Bronte Capital down in Sydney stayed up late to listen to Warren Buffett on CNBC and transcribed the following observations about the banks from the Sage of Omaha. These were obvious to anyone who cared to look closely at the numbers, but ignored in the general panic over banks.

BUFFETT: Yeah, the interesting thing is that the toxic assets [of American banks is] if they’re priced at market, are probably the best assets the banks has, because those toxic assets presently are being priced based on unleveraged buyers buying a fairly speculative asset. So the returns from this market value are probably better than almost anything else, assuming they’ve got a market-to-market value, you know, they have the best prospects for return going forward of anything the banks own.  The problems of the banks are overwhelmingly not toxic assets, you know. They may have been one or two at the top banks, but they are not going to do in–if you take those 20 banks that are subject to the stresses, they’re not going to do those banks in. Those banks have the earning power which has never been better on new business going out of this to build capital positions if they pay low dividends which they’re starting to do now.
BUFFETT: Toxic assets really are not the problem they were. Now, when I said it was contingent–I didn’t remember being exactly contingent on TARP, but it was contingent on the government jumping in. 
BUFFETT: The government needed to act big time in September, I will tell you that.
BUFFETT: And they did act big time.
JOE: So you are OK with the shift to providing the banks with capital as opposed to the original intention of the TARP for actually getting the toxic assets off the books.
BUFFETT: Yeah, and interestingly enough, they don’t need to supply the banks, in my view, with lots of capital. They need to let almost all of–I mean, the right prescription with most of the banks is just let them pay very little in the way of dividends and build up capital for awhile, and they will build up a lot of capital. The government has needed to say–what the government needs to say is nobody’s going to lose a dime by having their deposits in these banks. They’re going to make lots of money with the deposits.
JOE: Hm.
BUFFETT: The spreads have never been wider. This is a great time to be in banking, you know, if you just get past the past and they are getting past the past. I mean, right now every time a loan is made to somebody to buy a house–and we’re making, you know, making millions of loans–four and a half million houses will change hands this year out of a total stock of less than 80 million. So those people are making good mortgages. You want those assets on your books and you get a great spread in putting them on now. So it’s a great time to be in banking, but you do have to get past this past. But the toxic assets, in my view, you know, if they’ve been written down to market, I’d rather buy those assets from the bank than any other assets they’ve got.

To translate into English: first, the so-called toxic assets are throwing off enormous cash flows and are dirt cheap at current prices (for example, well-structured AAA’s with a first call on all cash flows and a 35% buffer against losses from subprime mortgage collasteral). Second, spreads are so wide that banks make enormous profits lending. As long as the government allows them to borrow cheaply and avoid deposit runs, most of the banks can make money and rebuild capital in this environment, as Vikrim Pandit claims Citicorp is doing.

A great deal of confusion is generated by FAS 157 accounting, a point that the analysts at Tom Brown’s Bankstocks (among others) make again and again. Mark-to-market accounting creates instant insolvency at this point in the cycle.

The banks are the beneficiaries of panic, particularly those banks that own the top of the capitl structure (the “toxic” structured securities that skim the first cash flows and assign losses to other bondholders or providers of insurance). Citigroup actually may be one of the more profitable institutions in this environment. Would you rather own a AAA security backed by subprime collateral (or commercial mortgage backed securities), or a portfolio of “prime” consumer and commercial real estate loans? I use the term “prime” advisedly, for what was prime in 2007 may be prime beef on today’s grill. Wells Fargo and Bank of America were prime rather than subprime lenders and have a loan book which must absorb losses directly. Citi’s portfolio, I believe, is more concentrated in structured product with a high degree of loss protection.

Citicorp was the most aggressive buyer of asset-backed AAA’s through its Structured Investment Vehicles during 2005-2007, and its need to bring these assets back onto its balance sheet and de-lever at extremely discounted prices explains its mammoth loss during 2008. Now that its capital position is stabilized and it can hold its portfolio, Citigroup may be in a very good position to clip coupons at stupidly wide spread levels.

This entry was posted on Tuesday, March 10th, 2009 at 4:55 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.