Credit Cardholder "Bill of Rights" Looks Like Sensible Regulation

One of the biggest concerns from conservatives since President Obama's election has been the possibility of new, overly burdensome government regulation on various aspects of the economy and financial markets. While this should be a real concern, it is unfair to assume new regulations will be over-the-top before any of them are actually drawn up, passed, and enacted.

Among the first is a credit cardholder "bill of rights" which is supposed to protect consumers from unfair and deceptive credit card issuer practices. The U.S. House of Representatives overwhelmingly passed its version of the bill (the Senate is working on possible modifications), so I thought I would go through the summary of its contents to see how reasonable it is. Below are the details:

Interest Rate Increases

1) Limits interest rate increases on existing balances to those cardholders who are late with their payments, have a promotional rate expire, or have a card with a variable rate

2) Requires card issuers give consumers 45 days notice to any interest rate changes or significant contract changes

Credit Limits

1) Lets consumers set their own fixed credit limit

2) Prevents over-the-limit fees for consumers who have set a limit or for "hold" transactions

3) Limits (to 3) the number of over-the-limit fees issuers can charge for the same transaction

Penalties for On-Time Payers

1) Ends "double cycle" billing - interest charged on balances that were paid on time

2) If cardholders pay on time and in full, prevents issuer from charging left-over interest fees

3) Prohibits additional fees for paying over the phone or internet

Allocation of Consumer Payments

1) After the minimum amount due, payments must be allocated proportionally to high interest and low interest balances, not exclusively to the lowest interest rate debt

Due Dates

1) Billing statements must be mailed 21 calendar days before the due date, payments received by 5pm local time on the due date must be considered "on time"

2) Extends the due date to the next business day if the due date falls on a day the card issuer does not accept or receive mail

Misleading Terms

1) Establishes standard definitions for terms such as "fixed rate" and "prime rate" so as to ensure clarity in marketing materials

2) Gives consumers who have been "pre-approved" for a card the right to reject the card prior to activation without negatively impacting their credit score

High Fee, Subprime Cards

1) Prohibits issuers of subprime cards (cards with fixed annual fees that exceed 25% of the card's credit limit) from charging those fees to the card itself, which often results in consumers going over their limit

Issuance to Minors1) Prohibits card issuers from knowingly issuing cards to individuals under 18 who are not emancipated minors

After reviewing this "bill of rights" I was pleased to conclude that none of these measures, in my view, would be considered excessive regulation by the federal government. I think we all need to take more responsibility for our actions and our financial situations, and empowering the consumer with information and the ability to avoid certain products if they choose to can only aid in that process. Kudos to Washington on this one (hopefully the Senate doesn't mess with it).

Paulson Threatened To Remove Ken Lewis If He Backed Out Of Merrill Lynch Deal

Some people are worried that President Obama is going to try and run the banks and credit card issuers but how about this little tidbit from the Wall Street Journal:

Then-U.S. Treasury Secretary Henry Paulson threatened to remove Bank of America Corp. Chief Executive Kenneth Lewis and the bank's board of directors if the bank backed out of its merger with Merrill Lynch & Co. last year, New York Attorney General Andrew Cuomo said.

Mr. Lewis had informed Mr. Paulson on Dec. 17, 2008, that Bank of America was planning to invoke a material adverse event clause in the merger agreement that would allow it to call off the deal, Mr. Cuomo said. Three days before, Mr. Lewis had learned that Merrill Lynch's financial condition "had seriously deteriorated at an alarming rate" since Dec. 8, 2008, Mr. Cuomo said.

The difference between this news and the ouster of GM CEO Rick Wagoner, of course, is that the government is a creditor of GM and without having lent them money, GM would have filed bankruptcy a long time ago. Forcing shareholder-owned companies to merge simply to prevent possible instability in the financial system is questionable at best and completely inappropriate at worst. I hope the Obama administration doesn't repeat these types of things. Fortunately, pushing for a credit cardholder bill of rights, as discussed today in Washington, does not fall into such a category. Let's cross our fingers it stays that way in the future.

First Quarter Best Quarter Ever for Wells Fargo

No wonder the market is up huge today. Before the bell, Wells Fargo (WFC) announced that it would earn a profit of $3 billion in the first quarter, making it the best quarter in the company's history. Even more impressive, that result includes $372 million in TARP preferred dividends paid back to the government.

Some numbers from their press release:

Revenue $20 billion (+16%)Pre-tax, pre-provision profit: $9.2 billion

Provision expense: $4.6 billionPre-tax profit: $4.6 billion

Net earnings: $3 billion

Allowance for future loan losses: $23 billion

Why isn't the Wachovia deal killing them? As I have pointed out before, purchase accounting lets you write-off loans when deals close, so Wells was able to take most of the Wachovia losses up front, which boosts earnings in the future quarters. As we can see, this is the first quarter for the combined company and they are really executing well.

Full Disclosure: No position in WFC at the time of writing, but positions may change at any time

Unconventional Wisdom: Consumers Reduce Debt During Recession

The conventional wisdom has been that as the recession deepens and more people lose their jobs, they will rely more heavily on credit cards, etc to fund their expenses, consumer debt will rise, and banks will struggle with more and more debt that is less likely to be repaid.

Well, based on the graph below from the April 13th issue of Business Week, the consumer is de-leveraging, not borrowing more. This trend is also seen in the savings rate, which has spiked in recent months. As a result, consumers might be in better financial condition after the recession than before, ironically enough.

Reducing Unused Credit Card Lines Is Probably A Good Thing For Everybody

Meredith Whitney, long time bear on the banking sector, is pointing to the possibility that reductions in credit card lines could result in a sharp drop in consumer spending over the next year or two. In a recent television interview she predicted that outstanding credit card lines in the United States would drop from $5 trillion to $2.3 trillion by the end of 2010, a drop of more than 50 percent. Having less available credit, Whitney argues, will result in even less consumer spending and major problems for the economy.

While I don't disagree that credit card issuers are going to reduce credit lines (we are already seeing this trend and there is no reason to think it will cease anytime soon), I am skeptical about how much this will really impact consumer spending. The main reason is because there is only about $800 billion in outstanding credit card debt in the U.S. right now, and that figure has not been growing as fast as may have thought in recent years. While this is clearly a large number ($2,600 per person), it is dwarfed by the credit lines currently outstanding and as a result, the credit line reductions should not really have a major impact on day-to-day spending.

Essentially, Whitney is predicting that the credit utilization rate will increase from 16% currently (800 billion divided by 5 trillion) to 35% within two years. For someone with $2,600 in credit card debt, that means their credit limit will be reduced from $16,000 to $7,500. While that may make the consumer a little less confident that they have a huge cushion of credit to fall back on in the case of an emergency, I don't really agree that it will result in a significant pullback in regular spending habits.

Additionally, this action by the nation's leading credit card companies may in fact help them as well as our consumers, who hopefully will realize that they should have a few thousand dollars in a savings account in case of an emergency rather than assuming they will get cards should something unexpected happen. This would be a welcome event for our banking system, which benefits greatly from an increasing deposit base. As for Whitney's assertion that a credit card bubble is the next shoe to drop on our economy; call me a skeptic. The data simply isn't all that scary to me and if we slowly lower our dependence on credit cards, our economy will be on stronger ground as a result.

How The Financials Are Greatly Masking the Market's Earnings Potential

Some people are making the case that the stock market can rally meaningfully even without the financial sector recovering. I disagree simply because earnings are being negatively impacted so severely by loan losses and mark to market writedowns at the large financial institutions that investors won't get a clear picture of what a reasonable expectation for S&P 500 earnings are until financial sector earnings at least stabilize, if not climb back toward breakeven.

Jeremy Siegel, well known Wharton finance professor and author of "Stocks for the Long Run" (an excellent book) had an opinion-editorial piece in the Wall Street Journal recently that was titled "The S&P 500 Gets Its Earnings Wrong" (subscription only) that made some interesting points about the currently depressed level of earnings for the S&P 500.

Dr. Siegel explains that while the S&P 500 is market value weighted (larger companies are weighted more heavily in the index than the smaller ones), Standard and Poor's does not use the same methodology when calculated the index's earnings. Instead, a dollar of profit from the smallest stock is treated the same as a dollar earned by the largest. As a result, the losses being accumulated by a small portion of the index are negating the profits being generated by the majority, which is making the S&P 500's earnings look overly depressed.

Consider the data below, taken from Siegel's column:

Siegel is suggesting that the absolutely abysmal financial performance of the market's worst stocks last year (mostly from financial services firms, of course) is giving the appearance that corporate profits have absolutely fallen off a cliff in every area during this recession. He is quick to point out that 84% of the largest 500 public companies in the U.S. (420 out of 500) are actually doing quite well. That fact is going unnoticed because $1 of earnings from the smallest stock in the S&P is treated the same as $1 of earnings from the largest component, even though an investor in the S&P 500 owns 1,300 times more of the largest one than the smallest.

I'm not sure if Siegel is suggesting that they should actually go ahead and change the way they calculate S&P 500 earnings (and if so, I'm not sure I would even agree with him), but I do think this data is very helpful in seeing just how much the financial sector is masking corporate profits from other sectors.

My personal estimate right now for S&P 500 fair value is around 1,050 (14 to 15 times normalized earnings of between $70 and $80). I came up with those estimates before reading Siegel's article, but the data he provided give me comfort in the estimate. After all, if you assume the bottom 80 companies get back to breakeven and the other 420 companies maintain their 2008 profitability (both are conservative assumptions when the recession ends in my view), we see that S&P 500 earnings would range from $67 (if you use GAAP earnings) to $81 (if you use operating profits).

As you can see, any relief for the financial sector with respect to mark-to-market accounting principles could temper the writedowns going forward. Even getting the financial sector to breakeven by 2010 would reduce the negative earnings impact from the bottom 6% of the S&P 500, clearing the way for earnings to rebound pretty quickly from the $40-$50 level analysts are projecting for 2009.

Cash Flow Accounting Isn't So Terrible, Really

Last night on Larry Kudlow's CNBC show, the guests debated how proposed changes to fair value accounting would impact the stock market. The full clip is below, but the main argument was whether using cash flow fair value accounting (most likely what any proposed changes out of FASB will look like) is really that much worse than mark-to-market accounting. I have written about this before and I really don't understand the argument that somehow a cash flow based valuation of asset backed securities lacks transparency and allows bankers to value their assets at whatever number they want.

Gary Schilling, the bear on Kudlow's panel (who is predicting 600 on the S&P) argues that fair value accounting is just a forecast and you can't accurately forecast the cash flows from an asset backed security. This view baffles me. After all, non-packaged whole loans that banks hold are valued using cash flow projections. In fact, that is standard practice. If you have a loan that is being paid on time consistently, there is little reason to think you won't be repaid in full, and therefore that loan is reserved for much less aggressively than a loan you have where the borrower is delinquent.

The idea that one can't accurately forecast the cash flow from a loan (or an asset backed security) ignores reality. Every loan has an amortization schedule, so you know exactly how much principal and interest you are due to receive and when. Obviously, you have to build in some loss assumptions based on the economic environment, delinquency trends, credit history, etc, but it is far easier to predict cash flows from loans you hold than it is other assets like goodwill and other intangibles, or even equities.

The idea that someone else selling a loan makes every loan like it worth that exact amount ignores the fact that credit trends differ between banks, regions, etc. If you hold loans that are current on both principal and interest, there is no reason you should be forced to write down the value of that loan simply because a distressed seller, completely unrelated to you, is forced to sell their loans at a discount to get rid of them quickly.

Fortunately, the updated FASB guidelines should go a long way to solving this issue in the coming weeks. Banks lose money on loans all the time, and that will continue with or without mark-to-market accounting. There is no reason a financial services company should be forced to take an accounting loss on an asset if they are still being repaid on time and as expected.

Later this week I will illustrate why adjusting these accounting rules on financial services companies will do a lot to alleviate investor fears and bring some stability back into the stock market, which we have already begun to see in the last week or so.

How Bank Solvency Can Be So Hotly Debated

I wanted to pass along some excellent work by Gary Townsend of Hill-Townsend Capital on how there can be such a hot debate on Wall Street about the solvency of our nation's large banks. Essentially, it comes down to this: if you take loans on bank balance sheets and mark them to market, you can show that the bank is insolvent. Of course, bank loans held for investment are not marked to market according to GAAP (instead loan loss reserves are set aside over time to cover future losses), but why let some silly accounting rules get in the way of bank solvency analysis!

Here is a graphic put together by Townsend to illustrate how a bank (in this example, Capital One, a Peridot holding coincidentally) can be very solvent under GAAP but insolvent if you mark every loan on its book to market.

Gary comments on the data above by adding the following:

"So with full-bore MTM treatment of Capital One's balance sheet, after net MTM adjustments of just over $12 billion, the company's tangible book value of $28.24 per share falls to minus -$1.21. There are innumerable other examples.

The point is that the market takes Capital One's MTM disclosure, does the math, and values Cap One as if the loans were marked to market anyway. That's how Capital One and many other banks are well-capitalized according to GAAP and regulatory standards, but insolvent in the view of many market participants. GAAP results become irrelevant. And it's how Roubini and others come up with their huge loss numbers, on their way to declaring the U.S. banking system insolvent.

The problem, of course, is that the MTM results have little to do with the intrinsic value to a bank of a loan or a security that it plans to hold to maturity. In a bank, the decline in a loan's value is offset with a forward-looking provision for loan losses. The decline in the loan prices net of loan loss allowances is not due to credit deterioration; it's the result of the distortions and speculation in the world's financial markets. Mark-to-market accounting isn't improving the transparency of bank accounting. It has reduced it, with enormous and growing damage to our economy and prospects."

Full Disclosure: Peridot Capital was long shares of Capital One at the time of writing, but positions may change at any time

Proposal To Eliminate Government Subsidies Hammers Sallie Mae

Shares of student lender Sallie Mae (SLM) are down 42% this morning after the Obama Administration's newly unveiled budget included a proposal to eliminate government subsidies paid to private banks who make student loans. The subsidies, which cost the government billions each year, would cut government spending by $47.5 billion over the next 10 years. Wall Street is outraged, claiming that getting rid of the subsidies will drown out private student lenders and increase the market for government loans (and therefore government involvement in our economy).

I'm confused. I thought we all want a free market capitalist system? If private student loans are unprofitable (and therefore require government subsidies in order for banks to offer them), wouldn't the free market dictate that private student lending is not a worthy endeavor for private, profit-seeking banks? Maybe I'm missing the point, but I think reducing any government subsidy, and therefore the budget deficit, would be a good thing, especially for proponents of the free market.

As for the argument that this measure would virtually eliminate private student lending, I guess I'm not convinced. Given how creative and entrepreneurial our private industry is, do we really think they can't come up with a student lending program that is both attractive to the borrower and also profitable for the lender? I have no doubt that the banks would love to keep getting these subsidies, but the notion that student lending in the private sector can't be maintained without them seems a bit extreme, and even if that is the case, maybe private lending is a flawed model.

What do you think?

Full Disclosure: No position in Sallie Mae at the time of writing, but positions may change at any time

With Banks Cutting Common Stock Dividends, Look At High Yielding Preferreds

If you're a bank that took government TARP funds, whether you asked or were forced to take them, you better be very careful about paying for travel or entertainment for any of your employees or clients. Latest example: Northern Trust (NTRS), a custodian bank that had the nerve to send people and entertainment to the Northern Trust Open golf tournament. Of course, now people are irate because NTRS took $1.6 billion in TARP money and is now "using taxpayer dollars to throw parties."

Don't be shocked if they give the money back very soon. Northern Trust is not your typical lending institution, but instead focuses on back office services for financial services firms. As a result, the company is actually doing very well and continues to make good profits even in this environment. The company didn't want or need TARP money, but former Treasury Secretary Henry Paulson didn't give them a choice, he made them take more than a billion dollars.

We are now hearing that many banks (those that took TARP funds) are cutting the dividend on their common stock to one cent per share per quarter, thanks to the new wave of government involvement in the management of these firms. Since many investors rely on dividends for regular income, and some banks tried to reject the government money and the accompanying scrutiny, these dividend cuts are tough to stomach for the healthier firms and their investors.

There are alternatives though, namely the publicly traded preferred stock of these banks, which pay lofty dividends and aren't in danger of being cut because the government is getting paid interest in the form of preferred dividends. There is no way Treasury will make banks cut its own dividend payment, so as long as a bank is relatively healthy and is in little danger of being the next victim of the credit crisis, investors can dip their toes into the preferred stocks of the stronger banks.

Not only are these preferred shares trading at large discounts to par value, but the dividend yields range from 10% to 15% in most cases. In order for a bank to stop paying preferred dividends, it really has to be in bad shape, so if you are looking for high dividend yields in the banking industry, look at the preferred stocks of those banks you think will survive the current mess.

Full Disclosure: No position in Northern Trust at the time of writing, but positions may change at any time