Last year when many wondered if the US financial system would
survive the worst crisis in recent memory, we spoke with Anton
Schutz about his outlook for the sector. Most of his calls panned
out in the interve
ning 13 months; now that the banking system has returned to some
semblance of normality, we checked back with the manager of
Burnham Financial Services
(
BURKX
) and Burnham Financial Industries (
BURFX
) to get his take on what's next.
Most of the nation's major banks posted strong earnings in
the third quarter. Is the wind at their backs, or do problems
lurk on the horizon?
Capital markets have improved but remain fragile. Credit spreads
have come in and equities have appreciated, though stocks have
benefited from the weaker US dollar. It feels good that the market
is up, but it's up because of something that isn't good.
Banks have worked through some of the issues, but there's more
pain to come. Although residential real estate has stabilized,
commercial real estate is still a major issue.
Banks also face regulatory challenges. New rules likely will
require banks to hold more capital and impose limits on what
percentages of their capital can be allocated to certain business
lines.
Are banks going to be less profitable because of these rules?
Yes and no. Some investors think banks will become similar to
utilities, but they overlook that the basic banking model is more
profitable today than it was over the previous decade.
Banks no longer face insane competition from Wall Street and the
conduits that would lend at any cost because they were selling off
the risk. Today banks are getting spreads and are pulling in
covenants and guarantees. The deposit side of the industry is also
strong.
The last time we spoke you were particularly bullish on
community banks. Has the rash of failures over the past year
changed that?
I'm still of the same belief. It's helped that community banks
have re-priced their loans higher, but you have to be an astute
stock-picker because certain geographies remain under severe
pressure.
But there's still good news in these challenged areas because
the Federal Deposit Insurance Corp (
FDIC
) is making it very palatable for the healthier names to buy the
sicker ones. From loss-sharing agreements to giving away deposits
for virtually nothing, the FDIC is setting up deals that are
terrifically accretive for acquirers. Well-capitalized institutions
are going to survive and have a real chance to shine.
You still hold a number of mortgage real estate investment
trusts (REITs) in your portfolios, but the names have changed
since we last spoke. What's the logic behind these moves?
The names I held a year ago were the ones that spurned credit
risk. They used leverage to buy agency paper and benefited from a
steep yield curve and the benevolent policies of the Federal
Reserve. But rates can't go any lower, and funding costs will go up
once the Fed changes course. At the same time, if mortgage rates
come down and a wave of refinancing ensues, these trusts will lose
some assets to prepayment. Because these assets are trading above
par, these REITs could take a pretty good punch to the face.
Conversely, mortgage REITs that are credit sensitive will
benefit from refinancing because they're buying assets that aren't
as strong--the ones that people are dumping at cheap prices. These
guys are buying mortgages at 50 or 60 cents on the dollar; if the
borrower refinances, they get 100 cents on the dollar. And the
values of these distressed assets continue to go up as credit
spreads come in.
Companies like
Invesco Mortgage Capital
(
IVR
) and
PennyMac Mortgage Investment Trust (
NYSE: PMT) are taking advantage of the government's Public-Private
Investment Program. PennyMac is following a servicing model, buying
scratch-and-dent mortgages and working hard to restructure
them.
You also have what appear to be a few private-equity
outfits in your portfolios. Aren't those risky plays in these
markets?
Capital Acquisition Corp
(
CLA
) is about to go from being a special-purpose acquisition company
to a mortgage REIT in the vein of
Chimera Investment Corp
(
CIM
) or
Redwood Trust
(
RWT
). I'm buying the stock basically at book value, whereas the other
names trade at a premium. That play is a value manager's way of
getting into an attractive asset class.
The other one, Global Comsumer Acquisition Corp, actually closed
its deal and is now
Western Liberty Bancorp
(
WLBC
). The company has a bank charter coming and agreements to buy a
couple of banks in Nevada. It will use its excess capital to
participate in FDIC-facilitated acquisitions. Once Western Liberty
gets its first couple of deals on the table, the stock should
garner more attention.
A lot of names appear to be overvalued. Has that narrowed
your investment options?
Some of the biggest names appear to be overvalued, but the best
smaller names offer lots of upside.
That being said,
Bank of America
(
BAC
) still has 100 percent upside. I think the stock could trade above
$30. A normalized earnings run rate could be in the $3.00 to $3.50
range--if you put a ten multiple on it, there you go.
Some daunting challenges are keeping the stock at $17, but it
should pull through.
The bank's capital ratios grew last quarter, and the management
issues will be resolved--from Bryan Moynihan [current president of
consumer banking] to Alvaro de Molina [former chief executive
officer], there's a number of good candidates. Bank of America's
huge market share and leadership in a number of businesses
eventually will translate into higher prices. The Merrill Lynch and
Countrywide franchises are performing well, but the company still
has to work through credit issues in its consumer and credit card
portfolios.
Are there any nooks and crannies in the financial sector
that look attractive?
I spend the most time looking for potential mergers and
acquisitions. But you don't want the targets--the targets are
sick.
If you sift through all of the secondary offerings, most banks
are raising capital for two reasons. In some instances, these are
defensive moves to shore up leaky balance sheets, but most are
raising excess capital to go on the offensive.
1st United Bancorp
(
FUBC
) down in Florida-based is one example. I don't like the symbol,
but I like management a lot. The stock traded on the pink sheets as
recently as two months ago and had a $40 million market cap. But
management leveraged its reputation to raise $70 million, much of
which will be used to buy broken banks in Florida. The bank will
add tremendous value with each incremental transaction it
makes.
CenterState Banks
(
CSFL
) is another Florida bank on my radar. Like 1st United, it's raised
a bunch of money and is looking for distressed acquisitions in its
own backyard. FDIC-assisted deals not only raise earnings power,
but they also raise book value and are accretive transactions. In
these deals the acquirer takes the good with the bad, but the bad
isn't that bad when the FDIC shares the losses.
What's your best advice for the next twelve months?
Financial stocks should generate phenomenal returns over the
next three to five years because of the restructuring that's
underway.
The biggest names have already priced in a lot of good news, but
at these levels you should still be able to make a 100 percent
return on Bank of America's stock and a 50 percent return on
JP Morgan Chase
(
JPM
). I see even more upside in the smaller names that survive.
That being said, it will take patience to take advantage of
these opportunities, and you still have to approach the group with
a high degree of selectivity--an exchange-traded fund or other
blanket approach isn't the way to go. The nation's largest
institutions have survived, but a lot of smaller names won't make
it. Failures will definitely number in the hundreds. There's a lot
of risk out there, and you've got to know what you're doing. You
can buy a fund like mine or focus on companies that have raised
offensive capital.
