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Chasing Yield and Bank Reform does not mean Reformed Bankers

(Guest Commentary by Rick Konrad June 25, 2010)

Dear Subscribers and Readers,

For those who want to learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have brought in our regular guest commentator, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for several years and offers his unique insights to us in his twice-a-month mid-week commentaries.  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss his views on what investment vehicles may provide a good risk-adjusted yield for income investors, as well as his initial take on the U.S. bank reform bill and its consequences.  Without further ado, following is Rick's biography:

Rick is author of the excellent investment blog Value Discipline, founder of Value Architects Asset Management, and is a regular guest commentator on MarketThoughts.com (please see "The Discipline of Dividends Heading North for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Perhaps it is understatement to suggest that markets have been difficult. Sentiment is lousy. I completed a road-show in Florida this week and generally, expectations for the year as far as stock returns are abysmal. Clients are completely focused on yield plays, whether treasury or corporate, whether investment grade or otherwise. Closed end fixed income funds with high yields but employing some considerable leverage are also quite popular it seems.

A good example is PIMCO's High Income Fund (run by none other than Bill Gross, often regarded as the bond manager's bond manager) with a 13% yield. However, this CEF, symbol PHK, trades at a 46% premium to net asset value (as of last night) and employs 45% leverage. Leverage is a wonderful thing as long as short term rates remain low, but the combination of below investment grade bonds and a huge premium to NAV with leverage takes more faith than I am willing to muster.

I would prefer unleveraged funds at a discount to NAV, for example, BlackRock Corporate High Yield Fund (COY) which yields about 10.8% and is trading at about a 2% discount to NAV, and employs no leverage. Another interesting choice utilizing emerging markets debt (and currency) is Western Asset Management's Emerging Market Closed-end Fund (ESD), which yields a still respectable 8.5% but trades at an 11% discount to NAV...also employing no leverage.

Though the REIT space can be quite challenging at times, I am comfortable with a couple of high yielding mortgage REITS, MFA Financial (MFA) yielding almost 13% and Annaly Capital Management (NLY) yielding over 14%. In both cases, the underlying assets are mortgage backed securities, exclusively agencies in the case of Annaly and a blend of agency and non-agency for MFA. MFA utilizes considerably less leverage at about 3 times equity as compared to NLY at about 6 times.

The ownership of mortgage REITs in some ways can be compared to the ownership of a bank but with a lot more transparency. Most large banks securitize their mortgages rather than own mortgages outright and fund them similarly to mortgage REITs with low cost funding under the current interest rate scenario. However, banks have a much heavier overhead expense as a result of their branch system and can fund with sometimes zero cost deposits. Leverage though, is significantly higher with the best quality banks leveraging mortgage assets at between 10-15 times, down from headier days when leverage routinely ran at 20 times and up. The other advantage, of course, is the REIT structure where shareholders receive 90% of the income that is derived from the operation, ergo, the very attractive dividend stream. Remember, that the funding at these low rates will not be ad infinitum but, at least in the foreseeable future, I have other things to worry about.

Banking stocks are performing a little better, probably a relief rally, now that the financial reform bill has taken shape. The more I think about this bill, and I confess, I have not devoured the 2,000 pages it entails, the financial overhaul is not an antidote for another banking crisis.

Many years ago, the late Gilda Radner portrayed a recurring character on Saturday Night Live named Roseanne Roseannadanna. When confronted with a mistake or disagreement, she used to say, "It's always something." And that, dear readers is the problem with banks. Whether junk bonds, Florida swamp land, limited service hotels, S&Ls,etc there is always someone somewhere who is willing to borrow money to make what turns out to be a rather ill-advised speculation. In short, bank reform does not mean reformed bankers.

The new bank reform bill will reduce the scope for large institutions to increase leverage and take excessive risks. It also appears to provide a framework to wind down any large institution that fails. But don't take too much comfort in this. There is no legislation that can prevent the future mispricing of assets or keep speculators from borrowing money.

There will be curbs on proprietary trading and significant limitations on investments in hedge funds, though the limitations are not as severe as originally proposed. Derivatives will become more transparent. Perhaps one of the most important reforms relates to securitization.  Banks will now have to keep at least 5% of any asset-backed securities that they issue on their balance sheets. Literally, they will have to own in order to recommend to others.

Strangely, there is the introduction of a new tax (amounting to some $19 billion) which will lower overall capital levels. Huh??? Given the weak propensity to lend as it is, this doesn't sound like the brightest idea for the time.

We have liked one of the least bank-like of the banks, Bank of New York Mellon (BK). Having $22 trillion in assets under custody, this is the go-to global custodian.  This is a business which sees tremendous flows in and out, on which the bank captures a tiny bit of a toll every time money passes through. On the asset management side it owns Dreyfus, which has a huge money-market-fund business, and several smaller boutique managers. There is a significant wealth management business catering to high-net-worth families. Some 75% of the revenue stream consists of fee income rather than interest income.

Stung by some bad real estate loans, BK took its lumps like others, but to a far less significant degree. Though valued in this market like any other bank, over time I think its valuation will evolve into that of an asset manager, given its unusual revenue composition relative to commercial banks.

As far as the overall market, I am actually getting increasingly bullish as bargains seem to be increasingly evident. Yet, I am reminded of Roy Neuberger's counsel many years ago when he said, "Analysts!!!.- .in a bull market, who needs them, in a bear market, they'll kill you."

Disclaimer: I, my family or clients own positions in all of the securities mentioned in this post other than the PIMCO High Income Fund.

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