Fueling recovery: business and consumer lending on the rise

Credit is the fuel for economic recovery and expansion. We may be seeing the beginning of the next credit expansion, with the nation's largest commercial banks finally increasing their lendings to both businesses and consumers, see this WSJ report.

Signs of a lending rebound in business loans already were evident at some big U.S. banks, and Mr. Dimon cited "fairly broad-based strength across corporate, middle market, even small business." But consumer lending has lagged behind because of unemployment, foreclosures and the reluctance of many Americans to go deeper into debt.

Now, the economy is gaining momentum, as shown by the Commerce Department's report Friday that consumers spent more for the sixth straight month. That means profit-hungry bankers are growing more eager to make new loans, especially to borrowers with strong credit histories.

JP Morgan has just reported a great quarter. More are yet to come from Wells Fargo, Bank of America, and Citi this week.

According to Dick Bove, an influencial bank anaylst, banks are entering a "golden age."

Happy holidays, but be worried about global risks

The year end rally has been strong. It's not all surprising given the steady climb in auto and other retail sales. Consumers maybe back from more than two years of belt-tightening. That's a big deal.

Retail investors may be tip-toeing back to equity markets as well, moving away from bond funds as the long-term rates are rising.

Institutional investors may be pushing the winners all the way to the end of December. We don't know. But given the predominately bullish commentaries we read everywhere, there is a great likelihood the market is setting itself up for a big correction comes January.

Here is an interesting indicator of the extreme bullishness.

Banks and other financials may be in a good position to benefit from the firmer recovery undergirded by the Fed's QE2 and the Congress's tax deduction extension. We have benefited a great deal from our large positions in WFC, BAC, USB, and some home builders.

But, this is the time to be very cautious. Dark clouds are swirling, people just don't talk about them much. European debt crisis is very much alive and not going away anytime soon. US unemployment rate will be elevated for years to come. Deficit problem is not been tackled in any systematic way. China's inflation problem may require much more severe measures than expected. These are known problems. Granted, market's tolerance is higher when these problems are known. Still, it seems very likely that more surprises may be lurking around the corner.

Andy Xie, an independent economist, has this piece about US and China. His main point:

China may have won the last race. To win the next one, China must tackle its inflation problem, which is ultimately a political and structural issue, in 2011. If China does, the U.S. will again be the cause for the next global crisis. China will suffer from declining exports but benefit from lower oil prices.

On the other hand, if China has a hard landing, the U.S.’s trade deficit can drop dramatically, maybe by 50%, due to lower import prices. It would boost the dollar’s value and bring down the U.S.’s Treasury yield. The U.S. can have lower financing costs and lower expenditures. The combination allows the U.S. to enjoy a period of good growth.

One could describe the global economy as a race between the U.S. and China, to see who goes down first.

We're now 50% cash, increased our shorts. We'll be even more defensive if the market continues to rally next week.

State Budgets: Day of Reckoning

While the VIX has been trending down to below 16%, the lowest level since April of 2010, the Muni bond market may be telling us something quite different. The yield spread (against an index of the highest-rated muni bonds) on debt issued by the State of Illinois, for example, has been increasing rapidly from pre-crisis level of about 0.2% (2008) to about 2% in late 2010.

The video below from CBS 60 Minutes is a must see.


Will weak local governments create a similar systematic financial problem posed by the weak Euro members?

Rising mortgage rates goes with rising housing starts?

Housing starts have been in the dump for most of 2010, especially after the experiation of the tax credits. This morning's report shows some life in this important sector. Perhaps the sector is now ready to stand on its own feet.

Mortgage rates however have been rising rapidly since the Congress and the Administration started to work on extending the Bush-era tax cuts. Investors have been shunning Treasuries, in favor of cash, commodities, or equities. This is not necessarily a reflection of rising inflation expectations, although that could be part of the reason (judging from the implicit inflation rate priced into TIPs). On balance, investors are probably betting that the expansionary monetary policy as expressed in QE2 should work well in the thort term with the accommodative fiscal policy should it passes the House. Rising long-term T rates, which causes the T yield curve to steepen, is a sign that the economic recovery may quicken 2011-2012.

The Fed's goal was to stimulate the economy via asset inflation. It has so far succeeded in chasing investors away from the "safe haven" of the Treasuries, into more risky assets that are more tied to the US and global economies.

That's only the beginning. For this twin stimulus to work, the private sector needs to move up in a big way to employ more works. Millions more. More jobs would help housing starts. And more housing starts would jump start more construction jobs.

For people looking to buy a house, mortgage rates in 5-6% are still relatively low. The dominating variable is job security. Besides, when the rates rise to a certain level, bond funds and foreign government would purchase more long-term US government bonds to help hold down the rates.

In this mix, banks that have repaired their balance sheets and have successfully re-positioned themselves to take advantage of the steep yield curve and the economic recovery should be ready to print profits in the boat loads. One of the prime beneficiaries will be Wells Fargo, whose market cap has again overtaken that of JP Morgan today with its share rising over $30. A recent Barron's article has put WFC's shares at $35-40 range based on its normalized earnings power, which it should start to show itself in 2011 when Wachovia branches are all converted.

Investors should hold on to these bank shares, and some of the home builder shares for an interesting "rabbit ride" in 2011. 

US Banks with funding cost advantage may be the place to be

Investors are focusing on Euro crisis. Quietly, US economy may be gathering steam, despite all sorts of political problems. Consumers are saving more, but they've not stopped spending. Manufacturing is still expanding.

Housing is soft, which is adding a big drag on the recovery.

Employment situation may be slowly improving. Economists are expecting 150,000 jobs being added in Nov. Most of them should be in the private sector, especially services. This Friday's report will be a key event.

The Fed will maintain low rates and east money stance, at least for the first half of 2011. Bonds are expensive. Stocks are relatively cheap.

US banks that are not exposed to the European problems may be a relatively safe place to park cash, to pick up some nice gains as we move into 2011.

Low funding cost will be a key advantage.

Credit default rate is coming down as consumers repair their balance sheets. Capital requirement is less of an issue now. The yield curve is fairly steep so the interest differential is healthy (10-year Treasury is yielding close 3% while the funding cost for banks could be zero.). The Fed will be slow to raise short term rates even when the economy starts to pick up.

Banks such as Wells Fargo that are focused on building the coast-to-coast distribution network and executing its time-tested business model are well-positioned for earnings growth.

Double-dip?

Fear of a double-dip recession has returned to the U.S. market. Housing is weak, and looking weaker without more government support. European sovereign crisis has added to the global banking worry. China's tightening to release inflationary pressure has taken away another support for global recovery.

In other words, aggregate demand is weak. And governments are either not able or unwilling to create more aggregate demand.

All these are reflected in the U.S. bond yields. The interest rates for long bonds are heading to new lows, along with the mortgage rates.

We had expected that the private sector to start adding more jobs by now, but the reality seems to point to a discouraging picture of reluctance. Corporations are still waiting. Consumers are still reluctant. Banks claim they cannot find enough qualified borrowers. Every developed country is hoping that external demand will create enough pull for their export sectors. Aging population and pubic debt burden ... all seem awfully hard problems to solve.

It seems no news is good enough. Rallies are now short-lived.

The lack of confidence itself could aggravate the risk of the double-dip recession. The housing market appears already heading that way with the expiration of the home-buyer tax credit. Housing-related stocks have seen a steep selloff in recent months.

The risk of general deflation is much higher now than two months ago. This is the time for the Fed to renew its innovative push.  

Wells Fargo has become the largest U.S. bank

Less than four months after my earlier post about Wells Fargo becoming the largest capitalized U.S. bank, it has now overtaken JP Morgan and Bank of America in market cap. At $33.5/share, Wells is valued at about $175B, while BofA is at $172B, and JP Morgan which used to be the largest is now at about $164B.

This change of positions are largely due to the potential impacts from the pending financial regulations which aim squarely at Wall Street and trading operations. Among the large banks, Wells Fargo has the least exposure.

In addition, the recent European sovereign turmoil, and the worry about writedowns that many of these European banks and international banks may suffer from, have added to the change. Wells Fargo is more of a pure U.S. commercial banking play, whereas B of A and JP Morgan, Citigroup all have sizeable international franchises.

It is also interesting to observe that HSBC which has more concentration in Europe and Asia, has seen its market cap drop to about $172B, behind Wells as well.

It pays to be more focused on earnings quality and being truely conservative.

The widening criminal investigation on Wall Street firms from Morgan Stanley, to Citigroup, to JP Morgan in particular may do a lot of damage to trading firm's reputation. Interestingly, Goldman Sachs, being the first to be investigated now may start to gain back its composure because everyone on Wall Street is in the same boat. When Goldman's clients look at this picture, what are they going to conclude? You still go with the "best."

Subprime Crisis Act II: The Greek Tragedy

Goldman's testimony was just a distraction. The real act was the country that gives us those letters to describe derivatives and volatilities.

Following last Thursday's report that Europe’s statistical office (Eurostat) had revised up the Greek 2009 budget deficit and Moody’s subsequent downgrade of Greece’s credit rating by one notch, another major rating agency S&P lowered Greece’s credit rating to BB+ from BBB+ and warned that bondholders could recover as little as 30 percent of their initial investment if the country restructures its debt.

That means Greece's credit standing is now "junk," or the sovereign equivalent of a subprime borrower.

The downgrad marked the first time a euro member has lost investment grade rating since the currency’s 1999 debut. S&P also reduced Portugal by two notches to A- from A+.

According to Bloomberg news, Greek 2-year note yields soared 505 basis points to almost 19% and Portugal’s jumped to 5.7% as credit-default swaps on Europe debt surged to a record. The yield on Greek 10-year bond climbed 45 basis points to 10%. That makes the Greek bond yield curve even more inverted, signalling a short-term tragedy and a long-term pain.

The fear in the market is that the sovereign credit crisis may spread to other euro members, notably the other PIIGS countries.

What's the way out?

According to Stratfor,

An EU-IMF bailout of Greece would ultimately give Athens the choice of becoming either an Argentina or a Latvia. A financial assistance program that does not involve substantial structural reform on Greece’s part would lead to a default a la Argentina. A bailout that forces Greece to get serious about reforms would mean Greece becomes an IMF-ward like Latvia, with default still a serious possibility down the line. In either case, Greece will essentially lose control over its destiny.

Yet another way out perhaps is to let Greece out of the euro pact quickly, so that it can persue its own independent monetary policy (i.e. print money).

Whatever it is, the European banks or other investors holding these sovereign debts are facing the pressure of a massive writedown, thereby weakening the already weakened European banking sector. This threatens the nascent global recovery currently underway, but shouldn't derail it.

See a more detailed analysis on why PIIGS crisis matters.

Is Goldman a buy?

Goldman Sachs is facing a political firestorm. Some heads may have to go, but it has a deep bench.

The forward P/E and the trailing P/E all look attractive at 6-7 range, now that the price is at $152/shr.

Is it a buy? Popular bank analysis Dick Bove thinks so.

We note in the Abacus deal, John Paulson came out ahead with $1B, and the losers were a German bank, IKB, which lost $150M, and Royal Bank of Scotland (RBS), which lost $840M.

The congressional hearing on Tuesday may yet create more discount on the shares.

What drive the V-recovery?

More and more investors and business leaders now believe we are onto a normal V-shape recovery. The supporting evidence from GDP growth and leading economic indicators to corporate and consumer spending are just too strong to ignore. Yet this vision of a normal recovery clashes with other pieces of hard evidence of sluggish job creation, persistent high unemployment, sluggish construction spending and slow lending to consumers and small businesses.

So where does the apparent V-recovery come from? Is it for real and sustainable?

Many economists and analysts have tried to gain insights for these question by examining aggregate reports and statistics such as GDP, Employment Situation, Housing Starts, Existing and New Home Sales etc. While these analyses are useful, many important forces can get lost in the statistics and aggregation. Skeptics and conspiracy theorists will continue to find holes in any of these numbers and trends. Discussions can easily become sports fans' wars of taking sides, or economists' religious fights, both are largely a matter of which college they've gone to.

I'd like to do this differently. Much like what Warren Buffett has been doing by looking into Berkshire Hathaway's component businesses that are vital to the economy: Railroad, Banks, Home Construction and Mortgage, etc.

Today, let us examine one of Mr. Buffett's long-time holdings, American Express, in hope to gain more insights into the question imposed above. American Express (AXP) is nearly perfect for this purpose, as it is a global business focusing on credit-based transactions and credit lending. We all know that the great recession we are now recovering from was in large part caused by a credit crisis. Whether or not we're indeed experiencing a V-recovery must be reflected in its various business segments.

Last Thursday, AmEx reported first quarter net income of $885M, double the $437M it earned a year ago during the depth of the recession. Consolidated revenue increased 11% from $5.9B to $6.6B. Both exceeded analysts' expectations. Provisions for losses totaled $943M, down nearly 50% compared to $1.8 billion in the year-ago period. The decline reflected continued improvement in credit quality on the overall portfolio.

It is a very strong rebound. Almost V-shaped, as we will see below in more details.

AmEx has two broad segments: payment business (called "Billed Business" by the company) and lending business ("Cardmember Loans"). So it is very transaction- or spending-based, with about a quarter of sales coming from its leading business. Both businesses are international. They are very sensitive to the speed of economic activities and credit quality.

Chart 1 below from AmEx shows customer spending in dollar amount and in year-over-year (YoY) growth rates in both "as reported" and "FX adjusted" bases, month by month. Click to enlarge.

 
For the first quarter of 2010, customers increased spending by 16% from a year earlier. And the YoY growth rate has reached 20% for March. During the first quarter of 2009, the business had a most steep deline YoY in February when the growth rate was negative 20%. The recovery in growth rate is remarkably V-shaped.

In fact, according to the CFO, March 2010 has been the highest March ever for the billed business. During the conference call, when asked how can that be when more people are unemployed and companies seem to be spending less, the CFO said (my amphasis):

I think what we see here is when things improve that discretionary spending is coming back. I think it is really the impact of a more affluent customer base. I think that is one part of it. The next part has to do with corporate card. Corporate card generally is more of a V. It goes down sharper than the rest of spending and it comes back a lot steeper and I think we are seeing that make a strong contribution here. We have a very strong position in corporate card.

Thirdly we have a strong G&S ["Global Network Services"] business. As you can see from the charts spending on cards issued by our partners that run on our network is performing very well. ..

Right there are three important insights for the V-recovery. First, more affluent consumers have generally recovered, perhaps due to both of their more stable income and wealth recovery. We see more and more retailers catering to affluent customers reporting knock-out earnings and revenue growth. And, they are big spenders.

Second, corporations have come out of the recession in a much more healthy shape than consumers. It is really interesting to see the V-shape remark on corporate spending. Executives need to travel more as soon as business starts to pick up and corporate accounts are not as pinched as consumer accounts.

Third, both export and import have been surging. Trade with emerging markets has been a growth contributor, which has bounced back a lot faster than consumer-focused businesses.

We should also note that the current recovery has also been led by manufacturing and technology, most of the activities going there are tied to business-to-business and trade.

Chart 2 takes a further look at the growth rate of the billed business by its following segments: U.S. Card Services (USCS), International Card Services (ICS), Global Commercial Services (GCS) and Global Network Services (GNS). The first quarter revenue of these segments are, respectively, $3.5B, $1.1B, $1.0B and $997M. Click to enlarge.

The most V-shaped recovery is the GCS segment, "reflecting increased spending by corporate cardmembers and higher travel commissions and fees."

The GNS segment has been the most remarkable. It never stopped growing, although its growth rate was tempered by the great recession. The first quarter result reflects "higher merchant-related revenues from the rise in global card billed business, as well as an increase in revenues from Global Network Services’ bank partners."

Of course, not all of AmEx's business receovery is V-shaped. Its card member loan business has continued to decline. Chart 3 shows the growth rate comparison between this business and the billed business discussed above. Click to enlarge.

During the height of the housing boom, AmEx made a strategic mistake to expand its lending portfolio, thereby increasing its credit exposure to consumers who were already very stretched.

The credit crisis has put a huge dent in AmEx's financial performance. But over the course of 2009, the company has sought to shrink the credit exposure by lending less and by controlling credit risk. Recovery for loan growth, however, is nowhere in sight. This also reflects consumers' de-leveraging behavior coming out of the crisis. The declining loan growth is consistent with the "soft demand" claimed to experienced by U.S. commercial banks.

We are witnessing bifurcated recoveries: There is a strong V-recovery, at the same time there is also a very sluggish L-recovery, with the former more tied to corporate spending and international trade and finance, and the latter more tied to domestic and less-affluent consumers. Depending on where you look, you see a totally different recovery.

For the economy as whole, it will take the shape of where the leading/expanding sectors are point to: a "normal" V-recovery.

Wells Fargo, positioning well

WFC missed on revenue, but beat profit estimate. Unlike other large banks, Wells Fargo does not have an big investment banking or trading operation. So it didn't benefit from security underwriting or trading. The flip side of this is that its business would be the least affected among big banks if Washington pushes through its regulation to separate deposit-based banking from investment banking and trading.

It has two main sources of revenue: interest income and non-interest income. They are about equal in size, each brought in $11B last quarter. Mortgage income about flat, which means the company saw a soft loan demand. Deposit had continued to grow. Net interest margin came down a few basis points at 4.27%, largely due to this good problem: lots of deposit that earns no interest, but Wells could not find meaningful ways to park them. So they are keeping their gun powder dry. Wait for the loan demand to grow with the economy.

The biggest positioing story is of course the Wachovia integration, which appears to be on track. Company expects to achieve $5b in merger savings. The value in this merger is to convert Wachovia into an extension of Wells Fargo, using the same focused business model to realize higher efficiency and revenue generation by cross-selling more products to the same customer base. The end result will be a stronger coast-to-coast national franchise.

For a good summary, other than my take on its positioning, see this. Wells is getting everything ready to thrive in a growing economy when unemployment rate starts to decline materially.

Focusing on earnings

The first week of the earnings season turned to be rather eventful.

Intel and JP Morgan reported fantastic results that pushed the market higher. Google's somewhat disappointed.

March housing starts was a positive surprise, even though it's still way below average.

Friday was a bomb. SEC's charge against Goldman, combined with weak reading on consumer sentiment sent the market sharply down, erasing the gain for the week. Goldman story will linger on for months, as it's a poster child for Wall Street's greed and power. Everybody will be jumping up and down on this unfolding saga, and people are expecting more and more followup scandals and discoveries... the political risk of owning bank shares is getting even higher.

For bank stocks, two things to focus on. (1) We can avoid these Wall Street concepts. I've sold off JPM and BAC for that reason. I've stayed with my long-term holding WFC, for it has a very small I-banking business inherited from Wachovia Securities, and the rest is doing very well. I still think it could become the largest bank stock in market cap. (2) Pick up some of the bank stocks such as GS if they are excessively over-sold, so that the political risk is well-compensated. One of the Barron's articles argues that GS already looks under-valued after Friday's selloff. I agree somewhat, but the article may have underestimated the political fervor. Similarly, JP Morgan also looks expensive. Jaime Dimon's approach to dealing with Washington may not help. These Wall Street firms don't seem to get it: Washington will not leave them alone to do business as usual, doesn't matter what they say or do.

Last week, Sandra Ward had an article on Barron's about how retail investors are finally following the lead of institutional investors in getting into equity funds. It's well worth a read. I think there is more to come, which can turn out to be a powerful factor for the stock market.

James Paulsen's thesis on the recovery appears to be intact. This week, he re-confirmed the view by observing that "Despite persistent, widespread economic anxiety, the contemporary recovery appears remarkably normal."  That is, there is no "new normal."

According to Tax-Refund Monitor,

... taxes withheld in March  showed a very large increase over February. There were no changes in law or withholding schedules ... it often indicateds activity has accelerated, but is not yet being captured in the labor-market data. ...

Last Friday's WSJ, however, did have an article on "Tech Leads Jobs Recovery" that shows that Silicon Valley is ramping up hiring on tech talents.

Investors with a long term view informed by economic data will be in an advantageous position to play this market. Stay in the market, raise some cash when your winners become too large, and pick up good stocks when they're wacked by short-term forces. This is a sound strategy that I've played with with good results.

On Monday my favorite builder SPF will report Q1 earnings at market open. I'm somewhat optimistic. Citigroup, Goldman Sachs and Wells Fargo will report too. During the week there will be existing home sales and new home sales reports. It'll be very interesting.

Consumers to solidify the recovery

Consumers are out shopping in March, despite lower income and still grim job prospect. Confidence is getting back up.

Sales surged 1.6 percent, the Commerce Department said, up from February's revised 0.5 percent gain. Economists surveyed by Thomson Reuters had expected a gain of 1.2 percent.

The increases were across the board. Car dealers, home furnishing stores, building suppliers, sporting goods stores, clothing retailers and general merchandise stores all reported gains. Auto sales surged 6.7 percent, the department said, the most since last October.

I was wrong, the retail strength now looks quite solid.

JP Morgan reported great earnings today. Its nonperforming loans, those that are in default or close to being in default, totaled $2.7 billion, up $946 million from a year earlier but a $763 million improvement from the final three months of 2009.

"We continued to see delinquencies stabilize, and in some cases improve, in our credit portfolios," Dimon said. "Ultimately, the health of these portfolios will track the health of the economy."

The strong result is also telling me that I may have been too cautious about big banks.

Bernanke, testifying before Congress, said that consumers are spending again after having cut back sharply during the recession. Going forward, consumer spending should be helped by a gradual pick up in jobs, a slow recovery in household wealth from recent lows and some improvement in the ability to get loans.

High unemployment rate and low inflation, however will keep the Fed from raising the rate anytime soon.

Retail and Banking: Beginning of a Positive Feedback Loop

(This article has been published on Seeking Alpha: http://seekingalpha.com/article/196282-a-positive-feedback-loop-in-retail-and-banking)

The last credit crisis was extremely dangerous, because the potential collaps of the financial system can create a chain reaction of negative feedback loops in the real economy. Unable to line up financing or refinance existing debts, companies were forced to dramatically cut back and sell assets, just to survive the credit crunch. Many businesses failed because of this, and because their customers suddently found themselves unable to pay, even in the short term. The problems with these businesses in turn hit their bankers or creditors hard.

So both the financial and the real sides of the economy went down together, and their problems feed on each other. Only the government had the power to step in and break the loops.

Now as the financial markets and the real economies stabilize, these same feedback mechanisms have started to turn to the other direction, i.e. the positive feedback loops. We can now readily see it in the retail sector and commercial lending. We discuss a particular example here to illustrate.

Select Comfort (SCSS), a highend bed manufacturer known for its Sleep Number beds, struggled mightily during the credit crisis. It almost went under, and relied on very costly private equity money to survive. Today, the company announced a new credit agreement with Wells Fargo (WFC). The credit agreement, which has a term through June 2012 and provides a commitment of up to $20 million, replaces an existing credit facility with a syndicate of banks.

"Our sustained improvement in sales and profit performance – along with increased cash generation, a stronger balance sheet and our positive cash position – have provided us the opportunity to replace our existing facility,” said Jim Raabe, chief financial officer, Select Comfort Corporation. “The new facility significantly lowers the company’s borrowing costs and fees and provides more financial flexibility as compared to the existing agreement.”

This is certainly a great news for Select Comfort. The stock went up 10% on the news, which signaled a further easing of credit restriction. At the same time, it also confirms the positive outlook of the company from the credit standpoint.

On the flip side of this agreement, it also signals an increased willingness of a conservative commercial bank to lend to recovering retailers. Many of these large banks have experienced difficulty finding qualified borrowers to lend money to. Now, as consumers return to the mall, retailers have reported improved sales and profitabilities. That will increasingly help these banks find qualified borrowers, putting the banking business on a firmer footing.

And as banking profits improve, their capital positions will be further enhanced, and they'll be able to lend more.

Of course, this positive relationship is dependent on consumers being confident enough to spend. And here, we're waiting to see the mother of all positive feedback loops to start to turn: More jobs and incomes lead to more spending, which in turn leads to more hiring; more hiring leads to more consumer lending and higher purchasing power; etc.

With some luck, we may actually get to see some sign of it this coming Good Friday in the employment report.

Wise to Invest Alongside Governments?

(This article has been published and distributed by Seeking Alpha.)

Recent events from China’s tightening, Euro-zone sovereign risk, to US policy towards banks have illustrated just how important it has become for investors to consider this question: is it wise to invest alongside the governments, or not?


This question is relevant not just for bond investors and credit investors, but also for equity investors.

PIMCO was known to invest alongside the US government when the government was trying to contain the financial crisis, and ripped huge benefits by doing so. However, it is clear from Bill Gross’ Investment Outlooks in recent months that the bond shop has changed its tune:

If 2008 was the year of financial crisis and 2009 the year of healing via monetary and fiscal stimulus packages, then 2010 appears likely to be the year of “exit strategies,” during which investors should consider economic fundamentals and asset markets that will soon be priced in a world less dominated by the government sector. If, in 2009, PIMCO recommended shaking hands with the government, we now ponder “which” government, and caution that the days of carefree check writing leading to debt issuance without limit or interest rate consequences may be numbered for all countries.

PIMCO’s New Normal has an inherent bias against equities. It argues that in this post-crisis world of de-leveraging, re-regulation, and de-globalization, there will be little growth, and hence little upside for equities. This is the year to preserve capital.

Sweeping arguments of this sort appear more self-serving than helpful to individual investors, however. If you’re an equity investor, we think the government factor will continue to play a large role. Investing in equities in 2010, by and large, is investing in economic recovery alongside the government efforts to spur growth and create jobs. No doubt, government actions also represent a great source of risk.

The US will in the foreseeable future have to focus on getting credit to flow, stabilizing the all-too-important housing sector, creating jobs either by directly expanding the public sector or by encouraging private hiring. This focus places a great importance on banking industry, housing industry and the industrial sector.

Banks are healing. Investors who invested alongside the government efforts in 2009 were rewarded. Despite the risk of new regulation and finger-pointing, credit creation remains to be the key for economic recovery. The remaining banks, especially the well-run ones such as Wells Fargo (WFC) and JP Morgan (JPM), continue to represent good opportunities to invest alongside the government.

The battered home building industry enjoys unusual government supports, yet it has caused much less controversy over bailout. The generosity from the government is beyond belief. Take the loss carry-back tax break, for example. Many commentators say it’s a one-time effect. But the fact is home builders are able to collect this benefit over many years. And the government, from the Fed, to the Administration, to the Congress, to agencies like FDIC, all appears determined to put a floor on property prices.

One recent example: The FDIC has chosen Lennar (LEN) as a co-investor in a $3.1 billion portfolio of distressed loans from failed banks seized by the agency. These loans are linked to both commercial and residential properties. The two parties will pay a combined $1.2 billion, or about 40 cents on a dollar. Lennar will contribute $243 million for a 40% equity stake in the venture, while the FDIC will pay $365 million for the rest. The remaining $627 million is seven-year interest-free debt provided by the FDIC. So if these loans, backed by land, developed lots, and other real properties, appreciate in value, Lennar stands to benefit alongside the government and the tax payer. On top of that, Lennar will collect a management fee from FDIC for overseeing the portfolio and loan work-out.

Success is not guaranteed, but with such generous financing terms and a determined government as co-investor, the odd is more than good.

By taking a 60% equity stake, FDIC appears to be sending a strong signal to the real estate market that there will be no fire-sale, and that a bottom has in all likelihood been reached, or supported.

Other builders, if nothing else, should benefit from the price support.

If Uncle Sam is becoming more of a shareholder, shouldn’t individual investors?


Disclosure: Long WFC, JPM, SPF

Wells Fargo may soon become the largest bank

The Obama proposal to limit bank size and activities (The "Volker Rule") has already had a differential impact on the big banks. JP Morgan, which has sought to expand both its commercial banking and investment banking operations during the financial crisis by acquiring Washington Mutual and Bear Stearn, has been pummeled. Its stock price has dropped about 10% since the announcement on January 21. Similarly, Bank of America and Citigroup have been adversely affected. On the other hand, Wells Fargo appears to be least affected, as its acquisition of Wachovia was mostly an expansion of the commercial banking franchise.

Only two weeks ago, WFC had a much lower market cap than JPM, and was behind that of BAC. This week, WFC has over-taken BAC, and has come very close to JPM's market cap of $153 billions. The market reaction is quite understandable, if the rule is designed to separate the deposit-based business from the trading-based business that came to dominate the Wall Street. If this trend continues, Wells Fargo will soon become the largest bank in terms of market cap.

JPM has been viewed as the best capitalized large bank, also as a go-to bank for the government when it needs help in closing down a failing bank. As such, JPM has benefited tremendously through the crisis and has come out stronger.

Wells, on the other hand, has always had some problems with its capital position after the merger with Wachovia. In particular, its tangible common equity ratio is thought to be the lowest among the large banks. Even though it has a superior earning power, investors have not been willing to believe that it can earn its way back to the best capitalized bank.

Much of that is of course dependent on how well the economy recovers, in particular, how well the housing market recovers. Wells, because of its focus on community-based banking, may benefit disproportionately from the recovery, more so than trading-dependent operations. Perhaps for this reason, investors now are willing to give it more credit, in light of the new political climate and recent data that the economy is slowly but surely on its way to recovery.