Banks Keep Failing, No End in Sight; Good Opportunity for Biggest/Strongest

The largest number of bank failures in two decades has added to job losses, dried up lending and left surviving banks with less competition and more pricing power.

Nearly 300 banks have failed in the past two years, since Sept. 25, 2008, when Washington Mutual became the biggest bank failure on record. WaMu's seizure eclipsed the failure of Continental Illinois in 1984; WaMu has seven times Continental Illinois' assets. 25 banks failed in 2008, another 140 in 2009 and 129 so far in 2010. Fewer than 40 banks failed in the preceding six years. There are now 829 banks on the FDIC's "problem list", up from 702 at the beginning of the year.

In a recent report, the Congressional Oversight Panel on TARP indicated that the number of U.S. banks could fall to 5,000, from about 8,000 today, over the next decade as a result of seizures and failures. In the short-term, the contraction threatens banks' capital, lending to businesses and the overall economy. In the longer-term, though, the consolidation could serve to cleanse the banking industry and result in a healthier financial sector since many of the failed banks are relative newcomers which grew too fast and made loans that are now seen as excessively risky.

The poster child was the 9-branch bank of Imperial Capital Bancorp, in our backyard of La Jolla, CA. Imperial, which specialized in real estate lending, stretched beyond its home market and lent nationwide. The bank doubled its assets to $4.1 billion from 2003-2008, according to an FDIC report. Then, Imperial purchased $826 million of mortgage-backed securities. When it was seized in 2009, real estate accounted for more than 95% of its loans, compared to less than 35% for its peers.

Many analysts believe the impact to the financial system from the current crisis has been far greater than the S&L crisis of the late '80s-early '90s. Not only have government rescue measures been far more sweeping this time, the weakness in homebuilding and commercial real estate has continued to dampen economic growth.

[Editor's Note: While there may be better investment opportunities for financial institutions in the months ahead, it's interesting to note that some of the largest financial institutions are trading at generational low price-to-earnings ratios and multiples to book value. And, they're likely to benefit from FDIC seizures of their smaller brethren and consolidation in the banking industry. Bears would argue that earnings may be poised for a further decline and book values may be misleading if large write-offs are ahead. It's pretty clear that Washington has brought the largest U.S. financial institutions "inside the tent."  Long-run, investments in mega-banks like Bank of America (P/E of 26.4 and .63x book value), Wells Fargo (P/E of 10.4 and 1.22x book value) and investment bank Morgan Stanley (P/E of  13.1 and .87x book value) may prove lucrative.]

"Junk" Debt Defaults Near Pre-Crisis Low

Corporate debt-default rates are expected to fall to the levels prior to the financial crisis of September, 2008, good news for the most troubled U.S. companies and their lenders.

Moody's expects the U.S. default rate to fall below 3% by December, a stunning drop from the 14.6% peak of November, 2009 and below the default rate of 3.1% from August, 2008, the height of the financial crisis. "The rebound is breathtaking," said David Keisman, a Moody's senior vice president.

The measure reflects the percentage of companies with "junk" credit ratings that failed to meet debt obligations during the trailing 12-months. The rate's stunning decline suggests the corporate bloodletting following the collapse of major financial institutions like Lehman Brothers, AIG and Fannie Mae may have peaked and are heading in a positive direction. If it continues, that should be a boon for hiring and - at some point - help bring down nation's record high unemployment rate.

The improvement is also visible in a new Moody's report profiling the "Bottom Rung," which tracks companies most in danger of debt defaults. At the peak, in June, 2009, 288 companies with Moody's ratings of BBB or lower were on the list; today, just 195 remain.

[Editor's Note: Historic low interest rates have clearly had an extraordinarily positive impact on "junk" default rates. While rates are likely headed lower still in the months ahead, many smart investors are betting on inflation and higher rates in the years ahead. That likely augers for higher (much higher?) default rates for weaker borrowers.]

Europe Debt Crisis Is Over, Declares Spanish Leader

Spain's Prime Minister, José Luis Rodríguez Zapatero, declared that the European debt crisis is over but said governments must work better together to prevent such events in the future. "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said in an interview with The Wall Street Journal in late September. Mr. Zapatero expects no contractions in Spain's GDP in coming quarters and offered a strong defense of Spain's economy and the austerity package he has pushed through Parliament. "Confidence has been restored," says Mr. Zapatero, particularly after the country released results of tests that evaluated the soundness of its banking system in July.

[Editor's Note: There are an estimated 2,000,000 unsold homes in Spain.]

Las Vegas Faces Deepest Downturn Since 1940s

Many cities - including Houston, Denver and Seattle - are seeing signs of a rebound from the worst recession since the Great Depression. No such luck for Las Vegas.

The nation's playground is crushed under a perfect storm of economic forces that has sent Vegas into its worst slump since east coast mobsters first began building casinos in the Nevada desert in the 1940s. While Las Vegas officials and hoteliers remain hopeful that gambling and lodging revenues will rebound with the nation's economy, experts project that it will not be enough to offset even bigger pressures brought on by this recession - the collapse of the construction industry, the city's other main economic support.

Las Vegas' unemployment rate is now 14.7%, the highest of the nation's largest cities and a nearly four-fold increase from the 3.8% rate of ten years ago. Nevada also leads the nation in housing foreclosures - for the 44th consecutive month.

While Las Vegas Mayor Oscar Goodman remains "very bullish on our future," he notes that the present is not so rosy. According to Goodman, "Our daily room rate average is not what it was. Our hotel room rates are bargains now. People aren't spending on gambling as they have in the past. Ordinarily, Las Vegas was the last to go into a recession and the first to come out. This one is different."

[Editor's Note: Pathfinder has underwritten dozens of potential investment opportunities in Las Vegas over the past several years. We've not been able to make any of these deals pencil - even at acquisition prices of 20-30% of peak values. To date, we've made precisely zero investments in Las Vegas and are more concerned about the market - because of the sky-high unemployment and foreclosure rates, large housing inventories and massive losses of population - with each passing month.]

On Consumer Credit and Consumer Spending Trends

Retailers have been expanding at a frenetic pace for years. A parsing of the data suggests that much of their optimism is based on historical consumer spending, much of which has been driven by consumers' insatiable appetite for credit - until now.

Consumer credit grew from about $1.5 trillion in 2000 to $2.4 trillion in 2010 - a 60% increase. During this same decade, Target grew its store count 75%, from about 1,000 to 1,750. Lowe's grew from 600 to 1,700 stores - a 183% increase. And Kohl's grew its store count by 250%, from 300 to 1,050. Even giant Wal-Mart more than doubled its stores, from 4,000 to 8,500.

To retailers, same-store sales growth is the Holy Grail, which tells the story of how productive those new stores are and whether they're cannibalizing the pre-existing store base. In Target's case, the company has 340 more stores than five years ago, $12 billion in additional sales and virtually the same profit. Kohl's fared even worse with 240 more stores than in 2005, $1.6 billion in additional sales and $100 million less in profit. Lowe's brought up the rear - 500 more stores than in 2005, $4 billion in additional sales and $1 billion less profit. Wal-Mart kept the profits flowing, due to its aggressive international expansion.  

  
Why the downward profit (and same-store sales) trends? The American consumer is deeply in debt. Much of the retail spending during the past decade was driven by mortgage equity withdrawals. Using your home as an ATM today - fuggedaboutit. There are about 15 million unemployed Americans. Home equity is at an all-time low and about one-fourth of homeowners are under water. Yet, consumer spending still accounts for 70% of GDP. To return to equilibrium in the new era, consumer spending likely needs to return to 65% of GDP, which would require an annual reduction in consumer spending of about $800 billion. Target, Lowe's, Kohl's and other large retailers (and many other consumer-based businesses) are only now coming to grips with the implications of these massive forces on their businesses in the years ahead.

At Current Pace, Special Servicers Have 13-Year Supply of Workouts

We're indebted to the folks at KCV Capital, who parsed through the August special servicing data and made several interesting observations:

• Loans in special servicing increased to $90.8 billion - 248 loans with a balance of $5.2 billion were transferred to special servicing in August. About $3.2 billion, or 61% of the loans were issued in 2007. Approximately 11.7% of all outstanding CMBS loans are now in special servicing.

• Special servicers liquidated 95 loans with an original balance of $583 million - This is a sharp drop from the July level - 200 loans with a balance of $1.0 billion. The total loss in September was $354 million, or 61%. Year-to-date, 839 loans with an original balance of $5.0 billion have been liquidated with losses of $2.2 billion, or 44%.

• Large (over $10 million) loans were liquidated at a loss rate of 69% - 17 large balance loans with a combined balance of $334 million were liquidated with a loss of $230 million, or 69%. Another 78 small balance (below $10 million) loans with a combined balance of $249 million were liquidated with a loss of $124 million, or 50%.

• At the current pace, there is almost a 13 year supply of workouts - Dividing the total amount of loans in special servicing ($90.8 billion) by the August loan liquidations ($583 million), indicates it would take another 155.7 months, or almost 13 years to work through all of the loans.

[Editor's Note: Our special servicer and receiver friends report that they're busier and busier with each passing quarter.]

"Canada's Warren Buffet" Betting on Deflation

Fairfax Financial Holdings, Ltd., a Canadian insurance company, has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an indicator of inflation. The hedge could generate huge profits if deflation occurs.

Fairfax purchased some derivatives in the first quarter of 2010 when deflation wasn't on most radar screens and the cost of such protection was cheap. The insurer added to its position in the second quarter and the value of the derivatives is now up 50%. The derivatives are meant to protect Fairfax's $22 billion investment portfolio.

Paul Rivett, Chief Operating Officer for Fairfax's Investments department, says "We are extremely concerned about a double dip in the economy and about a deflationary environment." Fairfax was founded in 1985 by Prem Watsa, who has been called Canada's Warren Buffett. The company's stock price has quadrupled, from C$100 to more than C$400 in the past four years. Fairfax believes U.S. households have just begun reducing borrowing and increasing savings, which they expect will lead to lower spending, higher unemployment and deflation.

[Editor's Note: We've been squarely in the deflation camp for many months and expect the trend to continue as the Fed follows its quest to drive down long-term interest rates. At the end of the day, though, it's hard to imagine we won't have to pay the piper for such profligate spending, which means inflation at some point down the road.]

Toll Brothers in Black for First Time in Nearly Three Years

After a very rough few years, luxury homebuilder Toll Brothers, Inc. posted its first quarterly profit since 2007 in the quarter ended July 31. Toll earned $27.3 million ($.16/share), compared with a loss of $472 million (-$2.93/share) for the same quarter in 2009. Gross margin rose 3.5 percentage points on a 1.6% drop in revenue. The results surprised Wall Street, where analysts had expected a -$.14/share loss for the quarter.

QE2: How to Play it

The Federal Reserve has been actively engaged in quantitative easing - the process by which the Fed buys massive quantities of bonds to drive down interest rates with the aim of preventing the economy from unraveling - since last year. Now, news reports abound about a second round of quantitative easing - QE2 - this fall. The bond market's big rally over the past several weeks signals that investors are convinced that QE2 is a done deal. In-the-know friends are calling for the yield on the 10-year Treasury bond to fall to 2.00% from its recent level of 2.33% (and 3.01% just 12 weeks ago) by year-end. More than 70% of institutional fixed-income investors polled recently by Jefferies & Co. expect the Fed to announce more QE at its Nov. 3 Federal Open Market Committee meeting. The idea is that it would further reduce borrowing costs, particularly mortgage rates and help spur economic growth.

QE2 - estimated at $500 billion to $1 trillion - would dwarf the $300 billion in Treasuries the Fed bought during QE1 in 2009. Lower rates would mean more pain for savers and those on fixed incomes, hurt the value of the dollar and spark inflation fears. It could, however, generate renewed interest in Treasury Inflation-Protected Securities (TIPS); prices have been climbing steadily for two months.

[Editor's Note: A recent piece in David Rosenberg's "Breakfast with Dave"  caught our eye. "Rosie" is the Chief Economist for Canadian wealth management firm Gluskin Sheff. He points out that since 1999, the yield on the two-year Treasury Note and the S&P 500 stock price index have had a 75% positive correlation; when one goes up, the other follows, and vice versa, 75% of the time. He notes a massive divergence since late 2008 - with the two-year yield heading south and the S&P 500 index rising about 70% - during that time. He thinks that's unsustainable and something has to give. We think Dave's on to something.]

Faulty-Foreclosures Spur Moratoriums, Mayhem