Stock Discussion - WFC Revealed

There you have it folks, the results from WFC came out this morning and we had some good news! Let's take a look at the results:

As we discussed on the last post, WFC was expected to earn $.033 for the last quarter on $11.65 billion of revenue. Actually, they missed both numbers....badly. Instead, they recorded a LOSS of $.79 a share and revenue of $8.93 billion. They took billions of dollars of writedowns to account for future loan losses associated with the weak housing market as well as the acquisition of Wachovia.

So the stock was probably taken through the ringer, right? Wrong...actually, the stock was UP 30%! Why is that? Well, that's because as bad as the results were, they were the exact opposite of the results another seemingly strong bank (Bank of America) had earlier in the month. Let's break down the reasons why:

• The dividend was not cut - like I mentioned earlier, there is an expectation that the dividend will get cut substantially to beef up capital reserves. They didn't do it this quarter. It doesn't mean they won't in the future, but the fact that they don't have to do it now does give a vote of confidence.
• Aggressive Loan Loss Reserves - WFC is accounting for huge future losses over the next few quarters. But they're accounting for them now...not later. Only a strong bank would be able to do this...the conservative management team that I had mentioned in my previous post is taking it's losses early so it can have good growth later.
• No Surprise Losses - The Wachovia intergration is going as planned, and there doesn't seem to be any hidden losses outside of what WFC was planning for. Unlike the Bank of America/Merrill Lynch deal, this one looks like it will be good for WFC in the long run.

As mentioned in the article below, ""They are aggressively writing down risky assets in both the Wachovia and Wells Fargo portfolios, especially the toxic Pick-A-Pay loans that let the borrower determine how big or small the payment will be," Bart Narter, senior VP of Celent Banking Group," This aggressive strategy that management is taking is exactly why I bought this bank instead of the others and is what has kept them successful over the years.


The stock was up 30% today due to the not bad news. But I sitll think, long term, the company has a great deal of value to unlock. Deposits were up a record 31% last quarter - something I mentioned is key for banks when they are trying to grow. The expanded branch network gained from the Wachovia merger, along with weakness from competitors, is sure to help that deposite base grow even more. I'm holding on to this stock. It'll be a roller coaster, but I think it'll be a fun one!

What do you think? Is WFC a buy?

The full story can be found here:
http://www.thestreet.com/story/10460422/1/wells-fargo-takes-wachovia-losses-head-on.html

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia

Stock Discussion - WFC

Check out the new poll! ------------------->>>>>>>>>>>>>>>>>>

Today I want to discuss a particular stock, Wells Fargo (NYSE - WFC). I think this company is a good microcosm of the financial crisis and can provide some unique insights to the financial crisis. Another reason I want to talk about it is because I own it personally, and tomorrow is a big day for WFC because it's coming out with quarterly earnings tomorrow morning. These earnings will be immensely important for reasons I will soon discuss.


What Does WFC Do?


WFC is a major financial institution engaging in a variety of banking activities. It has some retail branches, primarily located on the west coast and some in the midwest. However, a big chunk of its business comes from the mortgage industry. In fact, it's the world's second largest mortgage lender which, at one point last year had a mortgage portfolio of over $83 Billion.


What Makes It Different from Other Banks

During the real estate boom years which lasted most of this decade, WFC maintained a significantly more conservative risk profile than many of its competitors. It did not get heavily involved in the MBS market and maintained strict lending standards that, although prevented it from making the vast sums of money during the boom years that some of its competitors did, also helped it whether the downturn much better. The chart below shows the 2 year performance of WFC compared to the general banking index. As you can see, it has, for the most part, outperformed it's competition thoroughly:




Why the Recent Price Drop - A Tale of Two Banks

As you can see, WFC's stock price has dropped percipitously in January. Although the price is consistent with the industry's performance, I just said that the company is head and shoulders above its industry, so it should perform better, right?

Well, that would be true if it weren't for one thing - in the fall of 2008, WFC acquired a major competitor that was well on its way to becoming the next Lehman Brothers. Wachovia Bank, at one point the 4th larget bank in the US, suffered greatly through the financial crisis due to its exposure to the toxic financial assets. When it's prospect looked bleak last September, both Citigroup and WFC made competing bids to buy the company. WFC eventually won the bid because it offered signficantly more money than Citi and did not really on government support unlike Citi's offer.


This midnight deal gave a huge boost to WFC's branch network and deposit base, which is now estimated at almost $1 billion dollars. However, concerns arose around the toxic assets that WFC was also acquiring and if the company performed the necessary amount of due diligence to really understand what they were buying. These concerns came to a head over the last couple of weeks when Bank of America, who recently made its own major acquisition of Merril Lynch last year, revealed huge losses ($15.3 Billion) stemming from the takeover and prompted the Charlotte, NC based bank to ask for more government TARP money. Furthermore, B of A also cut the dividend it pays to investors to just $.01.

This news spread to WFC as well since the acquisition was made under similar circumstances - last second deals at the height of the crisis. Investors are worried that WFC will come out with similar results and may need to take a huge loss associated with the Wachovia deal now that WFC has had the time to digest it a little.


Why I Own The Stock

Many of you are probably asking why I would even think about buying a bank stock in this enviornment. In fact, I've been asking this a little myself with the recent performance of WFC I bought WFC last July at about $24 a share. After rising to almost $40 during the fall, it has since fallen to its current level of about $16. Well, here's a list of why I bought the stock:

• An unmatched record of ethical and stringent lending practices - the company is famous for it and, since the company doesn't get involved in the risky stuff, it provides better rates for it's higher credit mortgages. In fact, my parents have had 2 mortgages their lives, and both have been from WFC
  
• Increased Deposits During the Recent Storm - With other banks going under, more people have been moving their money to WFC. This positions the bank strongly to lend and grow once the enviornment gets better
• Well Respected Management Team - This is somewhat related to the first point, but the management team at WFC is comprised of longtime WFC veterans that closely follow the banks philosophy - thereby reducing the chance of a drastic departure.
• Warren Buffet Believes in it - Yeah, as cliched as it may sound, Warren Buffet is the single biggest shareholder of the company with an almost 11% stake through Berkshire Hathaway. My investing philosophy closely follows his, so it is a vote of confidence.
  

With those high level points (there was quite a bit of number crunching involved, but I'd rather not bore you with those), I really feel that WFC is a good investment for the long term. This is why I didn't sell the stock when it almost hit $40...I really feel that WFC will be able to take good advantage of a recovery with is positioning itself to become a major banking player.


What to Expect Tomorrow

Tomorrow morning, WFC will come out with earnings which are expected to be at $.33 a share on revenue of $11.65 Billion. Although these numbers will be important, the market will also be closely listening to any indication as to the state of the Wachovia integration and any new losses stemming from the acuisition. If WFC can manage to dodge a bullet and hold the guidance they've previously provided on the deal, I can see the stock moving up significantly (10%+) as it will be a big sigh of relief. But I also think there's a good chance that WFC will be conservative in its results and write down all potential losses as early as possible in order to promote long term growth (this strategy is what convinced me to invest in them in the first place). Therefore, I wouldn't be surprised to see a big miss on the earnings front due to a large writedown, but promising future guidance.


We shall see what comes out of tomorrow's earnings release. Keep checking back on investingdecoded - I'll definitely share the news when it comes out.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia

The Oil Game - Don't Get Too Comfortable (Part II)

Before I get started on today’s post, I wanted to mention some great feedback I received from a reader recently. This person mentioned that, although the information on my post is extremely insightful and great for anyone to read, the style of the writing can sometimes come off as a little difficult to read. As I’ve said since day 1, I value any feedback I can get for my blog. After all, the whole point of it is to make readers more aware of the investing world and relate the major events in the investing world to real-world impacts. I’d like to thank that person (You should know who you are J) and invite everyone to offer any sort of feedback, whether it be for writing style, topics, structure, anything at all. I’ll try to incorporate the feedback as best possible.

With that said, let’s go on to the conclusion for the Oil Industry….

With the last post, we learned the details of the oil industry and how it works. Forgive me for sounding like a textbook in that post, but I feel that it’s important for people to know about the industries they’re investing in. Much of what I mentioned during the post should be known by anyone buying an oil stock. Like Cramer says on ‘Mad Money’, do your homework! If you don’t understand the company you’re investing in, then it’s nothing more than gambling. Before I give my opinions on any industry, I want to make sure that people understand where I’m coming from, thereby making sure that people understand where the opinion is coming from.

We learned that the price of oil, and the corresponding fuels created from it, is largely determined by investors and traders on the futures markets. These investors take their own as well as their clients’ money, along with their understanding of the oil industry, and buy and sell futures contracts for the sole purpose of making money. There’s nothing really that special about oil in that sense. They do this with all types of commodities. But, the price that oil is trading at directly affects the price you pay at the pump. Until the summer of last year, the price of oil had gone on an unprecedented rise. A barrel of oil (the unit in which oil trades which equals about 42 gallons) rose to almost $150. This was well beyond its historical norms between $20-$40 a barrel. This resulted in a price rise at the pump, as I’m sure most of you already know, of almost $4 a gallon for regular unleaded.

Now, I really feel that there are many reasons for the rise – some justifiable, others questionable. The justifiable reasons were driven by a fundamental demand scenario – the emerging markets like China and India were experience huge growth that changed the supply/demand structure of the oil market. These countries demanded huge amounts of oil and this increased demand led to a natural increase in price. But did it justify $150 a barrel oil? I don’t think so. Instead, I really feel the justifiable price is more around $70/barrel. This price really accounts for the changed supply/demand landscape that China and India have caused. Furthermore, contrary to what many people may believe, there is no imminent shortage of oil available in the world – the current projections say we have plenty of oil for the world until at least 2030 – despite the increased demand.

You might then ask why would oil rise to $150 when the fundamentals only said $70. Well, let’s go back to the concept of the investors playing a big part in determining the final price of oil. Many of these investors are banks and hedge funds (money managers who invest billions of dollars for very rich people using extremely sophisticated investing strategies). Remember when we talked about how banks worked and the ‘L’’s – leverage and liquidity? Well, the huge amounts of leverage and liquidity available to these banks had other impacts than just housing investments. The financial instituations poured billions upon billions of dollars into the commodities markets as well. They were able to buy futures contracts at higher prices than the fundamentals dictated knowing that someone else would probably come along and buy it at an even higher price. They could ride the upward momentum in price as long as possible and still make money through it. The amount of cash the investors had caused an artificial increase in demand for the oil futures, but not necessarily for the oil itself. This demand caused a surge in prices which proliferated through the energy complex resulting in higher gas and energy prices for everyone. There was also very little decrease in the demand for energy despite the increase in prices, consumers just coughed up the extra cash to put gas in their SUV’s since even they had fairly easy access to liquidity through the housing boom. The prices acted like a ‘tax’ to the consumers that, for several years, were willing to pay.

Other than the investors, other beneficiaries of the higher oil prices were, of course, the energy companies. Due to the higher prices, the profit margins for these companies grew dramatically, making the industry one of the most profitable in the world. Also, the countries from which the oil came from became vastly richer. Of the $150 for the barrel of oil, a large proportion (my guess would be 30%+) went to the country from which the oil came from. As oil tycoon turned renewable energy promoter T. Boone Pickens said, this resulted in the largest transfer of wealth from one region of the world to another (the middle east where most oil comes from) in the history of mankind.

After the boom years were over, and banks began to lose all that capital they were able to raise, there was going to be a natural decrease in oil futures prices. This, coupled with the natural decrease in demand that comes from any recession, has caused oil prices to drop dramatically to their current level of about $35 a barrel. However, don’t get too comfortable with these prices. I still believe those futures traders have a big part to play here as well. Like I said, fundamentally, I feel that prices should be around $70/barrel in the long term. But because these investors lost so much money in other areas, they have been forced to liquidate in previously profitable areas – namely oil – to cover capital positions. Futures contracts have been glutted into the market with sheer lack of demand, causing artificially low prices.

The Bottom Line

Bottom line, once the banks stabilize and investors come back into the market in full force and more cash, I can see oil easily going back to $50-60 a barrel. Furthermore, once the economy begins to recover, I see oil going to a fundamentally sound $70/barrel over the next 2-3 years. All this results in pump prices for people to average a little less than $3/gallon for the long term.

Disagree with me? Don't keep it to yourself. Let’s start a dialogue.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

© 2009 Sahil Bhatia

The Oil Game - Don't Get Too Comfortable (Part I)

For today's post I thought I'd discuss something that at least used to be a cause of worry for many people, and something that, I think, still should be a source of concern. The world's energy industry is incredibly complex and convoluted. Why wouldn't it be? Since the industrial revolution, the world, especially industrialized nations, really on this energy infrastructure just to function. Furthermore, over the last few years, this industry has come to the cultural, economic, and political forefront due to an unprecedented rise in energy prices for the end-consumer. But, in order to really understand the reasoning behind the precipitous rise and even more precipitous fall in energy prices, one must think like an investor because, at the end of the day, it's investors, not necessarily the oil companies, that determine the price of a gallon of gas that you put in your.


How Oil Works




The process of getting oil (or any other type of fossil fuel) from the ground to a machine that will consume it is a symphony of logistics, geological sciences, politics, and a little luck. From my understanding, the oil complex can be broken down by components in the following way (keep in mind that I say Oil since that is the primary energy source for most of the world. Coal, natural gas, or any fossil fuel works in similar fashion with some variations):

1. Drillers - These are the guys that go out and perform the first major step: finding the oil and pulling it out of the ground. This often arduous and expensive process factors in two major components of the symphony mentioned earlier - Geoscience and Politics. The geoscience part is pretty self-explanatory. These companies spend tens of millions of dollars, extremely advanced technology with some of the fast super-computers on earth, and a bunch of very smart people researching the best places to find oil on the planet. Once they find this oil, however, they have to negotiate with whichever government the land/water belongs to so they can drill for that oil. Generally, the government gets a large percentage of the money made from drilling that oil, but sometimes, there are political hurdles to overcome (Venezuela being a prime recent example). Major players in the drilling business are Exxon-Mobil, BP, Shell, all the big name guys (these big names pretty much are involved in all components of the oil complex. Other, less household names are Transocean (the biggest name in offshore oil drilling), Constellation Energy, and StatOilHydro. These guys are common names on Wall Street.
2. Refiners - Once the oil is dug up, it needs to refined into a petroleum product that can be used in our engines, furnaces, poweplants, etc. The refining process is basically taking the oil that comes out of the ground, a.k.a crude oil, and doing all sorts of crazy chemistry stuff to it to break it up into individual component fuels. Example fuels are kerosene, gasoline, diesel, etc. This 'refined' product is then ready for consumption by the end user. The major players in the refinery business are the big names I've already mentioned plus others like Murphy Oil, Frontier Oil, Tresoro Corp.. These guys make their money by taking the oil and refining it to sell the component fuels. The difference between the crude oil price and the fuel price (known as the crack spread) essentially determines the profit margin that the refiners make.
3. Retailers - The retailers are the ones that actually sell the oil to the end user, the most common example of which is the gas stations we see every day. These guys take the finished product from the producers and sell it to consumers. Believe it or not, the retailers make very little profit from the fuel itself. For example, your local Mobil station will only make a few cents for every gallon of gas you buy; most of their money is actually made from ancillary products like the stuff they sell in the convenience stores. One thing to note, however, is that many gas station brands do not refine their own fuel. Some of the less known brands actually buy their fuel from a refiner like Murphy and then sell it as whatever brand they want to. I'm not saying that this gas is any better or worse than the major brands, but it is something to keep in mind
4. Pipelines, Shippers, Equipment - Finally these are the names that work within the above three to makes those components fit together. The pipelines are the on land transportation mode for oil. One common example are the lines we have from Alaska and mainland US. If you've been listening to the news lately, you've heard of another big example of the pipelines from Russia to the EU and how they're having issues with keeping them online due to the conflict with the Ukraine. Some big names are Williams, Kinder Morgan, and Enbridge. The shippers are the HUGE oil tankers you see on the news sometimes. These guys move oil from the drilling site to the refinery site and the refined product to its final destination. Teekay, Frontline, and General Maritime are examples. Finally, the equipment services names are the ones who make the large rigs and drills to give the drillers and refiners the ability to make the fuels. Big names there are Baker Hughes, Haliburtun (Yeah, Dick Cheney's Posse), and Schlumberger.

How Oil Works - On Wall Street and Futures Contracts



Now that we understand how the oil complex works, we need to understand how it's priced. In a way, the pricing of Oil is fairly simple - it's whatever the front month contract for light sweet crude is selling for (if you're looking in the US market). What is a contract, you say? Well, way back in the day, farmers had a dilemma - "how do I know how much seed to plant in a given season when I can't predict what the price for my crop will be come harvest season?" If they planted a whole bunch of corn, when it came time to sell the corn to merchants, if there was too much on the market, the price would be too low. The same issue worked the other way - merchants wanted some predictability as to what price they would be able to buy the corn so they could better forecast how much they should buy and what kind of margins they could achieve. This unpredictability created a level of risk for both sides that needed to be resolved. So what the farmers and merchants started doing was entering into contracts that would guarantee the price of the product at a specific time in the future. These contracts came to be known as...wait for it....wait for it...futures contracts (they're business people - not very creative I know)! The futures contracts (often just called futures) gave the farmer a minimum as to what price he would be able to sell the product, and the buyer a ceiling as to what price he would buy the product, thereby reducing the price fluctuation risk exposure both had. Entering into a futures contract is also known as 'hedging', the process in which to dramatically reduce risk while potentially reducing some reward (hence the term, hedge your bets).



Well, eventually futures were created for EVERYTHING....corn, sugar, hogs, chicken, steel, currencies, and, yes oil and it's products, gasoline, diesel, etc. Also, central market places were created to trade these futures, the biggest in the world being in Chicago. Here, buyers of the products (an example being an Airline buying kerosene for its planes) can enter into contracts with suppliers (maybe a refiner like Murphy) to receive their product at a specific date and a specific price and the price you see on TV for things like Oil is the price the latest oil contract is selling for on these exchanges.



However, there was an additional consequence of creating futures markets. Having these markets gave the ability to investors who had no intention of actually taking delivery of the product to trade the contracts as well. The investors would hope the either the demand or supply of the product would change significantly prior to the contract date, thereby affecting the value of the contract. If the value changed the way they expected, they would make some money out of it. Let's take an example. Let's say I buy a Oil barrel future for $40 because I think the price of Oil will increase. If I do nothing, on the expiration date for that contract I will take delivery of that barrel of oil and the contract is worthless. But let's say a conflict starts in the middle east, affecting the supply of oil to the refineries. Well, the supply/demand picture has changed and there will be expecation that the price will increase. Therefore, the value of that contract will likely increase. I can then go ahead and sell that contract (before it expires) to another buyer, either another investor or an end user (like that Airline) and make a profit.



I hope you guys can now see how investors really are the ones that determine the price of oil. There are so many investors in the market compared to actual oil buyers that for every $1 dollar of trading an actual buyer conducts, investors conduct $13.



You Still Haven't Answered Why The Prices Fluctuated So Much




I know, I know. I think I've given you guys enough info for this post. Stay tuned for the next one where I'll answer this question and why I think you shouldn't get too comfortable with the low gas prices at the pump.



Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Reader Question - Berkshire Hathaway

Here's a bonus post! A reader posed a question on a particular stock. As people ask me questions on stocks, topics, etc., I will try to post the responses on investingdecoded for the benefit of all. These 'Reader Question' posts will usually be bonus posts outside the usual topics that I'll be discussing.

However, before getting into the question, I first want to thank everyone for their support for investingdecoded. I've gotten a lot of positive feedback from many readers over the past few days, and I'd like to thank everyone. As always, let me know if you have any questions/comments/suggestions - I'd love to hear them!

So a reader asked me about a specific stock that he wanted to get my take on - Berkshire Hathaway (BRK.B). What a great stock to start with! An investing company who's genius leader, Warren Buffet, is someone that I try to emulate in my investing strategies. He's nothing short of a role model for me and many value oriented investors around the world.


What Does it Do?


First, let's take a look at what Berkshire Hathaway does. On paper, it considers itself a reinsurance company - somewhat similar to a CNA or a General Re. However, in reality, it is much more than that. It's actually more of an investment fund that buys various types of companies for long periods of time and holds them. It uses a value investing strategy when making investment decisions to buy companies that are, in Mr. Buffet's own words 'great companies at a fair price'. It then holds these companies for long periods of time. The company is a legend on wall street. Over the past 50 years, it has consistently outperformed the market and has provided superior results to its shareholders. Some of the more famous names under the Berkshire Hathaway umbrella are Dairy Queen, GEICO Insurance, and NetJets.

How is it Doing?

Being an investment company, BRK has been hit fairly hard by the economic downturn. As you can see from the chart below, it's down 25%+ over the last year (check out that spike downwards in Nov....now that's just fear selling from the Lehman fiasco)










Now seeing this graph might spook a lot of people for a few reasons:

Price - Yikes! This says the stock is about $3,000 a share! I can't afford that. Plus, even if I could, I wouldn't be able to make any money since I could only afford a few shares.
Don't fall into that trap! Warren Buffet intentionally does not split his stock (i.e. bring the price of the shares down and multiplying the number of shares available to make the price look less scary). He knows that many investors (professional and amateur) have a false understanding that an expensive stock will return less profits. These investors are exactly the type that he wants to avoid investing in his company at all, which is why the stock is at that price. The truth is, all stocks work on relative valuation - the idea that the price of a stock is dependent on factors that are measured on a per-share basis instead of an overall basis. This means that even if a stock is a million dollars a share, if it's earnings (on a per share basis) are a million dollars a share or somewhere in that magnitude, then it could be considered cheap and move higher accordingly. It doesn't really matter as much what the actual price is.

Of course, because of BRK's success, the stock has gone up substantially over the past 50 years. In fact, the $3000 a share above is not even the normal stock, it's the B-class share (shares that are still essentially the same company, but have certain restrictions that don't apply to the common stock, like voting rights). The A class shares a BRK (BRK.A) are actually running around $94,000 a share! How does that sound for success!

Downward Path - The stock is down over $25% in the last year! What's going to keep it from going down more?
It is true that BRK is facing many of the same challenges as other financial companies. And, in my opinion, these challenges have been reflected in the stock price. There is a definite downward trajectory in the earnings projections for BRK as well. But the argument can be made that many of these challenges are already priced into the stock and, when looking at a longer term chart for the company, it's apparent that a long-term outlook seems to say that BRK knows what it's doing through its consistent market outperformance.


Why You Do Want to Buy BRK.B

1. Top notch management that has a strong and unmatched track record in investing in little known, but quality companies, and turning them into gems.
2. A very strong credit rating (mainly due its strong management) that will allow to take advantage of opportunities that its competition can't - In fact, it just issued $250 Million in 10 year notes at AAA yields of 5.4%
   
3. A recent drop in the stock price making valuations much more reasonable which could provide for a great buying opportunity
4. They've done more buying in the last quarter than in any quarter in the company's history - classic Warren Buffet taking advantage of business conditions
   

Why You Don't Want to Buy BRK.B

1. The stock hasn't shown any signs of strength since the last downturn - there's no evidence of any trend changing
2. If the overall economy continues to worsen, then all this recent buying may take much longer to bear fruit
3. The company does demand a premium price compared to its competitors - merely for its brand name, so valuations get a little high. If for some reason the company loses this reputation ( e.g. several bad quarters of performance) it will likely lose that premium.

Final Thoughts


To buy the stock or not is a decisions that someone has to make base don his/her own situation. But to me, BRK is a strong name to hold if you really want to get into financials while hedging yourself from the risk brought on by some of the bank names (Do know that BRK has a large stake - I think around 9% - in Wells Fargo Bank). Actually, I hold BRK.B in one of my own portfolios since 2004. However, I do think that many of the investments its making right now will take a long time - 3-5 years - to really show some results and the stock is mainly a victim of the overall macroeconomic conditions at this point. Therefore, if you do buy it, expect to be on a roller-coaster probably for 2009. But the upside there is if you can tough out the roller coaster, there's the possibility of pretty good returns.

What do you think? BRK a buy or not? let me know and we can start a dialog!


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

The Current Financial Crisis – What the Heck Happened? (Part 2)

Welcome back! Now that you've had some time to ruminate over the first post and the setup for the financial crisis, let's now go ahead and see what actually triggered the downturn. When we last met, things had been going pretty well for the market, and the dream of home ownership had become a reality for more people than ever before through some of the most sweeping and creative changes made to the mortgage market. But with this new system came consequences that people either did not understand, or choose to ignore (we'll discuss this towards the end). To bring this topic to a head, let's see what I'll be talking about on this post:

1. The Perfect Storm - The various factors that led to the collapse
2. Victims of the Carnage
   
3. Who's To Blame
4. Where We Are We Go From Here

The Perfect Storm - The various factors that led to the collapse


In my last post, I gave you what I think is the root cause of the collapse of the mortgage industry. If I had to say it in one oversimplified sentence, it would come down to this: The mortgage crisis stemmed from a breakdown in discipline by mortgage originators and investors due their inability to adequately model and track risks associated with relatively new mortgage investment vehicles. Yeah, it's high level and not a complete picture, but it give you the essence of what started this mess. But the important part of this sentence is how it identifies the root cause of where the breaking point originated - specifically "mortgage originators and investors". That is where the mess began, and they are the ones who paid very heavily in the debacle. Let's see how and why...


The 2 "L's" - Liquidity and Leverage


Ahhh, the banks. Mammoth institutions that form the backbone of capitalism and give the world what it needs to do business. They provide the economy with the means and opportunity to become financially successful through a myriad of services and products that range from interest bearing savings accounts, to complex financial restructurings that allow companies to transform themselves. But in all that fancy jargon and hooplah, banks essentially work off of two basic concepts, Liquidity and Leverage. And understanding these two concepts will help you understand they suffered so greatly in the financial crisis.


Liquidity is simple - it's the the ability to access money easily (at least in my non-professional terms). The more cash you have on hand, the more liquid you are considered. For banks, liquidity is very important in that it's what allows them to do their day-to-day operations. They take their sources of liquidity - money invested in them by clients (through mutual funds, pension funds, bank deposits, etc.) - and invest that money into the market in the hope of making a return. They then come back and, depending on the source of that liquidity, pay their clients back. They can also use various other sources of liquidity like issuing credit.


Leverage - A little more subtle, but still not difficult to understand, leverage is how banks multiply their returns without needing as much liquidity. In other words, the bank will take $1 of cash it has on hand and use it as collateral to borrow more money - usually from other banks or the government. It then takes that increase in liquidity and goes and invests that money. The bank can essentially make the returns of more than $1 without needing to have more than $1 on hand. BUT, it also opens itself to the risk of losing more than $1 when it originally only had $1 to invest - I'm sure you can see the problem there.


Sorry to sound like a textbook, but those two concepts are important (I promise, no more for the rest of this post). Going back to our train-wreck analogy, during the peak of the mortgage bubble, banks were able to access a lot of liquidity and gain a HUGE amount of leverage. Why? Without going into too many details, basically the previous few years (some say from 2002 onwards), money was cheap to borrow for the banks. They were able to access huge amounts of capital. They then used that capital and leveraged it to obtain even more capital. By market peak, both liquidity and leverage ratios were at historical highs for banks - all because things were going so well, that the more leverage they had, the more money they were making. This is analogous to attaching rockets onto our train. It was going very very fast. Things were good...too good.


Well, then it happened. The mortgage market started turning sour around mid-2007. Why then? I'm really not that sure. If I had to guess, I would say that it was a natural tipping point for the American consumer - they just couldn't afford to take on anymore debt. This over-extension had to snap back at some point, and this seemed to be it. It looked like an economic downturn was on its way, but, unfortunately, this one was going to be a lot worse than previous ones. The reason for this was because the banks were over-leveraged in the mortgage market, and when the market collapsed, they were unable to pull out in time to recoup their losses. In fact, some banks were leveraged well beyond historical norms to about 30:1. This means that they were borrwing $30 to every $1 they had in hand. They then took that $30 and invested in the MBS's we had discussed earlier. Now, if the mortgage payor is the over-extended consumer, then they will likely not be able to pay that mortgage and default. This caused the prices of the MBS's to plummet, and the banks that were deeply involved in the MBS market were unable to sell the MBS's since they were now considered 'toxic' assets.


The Ensuing Panic


Remember when I mentioned that there was no market for MBS's and, thus, no direct way of determining exactly what the value of the MBS is? Well, here's when it caused real problems. Because of this lack of transparency, nobody wanted to trade the MBS's...essentially making the worthless. Because the banks had so many of these assets on their books, their was a general loss in confidence in the viability of those banks. Think about it, if you're a banker, and another bank you're dealing with had what at one time was $100 billion worth of MBS's on their books, you would likely think that they were $100 billion in the hole. Consequently, you'd like be worried that this bank wouldn't be able to pay you back and you wouldn't do business with them. Well by the beginning of 2008, when it became apparent how bad the mortgage market was going to get and how deep some banks were involved in it, this started happening all over the place. Banks stopped doing business with each other, causing a huge shutdown in the markets.

Now, you're probably wondering why this became such a huge issue outside of the banks. Why were so many people and businesses outside of the financial industry impacted so heavily by this shutdown in the banking system? In fact, a 'investingdecoded' reader commented that there were a lot of other things that caused this downturn to occur other than just the housing market. While that is true, I do argue that the collapse of the housing market, which in turn caused the collapse of the banking industry, caused many of the economic woes people are experiencing today. This is because, in the panic that ensued with the mortgage crisis, many banks stopped lending money all together for fear that they needed that money to cover current obligations. A massive de-leveraging began occuring so the financial system could backtrack into it's original state. Unfortunately, this had a wide-spread impact on all businesses. Most businesses, especially major corporations, need credit lines in order to do day-to-day business. Whether it's a loan to build a new factory, or a line of credit to acquire raw materials with which to produce goods, in some form or another, these businesses interacted with banks to get the capital needed to build new businesses. Well, as these banks were de-leveraging, this capital became either prohibitively expensive, or impossible to find all together. This phenomenon known as the 'freezing' of the credit markets had the cascading effect of a larger economic slowdown. At the same time, the consumer, which accounts for about 70% of the American economy, drastically cut back on spending as part of its own de-leveraging process, further adding to the woes of the economy and putting us in the place we are today.


Victims of the Carnage


In all this mess, there were a few names that really stand out as 'victims' of the downturn. Most of these names are associated with the financial services industry and were either bought out by healthier competition for pennies on the dollar or went outright bankrupt. Even a whole industry as we night it may be considered 'dead'. Here's my list of the victims:

Countrywide Financial - The first and most spectular collapse, Countrywide played a key role in the rise of the MBS market and the creative new mortgages that allowed all types of people buy all types of homes. Even as the crisis began, the CEO of Countrywide, Anthony Mozillo, adamantly stated that the market was solid and healthy. Not too long after, the company was bought out by Bank of America for literally pennies on the dollar...they still may have paid too much.

Lehman Brothers - A highly reputable name who's collapse really led to the freezing of the credit markets. This company was over 150 years old and survived 2 World Wars, a Great Depression, and even the Civil War. Unfortunately, as a big holder of MBS's and a key player in the credit markets, it found it difficult to find other banks to do business with due to sheer fear. On the other side, its clients were pulling money out at an alarming rate, basically causing a run on the bank. By the fall of 2008, Lehman Brothers would no longer exist.

Citibank - The largest financial institution in the world was having trouble long before the crisis even began. People said its sheer size and complexity resulted in an overly bloated structure that couldn't react well to changing market conditions. Well, it wasn't able to react quickly enough to this massive change in conditions and has been hit hard as a result. Last I checked, they were well on their way to firing upwards of 50,000 of their employees, but at least they're still in business!

AIG - Banks weren't completely dumb in recklessly buying MBS's without mitigating their risks. Many bought insurance policies on those securities in case they did lose value as a hedging strategy. Well, AIG, the largest insurance name in the world, was a big originator of these policies better known as Collateralized Debt Obligations (CDO's). But when the MBS's became worthless, the banks went to cash in their policies, putting an immense strain on AIG which, eventually required government help to stay afloat to the tune of $100+ Billion (last I checked).

Investment Banks - The term investment banks refers to banks that did not take regular deposits from consumers and, therefore, are less heavily regulated than commercial banks. These guys (names like Goldman Sachs, Merrill Lynch, Lehman Brothers, etc.) were able to take more risks and, for a while, gain huge rewards for their clients and themselves. As the market went bad, so did their businesses. In fact, their business went so bad that they needed government help to stay afloat. To get that help (by way of the $700 Billion TARP program), however, they needed to be commercial banks (like Citi, JP Morgan, Bank of America etc.). Therefore, most of the major investment banks either changed to commercial banks or went belly up, or were acquired by other names, thereby ending the concept of the investment bank altogether.

Financially Responsible People - Yes, you guys that didn't get crazy mortgages and didn't over-extend your finances are paying for the mistakes of others. It's unfortunate, but it's what the reality is. Makes me almost wish I bought a Ferrari by re-financing a house that I never planned to pay the mortgage for or something...


Who's To Blame


Now that we have an understanding of what happened, the natural question becomes who's responsible for it. Like any problem of this magnitude, I think it's safe to say there are many culprits. The banks are an easy one. The greed and manipulation that overtook Wall Street for many years resulted in banks taking way too many risks with their client's money. The models they were using were broken, and they didn't see it. Whether that was intentional or not, I'm not sure - but if it was truly uncontrollable, than banks like Wells Fargo and US Bank, who were able to stay healthy through all this carnage must be really really really lucky.

Blame can also be placed on the government. Why were financial institutions allowed to over-extend themselves to such a great degree? Why didn't someone (SEC?) say something to regulate how the mortgage industry could be traded. Furthermore, the Federal Reserve played a large role in giving banks the cheap capital it used to fire up the MBS market. Where was the intervention there through tools like interest rates?

Finally, one that I particularly want to point out is people's common sense. If you make $50,000 a year, you shouldn't be able to afford a $750,000 house, I don't care what your monthly payments are. If it's too good to be true, it probably is. And I don't care what that mortgage broker told you, you are over-extending yourself beyond your means. Common sense took a back seat in many people's minds. Hopefully it's coming back now.


Where We Are We Go From Here


So here we are, a year and a half into this whole fiasco. The credit markets are slowly un-freezing and companies are finding ways to do business again. The US Government has stepped in and pledged trillions of dollars to support the economy and world governments have followed suit. However, the damage has been done. Literally trillions of dollars of wealth has been wiped out of the market. You can't have something like that happen and just bounce back from it. That's why I feel that it'll take at least through the rest of 2009 before we seen some real growth in the economy again. Furthermore, there will be major changes in the financial industry to try to ensure something like this doesn't occur again. You'll probably see some more banking names disappear as well.

There are some bright points, however. I really believe that, unlike the 2000 recession, the market has been much more drastic in the realization of the downturn. By that I mean that this downturn was so sudden and dramatic, companies also reacted with similar intensity. As a result, I think a great deal of the layoffs and cutting of business capacity is in place. Although I do think more will still be happning, the worst is behind us. Now I expect an era of rebuilding the foundations of the market for the rest of 2009 and a return to growth sometime in 2010. If you're a long term investor, it isn't a bad time to start nibbling again. We just have to hang on a little longer, but we'll get there.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

The Current Financial Crisis – What the Heck Happened? (Part 1)

Alright, my first real post! I figured I might as well start out in an area where everyone is probably interested in, the current financial crisis and how we got here. There's been a great deal of coverage on this topic through various news channels outside of the financial-specific type. I even saw a documentary on it on the History Channel recently titled with something like 'The Next Great Depression'. Although I strongly disagree with too closely aligning this crisis with the great depression - there are some very important differences - I did find it an interesting and easily understandable piece on the origins of the crisis.

What I'll do here is to try to give some context as to what's going on while also giving my take on where we go from here.

The Way Things Were and Where Things Went Wrong

To understand what's going on, it's important to understand what changed in order to set the crisis up. It all really boils down to mortgages...and how they're created, who gets them, who owns them. Back in the old days (meaning 10+ years ago), getting a mortgage would be more like building a relationship with a bank. The banks wanted to know who you were as a person, as a borrower, and as a money spender. They wanted to know these things because that's how they would evaluate their risk when you asked them for a mortgage. If they decided to loan you money, they would own a mortgage (which is like any other asset a bank or company can have), and they wanted to make sure that you wouldn't default on this mortgage.

The system worked in this basic manner for decades, and the banks were able to build highly refined risk models to accurately predict a person's profile. In the end, they became very good at assessing risk because they needed to be good, otherwise it was them who would lose out if the borrower defaulted.

So, what changed?

Now things start getting a little tricky. The government began a long term political quest to promote home ownership in every person possible. To do this, they created new enterprises (Freddie Mac and Fannie Mae) to essentially share the risk of mortgages that were given to people that banks would normally not lend to. The aim was to help people generate wealth through the biggest single asset a vast majority of Americans will ever have - their homes.

Well, although this was a novel and highly regarded endeavor, it had some not so fun consequences. See, now that it was common to share mortgage risk with other banks, these banks started getting a little creative. They found ways to not only share the risk with the government, but with other investors. What they did was take the mortgages they created and packaged them into securities. Essentially, these mortgages turned into mini-stocks and they traded like those stocks. They came to be called Mortgage Backed Securities or MBS. Now, the banks could issue loans and makes money from the fees associated with those issuances, but turn around and sell part or all of the mortgage to investors as MBS's. In essence, they no longer had to worry as much about the risk associated with these loans since they wouldn't have them on their books. It would essentially be up to the investors who bought the MBS's to figure out what their worth was.

But here comes another problem, although these MBS's looked like regular stocks, they didn't trade like them as in, they don't have a market like the NYSE or NASDAQ where all the buyers would come in and the price was determined by the amount buyers were willing to pay and sellers were willing to sell at. Instead, the MBS's traded over-the-counter (OTC) meaning there were direct trades between buyers and sellers. This direct trading method made pricing the MBS's more difficult since there was no central market place and, again, put more onus on the investors to price the MBS's appropriately since they would have little reference as to the market value like they would on an exchange listed security.

The Rise Up

So now the train is leaving the station for what will eventually turn out to be, for lack of a better term, an economic wreck. Initially this worked out great for everyone involved when this risk sharing model was created. The economy was coming out of the dot-com bust. Interest rates for mortgages were historically low and the government promotion for home ownership was still going on. Banks were lending out more and more money to people that maybe weren't qualified for the mortgages they were receiving. New types of mortgages came out (option ARMS, Alt-A, etc.) that gave people the ability to afford homes that were way out of their usual price range with little or no money down. The banks realized that there was a virtually infinite demand for homes, and, with MBS's, they could loan out money beyond their usual risk tolerances. Consequently, home prices kept on rising, further increasing the level of indebtedness for Americans. People could easily refinance their homes to pull the equity out and buy more things like cars, LCD TV's, pools, all the good stuff. Eventually, Americans were more in debt than ever before. On the other side, investors kept on buying those MBS's, and as home prices kept on rising, they were still making money.

Everyone was happy. Money was being made. And then things got ugly...and that's where I'll pick up my next post!

Hope you liked my first one.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.

Welcome!

Welcome!


I’d like to welcome everyone to my newest endeavor and New Year’s resolution: A blog about investing and various topics relevant to personal investors. Really, it’s a blog about what’s on my mind and, as such, I may talk about things other than investing once in a while. But, as many of you already know, investing is something I do…all the time. It’s something that I’ve been doing over 10 years now and, along the way, I’ve learned a whole boatload of stuff that I sometimes don’t know what to do with. Well, this blog is just a way for me to get my brain on paper and share it with people with the hope that others can learn as well. Hopefully you’ll check back regularly to see what’s one here and even contribute by commenting on my posts with suggestions/feedback, etc.


Why would you ever want to read this?

Good question. Why would anyone want to read about investing – especially if you don’t do it regularly? Well, my goal here is to take some of the most complicated and confusing things about investing and simplify it for you. Over the years, I’ve had countless friends and family ask me questions about investing and money management. These questions ranged from how to allocate a 401K, to what an ETF is, to why did the current financial crisis happen. Answers to questions like these are something I realized I was taking for granted – I realized that these are important questions to people and I have answers to them in my brain, which they can’t see unless they ask me. Most people will at some point have similar questions, and I want this blog to be one of the sources where they can get answers. In other words, this blog is to answer questions, some of which you may not have even asked yet. At the end of the day, though, I just hope to impart a little wisdom that has been imparted to me over the years.


Why even listen to me?

Another good question. First off, I am not a professional investor…far from it. For those of you who don’t know already, I’m a consultant at Accenture who has an undergraduate degree in Aerospace Engineering. A reasonable conclusion here would be I don’t know enough about finance/investing in order to be giving advice, and I agree. Like I said earlier, this is just me spilling my mind on a blog. Please please please think for yourself before acting on any of my advice. I even think it’s worth consulting a financial advisor.

With that said, many of you already know that investing is probably the biggest single hobby that I have. I’ve been doing it since I was 14 and have been active in it since then. My dad has entrusted me with all of his investments, and I don’t take the responsibility lightly, nor do I mind spending hours on end every week managing that money. I keep very very close tabs on the market. I’m always thinking of new ideas…new stocks…new industries, because it excites me and keeps my brain occupied. Some people paint, others read books, while others play video games. I spend my time on Yahoo Finance, Businessweek, Forbes, Bloomberg, thestreet.com, yadda yadda yadda, all while having CNBC on TV. As nerdy as it sounds (yes, I can admit it), it’s what I like to do. Through the years, I’ve picked up knowledge that even people I know who are in finance as a profession are impressed with. Do I know as much as a professional, definitely not. But I hope to share what I do know in the hopes of it will at least help others answer questions they might have. And I will do my best to make it simplified so everyone can understand what I’m talking about. At the same time, I really feel writing about many of the topics will help me learn myself, so that’s another goal right there.


How will this work?

I will try to post on this blog at least once a week. I will be posting about a topic that could fall into any of these categories:

• Recent news in the business/investing world
• A stock/investing idea I may have
• A topic in investing that’s worth talking about
• Other random things that are in my head (may not be investing, but I’ll try to tie it to investing somehow)

For all those loyal readers out there, I will definitely appreciate any feedback/comments/suggestions you may have for topics to talk about and those not too. If I can help one person, my time will be worth it. I would even love a good debate with someone if he/she disagrees with me since I believe that’s one of the best ways for people to learn.


Other Stuff

Please note that everything I write is how I understand it (which is why it’s in the title of the blog itself). I in no way guarantee any of the stuff I say is correct, although I will try my best to be as accurate as possible. Also, this is a blog and, as such, my writing style may be a little stream of conscious and lacking structure. Again, I will try to be as logical and ordered as possible, but I apologize if I’m not. If I do confuse people, please don’t hesitate to ask for clarification! Chances are, more than one person will be confused and I’m always up for improving my writing style.

Finally, thank you for reading my first-ever blog post. Keep an eye out for my first topic. I’m thinking it’s going be a good one: ‘The Current Financial Crisis – What the Heck Happened?’ Have a great start to the year!


The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I’ve said above. This includes consulting with a financial advisor.


Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!