Ellison: Banks Still Working Through Credit Crisis

Ryan Leggio: Hi. I am Ryan Leggio. I am a mutual fund analyst at Morningstar and with me today is David Ellison. He is the portfolio manager at FBR Small Cap and FBR Large Cap. David thanks so much for joining us today.

David Ellison: Good morning. How are you?

Leggio: Good. Thanks. I really wanted to ask you about how you manage your funds, and in particular, you are one of the few financial sector managers that really manage their funds in an absolute return kind of orientation.

Can you explain, why you decided to run your funds the way you have, which has really helped shareholders? In 2008, for example, the small cap fund was down less than 10%, and this is a financial fund, less than 10% in 2008, while your competitors were down, 30%, 40%, 50%, but also how the absolute return focus helps over the long-term?

Ellison: Well, I think in the sector area, two things, one, I own the portfolio, and so when you treat the portfolio, if it's your own money, you don't want to lose money. And so the idea is that, I run it to sort of, say, well look when things are tough, I want to generally be out of this space and I think I had about 60% cash when things were tough, and I would have had higher cash if things had continued to be difficult, but more importantly, this industry is cyclical. There are times when it does very well, and there are times when it does very poorly and you want to generally be in the industry when it is improving and be out of it when things are deteriorating.

And the big driver of that is credit. Credit in the sense is the big creator of value, which I think we are seeing today, and we will see the next five or 10 years, but is also the huge destroyer of value, and you saw that with Bear Stearns, you saw that with Lehman, you saw that with Washington Mutual; you pick your failure de jour, right? And so, we had, three years ago, non-performers were rising, and I said, look, let's get away from it, because that destroys value and I have seen it before. I have been managing money since 85, and I went through that, FIRREA bailout in 1991-92, and I saw that a lot of banks failed, and so the idea is that you want to generally be away from that. So, that's generally how I run the portfolio.

Leggio: We've come a long way since non-performings rising, bank failures every Friday night in local communities around the country. Where we are now in that kind of credit cycle and how do your banks looks both large and small to you?

Ellison: Well, I think that's a great question, that's what everybody is focused on, in a sense, where are we, in a sense, we've had this rising credit, we've had a decline in home prices across the country, which is the first time it's happened in the history of the data. We've pockets of home prices decline. Texas, lets say New England, back in the early 90s, but on average this is the first time in the history of the data that home prices have declined across the country on average. And they didn't go down 1% or 2%, they went down 20% or plus, if you look at the Case-Shiller, which everybody has access to.

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So that's been the real the win, that's been the sucker punch. So now the issue is that, I think we are at a point now where, obviously, we've had a two-year, all hands on deck fire drill in this industry. Everybody, saw it happen, they all understand it, they all are trying to get better, and so now the battle here is to sort of work through that. And I think we are at a point now where in a sense, we are starting to work through that.

We are starting to see the benefits of their work. These companies are working very hard to get better and we are seeing on average non-performers start to decline and as you look at the most recent news report, they are reporting now their June results, and we are starting to see the benefits of that. So, I think that will continue.

Leggio: Since you talk to a lot of smaller banking, either presidents or credit officers, and you really can see that's happening in different parts of the country, are there any themes that are popping out to you, which areas of the country maybe are recovering the fastest, which areas maybe aren't, and are banks partly to blame for some of the areas that aren't recovering as fast.

Ellison: Well, I think what we are seeing is in a sense the benefits of consolidation and the unfortunate things that happen when there isn't consolidation; in a sense, if you look at New England, for example, they were – that region was very much consolidated in the last banking crisis. And; remember Bank of New England failed in New England, it had a huge franchise and when that failed, that was the fifth largest bank in the country.

So New England was just decimated, because they had the biggest share of anyone and that drove a lot of other banks into trouble, but that's all being consolidated. That market has been very good, I mean I live there. I am from Boston, been there since the early 80s, went through the cycles and that economy has been reasonably good, but if you look at some of the other areas where there is a more or less consolidated industry, like in Florida, like in Arizona, like parts of Pacific Northwest, like up in the Midwest; it's much harder because those banks are in trouble and they are so small. They don't have access to capital. They're not going to Wall Street for capital. The FDIC doesn't really care about them. They're small enough to fail as opposed to too big to not fail, all right. So that makes those economies much worse than they would be otherwise. So what we're seeing is that the banking industry is a big part of how those local economies work. If the banking industry is in trouble, those local economies are in trouble.

Leggio: Any thoughts as to when we might see substantial dividend payments again for a lot of the large financial institutions? And then, secondly; how important is paying dividends again to you right now?

Ellison: Well, to me, the most important thing now is to watch the credit trends. I mean, to me, it's not about valuation of, you look at price-to-book, you look at PE of the individual companies. The important thing is, if we continue to see improvement in credit, that's going to mean that unemployment, hopefully, gets a little better, home prices stabilized a little bit, we don't need them to go up. We just need – we need home prices to stay stable. We need unemployment to get a little better and if that happens, the earnings are going to recover and the stocks are going to fall.

We're going to worry about valuation. We're going to worry about dividends a year from now. And I think dividends are important, but it's a sign that things are getting better. And this industry sort of goes through the cycle of ugly, to okay, to good, to great, and we are in an ugly position now and you want to own them now with a presumption that in three to five years, when things are great, you're going to sell them.