The Outlook for Financials

January 1, 2008

Dear Investor:

The collapse of real estate looks long and deep. Mean estimates for the bottom are mid-2008, but many of these rosy predictions come from biased sources, such as real estate trade groups—who until earlier this year were still maintaining there was no such thing as a real estate bubble. We feel that housing prices won’t reach bottom until 2009-2010, with a slow recovery matching the inflation rate for 2-3 years thereafter.

2007 saw devastation in the financial sector, with expected casualties among mortgage lenders, mortgage insurers and homebuilders. Many of these companies will exit the stage, never to be heard from again. Also crushed were money center banks and diversified lenders, many of whom are now trading at the most attractive valuations in 20 years. These strong and able financial institutions will use the current crisis to gain market share and return to dominance.

Some banks, such as J.P. Morgan Chase, were able to do a fine job avoiding subprime exposure. Others, such as Citigroup, were left flat-footed, as they had done little to purge their books of recycled and repackaged mortgages known as CDO’s. As we own both of these stocks for clients, both in our Fund and in separate accounts via mutual funds, we were proud of Chase and disappointed in our decision to own Citi. But Citi is bruised, not broken.

All the money center banks, including Chase and Citi, are well-capitalized and should weather the debt crisis with their balance sheets in decent shape. Despite Citi’s well-publicized equity sales to raise cash, it should be noted that these are required to get the bank’s Tier 1 ratio (a measure of capital strength) up toward 8%, not to salvage the bank from insolvency. A Tier 1 ratio of 6% is considered the regulatory definition of a well-capitalized bank, and Citi had not gone below 7%, even after their write-offs. More write-offs will surely be followed by more asset and equity sales, but Citi will recover. Chase and other smarter lenders like American Express will use the crisis to pick up business and acquire their less able competitors. Those who overweight financials should make a lot of money over the next few years, just like those brave souls who bought bank stocks in the early nineties, after the last banking crisis.

A forgotten story is how the yield curve has normalized somewhat over the past several months, putting ten year yields above short rates and allowing banks a decent spread on their lending. This boost to bank profit margins will allow them to build up their balance sheets over the next year.

We made a major rotation into financials in December, and we will continue to increase the allocation where appropriate. Headlines will continue to alarm, as the debt crisis spreads to other types of consumer loans, but this is the time to start loading up on financials. By the time the crisis clears the media, it will be too late.