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Broyhill Letter (Q2-08)

Broyhill Letter (Q2-08)

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Published by: Broyhill Asset Management on Feb 03, 2013
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07/17/2013

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COMMITTED INVESTORS ALONGSIDE YOU

S E C O N D Q U A RT E R 2 0 0 8

THE BROYHILL LETTER
In a few years, we shall look back at this time as one that redefined the landscape of the US financial 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 1980’s 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 investment world. The past 28 years of financial market deregulation has unmistakably begun to reverse. Something has changed, and changed materially. Consequently, the tide is now flowing 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 aren’t keeping up with the proportion of loans that are actually going bad. The industry’s 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 we’ve observed to date.

Office 828-758-6100 PO Box 500

Fax 828-758-8919

To l l F r e e 8 8 8 - 8 1 8 - 4 4 5 5 w w w. b r o y h i l l a s s e t . c o m

800 Golfview Park

L e n o i r, N C 2 8 6 4 5

COMMITTED INVESTORS ALONGSIDE YOU

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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-value accounting 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.

Office 828-758-6100 PO Box 500

Fax 828-758-8919

To l l F r e e 8 8 8 - 8 1 8 - 4 4 5 5 w w w. b r o y h i l l a s s e t . c o m

800 Golfview Park

L e n o i r, N C 2 8 6 4 5

COMMITTED INVESTORS ALONGSIDE YOU

S E C O N D Q U A RT E R 2 0 0 8

Where to from Here
This argues for using a higher discount rate on the expected future earnings of financials, 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, today’s 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. Energy’s weight in the S&P 500 tumbled from 31% in November 1980 to 15% in December 1983 – a 16 point drop over three years. Technology’s 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 government’s 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
Office 828-758-6100 PO Box 500 Fax 828-758-8919 To l l F r e e 8 8 8 - 8 1 8 - 4 4 5 5 w w w. b r o y h i l l a s s e t . c o m

800 Golfview Park

L e n o i r, N C 2 8 6 4 5

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