration is right in limiting the government’s upside potential in all of this, because in the end there is going to be a backlash that buyers and the government took advantage of the original holders of these instruments, and underpaid for them. Put that in your pipe and smoke it, Mr. Roubini.