Target Rich

Would you want to run a big bank? It could be bad for your health.

The recent downturn has been brutal on bank chiefs. Pay and promotions have been politicized, and the government has shown a need to “get tough.”. Ken Lewis of Bank of America is an easy mark. He makes a $1.5 million in salary, and oversees billions in bonuses while taking $45 billion in government bailout money.

But banking has never been popular. When you can’t afford a Rolex watch, you don’t complain about how unfair it is that they won’t cut the price for you. But when the bank denies you a loan, it seems so unfair. And they still ask for your deposits!

So it came as a surprise that Lewis and his Board were reelected yesterday. Still, that doesn’t mean he’s home free. If the politicians get exercised, Ken Lewis may have to pay a visit to former GM chief Rick Wagoner. Because in an era of intervention, the air we breathe is political.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Too Much Too Late

The economy is looking up. So what’s up with the big banks.

With the economy gaining some traction one would think that the big banks would be out of the woods. But not yet, according to some. The Wall Street Journal noted that as a result of the Treasury’s tests Citibank and Bank of America each need to raise billions in capital. The banks are disputing these findings, arguing that their capital base is strong. But the market doesn’t seem to agree, with Citi’s and Bank of America’s stock trading off.

While the specific outcome of this debate is up in the air, one thing is certain: change is coming. The old days of using corporate checking accounts to fund mega-investments in wacky securities is over. While a modern financial system needs default swaps and securitization, we’re delivering now even as the economy recovers. Ten years from now our most levered institutions may not even be recognizable.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Bay of Pigs

Just what the economy doesn’t need: a major health threat.

So far, the swine-flu outbreak has been fairly mild, with about 1600 cases reported in Mexico, but spring-break trips may have transported the virus to the US, Israel, and even New Zealand.

Last year a World Bank report claimed that a pandemic could cost the global economy $3 trillion and could trim 5% from global growth. For what it’s worth, the IMF predicts a 1% economic decline this year. A 6% global decline would be a disaster.

While it’s likely that the IMF report is too gloomy, a global pandemic would certainly hurt. So what are its chances? Health-care surveillance has advanced tremendously in recent years, especially in light of the bird-flu dress-rehearsal of a couple years ago. My Impression is that our health-preparedness is good. But that does preclude a “Bay-of-Pigs” like problem.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Lake Wobegon Banking

In Garrison Keillor’s Lake Wobegon, all the women are strong, all the men are good looking, and all the children are above average.

Well, now we have Lake Wobegon banking, where all the banks pass the government’s stress test, no matter how poorly capitalized they are. Banking is a funny business: by gathering small deposits and making larger loans, the system places capital where it can be used productively. But when a herd-mentality takes over, the banker’s emphasis on character, capital, and cashflow can get overwhelmed in a tsunami of conditions.

That’s what happened in the early ’90s, and that’s what’s happening now. Seemingly rational lenders, borrowers, and insurers went collectively insane, betting the world’s financial system on NINJA mortgages. Well the bill has come due, and someone has to support the financial system, at least temporarily. There is no alternative, unless we want to see mega bank failures.

The genius of Lake Wobegon was how the honest work of ordinary Americans built a remarkable, welcoming culture. The irony of Lake Wobegon banking is how the greed of a few could threaten this healthy culture for millions.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Gentleman

Many people are trying to understand Secretary Geithner. The answer is in the text.

He grew up overseas and went to high school in Bangkok. He focused on Asian Studies at Dartmouth and Johns Hopkins, and speaks Chinese and Japanese. He worked for the State Department in Tokyo, and was Bob Rubin’s point man on the Asian Financial Crisis of the late `90s. In sum, Mr. Geithner has been a student of the East.

And what do we learn from this? In the heart of The Analects, Confucius notes: “In his dealings with the world, a gentleman is not for or against anything. He is on the side of what is moral.” Tim Geithner’s tenure at Treasury will be pragmatic, non-idealogical, and adaptive. The Confucian ideal is not leadership, but analysis.

So what should we expect? Continual conflict with a partisan Congress that’s looking for a grand plan. Geithner will give them piecemeal approaches to specific problems and will adjust as circumstances change. Will it work? Beats me. But I think we can bank on a rough ride.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Alice Through the Accounting Glass

This market gets curiouser and cursiouser.

In its last earnings report, Citigroup noted a $2.5 billion credit due to the fact that their debt is cheaper. In mark-to-market terms, they discounted their debt, and so recorded a profit. On the other hand, Morgan Stanley’s credit quality improved, so they had to record a $200 million charge. So Citi is profitable because their credit is worse, and Morgan lost money because their credit is better. As Dave Barry would say, I am not making this up.

This illustrates why the whole concept of mark-to-market has to be carefully re-thought. Sure, if Citi could buy back all their debt at discounted levels they could record a profit. But they can’t, so why should we pretend that they can? The real question is: “What is Citi’s value as a going concern?” Everything else just gets in the way of this analysis.

There are a lot of regulators who never made a loan passing judgment on banks and a lot of accountants who never had to manage a portfolio. There is no substitute for real-world experience. Let’s hope that our latest experience will make us all more realistic.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Next Shoe

So what’s the next shoe to drop? In my opinion, it’s commercial mortgages.

Residential mortgages are loans you take to buy your home. Commercial mortgages are loans that a developer takes to buy a commercial building. Commercial real-estate is a lot different than residential property. For one thing, it’s tied a lot closer to the economy. For another, high-end marquis properties like big-city skyscrapers usually hold their value.

Until now. Recently Boston’s John Hancock Center went through a bankruptcy auction and sold for $660 million. That’s about half the value it went for 36 months earlier. In the mean time we’ve had an economic crunch in finance-a major part of Boston’s economy. That’s created vacancies in downtown office buildings, which has pushed down their value.

Add all this up and we’re not out of the woods yet. That’s what the market has been saying the past couple days. During the first quarter the banks proved that zero interest on deposits and 4% on loans means they can rake in earnings. Let’s hope they can earn enough to stay ahead of the curve.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Newsprint Market

Yesterday I noted how a government program is depressing the newsprint market. But wait, there’s more.

Abitibi-Bowater is the largest maker of newsprint in the world. They also happen to be in bankruptcy. In 2007 the two paper behemoths joined forces and dominated their industry. After a host of sales and spin-offs, slumping demand and weak prices left the company unable to service its debt. So it sought to negotiate swap with its lenders.

Here’s where it gets interesting. Negotiations are pretty standard when conditions change. Often the existing shareholders usually get diluted and the lenders control the company. Not a great situation, but avoiding court is usually faster and cheaper.

But not this time. Many lenders have purchased default protection on Abitibi. So someone else will make good on Abitibi’s debt if they have to file for bankruptcy. This makes some sense, but now the lenders have no incentive to keep them out of court. Shoot, it’s in their interest to give them a push, where the big winners are often the lawyers.

So we have a government program and credit derivatives combining to push an industry giant into bankruptcy. Can we just call for a do-over?

Douglas R. Tengdin, CFA
Chief Investment Officer
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Unintended Consequences 201

Grrr. Is there anything that the government can’t mess up?

In an effort to encourage the use of bio-fuels, the IRS is paying paper mills almost $10 billion to burn a wood by-product that they already were using to generate their own electricity. Now they run their mills flat-out to maximize the benefit, in spite of depressed pulp prices. With losses mounting and the industry in crisis, the bio-fuel subsidy has acquired a life of its own, supporting the paper industry and thousands of jobs.

It reminds me of a story from the former Soviet Union: Cotton farmers in Central Asia used so much water from around the Aral Sea that the shoreline receded hundreds of miles. Problem was, there were fish-processing plants on the shore. So to save jobs the government flew fish thousands of miles from the Baltic Sea to be processed near the Afghan border.

At the time, I thought, I’m sure glad I live in an open economy where the government doesn’t do such economically stupid things. Uh huh. Milton Friedman once said that most government programs are designed to fix errors caused by government mismanagement. He sure got that one right.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Confidence Game

Can animal spirits revive the economy?

That’s what many claim. They note before that consumers start to spend again, they’ll need to have confidence in their personal finances. By this reckoning, what’s needed is a massive infusion of cash into consumer’s pockets. Extra cash will encourage extra spending, which will get the economy back on track.

But that’s putting the cart before the horse. Confidence isn’t bolstered by a handout or some temporary make-work job. It’s encouraged by permanent, productive employment-where your skills are put to work and you can see that you make a difference. Real confidence doesn’t come from putting humpty-dumpty back together again. It comes from serving or healing or making things faster, better, and cheaper than ever before.

The result is a stable wage and assurance that your income can grow. This kind of “animal spirit” will revive the economy. But it doesn’t come from free money or happy talk. It comes from rolling up our sleeves and getting to work.

Douglas R. Tengdin, CFA
Chief Investment Officer
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