Stephen’s Posterous

Huntington Executives Put Money in the Bank by David J. Reynolds, WSJ.com

The chief executive, three top officers and 10 directors of Huntington Bancshares Inc. purchased a total of $1.58 million in company shares the week of April 20, 2009, a positive insider signal at an embattled regional bank.

Stephen Steinour, who became the bank's chief executive and chairman in January 2009, bought about two-thirds of the shares for just over $1 million on the open market, according to regulatory filings. He didn't hold any Huntington stock before his buy.

Insider-transaction analysts viewed the purchases as a moderately bullish sign, but said their excitement is tempered by the fact that Mr. Steinour is required by his employment agreement to acquire shares. Ben Silverman, director of research at InsiderScore.com, noted that Mr. Steinour receives a $1 million base salary and that his employment agreement requires him to hold $5 million in company shares by the end of his fifth anniversary as CEO.

"He's put his annual salary to work in the stock," Mr. Silverman said. "Now he's 20% of the way toward his requirements."

It has been a rough ride of late for Huntington shareholders. The Ohio-based company, which operates Huntington National Bank, has been hammered by sour loans and recently posted a quarterly net loss of $2.4 billion because of a noncash $2.6 billion goodwill write-down. The stock has lost about 90% of its value over the past two years.

Since touching a low of $1 in February 2009, Huntington stock has shown some signs of life, trading Tuesday at $2.78. The 14 Huntington insiders paid an average price of $3.44 for their shares.

Among other measures to shore up its capital position, the bank last year accepted $1.4 billion in funds from the U.S. Treasury's Troubled Asset Relief Program, or TARP, adding extra scrutiny to the stock transactions of its insiders.

"Anyone who's a TARP recipient, taxpayers like to see them buying instead of selling," Mr. Silverman said. The Huntington buyers join a long line of insiders purchasing shares of financial companies, almost always with disappointing results.

"For the last two years, we've watched banking insiders buy, thinking their businesses were stronger than they actually were," Mr. Silverman said.

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Jamie Dimon has never been one to shy away from making the occasional comment to stir the pot. But the JPMorgan chief outdid himself when discussing the bank’s first-quarter earnings, taking the opportunity to land multiple punches on government policy. He might not always have that luxury.

First, he dubbed the Troubled Asset Relief Programme the “Tarp baby” and a “scarlet letter”, a public mark of shame. Unsurprisingly, he said JPMorgan wants to pay back the $25bn it received from the US Treasury and could do so tomorrow if regulators gave the go-ahead.

Dimon even put one over on Goldman Sachs, claiming JPMorgan could reimburse the government without having to raise more capital, again assuming regulators agreed.

He’s not alone in condemning Tarp: US Bancorp boss Richard Davis recently called it lousy and Wells Fargo chairman Dick Kovacevich attacked Washington’s decision to add punitive features to it retroactively.

Dimon didn’t stop there, though. He also took issue with the Public-Private Investment Programme designed to remove problem assets from bank books. Granted, he said it could be of use for the financial system, but called it “irrelevant” for JPMorgan, asserting the bank wouldn’t take part.

Refusing to sell any of its dodgy assets is a way to underline his belief in the bank’s risk management and pricing, which has held up pretty well so far. That’s also why he described the recent softening of mark-to-market accounting rules as “a hullabaloo about nothing”. In any event, he could probably change his mind about selling into PPIP without much backlash should he need to.

But it’s his decision not to be a PPIP buyer that will raise more eyebrows. With government-funded leverage, the programme could be a big money-spinner. But, says Dimon: “We’re not going to borrow from the Federal government. We’ve learned our lesson about that”, another shot at retroactive Tarp restrictions.

Throw in a stout defence of bank lending volumes and an implication that FDIC-guaranteed bonds do little for JPMorgan’s cost of funds, and Dimon got a fair bit off his chest.

Of course, it helps to have strong earnings, $2.1bn for the first quarter and a strong balance sheet even without Tarp as cover to throw the punches. But Dimon probably shouldn’t make a habit of using Washington as a public punchbag.

Source.

Despite a fabled brand name and an affluent, free-spending clientele that is the envy of the charge-and credit-card business, American Express has gotten caught in the same downward vortex as the rest of global financial industry.

Indeed, its once-highflying stock crashed to under 10 in early March 2009 from more than 50 last spring, before rebounding to 18.83 on Aparil 9, 2009. Negatives seem to abound. A poor economy caused card usage, both business and personal, to slow, and in some categories, to drop.

Amex credit-card delinquencies and charge-offs hurtled to higher levels both in the second half of 2008 and the first two months of this year. And an ill-fated company decision to push credit cards on folks with multiple mortgages resulted in Amex dramatically increasing its exposure to customers in the epicenter of the home-price collapse in California and Florida.

Not even American Express (ticker: AXP) thinks things will improve much for at least the next three quarters, or so Amex Chairman and CEO Kenneth Chenault said in recent shareholder communications; company officials were unavailable to comment to Barron's, since Amex is in a "quiet period" before releasing first-quarter earnings.

Yet American Express' outlook isn't nearly as hopeless as is commonly thought on Wall Street. For one thing, unlike its peers, the company gets the bulk of its revenue and earnings from fee income generated by transaction volume, not the extension of credit. This is because charge cards, which are supposed to be paid off monthly, make up a substantial share of American Express' volume. AmEx therefore has substantially less credit risk.

Likewise, the company has addressed its credit-card mistakes with some vigor since the fall, and should be able to stem the surge in defaults in the next couple of quarters. Not least, with the help of various government bailout programs, AmEx seems to have ample liquidity to ride out the current economic downturn without having to dilute shareholders by selling stock.

To be sure, plenty of uncertainties remain for the New York-based company. The outlook for home prices and unemployment levels weighs heavily on any credit-card lender like AmEx, and remains a wild card in a weakening economy. As a result, analysts' estimates for AmEx are all over the place.

Consensus forecasts for this year vary from a profit of $1.65 a share to a loss of $1.11, with the average of 19 estimates coming in at 55 cents. Next year has spawned even wilder inconsistencies in earnings forecasts. The average forecast of $1.16 includes high and low estimates of $2.79 and negative 27 cents.

Yet William Ryan of the financial-industry research boutique Portales Partners recently issued a Buy on the stock at 15, after rating AmEx a Hold since it traded above 60 in July 2007. He reasoned that even with higher credit-card charge-offs coming in the near term, the stock is a great buy in the longer term.

"Look, we never know until after the fact when the inflection point comes, as low valuation finally trumps near-term fundamentals," Ryan says. "Most people are going to miss the party if they wait for the turn in credit losses."

Ryan and Portales refrain from giving out target prices. But an analyst at a large, low-profile hedge fund that has been loading up on American Express wasn't so constrained. "I think AmEx is at least a double over the next year or two," he avers.

Much of Amex's resilence to tough times comes from a business model that emphasizes lower-risk transaction-fee volume rather than lending, according to Fox-Pitt Kelton analyst Bill Carcache. Last year, for example, AmEx cardholders used their charge and credit cards to buy $683 billion worth of goods and services, a volume that dwarfed that of their competitors.

Chief among the transaction fees generated by this prodigious volume is the industry-high 2.5% fee that AmEx typically charges merchants for access to AmEx's big-spending cardholder population.

AmEx gets to keep the bulk of this fee income, since unlike most card sponsors, the company runs a closed-loop network in which it issues and markets cards, handles all transaction processing and even "acquires" and directly pays off all its merchants around the globe. Most bank issuers have to share their merchant fees with the likes of Visa (V), MasterCard (MA) and First Data.

Credit risk from customers stiffing credit-card companies looms smaller at AmEx. It had extended $72 billion to cardholders as of year-end 2008, less than half the total in cardholder receivables carried by competitors Citigroup (C), Bank of America (BAC) and JPMorgan Chase (JPM).

Much of the investor concern over AmEx arises from the sudden surge in delinquencies and, even more damaging, loan charge-offs in excess of the company's competitors. This wasn't supposed to happen at American Express, given the company's more affluent customer base.

Yet after lagging behind industry averages for most of 2008, charge-offs at AmEx began to skyrocket in the fourth quarter, according to closely watched monthly performance data taken from the company's major credit-card-receivables securitization. By February of this year, charge-offs in the AmEx trust had vaulted to 9.31%, far above the industry's monthly average of 7.76%.

The jump in AmEx loan defaults, however, may not be as telling as it first appears. The rates of late have been pushed higher by a wicked denominator effect, as management began reducing outstanding credit to U.S. consumers in the second half of last year by cutting credit lines and raising interest rates and fees on accounts. The company even offered some account holders with outstanding balances a $300 gift card in exchange for closing the accounts.

The efforts earned AmEx some bad press for its hard-nosed tactics but enabled the company to reduce its U.S. credit-card receivables total (the denominator of the charge-off data) to $57.8 billion at the end of February from $65.9 billion at year-end 2007. This also magnifies the default rate vis-á-vis peers who were less aggressive in paring back their credit exposures.

Other factors also may work to blunt the recent vertiginous rise in AmEx's U.S. charge-offs. After closely examining the February trust data, Portales' Bill Ryan sees some favorable developments. While charge-offs surged in the month, loan delinquencies, the raw material for future charge-offs or defaults, were far better-behaved.

Total delinquencies in the trust rose just 12 basis points, 12 hundredths of a percentage point, to 5.40% of total U.S. credit-card receivables or borrowing, compared with a sequential monthly jump of 42 basis points in January. But even more telling, according to Ryan, was the fact that in February, early-stage (31-to-60-day) delinquencies actually dropped from the month before by nine basis points, to 1.38%, while mid-stage (61-to-90-day) delinquencies rose but five basis points, to 1.23%.

Early-stage delinquencies normally drop some in February, for the simple reason that many cardholders labor hard to pay down swollen balances quickly from the holiday season. But the drop this February was larger than usual.

As a student of the credit cycle, Ryan thinks that yet another factor may soon steady AmEx's fortunes. AmEx currently is paying the price for its promiscuous extension of credit and bad underwriting practices of recent years that saw its U.S. card-lending jump from $39.9 billion at the end of 2004 to the aforementioned peak of $65.9 billion at the end of 2007.

AmEx was looking for love in all the wrong places, oblivious as were most Americans of the approaching financial and economic tsunami.

Yet, says Ryan, the losses AmEx is now suffering from bad underwriting decisions tend to be short-lived and violent, compared with losses that creditors suffer from economic weakness, with its attendant rise in unemployment and drop in consumer spending.

"I'm not saying that credit losses at AmEx won't continue to rise some in the months ahead, but the deterioration in charge-offs compared to that of its peers will be tempered somewhat as the underwriting mistakes are quickly washed through AmEx's system," says Ryan.

Liquidity has been yet another concern of investors, about AmEx specifically and the financial industry in general. Beaten-up stock prices in the sector make stock offerings punishingly dilutive to current stockholders. Even more damaging has been the freezing-up of the all-important asset-backed securitization market, which allowed lenders like AmEx to bundle vast hunks of their credit-card receivables and sell them off to investors in the form of bonds.

At the end of last year, such securitizations accounted for some $29 billion of the $72 billion in credit that AmEx had extended to cardholders in both the U.S. and abroad.

After the collapse of global credit markets following the Lehman bankruptcy last September, AmEx, like other U.S. financial institutions, has made ample use of the panoply of U.S. government liquidity and credit facilities to fill in the financing breach. It received an injection of $3.4 billion under the now somewhat notorious Troubled Asset Relief Program.

AmEx also availed itself of $5.9 billion in borrowings under the government-guaranteed Temporary Liquidity Guarantee Program. In addition, AmEx has plenty of unused credit capacity, including $7.4 billion under the TLGP, $8.7 billion under its bank facilities and a $5 billion credit conduit that won't expire for several months, according to a recent report by JPMorgan analyst Andrew Wessel.

All of this has left AmEx with about $25 billion in cash and readily marketable securities, which more than covers its liquidity needs for the next 12 months. They include some $20 billion in long-term debt and asset-based-securitization maturities.

American Express seems to have ample capacity to weather the current financial storm and survive comfortably until charge-offs abate and the all-clear sign is posted for the economy. Among other things, the company recently exhibited its confidence by affirming its current dividend-payout level, which costs it some $200 million a quarter.

And as AmEx recently observed on its Website, its ratio of tangible common equity to risk-weighted assets was 8.5% at year end, "higher than that of most bank holding companies, and all our regulatory ratios are comfortably above the 'well-capitalized' thresholds."

The government facilties eventually will expire. Yet AmEx is hard at work developing other funding sources should its access to traditional capital markets remain difficult. It is now availing itself of retail certificates of deposit pushed by traditional brokerage houses like Merrill Lynch as an investment alternative to high-net worth customers. This program has yielded some $8.8 billion in funding since last fall.

The company also plans to roll out a new program this quarter designed to attract direct deposits to American Express using direct mail, the Internet and other forms of advertising. With the cachet of the American Express name, the company should have no trouble using these channels to replace the securitization market as a source of cheap funding.

Given the necessity of carrying a larger capital base even after the economy improves, AmEx said in its annual report that in the future it expects to deliver a return on equity of more than 20%, instead of meeting its old goal of better-than-33% ROE. Of course, 20% is a return that most companies would die for.

Investors could do a lot worse than shares of American Express, especially at current price levels, even if it no longer aspires to be the fastest car on the track.

Source.

From Roger Altman, Chairman and CEO of Evercore Partners and former Deputy Secretary in the Clinton Administration

The rare nature of this recession precludes a cyclically normal US recovery. Instead, we are consigned to a slow, painful climb-out, as are nations such as Japan and Mexico that depend on US demand. The implications for US policy include a likely second round of stimulus, much more federal capital for the banking system and stunning budget deficits that will slow key initiatives for President Barack Obama, such as healthcare and energy reform.

What is unusual is that this is a balance-sheet driven recession, centred on the damaged financial condition of both households and banks. These weaknesses mandate sub-normal levels of consumer spending and overall lending for about three years.

In contrast, most postwar recessions had a different sequence – rising inflationary pressures, a monetary tightening to counter them and, then, a slowdown in response to higher interest rates. This was the pattern of the sharp 1980-81 slowdown.

None of that happened here. Instead, we saw a housing and credit market collapse that caused enormous losses among households and banks. The result was a steep drop in discretionary consumer spending and a halt to lending. To see why recovery will be slow, we can look at the balance sheet damage.

For households, net worth peaked in mid-2007 at $64,400bn (€47,750, £43,449bn) but fell to $51,500bn at the end of 2008, a swift 20 per cent fall. With average family income at $50,000, and falling in real terms since 2000, a 20 per cent drop in net worth is big – especially when household debt reached 130 per cent of income in 2008.

This debt derived from Americans spending more than their income, reflecting the positive wealth effect. Households felt wealthier, despite pressure on incomes, because home and financial asset values were rising. Now that wealth effect has reversed with a vengeance.

The crisis and unemployment have frightened households into raising savings rates for the first time in years. They had been stagnant at 1-2 per cent of income but have surged to nearly 5 per cent. With reduced incomes, only cutting discretionary spending can produce higher savings. This explains why personal consumption expenditures fell at record rates at the end of 2008.

Consumer spending, however, has approximated 70 per cent of US gross domestic product for the past decade and dominates our economy. But household balance sheets will not be rebuilt soon.

Home values will keep falling through mid-2010 and there is no precedent for equity markets, still down 45 per cent from their peak, to make those losses up in just two years. It is illogical, therefore, to expect a full snap-back in the consumer sector in 2010 or 2011. This alone mandates a drawn-out, weak recovery.

The second key sector is the financial one. According to the International Monetary Fund, western financial institutions, mostly in the US, have realised $1,000bn of losses on US-originated assets since the crisis began. The IMF has estimated that unrealised losses may amount to another $1,000bn.

With residential and commercial real estate steadily declining, this is possible. This is why the banking sector cannot make new loans. These losses are eating into banks’ capital and shrinking their capacity to add assets. Funds from the Troubled Asset Relief Program are only replacing lost capital, not increasing it.

When might they end? With key categories of toxic assets still losing value, the answer is: not soon. The scale of lending needed to support a normal cyclical recovery will not materialise.

A third constraint on recovery may involve the federal balance sheet. The fiscal and monetary engines are currently on full throttle. But, within two years, concerns over budget deficits and inflation may revive, compelling the Federal Reserve to raise interest rates and Congress to adopt deficit reduction steps. These actions, contractionary by definition, could occur before a full recovery has asserted itself. On that basis, the federal balance sheet would also limit a full recovery.

This weak outlook is likely to force a second injection of spending rises and tax cuts in 2010 to prod demand. Despite public opposition, substantially more federal capital will be required for banks.

The deficit outlook will worsen, perhaps to $1,000bn annually over 10 years. That will force a slowing of Mr Obama’s investment plans. That is a shame, because those investments are needed, but this balance sheet recession will be too deep.

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The story of our economic crisis mirrors every great market bubble in history. Clearly, banks were key participants, but they were not alone. Mortgage lenders, borrowers, regulators, policy makers, appraisers, rating agencies, investors and investment bankers all played a role in pushing economic excesses forward.

The institutions that gave in completely to the frenzy are no longer with us. Those that balanced the need to compete with the need to lend prudently survive today and are helping to stabilize the system.

Amid the turmoil, it has become clear that banks need to make changes in the way they run their business, from risk management to expense control to compensation practices. Most banks are making these changes in a good-faith effort to adjust to new economic realities.

And what role should government play in this? Speculation is rife about whether banks need more capital assistance from the government or whether they need to be nationalized. Unfortunately, our current debate has been riddled with misinformation that will not help us understand our current reality, or help us decide on a sensible path forward.

I would like to provide some clarity on a few key claims that have been repeated so often they are now taken to be fact. They are not.

The banks aren't lending. This claim is simply not true. Yes, banks have tightened lending standards after a period in which standards were too lax. But, according to Federal Reserve data, bank credit has actually increased over the course of this recession, and business lending is trending up modestly so far in 2009.

Also, mortgage finance volume is booming as a result of low interest rates. What's gone from the system is the easy credit that got us into this mess, as unregulated nonbank lenders have disappeared, and the market for many asset-backed securities has all but dried up. Most banks are making as many loans as we responsibly can, given the recessionary environment.

The banks are insolvent. In the past 18 months, we've seen fewer than 50 bank failures. That compares to about 2,000 failures or closings of commercial banks or savings institutions between 1986 and 1991. There may be more to come, but the vast majority of banks will weather this economic storm.

The Troubled Asset Relief Program (TARP) hasn't worked. Not true. Last October, when the TARP was enacted, systemic risk threatened our entire financial system and economy. The point of the program was to stabilize surviving banks, prevent a total meltdown, and enable banks to lend more. The TARP and other government programs have worked, and banks are making more loans as a result.

Taxpayers have given the banks billions and won't get their money back. TARP funds are not charity. Banks that received TARP funds will make about $13 billion in dividend payments to the U.S. Treasury this year. TARP funds are loans yielding anywhere from 5% to 8% interest. This is a win-win: Banks are getting the capital they need, and taxpayers are getting a strong return on their investment.

The banks that caused this mess must be held accountable. In fact, while all banks participated in the bubble economy to some degree, the companies that did the most to cause this mess are gone. The managers and shareholders of those institutions have been held accountable by the toughest, most unforgiving master of all: the free market.

The only way to fix the banks is to nationalize them. This is a misguided premise. The announcement of nationalization would undermine confidence in the financial system and send shudders through the investment community.

Politicizing lending decisions and the credit allocation process would be destructive for the economy. Nationalization also would give the false impression that all banks are insolvent. We agree with Federal Reserve Chairman Ben Bernanke's statement that nationalization of banks is not necessary to stabilize the banking system.

Getting our facts straight as we debate the important issues will help us rebuild a healthy financial services sector that can better support economic growth. I have two thoughts to help us get started.

First, our industry must continue to work in partnership with the government to solve our toughest problems. Congress and the administration have already taken several very positive steps. The Fed is providing sufficient liquidity and has helped lower mortgage rates. The $787 billion stimulus package will help boost economic activity. \

The Term Asset-Backed Securities Loan Facility (TALF) will help liquefy the credit markets. And the administration's housing and foreclosure relief plan will be very helpful to both homeowners and banks as we work to stabilize housing markets across the country.

Second, one of our greatest challenges is balancing the need to extend credit with the need of households to pay down excessive debt. In an economy that became too dependent on debt-driven consumption to create growth, the prospect of household deleveraging is sobering. The answer, in my view, is to let competitive forces lead us back to responsible lending practices, not the type of indiscriminate lending that has created so many problems.

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Long before the Hollywood set started using energy-saving lightbulbs, Jack Robinson was investing in environmentally friendly companies.

He founded Winslow Management in 1983 to test his theory that an environmentally friendly investing strategy could produce market-beating returns, as well as contribute to a healthier earth. In 2001, he founded the Winslow Green Growth Fund (ticker: WGGFX), which regularly beat the market, until last year, when, according to Morningstar, it trailed the Standard & Poor's 500 by 24 percentage points. To Robinson, however, the future looks promising.

He talked to Barrons.com last week about the future of green investing.

Barrons.com: Given the sorry state of the stock market, are people more likely to shun their environmental principles for the stocks they think are most likely to go up, whether they're green or not?

Jack Robinson: People are definitely investing. We are net cash positive year-to-date and [investors put money in the fund] very significantly last year even at the end. There is just a lot of interest in the green space, and that is now being driven by the government taking a proactive position on climate change and energy security, and tying it into green jobs. Our investors generally have some level of green personal commitment. But what they also all share in common is what I call "G-squared" -- the other green is making money.

Awareness about the environment by investors in this country has never been as high as it is today. And why is that? Well we have just gone through a great deal of volatility in oil. We've had a lot of discussions about energy security. I mean we've got Boone Pickens saying we are sending billions every day to the Mideast and Barack Obama saying the same thing. So, we've got the left and the right pretty much on the same wavelength.

Q: A lot of these stocks, solar stocks for instance, have been very volatile. Why invest in them if they could flame out because of either technological or political reasons?

A: It has already become slightly less volatile. As the companies continue to put up good numbers and the consolidation in this particular industry goes on, I know you will see less volatility in the space by the winter...No. 1, people investing in the space know that it is new. No. 2, it is volatile because most of the most compelling "green companies" in the space are small-cap growth companies and by design are volatile. And No. 3, we try to tell them every which way we can that our portfolio is concentrated, and that you should not be looking to trade it, because you need to stay in it over a longer time period.

Q: In some ways, green investing has become more mainstream. The industries have matured somewhat. Does that change how you invest in this space?

A: Historically a lot of the green companies have been run by what you might call tree huggers, or types of people who are committed to the environmental side but not necessarily to the money-making side. And what we see happening as in the example of Energy Conversion Devices (ENER) with Mark Morelli who is the new CEO, you are seeing proven management teams come in, CEOs, CFOs joining up with these companies because they see the opportunity. These are not stupid people and they are not doing it just out of passion, because they see this as part of the solution and an opportunity to do extremely well financially.

In the case of First Solar (FSLR), you have a management team that is second to none. And all you have to do is look at the financial record of [Toronto-traded] WaterFurnace Renewable Energy (WFI.TO), for example, over the last five years and you'll be pleasantly surprised. It looks a whole lot better than many, many larger U.S. companies that have been touted to be the best-managed companies in the world when in fact they've blown up. This "too big to fail" doesn't cut the mustard anymore, and the nice thing about these companies is that they are continuing to grow in an economic downturn.

Q: Are there any other reasons green stocks are attractive?

A: The technologies are now much lower cost. Wind has been around a long time, as has geothermal and solar. Wind and geothermal today are a compelling investment because of the new tax offsets that have been introduced at the state level for a number of states. And also now at the federal level through the $18 billion footnote on the TARP [Troubled Asset Relief Program] bill gave major extensions of tax credits for renewable energy and the [American Recovery and Reinvestment Act] that was just approved had another $60 billion going into green stuff directly that we know of -- that doesn't include what's flowing into the states.

Q: What affect will the stimulus and other new government policies have on environmental stocks specifically?

A: The most recent bill that was passed which was part of the stimulus act took the cap off the amount you can spend for a green building project. For example, there used to be a $2,000 cap for a home or a small business. The $2,000 cap has now been eliminated, and so you get a 30% tax credit for an infinite amount of improvements. In theory you could set up a $10 million system and get $3 million back. That is just one of a whole series of things that has been going on.

Q: There have been some studies that looked at vice stocks versus more environmentally friendly or "morally upright" sort of stocks and found that vice stocks did better. How do you deal with that reality?

A: I think [vice stocks] tend to be defensive kinds of investments that do quite well in difficult times. But they are a target, I mean the cigarette tax is being increased everywhere in this country. Not to mention the problems we are having with cancer caused by primary and secondary smoke. The only reason the tobacco companies are growing is that they are selling a lot more to the developing world that doesn't really know any better. I think that if you make a product or have a service that kills people, has a toxic element to it, you are asking for trouble.

Source. Subscribe to Barron's. Winslow Management Company.

Robert Albertson doesn't see a quick end to the financial crisis, and believes it could drag on another two or three years.

The seeds of this crisis -- most notably, too much liquidity, in his view -- were sown earlier in the decade. Albertson sounded several warnings: "We conclude that denial is growing," he wrote in a November 2006 note. "The markets are hearing what they want."

The 62-year-old chief strategist for Sandler O'Neill & Partners has had a long career on Wall Street, including an extended stint as director of bank research at Goldman Sachs (1987 to 1999). Albertson joined Sandler O'Neill, an investment bank focusing on the financial sector, in 2002. Barron's caught up with him last week in his midtown office.

Barron's: In 2006, you wrote that the consensus economic view was way too optimistic. What concerned you?

Albertson: There were three key trends that had been growing over the years. The first was that there was a complete reversal of global monetary flows. We had never had the emerging markets running the show on liquidity, and it became huge.

Do you mean in terms of emerging-market governments buying Treasuries and basically funding a lot of borrowing in the U.S?

That is right, essentially. So it dawned on me that the Fed[eral Reserve] no longer really had control. But more importantly, the money flows were distorting interest rates to the low side -- ridiculously so. Then, starting in 2003, the Fed compounded the problems by driving rates even lower.

What were the other themes that alarmed you?

The assumptions on home prices in the United States and elsewhere were clearly decoupling from any kind of reality. And third -- and I didn't notice this until about 2004 -- the consumer in America didn't go through a recession in 2000; we had a half-recession, if you will. So [consumers] continued to spend. I looked at those three themes together, and I thought there was too much liquidity in the system, and that it was going to come back to haunt us.

Talking about subprime mortgages seems almost quaint these days, considering all of the other things that have happened in this financial crisis.

Everyone was noticing how much subprime delinquencies were going up, and by 2006 it was evident that [they were] unraveling. But then I looked at prime-mortgage delinquencies, and found out they were deteriorating at exactly the same time and pace. So this said to me it wasn't a subprime problem. When I looked beyond just mortgages, I began to see the same unraveling in all consumer credits in 2006. So the conclusion had to be that we were going through a credit-loss cycle to end all credit-loss cycles.

What is your biggest surprise about how this crisis has unfolded?

Instead of recognizing the damage in a controlled fashion and trying to deal with it, everything has gone to the other extreme. In other words, stress tests back in 2005 or 2006 were useless; they were silly and assumed things were going to continue to go to the moon. Now you hear about nothing but toxic assets and their worthlessness and the impending disaster, and I have to believe the reality is probably somewhere in between.

What is your sense of how far along we are in trying to work this out?

You have to look at this from the economic side, and then from the financial-sector side. On the economic side, all consumer debt is at 130% of income. Go back to 2000, and it was at 100%; 10 years earlier it was at 80% or 90%. It has to come down. So the first step is that we have to deleverage, probably by 10 to 20 percentage points, to repair the consumer's balance sheet.

Also, the savings rate used to be 10% to 12% of income, but it went to zero, and it is back up to 3%. It probably has to go back to somewhere near 10%. So, let us just say we got a 25% correction in consumer income, which is about $10.5 trillion. That is a $2.5 trillion headwind of income that has to go toward debt reduction and savings, as opposed to spending. But no government-stimulus program is going to offset that effectively. To me, it is a two- or three-year process.

Where do you think we are in terms of stabilizing the economy?

We are certainly in a recession, and it is probably a depression, if you define it as a long recession. We may have some false starts, but it is going to take two or three years to come out of this. In terms of the financial system, we have to recognize the damage to the balance sheets -- and there are various estimates. I have done a very granular-level look at bank loans, just in the banking system by category, and when I tally it up, it is close to $1 trillion of embedded losses.

The banking system earns money, so it can pay down some of that on its own. The banking system got $200 billion in the original TARP [Troubled Asset Relief Program], excluding the big investment banks, and that is helpful. But we probably then have another $200 billion to $300 billion of additional capital just to fill the remaining hole there. That is going to take a couple of years, if we want to get it from the private sector, as we should. Getting it from the government is wrong.

How effectively has the government responded to this crisis?

I'm seeing very odd interpretations from the government, in particular about what we need. The government isn't thinking about deleveraging. The government is talking about jump-starting consumer credit. I hear the word jump-start all the time. It is such a bad word. Jump-start consumer credit for what? So we can be more indebted?

So what has to be done?

We need to reduce the debt. If you jumpstart credit, you are just going to prolong the problem and deepen it. What we need now is the patience to de-lever. We don't need the stimulus package. We need a savings package, but that couldn't be further from the goals at the moment. The mistake is that the government believes credit drives the economy, instead of the economy driving credit. They have got that backward, and this is a very dangerous time to be misfiring.

What is your advice to the government?

The first thing you need to realize is that all that capital flow from emerging markets, which is now plateauing and likely to decline, will put enormous pressure on our government's borrowing costs.

Presumably if emerging markets curtail their buying of Treasuries, the demand for those securities lessens, pushing up rates. Then what?

The U.S. government is thinking in terms of adding trillions to our debt that is going to cost 5%, 6%, 7% or 8% eventually -- not 2% or 3%. If [officials] really understood that, I don't think they would be so ready to put the taxpayer at risk. Secondly, the consumer has gone through an artificially prolonged period of spending based on too much debt, house prices and home-equity lending, and that has to come out of the financial system.

But assume that consumers repair their balance sheets. Doesn't that make it harder for gross domestic product to recover?

There is no choice; that is where we are. We should have had this decline in consumer spending in 2000, along with the corporate sector decline that should have been the recession that reset the economy. We have a cyclical economy; that is normal. We had an 18-year expansion, which had never happened before.

What is the biggest danger of the stimulus plan?

That it will be a false start. It will be priming a pump that still has an empty well underneath. It will stop again even harder, and we will be further in debt and have further problems in the financial system from that debt.

What else concerns you?

Just as we ignored the absurdity of home prices before, we are now taking that absurd calculation to the negative in terms of bank balance sheets.

There are many securities in banks that are perfectly current and likely to pay over time that are now being marked down to 30 or 40 cents on the dollar -- because the accountants think they aren't going to work out. We aren't giving it a chance. So we are now absorbing problems that don't exist in the future. We are truncating them into the present, and we are making the hole that much deeper and the inability to fill that hole becomes that much more shocking and it scares the private investor away.

It looks like the stimulus package, whatever form it finally takes, will include some tax cuts along with a lot spending.

As I said, there is at least $2.5 trillion that has to come out of consumer spending in order to pay down debt and build savings. If you want to replace that $2.5 trillion with the government, they are only at around $800 billion. No. 2, going back to the economic stimulus of early 2008, we now recognize that the bulk of it wasn't spent; it was saved. So you can split this package any way you want. It isn't going to give the desired effect. It is going to give a false small blip, although it could give us a spike.

You noted recently that bank lending is a small fraction of consumer borrowing. Could you elaborate?

I'm fearful that the government doesn't understand how consumer credit is generated. If savings decline and deposit growth stalls, which it did, how did we have an expansion in the mortgage, auto, and student loans over the last five to seven years? We got it from Wall Street via the secondary market.

Wall Street went out and found investors willing to take a package of securities. When you go get a car and you do it on credit, you don't want to go to the bank. At the showroom someone helps you fill out the form for what is, in essence, a loan that is going to be funded by Wall Street, which then finds the investor. For all consumer debt, Wall Street has provided $3 out of $4 of the credit. That is what has collapsed, and that is what needs to be rebuilt.

What needs to be done to fix the secondary loan market?

No. 1, we have to have price discovery, so we all understand how toxic the toxic assets are. The second thing we need to do is literally rebuild what has been destroyed, somewhat unnecessarily, on Wall Street in terms of generating credit from investment pools and other liquidity pools – not from deposits. The final thing we need to do is to stock the banks with deposits, and we can't do that until people save.

Is it time to start nibbling at the financials?

The opportunity is coming, and it could come as early as later this year -- if it is clear the government understands the problem and does no more harm. This could be a massively great opportunity to invest, but it could also be a kiss of death, and you can't tell which one it is from the information we now have.

What is your advice to investors?

Keep your powder dry; focus on sectors outside the financials, and remember how we got here -- which was the enormous strength of the emerging markets getting the model right and building their own domestic infrastructures and their own domestic demand.

We make a big mistake when we think that we are still leading the world and that all those emerging markets rely on us and other industrialized countries for export demand. It is still critical. It is still important, but most of these countries, most notably Brazil and China, now have huge domestic markets, and no one has noticed that they are increasingly independent.

Your outlook is very cautious, but are there any sectors that look attractive to you?

My fear is that the recession is multiyear, and completely different from what we have seen before. It seems to me that the consumer is down for the count. The government can only go so far, and the corporate sector can revive eventually. If you want to focus on areas that are going to benefit from infrastructure improvement, that certainly makes sense. If you want to focus on agriculture, commodities and raw materials, and bet on the emerging-market demand driving those prices up, that makes sense as well.

Any parting thoughts?

Don't make the same mistake twice. Don't make an assumption that makes no sense. Everyone assumed home prices wouldn't go down, but don't assume they can't bottom and go up. No one would ever have guessed interest rates would have been this low. Don't assume that is a normal state; assume they are going back up again.

Everyone recognizes that recessions only last 18 months -- but that is wrong, some last longer. We are in a test now for what could be something longer. Don't be in a rush to commit funds. Do it very gradually and wait for conviction, as opposed to the fear of missing the bottom.

Thanks very much, Robert.

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Kenneth Lewis is getting a hard lesson in the new balance of power between Washington and Wall Street.

The Bank of America Corp. chairman and chief executive had agreed to buy brokerage giant Merrill Lynch & Co. in September, possibly saving it from collapse. But by early December, Merrill's losses were spiraling out of control. Internal calculations showed Merrill had a horrifying pretax loss of $13.3 billion for the previous two months, and December was looking even worse.

Mr. Lewis had had enough. On Wednesday, Dec. 17, he flew to Washington, ready to declare that he was through with Merrill, people close to the executive say.

"I need you to know how bad the picture looks," Mr. Lewis told then-Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, according to accounts of the conversation by people inside the government. Mr. Lewis said Bank of America had a legal basis to abandon the deal.

Messrs. Paulson and Bernanke forcefully urged Mr. Lewis not to walk away, praising the bank's earlier cooperation -- but warning that abandoning the deal would be a death sentence for Merrill. They said the move also could undercut confidence in Bank of America, both in the markets and among government officials. Despite the blunt talk, Bank of America executives interpreted the comments as a signal that the government was willing to work out a compromise.

Two days later, in a follow-up conference call, federal officials struck a harder tone. Mr. Bernanke said Bank of America had no justification for ditching Merrill, according to people who heard the remarks. A Federal Reserve official warned that if Mr. Lewis did so and needed more government money down the road, Bank of America could expect regulators to think hard about their confidence in management.

Mr. Lewis was told that the government would consider ousting executives and directors, people close to the bank say. The threats left no doubt: The federal government saw itself as firmly in charge of U.S. financial institutions propped up since October by infusions of taxpayer-funded capital.

During the four weeks that followed Mr. Lewis's conference call, federal officials and Bank of America hashed out a deal to salvage the Merrill takeover. The government agreed to provide $20 billion in additional aid for the Charlotte, N.C., bank, and to provide protection against losses on $118 billion in troubled assets.

The money is coming at a price. Six months into the great bailout of U.S. finance, Washington's rescue attempt has helped shore up the system. But that emergency effort, planned on the fly, has taken the government on a risky journey deep into the heart of American capitalism.

Bureaucrats are calling the shots behind the scenes at some of the nation's largest enterprises. Critics of the bailout program say its rules are opaque and its execution ad hoc, leading to a lingering lack of confidence in the the financial system. Some lawmakers are scrambling to steer funds to favored lenders.

Federal officials have said little publicly about their oversight of the institutions that received capital from the Troubled Asset Relief Program. Initially, the government seemed reluctant to use the ownership stakes it got in banks ranging from J.P. Morgan Chase & Co. to Saigon National Bank as leverage over bank executives.

But the tough negotiations with Bank of America, along with other recent moves by federal officials related to executive compensation and other issues, suggest that the government's attitude toward the troubled banking industry has changed, as financial markets have deteriorated further and political ire has risen.

When Citigroup Inc. took $25 billion in TARP funds in October, the executive-pay section of its pact with Treasury was just two sentences long and vaguely worded. A second rescue, for $20 billion in December, limits Citigroup's executive bonus pool for 2008 and 2009, requiring that a majority of 2008 bonuses be paid on a deferred basis.

Tough talk by President Barack Obama and other officials about bonuses and perks is making bank executives uncomfortable. Last week, under pressure from Treasury officials, Citigroup canceled its order for a corporate jet. The bank now is exploring its options for modifying the terms of a nearly $400 million marketing deal with the New York Mets. On Wednesday, Mr. Obama unveiled a series of executive pay curbs, including a strict limit on executive salaries for companies that receive an "exceptional" level of government assistance.

The story of Merrill Lynch's troubles and subsequent rescue negotiations, pieced together from interviews with people who participated in the process, suggests that the government's extension of control over the U.S. banking system is evolving on an makeshift basis. Despite agreeing to pump $25 billion into Bank of America and Merrill in October, the government had no idea the securities firm was hemorrhaging money until it was too late to avoid a second bailout.

By the end of November, two months into the fourth quarter, Merrill had accumulated $13.34 billion in pretax quarterly losses, according to an internal document reviewed by The Wall Street Journal. Some Bank of America executives expressed concern about proceeding with the takeover, people close to the bank say. On the advice of their lawyers, the bank decided to go ahead with Dec. 5 shareholder votes on the deal. Shareholders of both Merrill and Bank of America gave their approval.

After less than 48 hours of due diligence, Bank of America struck an agreement to buy the battered securities firm for $50 billion in stock, or $29 a share. The value of the deal has since declined along with Bank of America's share price. "I look forward to a great partnership with Merrill Lynch," Mr. Lewis said, toasting the deal with a glass of champagne.

A month later, Mr. Lewis was at the Treasury Department along with eight other chief executives of large U.S. financial institutions, summoned there by Mr. Paulson. The Treasury secretary wanted the executives to accept a round of government capital totaling $125 billion as a way of shoring up confidence in the banking system. Mr. Paulson explained that saying no wasn't an option, according to a person who attended the meeting.

"We are going to do this," Mr. Lewis replied, urging the other CEOs to call their boards if they needed approval. After persuading the nine financial institutions to take taxpayer money, the government, at first, refrained from flexing its muscles.

Bank of America executives remained confident about the deal. Doubts began to creep in shortly before Thanksgiving. With more than a month to go until the end of the fourth quarter, the pretax quarterly losses at Merrill were approaching $9 billion, according to people familiar with the figures. By month's end, the figure had exceeded $13 billion, or $9.29 billion after taxes.

Most of the losses were coming from the securities firm's sales and trading department. But business was even suffering in Merrill's lucrative wealth-management unit, which saw its revenue drop to $797 million in December, from $1.08 billion in October. Still, not all the losses, which included expected asset write-downs on assets such as Merrill's investment in rental-car company Hertz Global Holdings Inc., should have come as a surprise to Bank of America.

In meetings with Merrill managers, Mr. Thain acknowledged big losses, but said they weren't any worse than those of the firm's Wall Street rivals, noting that November had been a horrible month for everyone, say people who heard his remarks. At Bank of America, executives debated whether Merrill's losses were so severe that the bank could walk away from the deal, citing the "material adverse effect" clause in its merger agreement. Merger agreements typically specify certain "adverse" conditions that give an acquirer the right to abandon a deal.

But lawyers from inside and outside the bank concluded that the losses likely were in line with other firms, and recommended that Bank of America move forward with the purchase, according to people familiar with the discussions.

The deliberations continued up until a few days before shareholders of Merrill and Bank of America were scheduled to vote, one of these people says. Senior Bank of America executives had "mixed emotions," this person says, but "everyone wanted to see the deal go through."

On Dec. 5, the deal was approved at separate shareholder meetings in Charlotte and New York. Nothing was said about Merrill's problems. "It puts us in a completely different league," Mr. Lewis said about the deal's completion. On Dec. 8, Merrill's board gathered in Manhattan for their last meeting. Mr. Thain said the firm faced continuing losses, but they weren't unusual, given upheaval in the markets, directors recall.

The next day, Bank of America Chief Financial Officer Joe Price gave a detailed presentation to the bank's directors about its financial situation and Merrill's fourth-quarter woes, according to a person familiar with the meeting. Within a few days, Merrill's quarterly net losses had swelled to about $14 billion. People close to Bank of America say the losses ticked higher due to trading losses, as well as further asset write-downs.

The trading losses stem largely from legacy positions Merrill Lynch took in previous years. Mr. Lewis told Bank of America directors in a conference call that the bank might abandon the acquisition, which was supposed to close in two weeks. In mid-December, Edward Herlihy, a partner at law firm Wachtell, Lipton, Rosen & Katz who had helped set the merger talks in motion, reached out to Ken Wilson, a former Goldman Sachs Group banker and a top deputy of Mr. Paulson.

By then, Merrill's losses had reached almost $21 billion on a pretax basis, roughly equivalent to about $15 billion in net losses, and some of Bank of America's lawyers felt there was sufficient grounds to invoke the legal clause to torpedo the deal.

Mr. Herlihy, a longtime adviser to Bank of America, expressed concern to Mr. Wilson about the size of the losses, according to people familiar with the matter. Mr. Wilson was stunned by the news. Get Mr. Lewis to call Mr. Paulson, Mr. Wilson said, according to people familiar with the conversation.

At the meeting the next day, Dec. 17, Messrs. Paulson and Bernanke asked Mr. Lewis to give government officials time to think through their options, according to people with knowledge of the discussions. Mr. Lewis agreed and returned to Charlotte.

People close to Mr. Thain say he was unaware of Bank of America's concerns. On Dec. 19, he hopped a plane to Vail, Colo., with his family, people familiar with the matter said.

That same day, about 20 people in Charlotte and Washington dialed into a conference call that included Mr. Lewis, other Bank of America executives, Messrs. Paulson and Bernanke, and other Treasury and Fed officials. Mr. Bernanke told Mr. Lewis that Fed staff members had concluded there was no way for the bank to invoke the material-adverse-change clause in the takeover agreement that would allow it to abandon the deal.

Government officials also warned Mr. Lewis that withdrawing from the deal would frazzle the markets, spark a flurry of lawsuits against Bank of America and tarnish the bank for years. A senior Fed official ratcheted up the pressure, telling Mr. Lewis that any future requests for government assistance would cause officials to consider taking a heavier hand in Bank of America's operations.

The government's tone wasn't hostile. But the implication was obvious, people close to Bank of America say. As the bank's primary regulator, the Fed can force out executives if the agency concludes they are behaving irresponsibly. Mr. Lewis responded matter-of-factly that that government should do what it had to do, and Bank of America would do the same.

Asked what he needed to move ahead with the deal, Mr. Lewis responded that Bank of America wanted additional capital and protection against future losses on Merrill's assets -- something akin to the protection J.P. Morgan Chase & Co. received from the government when it agreed to take over Bear Stearns Cos. last March. Messrs. Paulson and Bernanke agreed to keep talking.

Over the next several days, government officials sifted through the books at Bank of America and Merrill, wrangling over which toxic assets to guarantee and how to value them, people close to the bank say. It became increasingly clear that Bank of America's balance sheet also was packed with assets that faced bruising write-downs, these people say.

Later, talks slowed because bank executives were concerned about the 8% interest rate the government wanted on new preferred shares it would take in Bank of America, these people say. Executives also complained that executive-compensation restrictions were being forced on it, despite government assurances that officials didn't want to punish the bank. The bank wound up agreeing to limit total compensation, including bonuses, to a fraction of the amounts awarded in recent years.

On Jan. 16, Bank of America announced the new bailout. At the same time, it disclosed Merrill's fourth-quarter net loss of $15.31 billion. Shareholders were floored. Bank of America reported a net quarterly loss of $1.79 billion. Asked by an analyst about his decision to go ahead with the Merrill deal, Mr. Lewis responded: "We did think we were doing the right thing for the country."

Source.