The Storm Intensifies

published 8 August 2008

No corner of the market has been more decisively beaten up than financial-services companies. Shares of financial titans with once-unassailable franchises have been cut to pieces right along with those of marginal and niche players.

Citigroup shares are down 67% in the past year. Merrill Lynch shares are off 64%. American International Group has seen its stock dive 63%. Their performances shine, however, compared with high-profile collapses of such companies as bond insurers MBIA and Ambac, investment bank Bear Stearns (since bought out by JPMorgan Chase) and mortgage company Countrywide Financial (bought by Bank of America in a deal likely to go down as one of the most ill-conceived and costly acquisitions of all time).

As uncomfortable as plunging stock prices can be, today's market should also be viewed as fertile ground for opportunity. When pessimism and fear rule, bargains are created that sow the seeds of future investment success. Strange as it may sound, for us, the excitement in hard times -- when stocks of great companies get cheap enough to buy -- often beats the rush in good times when existing holdings hit new highs. We describe the feeling of buying supercheap stocks as "trembling with greed."

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Before describing our rationale, we should point out that we seldom try to forecast macro-economic developments. They're exceedingly difficult to predict. Our time is more productively spent focusing on bottom-up analyses of individual companies' prospects. We also believe that the U.S. economy is resilient and will continue to grow over time, so for the long term we're bulls on America. We simply think it's too early to turn bullish on the financial sector.

To assess the prospects for financial companies, you must carefully analyze the ongoing collapse of the housing and credit bubbles. If the worst is over, then mortgage-related exposure on balance sheets will cease to be the ticking time bomb it has proven to be of late. At the same time, wider availability of credit will spark economic activity that will allow banks and others to start rebuilding their revenues and profits.

Amherst Securities Group, based in Austin, Tex., maintains an extensive database on every mortgage securitized in the U.S. during this decade, and its data tells a frightening story: Mortgage-lending standards became progressively lax starting in 2000 but really fell off a cliff beginning in early 2005, led by the unprecedented writing of subprime loans with two-year "teaser" rates. Sure enough, the holders of the loans made in early 2005 started to default in high numbers two years later, in the first quarter of 2007 -- which, not coincidentally, was the start of the current turmoil in credit markets.

The crisis continued to worsen in 2007, as even lower-quality loans made over the remainder of 2005 reset, triggering more and more defaults. Because it takes an average of 15 months from the date of a homeowner's first missed mortgage payment to get to a liquidation by sale or auction of the home, we're only now seeing the first round of foreclosures and auctions from loans written in early 2005. Given that lending standards got much worse in late 2005, continuing through the first half of 2007, the wave of defaults leading to forced home sales is in its early stages.

Worse yet, the mortgage crisis is morphing from a problem driven by a relatively small number of low-income and poor-credit-quality borrowers defaulting on loans they can't pay to one fueled by a much larger number of prime borrowers who won't pay, even if they can afford to, because their homes are now worth so much less than their mortgages. In particular, homeowners with option ARMs who have been making the minimum payment for up to five years while their loan balances have increased are more likely to walk away.

As millions of homes are repossessed by lenders, the impact on housing prices (not to mention families and neighborhoods) will continue to be devastating. While homeowners can (and do) take their home off the market if they can't sell it for the price they want, lenders are a different matter. When they foreclose on a home, they usually seek to monetize it as quickly as possible, generally via an auction, which results in a true market-clearing price. This can lead to a vicious cycle: As housing prices continue to fall, more and more homeowners are pushed underwater (meaning their mortgage is greater than the value of the home), and even those who are creditworthy default, pushing down housing prices even further.

Amherst Securities' data shows that the wave of foreclosures and auctions will build massively this year and peak in 2009 and 2010. Needless to say, the accompanying decline in housing prices will have a strongly negative impact on household wealth and will weigh heavily on consumer spending. While that picture may not be pretty for any domestic, consumer-focused business, it's particularly harrowing for most financial firms.

With the shares of so many financial companies down so far, the market clearly isn't oblivious to the dangers ahead. In fact, many of the best short-sale opportunities in the sector have likely passed. But it's a far cry to then conclude that buying opportunities abound. As David Einhorn, of the hedge-fund firm Greenlight Capital, commented last November when asked whether it was time to start bottom-fishing among financial stocks, "You don't have to be a hero." We couldn't agree more.

That said, there are surely some babies that have been thrown out with the bath water, providing opportunities today for courageous and clever investors. One financial powerhouse in that category is American Express (symbol AXP), the world's largest issuer of charge and credit cards as measured by purchase volume. Its 86 million cards generate about $650 billion of annual spending. It targets high-end customers who spend four to five times as much with their cards as Visa and MasterCard customers do. Because it has such attractive cardholders, Amex can charge merchants higher fees, much of which it then spends on rewards and services for cardholders. That helps attract and retain the best customers, creating a self-reinforcing virtuous circle.

Amex happens to be one of the world's great companies, with huge global growth opportunities that competitors cannot duplicate. That translates into high margins and returns on equity approaching 40%. And the business has gotten better over time as Amex has divested noncore and low-return businesses, resulting in a pure-play payments company that's both a card issuer and a rapidly growing network that issues co-branded cards with other banks, particularly in foreign markets.

For the past 20 years, Amex shares have traded at an average of 21 times earnings. But shares have tumbled from more than $65 a year ago to less than $40 and were recently trading for less than 12 times 2008 earnings estimates, their lowest valuation level since the early 1990s. No doubt Amex will have further charge-offs in its credit-card portfolio, but it has the financial strength to weather the storm, and its long-term franchise is intact and growing in value. That bodes well for buyers to be well rewarded over time.

What might send a signal that the worst is over for financials? One sign would be the bankruptcy filing of a major U.S. bank, an unfortunate but historically common occurrence during credit-market busts. In that regard, IndyMac Bank is too small a fish. Another sign would be a significant new investment in the sector by Warren Buffett. The fact that he has shunned new financial investments so far indicates that he also believes there's more pain to come.

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