Friday, May 08, 2009

Stress Test Done, Crisis Over; Buffett Wrong, Kass Right.

Fed Sees Up to $599 Billion in Bank Losses
Worst-Case Capital Shortfall of $75 Billion at 10 Banks Is Less Than Many Feared;
Some Shares Rise on Hopes Crisis is Easing

—The Wall Street Journal, May 8, 2009

Three weeks ago, in “Stress Test On, Crisis Over,” we here at NotMakingThisUp argued that the fact the government was finally getting around to “stress-testing” the health of the nation’s largest banks, at a time when banking fundamentals were starting to improve, meant that the crisis itself was over.

We summed up our admittedly cynical, but grounded-in-30-years-of-watching-The-Market view this way:

Putting it into a formula, we derive the following:

Improving Fundamental Outlook + Severe Government Reaction = Crisis Over.
And we think you can take that to the bank.

—NotMakingThisUp, April 17, 2009

Today, with the results of the Federal stress test in, and many financial stocks using the occasion to continue their recent rally, we think a greater and far more important voice than our tiny virtual speaker-phone could ever be—The Market itself—has made itself heard.

And we think The Market is saying, “Crisis over.”

Now, by what perverse logic has this come to pass, you may wonder? How, as Don Corleone would have asked, did things get so far—that bank stocks would actually rally on headlines that Federal authorities fear up to $599 billion in bank losses and a capital shortfall of $75 billion at the top 19 banks?


The Feds gave it their worst—for the moment, anyway—and that worst-case scenario proved to be not, as most investors had previously feared, widespread bank nationalization and more bank failures, but merely a new round of capital-raising that most of the banks in question appear capable of persuading The Market to handle.

In brief, the government has shown The Market its very worst case, and with that in mind, investors can now evaluate financial stocks they might want to own, without the sort of dreadful gnawing that some kind of unquantifiable black hole still lurks in the wings.

Which brings us to the headline of today’s piece.

What, exactly, did Warren Buffett get wrong, and Doug Kass get right?

Well, Buffett himself spoke out on the stress-test just last weekend at the Berkshire Hathaway annual meeting—Buffett’s “Woodstock for Capitalists,” which we attended with more than a rooting interest in the questions being asked of the “Oracle of Omaha.”

(See “What They Want to Know: Our Top Ten List for Warren Buffett ” from April 23, 2009 for details on those questions, and stay tuned here: we’ll have a follow-up on the meeting, and the questions that were asked, next week. But by way of a preview, Buffett was asked one of our Top Ten questions, and by Aznaur Midov, a student from San Francisco State University's Financial Analysis & Management Education group no less. Aznaur made the pilgrimage to Omaha with his fine classmates barely a month after we all met on their home turf for an intense, intelligent, and fun discussion of Buffett, Berkshire, and hedge funds.)

And what Buffett said, when discussing Wells Fargo—one of Berkshire’s largest stock holdings—was this:

“Wells Fargo is gonna be a lot better off—unless they have to issue a lot of shares, which they shouldn’t…”

Yet just this morning Wells Fargo issued 341 million shares, which is “a lot” in anyone’s book. In fact, it’s more than the 290 million shares that Berkshire Hathaway currently owns.

Buffettologists will, I know, complain that Wells Fargo really shouldn’t have been required to issue those shares, so Buffett wasn't really “wrong.”

They'll say today's 341 million share offering was done only in response to the Fed’s stress test, and besides don’t you know Buffett has compounded Berkshire at 20% a year for 44 years and who are you to point out something the Oracle got wrong, and when did you become the expert and yadda yadda yadda…

But the fact is, Wells was required to issue “a lot” of shares less than a week after those words were spoken.

Besides, there’s no criticism implied in making the point that Buffett got it wrong. For one thing, we've never been on the short side of Wells Fargo, for the simple reason that we remember too well that the same arguments now being made against Wells Fargo were being made back in 1990, when smart people told us how stupid Buffett was about Wells Fargo, and that Wells was up to its eyeballs in bad loans, and how could Buffett not realize Wells Fargo was going tapioca, and yadda yadda yadda…

...not long before the U.S. housing market, and Wells Fargo stock, began a very long rise up and to the right, to the benefit of Buffett and Berkshire shareholders.

Furthermore, the reason Buffett made the comment in the first place was that he'd been telling the story of how he told a business class from the University of Chicago, on the day Wells Fargo hit $9 a share, that, if he could, he would have put his “entire net worth” in the stock at that price.

Not a bad call at all. In fact, a great one.

(Having spoken to the very same University of Chicago Booth School of Business group just prior to their visit to Omaha, we give a shout-out to Chris Knapp, Jennifer Yang and the rest of that fine crew: they asked some of the best questions we’ve gotten about Buffett and Berkshire Hathaway, and it doesn’t surprise us a bit the Oracle mentioned their visit.)

Finally, the Wells offering makes our “Crisis Over” point better than anything we could write: the deal was priced at $22 and the stock is currently north of $25. A market that doesn’t blink while swallowing $7.5 billion of stock is a market that’s hungry for more.

Now what, you might be wondering, did Doug Kass get “right”?

For starters, in Doug's “20 Surprises for 2009,” which we highlighted late last December on these virtual pages, Surprise #2 was this:

Housing stabilizes sooner than expected.

That nugget—widely derided at the time—looks like it is coming to pass, with tremendous implications for all kinds of businesses.

But second, and more importantly, we recall seeing Doug on “The Kudlow Report” during the dark days of late February/early March, when the S&P 500 was on its way to a negative 25% start to the New Year, on top of last year’s performance-killing negative 37%, and not many people wanted to hear from optimists.

But Douggie was optimistic. And he said so.

His exact words, as we recall them, were an echo of Buffett’s most famous comment on The Market—indeed, the best and most unequivocal market call ever printed—“Now is the time to invest and get rich,” which Forbes published at the market lows in the dark days of late 1974.

Just as ridiculous as those words might have seemed when Buffett spoke them in 1974, they seemed ridiculous the night Doug Kass spoke them, before he went on to elucidate why he believed them true.

And in light of all that has happened since those dark days of early March, 2009, our virtual hat goes off to Doug Kass, for getting a big thing very very right.

For what it's worth, that same hat goes off to Warren Buffett and Charlie Munger, too, for taking the time to talk to shareholders for five hours last weekend. It's something no company Chairman or Vice-Chairman has ever made a regular part of his or her annual meeting, and likely ever will.

And it's something we think not only every investor, but every CEO, CFO and board director should experience at least once in their careers.

We’ll have more on our first impressions from Omaha come Monday.

Jeff Matthews
I Am Not Making This Up

© 2009 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.


CP said...

Sold to YOU

BobE said...

In re WFC's share issuance:

When Wells bought Wachovia, they said they would issue $20 billion of fresh common equity, since WB didn't bring any of its own (WB in fact had a common equity deficit of $3 billion owing to writedowns and charge-offs that consumed all of its equity).

Wells was able to issue $11 billion, but the eruption of crisis and the ever-changing rules promulgated by the government prevented them from doing more.

So, consider the offering today as the second half what they meant to do last fall.

What I really wonder is why Buffett didn't remember that.

Sam Antar said...

"Fed Sees Up to $599 Billion in Bank Losses"

Wow! At least its under $600 billion. The Feds must have taken a marketing course on Crazy Eddie:

"We are giving money away at a price that's insaaaaane!!!!!!!!"

Kieran McCarthy said...

I think you are a touch too confident in your declaration that Doug Kass was right. He may be right. But he might be wrong. Housing inventories are still at near all-time highs and existing home sales are still at near all-time lows. Delinquencies on prime mortgages have doubled in the last six months.This means that prices will likely continue to decline until that situation is remedied.

This rally has been impressive. I, too, was very bullish at S&P 700, but I am very, very cautious at these levels. And to declare the crisis over, definitively, when unemployment is still growing, strikes me as premature. It may be. But, given the debt levels, leverage, and changing social mood, it is far too early to declare any such victory.

Baghdad was conquered easily enough, but the clean up took a little longer than expected. A similar approach might be warranted with the "crisis" today.

invstmnt said...

Jeff Matthews shows more "Buffett-envy" in this story.

His "Buffett wrong, Kass right" headline reveals more about Matthews than about Buffett or Kass.

Why did he not entitle his piece: "Buffett right; Kass wrong"?
In the fact that Kass's prediction #1 did not come about. Russian oligarchs in fact were NOT found to be investors with Madoff and no attempt had been made on Madoff's life.
And the fact that Buffett made the ultimate call to those University of Chicago kids...that WFC was cheap enough to put an entire net worth into. The stock then tripled in the next 8 weeks.It's about making money not making 20 guesses each year and Buffett is well ahead of both Matthews and Kass in this regard.
Matthews will tell you that he mentions this in his commentary. But the headline says it all: Buffett-envy.

invstmnt said...

PS: Expect to see Berkshire Hathaway to be a buyer of 34M of those 341M shares issued by WFC today.

Jeff Matthews said...

"CP" may be right in the end, and that's what makes markets. Time will tell.

"BobE" brings up a very good point, well made. Thank you.

"Sam E. Antar," which is the commentator's real name, makes an amusing observation--yes, Sam, it is interesting that the number rounds down to 599...

"Kieran" takes the less-ebullient side of the housing market. By way of background, I have not always been a housing fan: I made a call on these pages in August 2005 that anybody buying a house at that point was an idiot; today I think anybody NOT buying a house is missing a terrific opportunity.

Supply is plentiful, bidders have been scarce, and interest rates are at multi-generational lows. Plus, real estate should provide a long-term inflation hedge, if the current deficit spending result in what many fear it must.

So I take the other side of Kieran's housing call. (By the way, inventories in CA are down to 5 months. I believe they peaked at 12 months, and I believe the current level is a 4 year low.)

But, again, that's what makes markets, and I appreciate the feedback.

"Invstmnt" goes off the deep end, as in past hyper-sensitive defenses of the world's greatest investor.

Both Buffett, when he told those Chicago B-School students he'd buy all the WFC he could get his hands on at $9, and Kass, when he told Larry Kudlow that 'now is the time to invest' somewhere around 666 on the S&P 500, made great calls.

And I said so.

Buffett's statement last Saturday that WFC shouldn't have to issue "a lot of stock" was almost immediately proven wrong--it's just a fact.

Does it matter in the grand scheme of things?

Not a bit--not to Berkshire shareholders including myself; not to anyone who bought WFC on the $22 print (it closed the day at $28.18); and certainly not to Buffett himself.

"Invstmnt" needs to take one of Buffett's best pieces of advice from last Saturday's meeting to heart: "You have to have an emtional stability, an inner peace" in this business.


cargocultinvestor said...

As you say differences in opinions make the markets

In the present situation my formula
is: Blogging hedgie sees blue skies ahead=top of bear market rally.

The 599 figure is interesting. As everyone knows the x99 is a marketing ploy to MINIMIZE the perception of the amount. ie this number indicates a mindset that is trying to put the best face on the issue, not really a worst feared scenario. That's my "tell" on the veracity of the stress test potential loss number. I doubt it really is their worst case. It might be way to low. Unless real estate markets rebound strongly I think it is.

We'll see.

Anonymous said...


It is rare when I disagree with your posts, but, respectfully, I must do so here.

I don't buy that Wells Fargo is out of the woods by any stretch of the imagination. One need only remember that, in addition to home loans, Wells Fargo also originates commercial real estate mortgages.

According to a report dated 4/23/2009 on Commercial Real Estate, Wells wrote over $70 billion of commercial mortgages in 2007 and over $30 billion in 2008. This doesn't include Wachovia's $90 billion worth of commercial mortgages in 2007 and $13 billion in 2008.

To readers, in the spirit of Jeff's mantra, I am not making this up. You can see the article for your self here.

The government's stress test scenario of Well's commercial loan holdings saw a total of only 10.7% for Wells' entire commercial real estate and industrial loan portfolio "going bad" in 2009 and 2010.

I wonder whether the government's estimated losses on Well's commercial portfolio goes high enough considering the worsening (slowing?) on the U.S. economy, and Wells is only setting aside $21 billion in loan loss provisions (see pg 37 of the Wells 2008 Annual report, in the balance sheet provision Allowance for Loan Losses).

I think the managers of Wells Fargo in 1990, Reichardt and Haizen, are far different from Stumpf and Kovacevich managing Wells today. Also, the size and scope of Wells assets has nearly tripled (I think) from 1990 to today. Wells is a different "financial animal" today, Jeff. The size and scope of Well's loan portfolio back then are not the same size and scope of commercial (and residential, I might add) loans Wells owns today.

I hope both you and Doug Kass are right but remember, markets have a funny way of allowing investors to be "fooled by randomness" (nod to taleb).

I could be wrong in my skeptical opinion above, however; guess that's what makes markets, right?

Anonymous said...

I have to agree the judgement that Kass was right looks premature. Rallies of over 30% are not uncommon after crashes like we had. I am a bit surprised though that Jeff is taking Feds tests so seriously. I think they were a lot more about trying to project some confidence than really testing... Worst scenario, really? 10% unemployment by year end? Hmmm

invstmnt said...


My comments were to your HEADLINE on Buffett.

"Inner peace" could be considered to be lacking for someone who needs to trash the greatest investor of all time in his headlines, and then try to provide some factual cover deeper in the story.
Your headlines are the tell for your thinking, Jeff. Buffett went after the hedge fund community a few years back and since then, I sense that you have never forgiven him for it.

His sole purpose in the market in his words is the following:
"Our method is very simple. We just try to buy businesses with good-to-superb underlying economics run by honest and able people and buy them at sensible prices. That's all I'm trying to do."
Everything else is just noise and banter. In the long run Wells will have looked to be a tremendous buying opportunity at these prices. Scuttlebutt about whether Kovacevich is going to wake up with a pimple on his butt tomorrow or not is irrelevant.
And for the short term oriented, envious hedgies attempting to play "gotcha" with Buffett, then that scuttlebutt is important.

You might well be served to focus on the same long term performance Jeff. The results are in his numbers and can't be denied.

Jeff Matthews said...

"Invstmnt" says 'I sense that you have never forgiven' Buffett for going after hedge funds.

Not sure what there is to 'forgive' and who cares what Invstmnt 'senses', but for what it's worth, I happen to agree with Buffett that many hedge funds haven't deserved the fees they've gotten, and that the tax benefit from the partnership structure is, as Buffett named his first corporate jet, Indefensible.

My point is far simpler: Buffett ran a hedge fund for 13 years, and he benefitted from the same high fee structure and low tax rate he now critizes. (In fact, the tax advantage was far higher back then.) That's just a fact.

It's one that Buffett doesn't raise much, and apparently some readers have a hard time grasping, but it's a fact.

'So we beat on, boats against the current...'


invstmnt said...

"My point is far simpler: Buffett ran a hedge fund for 13 years, and he benefitted from the same high fee structure and low tax rate he now critizes. (In fact, the tax advantage was far higher back then.) That's just a fact."

But in carefully selecting your fact, Jeff, you conveniently fail to offer up an even more important fact that, unlike you and other hedge funds today, Buffett set up a contractual obligation with his investors where he would participate in any losses in the partnership. Of course there were no losses.
But I don't see you or anyone else with the guts or confidence in his investing skills to take on that kind of clause in your partnership agreement.

In my opinion, he is fine to criticize the profit sharing, loss protected hedge fund managers of today.

Jeff Matthews said...

"Invstmnt": thanks for making the same point I already made.

It IS fine to criticize hedge fund managers; and Buffett, who criticizes them, started by running a hedge fund.

Let's move on.


invstmnt said...

Thanks Jeff. I also agree to move on.

And I assume that you acknowledge the point that Buffett did NOT have the "same" high fee structure that you or anyone else has today. He shared in the losses if there were any.

Jeff Matthews said...

Sorry, he got 50% of the upside, and that's "high" in anyone's book.

His willingness to take part of the downside was indeed unique. All in all, the incentive fee structure made him, as well as his investors, quite rich, which is how it should be in this business.

Read "Pilgrimage to Warren Buffett's Omaha"!