Here Comes the TALF!

Here Comes the TALF!

It’s Sunday evening, February 8, and the financial world is eagerly awaiting news from Washington. This week, newly minted Treasury Secretary Geithner will announce his bank bailout plan, while Congress will try to finalize an estimated $800 billion stimulus plan. Big events for the country? Yes, I think so.

These days, we’re always wondering whether we’ve hit bottom already, or whether there’s another leg down in the market. Having been burned several times in this market, investors are skeptical. Meanwhile, reports are that the economy, and the country, are not only suffering, but the situation seems to be deteriorating steadily.

Bottoms are really about finding buyers. No buyers, no bottom – that would be a very simple way to look at things (and I’m always a fan of the simple). So today, the government has simply become the buyer of last resort. In the private market, skeptics outweigh the buyers by a wide margin.

The good news is that this week will bring some clarity, and some direction. I say some, because if you’ve been following the news, the details of the banking bailout seem to be shifting day by day. And it’s very possible that Washington will disappoint the markets – the plan could be too vague, too incomplete when announced this week. Or, the market may not believe that the plan will help eliminate the bad assets sitting on the banks’ balance sheets. Still, a sense that the government is acting and moving forward will lift the morale of the markets.

So now, for the real question. What should you do as an investor? I think it’s nearly impossible to predict what will happen this week. It really depends on what the administration comes up with. And given that the details seem to be changing daily, Geithner might very well announce a framework for the bank bailout, but remain vague on the details of how to get rid of the toxic assets. In that case, I don’t think we go strongly up, but I don’t think we go sharply down either. I think we remain in a trading range, waiting again for more details from Washington.

For me, I am looking for one key element in the bank bailout: that bank common shareholders aren’t significantly diluted or even worse, wiped out. Basically, that’s what Paulson did, and we are now suffering the results. Not that I’m bashing Paulson, because I think Paulson did a very good job. We can criticize him all we want, but the truth is, he was chasing a moving target while trying to convince a reluctant Congress and nation that action was necessary. Can’t blame him for not getting everything right.

If the common stock were significantly diluted or wiped out, then we would essentially set up another run on the banks. If we knew that dilution was inevitable, bank stock prices would drop. Shorts would pile on, and we’d have another disastrous downward spiral. I would argue that this is obvious; still, there are some out there saying that common shareholders should be wiped out (yes, they’re on national platforms like CNBC). Thankfully, there is no indication so far that Washington is headed in this direction. Currently, the most likely route seems to be capital injections that would be preferred shares convertible into common equity within seven years. If this is the case, this might actually be bullish, because it allows investors to buy without fear of immediate dilution.

Where the Banks Stand

Many are concerned about increased regulation and conditions in part two of the TARP, now known as the TALF (that means Term Asset-Backed Securities Loan Facility, but did that really make any difference?). I think this will have the interesting effect of helping us separate the stronger banks from the weaker banks. Already there are rumblings from Goldman Sachs and Morgan Stanley, who are saying that they want to pay back the government as soon as possible. In recent weeks, there’s been support for Goldman Sachs stock, and Morgan Stanley has had a nice run. Given that there are buyers, the market clearly sees these two as some of the “stronger” banks. It follows then, that Goldman and Morgan might very well have a secondary offering of stock to raise money to repay Washington. If they do, existing stockholders will be diluted and their stock prices should fall just before the secondary. Afterwards, the cash injection should lift the companies’ prospects, and the stock should rise. An actual repayment of debt to Washington would be extremely bullish for these two banks.

And here’s another way all this government action will help us separate the strong from the weak. Some banks have refused additional government funds, and some will refuse money during the next round of capital injections by Washington. So simply put, those that can decline government money are stronger (or foolish, so do your due diligence). Those that need more money from Washington are the weak ones.

How do the banks stack up today? JP Morgan is generally considered the strongest of the big banks – best managed, and the most disciplined about take bad assets off the balance sheet (other than Goldman and Morgan Stanley). Still, Jamie Dimon, JP Morgan’s CEO, has said that 2009 will be a very tough year. Don’t forget that JP Morgan still has many problems to work out – it’s in the process of digesting WAMU and Bear Stearns, and it is still exposed to the crumbling commercial real estate market (as well as auto loans, credit cards, etc., we know all these things by now). Still, after we get past the write downs (and this will happen, someday), JP Morgan will have a huge asset base, thanks to the WAMU acquisition, and a solid investing banking division, thanks to Bear Stearns. All in all, a very promising long-term investment.

The other major banks have their own problems to deal with. Bank of America has received a total of $45 billion of government money. Last week, Bank of America CEO Ken Lewis categorically denied that any additional government money would be necessary, and even bought 200,000 shares of his company shares for just under $5 a share. Whether he is right remains to be seen, but in any case, Bank of America has serious problems to solve. In addition to withstanding the current problems in the economy, it still has to absorb Merrill Lynch and Countrywide. Both of these acquired companies have assets on their books that may continue to deteriorate. Given that Bank of America was “surprised” by losses at Merrill Lynch (just before the acquisition was completed January), the company may not understand the full extent of the liabilities on Merrill’s balance sheets. While there may be short term trading opportunities in Bank of America, the company still has a lot of cleaning up to do.

Wells Fargo also has its own set of issues. The company has taken $25 billion in TARP funds (less than Citi and Bank of America’s $45 billion), but many are betting that it will need more money from Uncle Sam. Keep in mind that Wells acquired Wachovia, and Wachovia’s balance sheet was full of mortgage-related assets. A little indigestion here as well, I think.

And then there’s Citigroup. Already the recipient of $45 billion from Washington, the bank may still need more. And January’s gunshot wedding of Smith Barney and Morgan Stanley further weakened the bank. Citigroup has also announced that it is looking to sell Nikko Cordial, its Japanese securities arm. The bank had previously stated that neither Smith Barney nor Nikko Cordial would be sold. By all reports, Washington is forcing Citigroup to downsize. This is a major problem for the bank, because regardless, Citigroup’s asset base is shrinking. That means it’ll have fewer ways to make money. Compare that to JP Morgan, who is likely to emerge from all this with a larger asset base and more ways to make money. I think Citigroup will survive, but in a smaller, shrunken version of itself.

While we are talking banks, I should also mention USB (US Bancorp), who I’ve talked about in previous articles. In the fourth quarter, USB was hit by losses, and it’s stock fell from the mid-20s to its current price of $14-15. That’s a big drop, but keep in mind that other banking stocks have fallen much more, percentage wise. Provisions for credit losses were up fivefold to $1.27 billion. A big number compared to history for the bank, but still much less than other banks. So the upshot is, USB remains a conservatively managed bank, one that I think will recover and do well. Still, there’s the risk that the first quarter of 2009 might also be harsh, so there’s no all clear for the moment.

Looking Ahead

For all the banks, we have the grace of no more major earnings reports for a month or two; the major news from fourth quarter earnings is out. We may stay at current levels, and we may even rally somewhat, but we have to know that there is a significant risk of bad news when first quarter earnings come around starting April 2009. Keep in mind that the problems haven’t been solved, and we’re unlikely to find a clear solution by the end of the first quarter. So whatever happens this week, or even over the next several weeks, it’s good to remember that there’s a danger point down the road. So in terms of investing, I end where I did last month: investing now is for risk takers; if you want a higher margin of safety, wait until the air is clear.

You might ask, why do I spend so much time on banks? For several reasons, of course. First, I think they’re a critical part of the economy, and it’s going to be difficult for the market to move forward without the banks. That’s because the banks reflect the mortgage problems in the economy, and that’s where we need to find a bottom before we can move on. Second, I think that despite all the bad, gut-wrenching news, there’s great opportunity in this sector over the next few years. So I think it will pay to keep an eye on these troubled companies.

A Low Risk Investing Approach

We’re also entering a time when stock-picking is very important. As you can see from our quick review of the banks, we have to separate out the good from the bad. I think there’s great opportunity there, as I’ve just stated. Still, if you have neither the time nor the inclination to research stocks, then it’s a good time to consider the indices.

I don’t normally recommend indices. Many say that if you buy a security that tracks an index, like the Dow or the S&P, you’re sure to do fine over time. That may be true, but it could be a very long time. Suppose you bought a Dow index when it was at the high of 14,000. Today, the Dow is about 8,200. It could be a very long time before we get back to 14,000. But if you buy today, or within the next 3-6 months at the 8,000 range, there’s a very high probability, I think, that the Dow will reach 10,000 within the next 2-3 years. That could be 25% within 2-3 years. Not a bad bet, and fairly low risk, I think.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.