Fire Sale on Financial Stocks

"A bank is a place where they lend you an umbrella in fair weather and ask for it back when it begins to rain."

Robert Frost could well have been talking about the current state of the financial markets when he penned this quotation. Even with all the information--and disinformation--swirling around the current financial market panic, it is possible to boil the problems down to one essential element: credit. The vast majority of financial companies need it, and right now, it is hard to come by. No one wants to lend money to a borrower (be it a company or individual) that might not pay it back. So many lenders have cut off riskier borrowers or closed their doors altogether. This had been feeding on itself in a type of vicious cycle that has hurt financial companies very broadly.

But we are fundamentally optimistic about the long-term health of the financial-services industry. We believe the current market storm will serve to winnow out weaker companies and more speculative investors and that the strong and well-run will survive. So investors with a long time horizon can ride out the current storm. We also believe that there are some adamantine backstops that should arrest any panic before it could destroy the financial system. Therefore, we have put our highest recommendation, 5 stars, on more than 50 financial-services companies. Many of these stocks have been victims of the credit crunch. We feel that the market is handing investors some fantastic values at today's prices and that long-term investors who can tolerate the current level of risk should reap handsome returns.

The Strong Will Survive
Credit, which was easy and plentiful mere weeks ago, is now much harder to come by and more expensive. This matters for businesses that depend on short-term credit to fund their operations. Some businesses that were completely dependent on short-term credit, such as  New Century , have already folded. Others that depend partially on short-term loans, such as  Countrywide , have been trying to shore up their credit lines and make sure that funding is in place so that they can survive the current storm. Others with plenty of funds in house, such as  Berkshire Hathaway (BRK.B) with $41 billion in cash on its balance sheet, have no need of credit.

So we have necessarily focused the bulk of our research on credit-sensitive companies. We have been evaluating whether they can survive without short-term credit, and if so, how long. For example, my colleague Erin Swanson has the following to say about Countrywide's position:

Assuming it originates and sells conforming loans at break-even and does not reduce its head count, Countrywide burns cash at a rate of about $1.4 billion annually, or $120 million per month. In addition, $12 billion of debt will mature over the next year. Beyond this $13.4 billion, we assume the firm will need to secure additional cash of $6.6 billion to meet any unforeseen contingencies, bringing the total amount of funding required to stay in business over the next year to about $20 billion.

Next, we examined the firm's funding sources; we're comforted by the diversified avenues the firm has available to meet its funding requirements (including deposits, Federal Home Loan Bank advances, federal funds, and commercial paper). We identified $15 billion of trading securities the firm could sell to the market to raise cash, most of which are agency or GSE, indicating that these securities could be sold at or near carrying value. Further, Countrywide maintains about $20 billion of mortgage-backed securities that can also be off-loaded in the market; however, the sale of any non-GSE securities would be at a discount to its carrying value.

That said, we see a lot of alternative means available to the firm before it must sell securities to meet funding needs. We expect the firm to aggressively solicit deposits and tap the maximum amount of FHLB advances at its disposal. It will only begin selling a significant amount of securities after exhausting the funds available via these avenues. As a result, we believe its access to liquidity will enable Countrywide to weather the current storm.

We don't know how long the liquidity crunch will last. But we do know that it won't last forever. We believe that the credit markets will want to extend credit to homebuyers and that lenders will continue making loans. The best companies will survive the storm and become even more dominant, and the weaker ones will not. We believe that long-term investors have a significant edge here. Investors with shorter time horizons, including many hedge funds and highly levered investors, cannot afford to wait out a difficult market. For investors who can, the "survivor" companies offer compelling value.

Safety Nets
What is to stop things from getting worse? What can stop the contagion from spreading with financial markets so tightly connected to one another? We see several forces in the market that can act as barriers to stop the current snowball from getting much bigger. First of all, there are the GSEs.  Fannie Mae (FNM) and  Freddie Mac (FRE) were created to buy mortgage loans in order to free up capital in the market and encourage lenders to write mortgages. Fannie and Freddie are still buying, and they may eventually be allowed to venture beyond the confines of conforming, fixed-rate loans. But even if they do not, they provide much-needed liquidity to the mortgage markets and give lenders the security of knowing that they can always sell these types of loans if they make them. This is a huge pool of credit that is now extremely valuable.

The government also provides a valuable bank safety net. Federal deposit insurance means that bank depositors can feel secure about giving money to an insured bank. Depositors effectively lend money to a bank, which can then lend it out to other borrowers, including mortgage customers. So banks with solid deposit bases have a ready source of credit at their fingertips, as is the case with Countrywide and its bank.

Last but not least, the Federal Reserve can have a huge impact. Through its open market operations, the Fed can manipulate interest rates and thereby encourage or discourage borrowing and lending. We expect the Fed to use its power to avert a potential disaster if conditions were to become significantly worse.

Firms at Fire-Sale Prices
A long time horizon, coupled with the confidence that the best lenders will survive this crisis, means that we are sticking to our guns and recommending some outstanding values. We will highlight a few names here, but Morningstar.com Premium Members who want a fuller picture of 5-star financial stocks can see them by  clicking here. (Data as of Aug. 16, 2007.)

 Countrywide Financial 
Current Price: $18.95
Fair Value: $48
Morningstar Rating: 5 Stars

Countrywide is the largest mortgage lender in the U.S. It has been caught in a barrage of negative sentiment surrounding its ability to borrow money to fund its operations. We think it will not only survive, but that it will emerge stronger in the future.

 CapitalSource 
Current Price: $16.02
Fair Value: $33
Morningstar Rating: 5 Stars

The company and its dividend still appear to be in good shape, and CapitalSource is well positioned to take advantage of current fears in the capital markets, in our opinion. When credit spreads widen, companies like CapitalSource can charge higher interest rates on loans, potentially improving net interest margin in future years.

 E*Trade Financial 
Current Price: $13.55
Fair Value: $24
Morningstar Rating: 5 Stars

In light of the difficulties in gaining access to short-term credit that other mortgage lenders have experienced, there appears to be concern that E*Trade may be dealing with many of the same issues. However, we believe that E*Trade has adequate access to liquidity in the near term through its substantial deposit base, as well as access to Federal Home Loan Bank advances. As such, the firm should be able to weather the current storm.

 Newcastle Investment Corporation (NCT)
Current Price: $16.28
Fair Value: $31
Morningstar Rating: 5 Stars

Of Newcastle's $9.1 billion in assets, $1.2 billion are subprime loans or subprime-backed securities. Going forward, there is still the risk that many of these assets may be further impaired; however, Newcastle is taking calculated risks and buying assets at distressed prices. This is core to the strategy in which they seek to exploit market turmoil. Besides credit concerns, fear about short-term liquidity problems is elevated in the mortgage real estate investment sector today. Newcastle has a balance of $300 million on its warehouse facilities. Meanwhile, it has $35 million in free cash and $154 million in restricted cash. Liquidity does not appear to be a concern in the short term, since the majority of assets are financed with long-term debt.

 Bank of America (BAC)
Current Price: $49.85
Fair Value: $70
Morningstar Rating: 5 Stars

This bank doesn't have credit woes. But as other lenders have caught colds, Bank of America has felt the chill. We believe the market is offering a tremendous discount for the shares of this giant.