On Thursday morning, President Obama and his economic advisors unveiled the “Financial Crisis Responsibility Fee” in an effort to retroactively punish the nation’s largest banks for risky decisions which nearly brought the US and global economy to ruins.  This new tax is expected to raise about $90 billion over the next ten years (or longer if necessary) and targets the largest Wall Street banks.  The ultimate target of this latest policy gambit–in President Obama’s own words—are “the obscene bonuses at the very firms who owe their continued existence to the American people.”  Rather than directly taxing the offending bonuses themselves, this new tax will be levied on the dollar amount of liabilities or risk that larger banks carry on their balance sheets.  It is estimated that the top ten largest financial institutions will pay 60% of the fees and that no bank with less than $50 billion in assets would be subject to the new tax.

The traditional media as well as the blogosphere have begun to digest the new potential tax, and it appears that the vast majority see this as a troubling proposal.  Here are some points that jump out at us:

• President Obama has acknowledged on many occasions the need to spur lending to help boost small business in particular.  Small business is the primary driver of job creation, and joblessness is the most pressing economic problem the nation faces today.  As recently as December, Obama invited financial “heavyweights” to Washington to discuss ways to increase business lending, which is still a fraction of its pre-crisis level.  Does the President really believe that levying a new, punitive tax burden of $90 - $120 million on banks will make them more inclined to lend?
• The tax is designed to discourage the culture of excess (risk and bonuses) on Wall Street.  However, critics argue that banks, brokers and insurance companies will simply pass along these mew fees their customers (more below).  Banks were urged to look to their bonus pools as a source of funds for cash to pay any risk tax, but that is wishful thinking on the part of the administration.  Any such fee would become a cost of doing business, and would only lead to greater fees for customers.  Just look at the recent bonus tax instituted recently in Britain.  Financial institutions preferred to pay the taxes out of the bank’s accounts rather than risk losing their upper level talent to an aggressive competitor.
• The proposal targets many banks which have already paid back their TARP loans in full plus interest.  Even though taking TARP funds was not optional, banks are now to be punished for taking the money.  Goldman Sachs (GS), Bank of America (BAC), JP Morgan (JPM) and many others have attempted to get back to business as usual by throwing off the yoke of TARP, but they will now be forced to pay for the other recipients of TARP  who will not be able to pay off their debts, in particular General Motors, GMAC, and Chrysler.  An administration official, in a weak defensive of this reality, said that “U.S. auto makers collapsed in part because of a financial crisis of the banks’ making”. 

Whether or not this tax actually makes it into law–which is certainly in doubt–philosophically speaking, this would set a precedent of taxing businesses for their mistakes, and is a further assault on our free market system.  By necessity, capitalist ventures are driven by risk and financial institutions make their living by assessing, managing and profiting from risk.  A more logical and simple way to safeguard the economy from excessive systemic risk in the future–and one that is favored by many policy-makers including the President’s economic advisor, Paul Volker–would be to restore the Glass-Steagall Act or something similar.  Separating the higher risk investment side of banks from their commercial banking operations, would reduce the systemic risk posed to our economy going forward, but this is a discussion for another time.

It could all be much ado about nothing and simply political grandstanding designed to buttress Democrats flagging popularity with the electorate but this proposal has the ability to do too much damage for us not take a stand.  At Ockham, we are concerned that the economy is still vulnerable to a double-dip recession and the President is courting disaster pursuing a number of programs which would be harmful to businesses if enacted.  The “Financial Crisis Responsibility Fee” strikes us as a terrible idea which will further burden a struggling economy at a very inopportune time.

In closing, Oppenheimer analysts Chris Kotowski did some quick calculations as to the effect of the proposal’s effect on some of the largest banks.  According to his analysis, Morgan Stanley (MS) would be the hardest hit with 11.3% haircut to 2011 EPS, and Citi (C) is not far behind with a 9.5% hit.  However, he concludes that investors need not worry:

“However, we don’t believe that the fee will run directly to the bottom line. We view it as effectively an increase in the wholesale cost of funds that will be  passed through to the customers that utilize these institutions’ balance sheets.” — Chris Kotowski

"But now there are only two banks left that need to issue stock to get out from under TARP, Citigroup and Wells Fargo, which denies it has to. But give me a break…With this stock offering, you’re getting Citigroup in a price that is far more beaten down than it deserves to be. And you have to take advantage of the discount…I want you to buy, buy, buy Citigroup." — CNBC’s Mad Money 12/14/2009

Recently, the largest banks in the country are following Bank of America’s (BAC) lead and exiting the TARP program through massive secondary offerings.  The latest to announce their intentions to repay the government loans are Wells Fargo (WFC) and Citigroup (C) and both will require billions of dollars of capital in order to accomplish this feat.  On Monday night’s Mad Money, Jim Cramer discussed why he thinks investors should buy into Citi on the secondary offering rather than Wells Fargo.  The Citi offering will be a gigantic $20.5 billion which dwarfs even Wells Fargo’s need for $10.4 and both of these will further dilute existing shareholders.  With the banks eager to lift the yoke of the increased government oversight that comes with TARP, it is a signal to the market that these formerly hobbled banks are returning to health.

Among Cramer’s reasons for buying into Citi over Wells is the banks strong presence overseas where the bank is respected far more than its tarnished reputation at home in the USA.  Furthermore, Wells has too much exposure to mortgage loans in California and other troubled mortgage loans through its acquisition of an east coast mortgage giant, Wachovia.  Cramer believes that the price, currently well below $4, is attractive and still far less than the company’s book value.  Cramer believes that this stock will triple by 2012 as the book value continues to improve along with its debt portfolio, and called the bank the "ideal speculation play".  He continues, "It’s like a lottery ticket with better odds of winning."

Despite Cramer’s enthusiasm for Citi, there are plenty of analysts who are not so bullish on this move.  Repaying TARP could in fact hurt the bank and their shareholders, as an article from Time Magazine suggests.

"But analysts say Citi’s rush to repay the assistance it got through the government’s Troubled Asset Relief Program (TARP) will make the bank weaker, not stronger. The move will reduce Citi’s capital ratios and hurt earnings; it may also accelerate a retreat of foreign investors from the company’s shares. Worse, the government is demanding stricter terms from Citi than it did from Bank of America on the repayment deal it struck just a week ago. The different treatment shows that the government remains more concerned about Citi’s finances than those of its rivals.

Veteran analyst Richard Bove of Rochdale Securities, who had been recommending Citi’s shares since the summer, downgraded the stock on news that it was going to repay TARP from a "buy" to a "sell" rating. "What does it do for the company? Management can increase [executive] salaries," says Bove, referring to the fact that Citi will now be free of the government’s compensation rules. "What else? Nothing." – Citi’s TARP Repayment: The Downside for a Troubled Bank, Time Magazine

Citi’s balance sheet will actually suffer as a result of the repayment instead of improving.  Recently recovered capital ratios will drop back to risky levels and no longer having government guarantees on some of the riskiest loans make the bank far more vulnerable to losses.  From a shareholder’s perspective, the massive dilution of this secondary offering is likely to reduce earnings per share by about 20% going forward.

At Ockham, we have had an Overvalued stance on Citi for the last few months.  This is not because the price is expensive because it clearly is not, but rather the fundamentals have been so hampered that the stock was at risk of a pull back.  Not to mention there has been massive dilution through all of the capital raising efforts that losses have necessitated.  Analysts anticipate earnings per share in fiscal 2010 of 7 cents, which makes the forward looking P/E multiple hardly cheap at more than 50x.  Any worsening in the condition of their debt (no longer guaranteed by the government) would put those slim profits in jeopardy, so even though Citi will now lose the stigma of substantial government assistance there is more risk to shareholders than before.  As Cramer suggests, this stock will almost undoubtedly be higher in 2012 and could very feasibly triple, but in the meantime it may be a bumpy ride.

The price to peak earnings multiple rose to 12.4x on Friday, which is the highest level this valuation metric has touched since September of 2008.  Positive macroeconomic data such as an unexpected, modest decline in the unemployment rate and increased productivity boosted the S&P 500 for the week .  In addition, pending homes sales were better than expected, providing another sign of stabilization in the housing market.  However, market gains were modest as November retail sales were slightly weaker than expected, which made some analysts less optimistic about prospects for the holiday shopping season.

Perhaps the most important development of the week was Bank of America’s (BAC) announced plan to repay TARP funding.  The bank currently owes the Treasury nearly $45 billion and will use a substantial portion of its recently-rebuilt capital reserves, as well as money raised through a planned secondary offering to repay that debt.  This is great news for taxpayers as BAC becomes the first of the “zombie banks” to lay out specific plans for repaying the government’s loans.  Bank of America’s decision to pay off TARP was received as bullish news as such a move would be inappropriate if the bank foresaw large future losses, but we think there could be an ulterior motive.  It is well known that Bank of America is currently in search of a new CEO, and government-imposed limits to executive pay appears to be complicating the bank’s search for a new Chief Executive.

The percentage of NYSE stocks selling above their 30-week moving average increased to 83% over the last week.  Our investor sentiment metric remains extremely bullish and we continue to believe that, over the coming weeks, it will revert to more normal levels.  This does not necessarily mean that that stock prices must fall in the coming weeks, but the pace of gains cannot continue unabated indefinitely.

Corporate insiders are clearly not bullish at the present time.  Based on the most recent data from finviz, insiders are selling far more than they are buying.  According to the last week’s data, insiders bought less than $12 million in stock while selling approximately $957 million, giving bears a whopping 82x edge in terms of dollar volume.  Since corporate insiders are generally considered “smart money”, it is instructive when they become

either overly bearish or bullish.  The overwhelming bearishness of last week’s insider trades suggests to us that they view the market as over-valued and view this as a good time to take some profits.

Our outlook on the market has been little changed for the last few weeks; we continue to believe that the current risk/return profile is unfavorable for committing additional resources to equities.  At this point, we see valuation as unattractive at current price levels, as the market has already priced-in a fairly robust economic recovery.  Furthermore, the recent bull market has shown remarkable resilience and sentiment has remained fairly elevated for a number of months.  We continue to believe that stocks are vulnerable to a pull-back and any unexpected piece of news could trigger an exaggerated response.  Insiders are selling, the dollar is weak and, despite a slight drop in the headline unemployment rate, the moribund labor market remains a real problem.  So far, the market has been pretty sanguine regarding the problems which plague this economy.  However,  if solid evidence of sustainable economic growth does not materialize soon, the stock market is vulnerable.  As such, at the present time we recommend that equity investors have a bias toward dividend paying, reasonably valued, defensive stocks.

As the market turned decisively negative on Thursday morning, no sector was hit heavier that the semiconductor industry.  An analyst at Bank of America Merrill Lynch (BAC) downgraded the entire sector’s outlook from “positive” to “negative” and also downgraded 8 stocks in the sector.  The most notable downgraded stock in the sector is Intel (INTC) which is trading 5.5% to the downside on heavy volume.  BofA had been among the more bullish on Intel with a price target of $27.00, but in today’s announcement they reduced that target significantly to $21.50.  Others stocks suffer downgrades include Texas Instruments (TXN) and Marvell Technology Group (MVRL).

Among the reasons for the bearish note on chip stocks were weaker trends in PC supply chains.  Bank of America contends that Intel and others have been shipping a greater number of CPU’s than PC’s that have been shipped, which suggests there is ample supply of chips to accommodate any build in PC demand.  The note went on to say that unless there was a sharp upturn in the economy there is a possibility of an inventory correction.  This scenario has skewed the risk-reward negatively and prompted the downgrades.

Intel and other chip stocks had enjoyed a decent run of late and that is partially due to positive comments from Intel’s CEO as he anticipated strong performance from a PC refresh cycle.  In September, Mr. Otellini made comments about the convergence of the upcoming release of Windows 7 (MSFT) and corporations starting to loosen the purse strings for IT spending as reasoning why the future is bright.  However, the market has not really caught on to the CEO’s pep-talk as the stock now sits lower than it did then, and the overall analysts action has been to lower estimates in the last month.  Perhaps the growth of the corporate IT refresh cycle is still coming, but up until now it must be a disappointment to Otellini.

As of this week’s report we are reiterating our Fairly Valued stance on Intel as it is trading about where we would expect given the current fundamentals.  It is trading within the historically normal ranges of price-to-cash earnings and price-to-sales.  In fact, it would take either a substantial improvement to fundamentals or for the price to drop another 15% for us to become more bullish on Intel.

Caller: Question for you, I know in the past you’ve liked Hudson City Bancorp. Do you still?

Cramer: Yes, I do. Very conservative bank. People don’t want conservatism they want explosive earnings. They’re not going to get it from Ron Hermance. The yield is good, stock is good, I want to be in it. — CNBC’s Mad Money 10/6/2009

As Cramer alluded to in this quick quip, Hudson City Bancorp (HCBK) is known for being a very conservatively run bank.  It is old-school in this way; they did not get caught holding a lot of sub-prime debt when the credit crisis hit, nor do they make a lot of moves in other risky assets.  Instead, management has run their bank by the book lending money to credit worthy borrowers and taking the slow and steady path.  They did not need TARP money and they have not raised capital, unlike so many others in their industry.

One would think such management would be rewarded, having been through the worst recession since the Great Depression.  However, this conservative management style has not found favor in this market as investors are looking for aggressive behavior to take advantage of the recovery.  For that reason, HCBK has greatly underperformed the larger banks over the last seven months.  For example, since the market bottomed in March, Hudson City Bancorp has appreciated 46%.  That is not a bad seven month return, but it falls short of the S&P 500 benchmark return of 55%.  Even more telling, the Financial Sector iShares ETF (IYF) has more than doubled the return of Hudson City, gaining 116%.  Even that outstanding performance pales in comparison to the performance of some of the government-backed, so-called “Zombie banks” like Citi (C) +357% and Bank of America (BAC) +445%.

The relative performance of Hudson City Bancorp is pretty stunning, as they are in effect being punished for conservative management.  There are those that believe Bank of America and Citi are still undervalued because they are operating with the understanding that the government will prop them up no matter what problems may crop up.  Even though that is true, it seems out of whack that these stocks would have nearly ten times the return of a Hudson City.  It is clear that traditional conservative banking has fallen out of favor with the market, but we have to wonder how long that trend will last.

We have gone on record many times on this blog that this rally is still very vulnerable.  The market– lead by the riskiest stocks– has rallied despite our growing concern over the real economy.  Jobs are still being lost, mortgages and consumer credit continue to default, and yet the market continues higher.  We think that it is likely that the recovery will be slower than the market has priced in already, and in that case the conservative nature of Hudson City Bancorp will look much more attractive.

We are maintaining our Undervalued rating on Hudson City.  We are not high on financials in general, particularly after their huge gains recently have made so many look rather expensive.  Hudson City currently trades at a very attractive 1.33x book value per share, and our model suggests could trade in the low $20’s for the current fundamentals.  HCBK is different from many of the other banks and could be an opportunity for investors that want to have a hand in the financial sector, but want to moderate the risks to an extent.  Not to mention, the stock has a nice 4.5% yield for investors looking for income.