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BirdsEye View

This week's quote comes from my son, Arik, 13. He is in love. When I asked him to describe his feeling, he said: "It's like this burst of energy and happiness that shoots throughout your body". I thought this is a spot-on description of this very special feeling, and had to share it, with pride, with you!

On another personal note, our family attended Superbowl this year. It was a memorable event for all of us, from the game atmosphere and staying at the same hotel as the Patriots to Tom Petty's half-time show, the nail-biter game itself, Eli Manning's miraculous recovery from the Sack and bumping into Hugh Laurie (House) after the game. I lost my cool (I'm a huge fan, from the Jeeves days) and hugged the guy, to our mutual embarrassment, guy memorialized the moment, though, and it's on the website slide show www.anatbird.com.

My friend Jackie Reeves, Managing Director of Bell Rock Capital LLC, put this article together. I added my two cents in, and the result is before you. What's your reaction?

Have a super week,

Anat

LOAN LOSS RESERVES AND CREDIT CYCLES: DID THE SEC GET IT RIGHT?

While hindsight is 20/20, we all knew that the SEC's victory over SunTrust in 1998 was not a good sign for the industry, even then. Recall the SEC held up SunTrust's deal to acquire Crestar Financial due to, in essence, excessive loan loss reserves. In the end, STI acquiesced to reduce its loan loss reserves significantly and restate earnings for 1994 through 1996. Several other institutions followed suit.

As we look into the future at the state of the financial services industry, and ponder whether Citigroup is a confident investment at 107% of book value and 174% of tangible book or whether Wells Fargo will indeed be an underperformer at 184% of book value and 250% of tangible book, I ask myself why? Why is there still so much broad-based uncertainty and lack of confidence in these companies and in their management teams?

One possible answer is the lack of reserves, which is the layer above the capital foundation. With another downward credit spiral, when time came to shore up provision for losses to cover the rise in nonperforming loans, the thin reserve ratios left no where else to go but straight to the foundationcapital.

Some of the responsibility for the lack of credibility and confidence in many mega-banks lies at the feet of the SEC and the Financial Accounting Standards Board. Past credit quality debacles and some first hand experiences remind us how high net charge-offs can be when the economy turns sour. Further, left field type of events such as Long Term Capital and the Russian Debt Crises can freeze markets and shake market confidence.

Following the SEC's decision in 1998 regarding STI's excessive reserves, the industry's reserves as a percentage of loans declined in each consecutive year to 1.13% as of 3Q07, from 1.77% in 1998. Accounting statements SFAS No. 5, No. 114 and No. 157, are leading us toward full fair-value accounting for assets and liabilities. They are essentially the guidelines for companies including: FASB No. 5, Accounting for Contingencies; FASB No. 114, Accounting by Creditors for Impairment of a Loan, and SFAS No. 157, Fair Value Measurements.

Over the last 58 years, the median reserves as a percentage of loans stood at 1.74%, but, the industry posted substantially less at 1.13%, in the most recent quarter. While bank and thrift regulators have typically been on the side of the more reserves an institution has the better, the SEC continued to push for transparency of the income statement. Few institutions have been able to defend strong reserve positions, but the industry as a whole has been compelled to reduce reserves and therefore be ill-prepared for the credit deterioration we're facing today.

To be sure, the industry has had reserve coverage of loans of less than 1%, specifically from 1978 through 1981 and in 1948, which is as far into history I could reach at the FDIC. These periods showed depleted reserve ratios. This, however, were not the result of accounting thoughts or pronouncements, but rather were related to economic cycles. Prior to these trough levels of reserves, the coverage stood at north of 2% of loans. Even with reserving in good times for the bad times, the industry drew down its reserve coverage by 50% during a downward cycle. Save for the rainy day has even greater meaning to extrapolate this solid, conservative parental guidance into the global financial marketplace. Perhaps when former SEC Chairman Arthur Levitt waged war on cookie jar reserving, he had simply forgotten this old adage.

An SNL Financial article from 1/14/2002 depicts the environment in 2002, where "earnings management" was the bane of the SEC. After all, this isn't the first time the SEC has talked a big game on earnings management. In a September 1998 speech before the New York University Center of Law and Business, former SEC Chairman Arthur Levitt went on the offensive against what he termed "an erosion in the quality of earnings." He cited four examples of gimmicks that companies used to manufacture earnings, two of which were and are still prominent in the banking industry: "big bath restructuring charges" and "cookie jar reserving."

A few weeks later, the SEC singled out SunTrust Banks Inc. for its reserve practices. The SEC made the case that SunTrust was reserving too much  that it was building a cushion from which it could draw when earnings growth started to slow and it needed another penny or two of EPS. Over the past several quarters (end 2001-beginning of 2002) as the economy has turned, many companies have come to realize how badly under-reserved they are. They shored up their reserves. This time the industry was not as fortunate.

So we ask, Where is the SEC Now? How could the SEC in all good consciousness force the entire financial system, the life-blood of the U.S. economy as well as a linchpin into the global economy, to slash reserves to the point of financial instability? Aren't the stability as well as safety and soundness of the global financial system among the primary mandates of our regulatory system? When companies are earnings deteriorating, the pundits recommended that they step up then and match losses, despite the lack of a solid earnings stream. When institutions lack the capacity to effectively execute that task, they may be forced, en masse, to hunt for capital across the globe and cut dividends in order to remain.

We realize that pure cash flow accounting idea was formulated, times were different, but we also all know that cycles persist. In the immortal words of Jacques Dejoux, head trader for HSBC Marine Midland in the '80s: "What goes up must come down".

When Jackie Reeve looked at the time period of concern to Levitt and the SEC and analyzed net income trends, she found that, if the industry was managing earnings, it were not very good at it! Over the last nearly 6 decades, net income growth for the industry has been as high as 78% and as low as -84%. One year which fell completely out of range was positive by a few hundred percent. Meanwhile the average and median net income growth over these 60+ years was 8.15% and 8.06%, respectively.

Many financial institutions have posted their fourth quarter and year-end results already. The write-downs were pronounced and credit quality continued to deteriorate. Bernanke remains poised to act to keep the economy from crashing; President Bush, Secretary Paulson and others in Washington D.C. are working on stimulus packages.

Is it the bottom of the housing market, in terms of stock prices? We think we are closer to the bottom than the top and look to the year-end conference calls as an indicator. Should the majority of banks be close to their pre-announced write-down ranges and earnings ranges, this will establish a floor for many financial services companies. Also, if more executives say their investment instruments will be written down substantially, the upside appears even more likely. Indications are that 4Q07 was indeed a huge "kitchen sink" quarter, despite all the accounting pronouncements outlined above, which means that 2008 might not be as devastating as we fear.

We believe 2008 will continue to be volatile.

• Merger and acquisition activity should remain energetic
• Earnings growth should be well below the long-term 8%, perhaps closer to a median of 3-4%
• Credit quality will continue to be addressed
• Earnings expectations have been rationalized
• Investor confidence and earnings credibility need to be restored

During this down-phase of the credit cycle, the industry was woefully unprepared, in large part due to the enforced reserve policies. Industry regulators and accounting professionals alike should re-evaluate and revise current reserve policies to reflect both up- and down-turns in our economy and to avert in the future the credibility crisis the financial services industry suffered this time around.