Let’s start with a brief analogy. Imagine you’re an investor with a million dollars to invest in bank CDs. However, the rules of the game state that only $100,000 may be invested in any one institution. Pretty easy decision, right? You would invest $100,000 in each of the ten highest-paying banks because the FDIC currently insures bank deposits up to $250,000. But now imagine that the rules of the game change such that there is no FDIC insurance. That would be a more challenging exercise to say the least. Instead of relying solely on the FDIC insurance to make investment decisions, the investor would have to perform credit analysis on each individual bank to ensure she will receive her money back (with interest). This would probably lead to a situation where smaller, less well-known banks would have to pay higher interest rates than their larger brethren in order to attract CD accounts. This situation would likely exist, despite the fact that many of the smaller banks might be less risky than some of the larger banks, because investors would rather blindly put money with institutions that they know than to do their own credit analysis.

Something similar to this now exists in the municipal bond market. Municipal bonds, issued by state and local governments, pay tax-free interest with many carrying insurance that guarantees timely payment of interest and principal. This insurance is issued by one of several major bond insurance companies, such as MBIA or Ambac. Most of these insurance companies were rated AAA but, due to the mortgage meltdown and shoddy underwriting, they have either been severely downgraded or eliminated from the market. As a result, municipal bonds that were initially sold with AAA rated insurance but no underlying rating (issuers would have to pay the rating service for an underlying rating in addition to the premium payment for the insurance guarantee) now trade in the marketplace with only a downgraded insurance rating or no rating at all. These bonds offer conservative investors an attractive yield because most muni bond investors refuse to take the time to do their own credit analysis on an individual issue. This dislocation in the municipal bond market has created an opportunity.

At Farr, Miller & Washington, we believe that carefully selected bonds of this type have excellent risk/return characteristics for investors looking for tax free income and a stable return on investment. For example, FMW recently purchased for clients a municipal bond issued by the American Red Cross. The organization issued taxable bonds in June 2007 with AAA rated Ambac insurance, but it did not apply for an underlying rating. FMW bought these eight-year bonds with a coupon rate of 5.56% at discount to par, an attractive yield premium over US Government and investment grade corporate offerings. Our internal credit analysis estimates that The Red Cross would garner an investment grade rating if it did decide to pay one of the rating agencies for a rating.

In the tax exempt arena FMW has been able to find attractive issues yielding 4% to 5% and in some cases even higher, and all federally tax free. That equates to a taxable equivalent yield of 6.15% to 7.7% for investors in the highest federal tax bracket. As an example, we recently purchased a medium-term, tax-free municipal bond issued by a southern state that was financing local infrastructure projects. The bond is backed by a pool of loans to local borrowers, with the added security of an appropriation from the state if any of the local borrowers were to default on payments. This bond was originally insured and rated AAA. Now that the insurance rating is essentially meaningless, the bond trades as a non-rated bond yielding over 5%.

These types of opportunities don’t come along all that often. Most of our client bond portfolios will continue to be dominated by AAA and AA General Obligation or essential service Revenue bonds. However, we believe that these opportunities are welcome additions to a conservative bond portfolio from both a yield and a diversification standpoint, without compromising the overall safety of the portfolio.

On the consumer side, most banks reported an improvement in credit card metrics and a decline in early-stage delinquencies across a number of consumer loan categories. At the same time, the data suggested that problem loans in the residential real estate category are growing at a slower pace than they had in previous quarters. Why is this important? It is important because a decline in the rate of increase in problem assets is a precondition to an eventual decrease in problem assets. Moreover, historical data suggest that bank stocks perform very well once the rate of increase in problem assets starts to decline. Essentially, investors are anticipating the return of normalized levels of credit losses well in advance of the actual improvement. They do this because as loss rates decline, banks are able to drop their large vault of accumulated loss reserves to the bottom line. Therefore, earnings growth can be very strong and bank stocks can do very well during this stage in the credit cycle. However, we would stress that it remains highly unclear as to whether or not we are indeed nearing peak loss rates for the cycle.

On the commercial side, credit metrics continue to come in much better than many had feared. The warnings that commercial real estate would be the “next shoe to drop” have thus far been largely unfounded. While losses and problem assets continue to grow, the rate of growth in problem assets declined signficantly in the fourth quarter and the situation is nowhere near the fiasco that many had predicted (at least not yet). Furthermore, management commentary regarding the sale of some problem assests suggest that the secondary market for problem loans is open for business again. This is also a positive.

As we continue to work through the cycle, one thing that is unambiguous is that bank balance sheets have improved dramatically over the past several quarters due to large capital raises and huge additions to loan loss reserves. Moreover, many of the banks have already repaid TARP and the resulting dilution is well known. The balance sheet strengthening is important because it offers protection in the event that losses come in much higher than the consensus expects. However, it is also important because if loss rates are indeed beginning to peak, there is a huge amount of reserves that can be dropped to the bottom line, resulting in outsized growth in book value. Under this scenario, bank stocks would likely perform very well.

So why aren’t we banging the table on bank stocks? We continue to believe that the apparent stabilization in credit quality may be a head fake. We continue to believe that a second leg down in housing may be in the offing based on the removal of key stimulus initiatives. Recent home sales data suggest that the $8,000 tax credits played a huge role in stimulating demand for housing at the lower end of the spectrum. At the same time, the Fed has kept mortgage rates artificially low by purchasing enormous quantities of mortgage-backed securities. Third, as much as 95% of new mortgage loans are now guaranteed by the government through Fannie Mae, Freddie Mac or low-down-payment FHA loans. What will happen when the government removes this support? The private banking sector is clearly not fighting over new mortgage loans, and housing demand will clearly subside when tax credits expire and mortgage rates rise by 50 or 100 basis points (or more). Lower demand for housing and reduced access to credit will mean further home price declines, more foreclosures, and another round of write-downs at the banks.

On the commercial side, we believe the reason for the better-than-expected credit performance within commercial real estate is that bank regulators have provided the banks with flexibility to work with borrowers such that losses will be spread out over a much longer period of time (years instead of quarters). So rather than allocating more capital and reserving for losses on underwater, restructured CRE loans, banks can now modify terms without having to take such measures. This Japanese-style flexibility essentially amounts to kicking the can down the road as these losses will have to be recognized sooner or later. The problem will grow with time.

The bottom line is that we remain cautious on banks as a group. Bank earnings are highly levered to the health of the economy, and we do not think there is much to sustain the pace of recent economic growth once the government steps out of the way. Having said that, we at Farr, Miller & Washington are long-term investors. We buy great companies for reasonable prices with the idea that they will be able to outperform the market over an economic cycle (3-5 years). Therefore, the recent sell-off in bank stocks due to the regulatory uncertainty may in fact provide us with an opportunity to add to our positions in two banks we believe are well positioned to withstand the storms we see on the horizon. However, we will remain underweight in financials until we see more definitive signs of an end to this miserable credit cycle. Finally, we would note that the BKX bank index (an index of 24 large bank stocks) has been flat since August while the overall market has trended higher.