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Some investment ideas simply belong in the “too hard” pile. For the past few months I’ve been wondering if the American banking sector isn’t one of those things. It isn’t that I don’t have experience with financial institutions and can’t understand them. In fact, I spent over a decade in the finance department of an institution that is engaged in residential mortgage lending. That experience, however, doesn’t make me more comfortable investing in banks. It makes me less comfortable.

A residential mortgage lender is in a high-volume, relatively low-dollar-per-transaction business. In order to put together a multibillion-dollar residential mortgage portfolio a lending institution needs to have a very decentralized structure with a lot of employees in different locations lending money. That means that there are a lot of decisions on who to lend money to being made every day by a lot of different people. Decisions on who to lend to isn’t directly controlled by the top executives of the lending institution, the decisions are controlled by the system of internal controls that the top executives have put in place.

And that reliance on a system of internal controls is what scares me. Because if you are relying on such a system, at the end of the day that system is still only as good as the people using it. The chief financial officer of a bank really doesn’t know the quality of the loans the manager of branch 5 in sector A is making. The CFO can only rely on the idea that the manager of branch 5 of sector A is adhering to the appropriate lending procedures. The problem with this reliance on controls is that poor lending decisions only show up after the fact, through delinquency statistics. Poor decisions on collateral accepted for loans will only show up if that collateral is called on. By the time the poor decisions show up, the damage is already done.

Now I have no doubt that the vast majority (in normal times) of loans are made in adherence with any bank’s lending policies. What concerns me is that when you are a financial institution leveraged 20 to 1 it only takes a tiny percentage of loans to be a problem in order to wipe out a big percentage of shareholder capital.

Am I being too dramatic? Yes, I think I likely am. Especially at this point in the banking cycle.

The banking business goes through moronic cycles of boom and bust. After a bust, lending standards are priority number one. Everyone is afraid to lend, and when loans are advanced, they are to creditworthy borrowers with ample collateral. The further out from a bust we get, the less the focus is on lending standards and not losing money lending, and instead moves to growing earnings and market share. At some point in the cycle, lending gets sloppy again, the dangers of being a leveraged financial institution forgotten, and eventually another banking sector blow-up occurs.

A pretty simple investing formula thus becomes: buy the banks that have survived immediately after a blow-up, when everyone hates them. Hold them for a few years until earnings and balance sheets recover. Then sell them when most investors are no longer afraid of the sector.

That formula seems to be exactly what Bruce Berkowitz of the Fairholme Funds and Warren Buffett are ascribing to. Both Berkowitz and Buffett bought into the banking sector in a large way in the early '90s after the last major banking collapse. Specifically, both made large investments in Wells Fargo (WFC) when the general consensus was that the California real estate collapse was going to destroy the company.

Now both investors are doing so again, with their headline investment being Bank of America (BAC). They buy when the banking sector is still covered with the wretched smell of the last disaster. They will sell when headlines improve and other investors lose their fear.

Another well-respected and risk-averse Canadian value investor named Francis Chou has also invested heavily in the American banking sector in the past year. Chou however has decided to try and amplify his returns by not simply investing in shares of Bank of America and other banks directly, but rather by investing in the warrants of these companies that were issued to the US Treasury during the TARP program.

When the US Treasury provided capital infusions to Bank of America, JPMorgan Chase (JPM), Wells Fargo and other American banks, those banks were forced to issue back to the Treasury as part of the transaction stock warrants that gives the holder the right to buy the stock at a specific price. When the various banks repaid the TARP funds, the Treasury either sold the stock warrants back to the banks, or sold them to the public.

As Chou explains in his 2010 semi-annual report, these TARP warrants are attractive for a number of reasons:

  1. They are long-dated, with most expiring in 2018 or 2019. This time frame of eight-plus years allows banks to grow their intrinsic value to a high enough level to have an appreciable impact on the strike price of the stock warrant.
  2. The strike price is adjusted downward for any quarterly dividend that exceeds a set price. Normally, you don't see that in a stock warrant. This is a truly stringent condition. In this case we should give the government credit for extracting a pound of flesh. An example: for Bank of America, class 'A' warrants, the strike price is adjusted downward for any quarterly dividend paid exceeding one cent a share.
  3. Many of the banks have excess capital on their balance sheets. When the economy settles down, we expect the banks to use this excess capital either for buybacks or a one-time special dividend that may reduce the strike price on the stock warrants if this provision applies.
  4. The concerns over financial reform and its ultimate impact on the earning power of the banks may be somewhat exaggerated. We believe the banks will most likely be able to pass the majority of the costs to customers. For an economy to flourish, we need sound financial institutions that can generate reasonable profits.
  5. Investing in financial institutions requires a leap of faith. Mind you, this leap of faith is no greater than those we make on any company's future prospects, its position in the industry and how well it will do in a future economy. Looking forward, as each year goes by, the quality of earnings of the banks should be higher, the books should be cleaner, the risks will be lower and management will be far more risk-averse. Too bad we had to go through so much turmoil to get there.

Here is a list of TARP warrants, their most recent price, their exercise price and the current underlying stock price for consideration:

Company

Warrant Price

Warrant Strike Price

Stock Price

Expiration Date

JP Morgan

$13.10

$42.42

$37.64

28-Oct-18

Capital One (COF)

$17.28

$42.13

$45.39

14-Nov-18

BofA, Class A

$4.09

$13.30

$8.22

16-Jan-19

PNC (PNC)

$9.01

$67.33

$49.31

31-Dec-18

Wells Fargo

$9.29

$34.01

$25.42

28-Oct-18

Comerica (CMA)

$6.00

$29.40

$25.22

14-Nov-18

Valley National

$1.74

$17.77

$11.76

14-Nov-18

I normally don’t like investing in warrants or options because I don’t like having a clock ticking on my investment idea. I can be 100% right, but if the market is too slow to realize it, I can lose my entire investment because of the expiry date. The dates on these warrants, however, are a long way out in the future, and by 2018 the world will be entirely different. If I was betting on banks, I think this is how I would do it.

I’ll be honest, having Buffett, Chou and Berkowitz all making significant investments in Bank of America is almost enough for me to follow, simply on the assumption that it is impossible for all three of these risk-averse investors to have made the same mistake. Perhaps it should be enough.

Source: Buffett, Berkowitz And Chou Can't All Be Wrong On The Banking Sector