Saturday, May 24, 2008

Where the Financial Crisis Is Headed Next

Barron's Online






Interview With Sy Jacobs, Founder, JAM Asset Management


THREE YEARS AGO, HEDGE-FUND MANAGER SY JACOBS TOLD Barron's that serious trouble was brewing in the housing market, predicting that "the bursting of the housing bubble [would] be a dominant theme for investing in financial stocks in the next decade." He was right. Jacobs, 47, is the founder of New York's JAM Asset Management, which runs two funds, both focused on financial stocks and closed to new investors. The larger entity, JAM Partners, follows a market-neutral, long-short strategy and has close to $300 million in assets. As of May 21, the fund's year-to-date total return, net of fees, was 9.6%, versus a 4.5% loss for the S&P 500. Its annualized return since inception in 1995 (through April 30) was 16.6%, compared with 9.9% for the S&P. The $45 million JAM Special Opportunities Fund invests in illiquid private-equity holdings. Jacobs' familiarity with financial stocks dates to the 1980s, when he worked as an analyst at firms like Salomon Brothers and Alex. Brown & Sons. To find out where Jacobs sees new problems emerging in the financials -- surprisingly, they're not in the subprime arena -- read on.

Barron's: You were early in detecting the serious problems in subprime mortgages. That turned out to be a great call.

Jacobs: About three years ago, we were worried about subprime specifically. And that view very much paid off for us as we were short a host of such companies. More than a year ago, in another interview with Barron's, we said subprime was already in a full meltdown mode, but the idea that subprime was somehow isolated was still popular. Our message was that the mortgage-credit tail was going to wag the capital-market and economic dog. That's coming to pass now.

Looking ahead, what do you see for the financials?

We believe the recent rally in financial stocks -- and for the whole market -- is a bit of a head fake that will prove to be a bear-market rally.

What's your premise?

After first ignoring subprime, people now are too focused on it and they're missing the broader storm coming -- that's the head fake. While the bursting of the housing bubble produced all sorts of headline-making losses for some, it is just starting to drag down the rest of the economy. Separate from subprime, you are seeing diminished ability for consumers to spend their home equity. The securitization market, which banks and finance companies use to get funding, has slowed. So we see consumer and business spending slowing; the economy will falter.

In a recent letter to your investment partners, you noted that you were very concerned about the health of construction loans. Could you elaborate on that concern for us?

I spent a week recently in California, visiting some troubled, or soon-to-be-troubled, banks. With home sales down so much, construction lending is becoming a problem. You have a lot of developers and home builders stuck with homes that aren't moving. And they are sitting on lots that have loans against them. Subprime is such a small piece of the banking industry, but construction lending is a core product. If the housing market stays weak for much longer -- and it seems to be getting weaker -- construction-loan losses are going to be a big problem.

After the brutal real-estate recession that occurred in the early 1990s, there was a sense that banks had finally learned their lesson and would be much better fortified for the next downturn. I take it you don't think that's true.

I take a pretty cynical view of whether bankers have gotten smarter. We've had a real-estate bull market ever since the early 1990s. I think you are going to see the same thing again. The number of banks that get taken over by the FDIC and disappear may not be as high as it was in the late-1980s and early 1990s because there is strength in the energy patch now. But real-estate lending institutions are the bulk of the community-bank world, and I think you are going to see a lot of banks disappear.

What's your sense of the prevailing views of the financials right now?

People are trying so hard to believe that the Bear Stearns crisis in March was some sort of financial crescendo and represents the bell that gets rung at the bottom, as if that happens. But just because we got saved from what would have happened that Monday if Bear went down doesn't mean we are saved from all the forces that conspired to get Bear Stearns to the brink in the first place. Bear was not the sacrificial lamb to the market gods. It got knocked down by the same winds that are affecting everybody else. Credit destruction is a process -- not an incident. And avoiding that particular meltdown doesn't mean that things are getting better -- and yet that is how financial stocks in particular and the market in general have acted ever since.

You're a fundamental stockpicker, but are there any interesting trends you see in the financials?

One of our themes on the long side is that local plain-vanilla, over-capitalized community banks, especially thrifts, are in a position to gain back market share in the lending business. And they have real deposit franchises that they can fund themselves with. They have been losing market share to the Countrywide Financials [ticker: CFC] of the world for a generation. Now, though, they are going to gain a lot of that market share back, because they suddenly have a funding advantage, relative to the larger financial firms that have been securitizing their loans. That market has been discredited. We're long lots of micro-cap ways to play this, but they're too illiquid to mention here.

Fair enough. Let's discuss some of your holdings, starting on the short side.

The first one is Wells Fargo [WFC], trading at 12 times '08 estimates and 2.7 times tangible book; the group trades at less than two times book. The Wells Fargo name has a storied past and gets the Warren Buffett halo effect because he owns a lot of the shares. But if you look back at the last real-estate recession in the early 1990s, the Wells Fargo side, focused on California, had a lot of credit problems in the real-estate area, and the stock underperformed during that period. The Norwest side, which has more exposure to the Midwest, still has a lot of consumer-credit exposure. Of particular concern is the bank's portfolio of home-equity loans.

What's the big worry there?

Home-equity line of credit (HELOC] is 16% of their portfolio. More than a third of their HELOC exposure is in California, which is now developing very badly on the home-price and employment fronts. And delinquencies and losses are already rising pretty sharply. But they also have a big unfunded exposure to the undrawn lines of credit. Also, despite their reputation for being conservative, their loan-loss reserve at the end of March was lower than their annualized charge-off rate for the first quarter. Given the prospects for rising losses that we see, that's not conservative. We think they will disappoint this year and next and, as a result, their premium multiple will go down.

Wells Fargo, however, is known as a well-run bank. One example of that is the company's reputation for being very effective at cross-selling its products.

We're most concerned with their exposure to home-equity loans at the top of a real-estate bubble. Remember that home-equity lines of credit sit on top of first mortgages. So if home prices depreciate, which is what is happening now, and a home goes into foreclosure, the home-equity line often gets wiped out. The first mortgage holder can get most of their money back, but the home-equity line absorbs all of the loss.



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