As usual, there was some good news, some bad news and some confusing news.

The good stuff:
Record pre-tax, pre-provision earnings of $9.2 billion

Record revenue of $21 billion

Core deposits up

Confirmed expected annual savings of $5 billion with Wachovia merger

Wachovia merger reported to be going as planned

Tangible common equity (TCE) and Tier 1 capital ratios both up

Nearly $23 billion in loan loss reserves, a $1.3 billion increase from last quarter and enough to cover 12 months of expected consumer losses and 24 months of expected commercial losses

A lot of Wachovia's really toxic stuff was heavily marked down with the acquisition. As a result, WFC asset quality is probably quite a bit better than their peers.

The rest:
That $3.05 billion profit is before paying out $661 million in preferred dividends, income to common share holders was $2.38 billion. $372 million of that dividend payment was to the U.S. Treasury on the TARP preferred.

Mark-to-market accounting appears to have played a significant role. Using the recent accounting changes, WFC reduced their unrealized losses by $4.4 billion before taxes, $2.8 billion after taxes. I agreed with the accounting rule clarifying/relaxing mark-to-market. However, if I read the footnotes correctly this was effectively the source of WFC's profit for the quarter and it's a one-time event.

Other comments and summary:

Mortgage refinancing is going very strong and should continue to generate good revenue from originations for WFC for a while.

WFC's comments in the release indicate they believe their loss reserves are more than adequate and that some of the reserves will come back at some point in the future.

I continue to believe WFC is one of the best managed big banks, however near zero Fed rates, the refinance boom and mark-to-model accounting loss reductions won't continue indefinitely. Furthermore, I don't see where the funds to repurchase the Treasury preferred will come from without credit losses leveling off and there isn't much sign of that.

After all the hype from WFC and other banks about record quarters and improving business conditions, I was disappointed to find that (I think) the profit was essentially due to an accounting change. If anyone familiar with accounting has looked at the WFC release, I'd appreciate comments either correcting or confirming my take on the accounting change.

I have owned WFC stock for sometime now and continue to believe they will survive and eventually thrive. However, after reading the earnings release, I straddled the fence between a continued rough near term view and positive long-term view by selling about half my shares. I feel pretty confident that some piece of bad news in the banking sector will pop up over the next few weeks or months and give me the chance to buy them back at a lower price. But not confident enough to sell all of it.

HTS is a mortgage REIT. They have been operating since September, 2007 and went public on April 30, 2008. The HTS website describes the REIT, "Hatteras Financial is an externally-managed mortgage REIT formed in 2007 to invest in adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities issued or guaranteed by U.S Government agencies or U.S. Government-sponsored entities, such as Fannie Mae (FNMA), Freddie Mac (FHLMC), or Ginnie Mae (GNMA)." HTS leverages up by borrowing via repurchase agreements. All of the assets are Level II under FASB 157, meaning they're based on market data, but not on data for identical securities. From the 10-Q, "The estimated fair values of MBS are generally determined by management by obtaining valuations for its MBS from three separate and independent sources and averaging these valuations." Seems like a fair approach.

The 10-Q for the quarter ended 30 September shows assets of $5.1 billion. Nearly all of the assets are mortgage backed securities (MBS). There are $4.6 billion of liabilities, nearly all repurchase agreements.

Over the quarter ended 30 Sep, the average cost of funds was 2.9%. The vast majority of the repurchase agreements have a term of less than 30-days and at end of quarter the average rate was a little over 3%. To limit the risk of financing longer term, ARM backed securities at short term rates, the company purchases interest rate swap agreements. They only buy interest rate swaps to cover a portion of the repurchase agreement financing. On 30 Sep, HTS had swaps covering $1.4 billion, so nearly one-third of their borrowing was covered. The manager has the flexibility to determine what level of interest rate hedging is prudent.

The primary reason for owning a REIT is dividend income and HTS really shines here. The company has only been public long enough to pay two dividends. Annualizing those two payouts gives a 14% yield based on the 28 Nov close. Annualizing just the last quarterly dividend gives a yield of over 16%.

As most investors know, yields this high don't come without some risk.

The income producing assets are all US Government backed securities, so default risk is near zero. There is a pre-payment risk; as the underlying mortgages get paid off either by refinancing or selling the home, the principal associated with the mortgage gets returned to the security holder. I'm not sure what happens in the event of foreclosure, I assume principal is returned with the government guarantee covering any shortfall from selling the property. Other than that, about the only asset risk would be if the government was to change its policy on backing Fannie and Freddie securities.

On the liability side, the risk is much clearer. Since HTS borrows using short-term repurchase agreements and buys longer term assets, a rapid rise in short term rates would hurt earnings. That risk is partially mitigated by the use of interest rate swaps and by the fact that the MBS are adjustable rate. But, the liabilities are only partly covered by swaps and the MBS rate adjustments have much longer terms than the repurchase agreements the company uses.

Another similar risk would be if the market narrowed the spreads between the MBS and short-term repo agreements. If this business model is solid, it's reasonable to expect more players to compete in the market which would narrow the spreads.

As long as the government continues to back Fannie and Freddie paper and the Fed continues to keep short term rates low, HTS should continue to deliver high dividend income. The company looks attractive, but HTS has rallied more than 15% over the past week. If I was going to buy it, I'd wait to see if it pulls back a few bucks before hitting the order button.

Disclosure: At time of posting, I have no position in HTS.

The Treasury Dept issued a term sheet with some of the capital injection details. Stepping through them should give some insight into how good or bad a deal shareholders and taxpayers got.

One key element of the plan is government guarantees for $306 billion of C assets. Citi isn't totally off the hook here. They absorb the first $29 billion of losses on these assets. Losses above that are shared 90/10 between the gov't and Citi. The TARP takes the next $5 billion in losses, the FDIC owns the next $10 billion. After that, the Federal Reserve covers the losses with a loan at 300 basis points over the Overnight Index Swap (OIS) rate. There appear to be several different types of OIS transactions and the terms sheet didn't specify details, but I assume the base tracks the Fed Funds rate pretty closely. The government share of the loss is covered by non-recourse loans, meaning all the Fed can do is seize the assets. And those assets will be worthless if the situation deteriorates to where the Fed has to seize them.

In exchange for this guarantee, Citi is issuing $7 billion of preferred stock ($4 billion to Treasury, $3 billion to the Fed) at 8%. In addition, there's a management oversight kicker, "[Treasury] will provide institution with a template to manage guaranteed assets. This template will include the use of mortgage modification procedures adopted by the FDIC, unless otherwise agreed."

One restriction I didn't see covered widely is dividends. Under this agreement, Citi cannot pay a dividend of over 0.01 per share per quarter for the next 3 years. Anyone buying the stock because a quote summary shows a 17% dividend yield is going to be very disappointed.

That covers the asset guarantee. Cost to Citi, $560 million per year in preferred dividends, they still own the first $29 billion of losses and 10% of everything above that. If losses on the guaranteed pool top $44 billion, Citi is covered, but only by loans from the Fed. And the common stock dividend is cut to the bone.

The other component of the rescue agreement is the government's TARP preferred investment. This one is a little simpler. The gov't is buying $20 billion of preferred with an 8% yield. Unlike the earlier TARP buys, the yield doesn't step up after five years. The same dividend restriction is in place, but the government would look favorably on a request to hike it if Citi successfully raises more private capital.

Citi also needs to submit an executive compensation plan for Treasury approval. Sayonara big paychecks and bonuses.

Treasury also gets warrants for $2.7 billion worth of common stock at a strike price of $10.61.

Summarizing, Citi shareholders got a better deal than an FDIC takeover or the very dilutive bailouts FNM, FRE and AIG got. In those deals the government took warrants for 80% of the companies at strike prices of near zero. Citi also has to follow the FDIC's mortgage modification procedures and we don't know how much of this loan pool fits that model.

Citi got $20 billion in cash and a cap on loan losses at terms better than they could have gotten in the market. The statement doesn't say, but it's safe to assume the $306 billion assets pool is the really ugly stuff. We don't know how much that may have already been written down or how much farther it has to go. Citi actually only gets covered for $13.5 billion of losses, the 90% government share of losses between $29 and $44 billion. If I read the term sheet correctly, the Fed guarantees losses above $44 billion, but those guarantees are loans to Citi, not outright coverage. Dividend payments to the government on the preferred will cost Citi $2.16 billion per year.

From a taxpayer perspective, the deal isn't bad, but isn't as good as it could have been. If Citi survives, the 8% coupon on the preferred is a pretty good return and the warrants give some upside if the stock price gets up into double digits. I think the 80% dilution in previous bailouts was excessive, but I would have liked to see a much lower strike price for our warrants in this deal.

The deal is punitive enough that I doubt we'll see banks lining up saying "me too."

One thing the government hasn't done with this deal is provide any consistency. Bear, Stearns was allowed to fail, Fannie and Freddie were bailed with massive dilution through warrants, the Fed stepped in to save AIG under similar terms to FNM and FRE, Lehman was allowed to fail, TARP was originally supposed to buy bad assets, then it was a capital investment program, now we have a new template for the Citi intervention.

The key questions remaining are whether this will be enough and who's next.

This plan takes a zero stock price off the table, but about the best that can be said for it from a shareholder perspective is it's better than the alternative. The 8% payout on the preferred is a substantial expense for a company that isn't making money.

I don't have a position in Citi and don't plan on buying or shorting it. The easy stocks are tough enough.

I decided to dig a little deeper into one of the banks that opted out on the theory that any bank turning down the government funds must be pretty confident in their prospects. Tompkins Financial (TMP) was the first 'thanks, but no thanks' announcement I saw, so decided to peel back a few layers of the onion.

TMP is a financial holding company headquartered in Ithaca, NY. They are the parent company for Tompkins Trust Company, The Bank of Castile, Mahopac National Bank, Tompkins Insurance Agencies, Inc., and AM&M Financial Services, Inc.

The company's homepage has a link to a statement by CEO Steve Romaine that includes the following, "Unlike the banks and Wall Street firms that are requiring government bailouts or filing for bankruptcy, Tompkins Financial has not engaged in subprime mortgage lending nor have we invested in securities backed by subprime mortgages. Tompkins Financial does not hold any shares of Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, Lehman Brothers, AIG, or Washington Mutual stock." Sounds like Mr. Romaine should be on the short list for CEO of a bigger bank or maybe Treasury Secretary.

On 22 Oct, the company reported earnings for the quarter ended on 30 Sep. I didn't find a conference call announcement or transcript so assume they don't hold earnings calls.

The first statistic that jumped out was the earnings comparison with the year ago quarter. Earnings for quarter ended Sep '08 were 0.81 per diluted share, up from 0.70 per diluted share last year. TMP actually grew year-over-year earnings in one of the most difficult financial environments in history. I don't have statistics, but the 'banks with growing earnings' club must have a pretty short membership list. Motley Fool's CAPS screener returned 108 banks with positive earnings growth over the past three years, but there isn't a screen option for 1-year earnings growth. I checked a few of the banks and many would not have passed a 1-year earnings screen.

Net charge-offs are growing, but are well below industry comparables. Loan loss reserves are just over one percent of total loans. That's a little lower percentage than most other banks, but TMP's loan losses are also running well below other banks'. The loan loss provision increased by $3 million over the first nine months of the year and is nearly 140% of nonperforming loans.

The market cap is a little under $500 million. At Friday's closing price of $46.06, the company is trading at a price to tangible book value of 2.61 and 14.44 times estimated 2009 earnings. Both numbers are at the high end of valuation for banks. Based on the good loan performance, growing earnings and sound balance sheet, the company deserves to trade at a premium to its peers. The 52-week trading range is $34.66 - $59.30.

The dividend yield is 2.90%, much lower than many competitors. With a 42% payout ratio and solid earnings, that dividend appears safe.

TMP proves that there are some strong banks out there. Loan losses are well below industry averages. Year-over-year earnings growth is particularly impressive. The stock trades at a premium to most banks, even other sound banks. That premium appears warranted. If I wanted to buy this stock, I'd be patient and hope for a pull back of 10-15% from here, although it may not come down that far.

The list of banks that said 'thanks, but no thanks' to the Treasury should be a decent start to a shopping list for anyone interested in sound, smaller, regional banks. The other banks that announced they would not be participating in TARP on Friday are: Kearny Financial (KRNY), First Financial Bankshares (FFIN), Commerce Bancshares (CBSH) and Charles Schwab (SCHW). According to the AP, there are 110 banks participating in TARP. That leaves a lot of companies who decided not to play. I'll leave researching those names to others for now.

Disclosure: I have no position in TMP at time of posting.

GHM reported earnings for their fiscal 2009 2nd quarter on Mon, 3 Nov. The numbers were only fair and the forecast wasn't as strong as the market would have liked. Earnings were 43 cents per share, missing analysts' estimates by 10 cents. CEO Jim Lines added, "Bookings this past quarter were down considerably and totaled $17.5 million. We believe the third quarter bookings may be light as well."

Nearly half of second quarter sales were to the refining industry and much of the business was outside the US. Refineries will continue to need repair, maintenance and upgrades, but it's tough to imagine that business gaining a lot of strength until the economy starts to improve.

Chief Accounting Officer Jennifer Condame presented the order backlog, "At the end of the second quarter, backlog was $69.7 million up 23% compared with $56.8 million at the end of the second quarter of fiscal 2008." However, the backlog decreased from $76.0 million at the end of the 1st quarter. Still, a nearly $70 million order backlog is great news for a company with a market cap of just over $140 million.

During the Q&A, an analyst noted that in past years, bookings for the next year nearly always accurately predicted sales for the year. However, this year, the company's guidance is slightly below the 2009 orders that were in hand at end of fiscal 2008. Mr. Lines explained that orders aren't being canceled, but some customers are extending projects.

The company has a strong balance sheet and is interested in pursuing acquisitions at the right price. When asked about plans, Mr. Lines stated, "...the acquisition size would be below $100 million, it would be engineered to order products that fit our brand, that are in the energy sector. Now in the energy sector, we are not just talking about oil refining and petrochemical. We are talking about power generation, alternate energy, [waste] energy, geothermal, areas where the Graham brand is exceptionally strong..." GHM has nearly $43 million of cash on the books and virtually no debt. With a balance sheet like that, they don't need to worry about tight credit markets. But some of their customers do.

Oil sands are a potential growth area for GHM, but many of those projects may be on hold at current oil prices. It wasn't mentioned in the call, but many alternative fuel processes require the type of equipment GHM sells.

In both my Marketocracy virtual portfolio and real life, I sold off most of my GHM holdings during the spring-summer run up, but have kept a few trophy shares to participate in future growth. GHM does pay a small quarterly dividend, but even with a raise in Sep and the share price drop over the past few days, the yield is below 1%.

GHM trades at value stock type multiples with a forward PE below 6. Unlike many companies, the strong backlog and long order-build-deliver cycle make earnings projections fairly believable. Countering that is a weak economy. At prices near $14 a share, the company looks cheap. It may stay cheap or get cheaper, but should be a good stock to average in and wait for the economy to improve. The stock is fairly volatile, so an active trader may be able to do well with it. With over $4 a share in cash and no debt, the company isn't in any danger of failing. Add in EBITDA of 3.6 and the company might look attractive as an acquisition target.

In summary, a former high flying, IBD momentum stock that's corrected to value territory. GHM probably isn't in the right business for the present economic cycle, but seems to be very well managed, has an outstanding balance sheet and could turn into a double or triple from current prices when the economy picks up again.

All conference call quotes from the transcript at SeekingAlpha.com

Comparable sales and operating income were up in all global regions even after adjusting European and Asia, Pacific, Middle East and Africa sales for currency exchange rates.

In the press release, CEO Jim Skinner stated, "... October sales trends remain strong and I am optimistic about McDonald's outlook."

During the conference call, Mr. Skinner indicated the specialty coffee program is on track in the US, stating, "about 3,800 restaurants are serving McCafe coffees and we expect to begin introducing the rest of our combined beverage business products, smoothies, frappes, and bottled drinks in mid-2009." There had been some reports of franchises having difficulty obtaining financing for the modifications, but the company says financing has been available.

For the value minded, it sounded like the Dollar Menu will stay, although there may be some minor changes to keep it profitable.

In Europe, comparable sales increased 8.2% in spite of, or maybe because of, a weak economy. McDonald's will be adding more extended hours for their European stores. Extended hours comparable sales are growing faster than other parts of the day.

Asia, Pacific, Middle East and Africa comparable sales were up 7.8% in the quarter. The company is focusing on breakfast sales here. In China, breakfast accounts for only 7% of sales compared with 20% in Hong Kong and Singapore. The Japanese equivalent of the Dollar Menu, the 100 Yen Menu, is helping drive traffic and sales in Japan.

Despite higher commodity costs, margins expanded in Europe and Asia, Pacific, Middle East, and Africa. US margins decreased slightly, attributed to higher commodity costs. For the full year in the US, McDonald's expects the 'grocery bill' inflation to be 7%.

Regarding credit, CFO Peter Bensen stated, "Our $1.3 billion revolving line of credit has sufficient term remaining and is unused and we secured attractive long-term financing in the first quarter to prefund debt that was retired in the third quarter and we have no additional significant maturities until late 2009."

Currency translation had been a net positive for MCD, but with the strengthening dollar it is expected to be negative for the 4th quarter. However, Mr. Bensen noted that the strengthening dollar has had a partially offsetting positive impact with lower oil and commodity prices.

In summary, MCD is growing revenues and earnings in a tough economy and they're doing it in around the world. The company has beat analysts' earnings estimates each of the last four quarters. The dividend was recently raised to $0.50 per share per quarter, yielding 3.77% based on Friday's close. For reference, that's a higher rate than a 10-year Treasury.

Over the past three months, the stock has traded as high as $67 per share and as low as $45.79. Friday's close of $53.06 is a little below the mid-point of that range.

This is one of the stocks I've been nibbling at lately. It's a tough market, but for those who want to put some money to work, MCD is worth a look.

All earnings call quotes from the transcript at Seeking Alpha.

$2.5 billion was applied to credit loss provisions against $2 billion of loan write-offs. Total loan loss provisions increased by $500 million to $8 billion or 1.95% of total loans.

Tier 1 capital increased from the previous quarter to 8.58%. The $25 billion of preferred stock that will be issued to the US Treasury will increase the Tier 1 capital ratio by nearly 0.5%.

Loan charge-off rates were mixed news. Consumer loans drove the loan losses, but after correcting for the change in charge-off policy from 120 to 180 days from the 2nd quarter, charge-off rate growth has moderated. Home equity loans are the primary loss driver. Commercial loan losses were down slightly from the 2nd quarter.

In loans 90 days or more past due but still accruing, the opposite was true. Both consumer and commercial past due loans increased, but the percentage jump in commercial loans was larger than for consumer.

A piece of good news for WFC is a substantial increase in deposits. CFO Howard Atkins stated, "Core deposits reached a record $334 billion at quarter end, up 10 percent from a year ago. Inflows of checking and interest bearing deposits accelerated sharply as the quarter progressed, across all customer segments - consumer, wealth management, middle market, large corporate and correspondent banking customers all contributed to the strong deposit inflows and increases in net new deposit accounts." The increase spiked later in the quarter, roughly coinciding with a flight to quality as bank failures made the headlines.

The merger with Wachovia is expected to close by the end of 2008. The acquisition is expected to be accretive to earnings in the first year excluding integration costs, write-downs, transaction charges and credit reserve build. The deal should be accretive to earnings by the third year without any adjustments. WFC is still planning on proceeding with the $20 billion capital raise announced in conjunction with the acquisition announcement.

The earnings report is a mix of good and bad. Continued deterioration in the loan portfolio is troubling. The ability to increase loss reserves faster than recording write-downs while still earning enough to easily cover the dividend is a positive. Troubles in the banking sector appear to be driving deposit growth and new customers for WFC, a definite positive. And, regardless of the political ramifications, WFC should be able to leverage the $25 billion of relatively cheap government capital into earnings going forward.

JP Morgan (JPM) also reported a small profit this morning, beating analyst's estimates. But, for an investor looking for one of the big 5 4 banks that has consistently earned more than enough to cover the dividend payout through the credit crisis, WFC is the only one left.

The stock price has held up very well over the big sell off the past few weeks. With all the market volatility we've seen, I suspect a patient investor may be able to pick up shares under $30. WFC can also be effectively purchased at a discount by paying attention to the arb spread and buying WB for those willing to accept the risk of the deal falling apart. WB at today's close converts to $30.43 for WFC, an 8.7% discount.

For this post, I'm going to try to set aside my opinion of the gov't plan and take a closer look at what it means for investors in the companies that will participate in the program.

First, how is the program going to work? I like to get source documents when possible since the media can be less than reliable. Treasury has issued an announcement and a public term sheet outlining the plan details.

Summarizing:

- Treasury may purchase senior preferred stock in qualifying banks (basically US based institutions). Maximum purchase amount is lesser of $25 billion or 3% of risk weighted assets.

- Banks must apply by 14 Nov and deals are expected to be completed by the end of 2008.

- The preferred pays a 5% dividend for the first 5 years and then jumps to 9%.

- The issuing bank can buy the preferred back after three years. They can buy it back earlier provided they raise at least 25% of the amount sold to Treasury in an offering of common or preferred.

- Preferred dividends must be paid before the bank can pay dividends on the common.

- The bank has to get permission from Treasury to raise the dividend or repurchase shares for three years, unless they've bought the preferred back from Treasury.

- Executive compensation restrictions.

- Warrants get issued with the preferred in an amount equal to 15% of the preferred sale. Strike price and valuation for determining the 15% are based on a 20-day trailing average from the date of agreement. The bank can buy the warrants back at fair market value if they've bought the preferred back. The number of warrants can be reduced by raising capital.

- The preferred stock doesn't give the government any voting rights or board representation. If the bank falls behind on the dividend payments, the gov't is entitled to board seats.

That's about as de-gibberished as I can make it.

From news reports I've read, there will be nine banks participating initially with the program being opened to smaller institutions soon. The participating banks and reported amounts are: $25 billion each - JP Morgan (JPM), Citigroup (C), Wells Fargo (WFC), and Bank of American (BAC) combined with Merrill Lynch (MER). $10 billion each - Goldman Sachs (GS) and Morgan Stanley (MS). $2-3 billion each - State Street (STT) and Bank of New York Mellon (BK). The Treasury statement indicates all participation is voluntary, but early news reports indicated some of the banks were pressured into agreeing. These nine banks get about half the initial $250 billion, leaving another $125 billion for the smaller banks.

In addition to the preferred stock purchases, the gov't will be guaranteeing bank debt and expanding deposit insurance coverage through the FDIC.

To help make sense out of this, I walked it through with WFC. That's a good choice because they had announced they were going to raise capital in conjunction with the Wachovia acquisition and because I'm a shareholder.

The $25 billion of preferred is pretty simple; WFC gets $25 billion of new Tier 1 capital at a cost of 5% or $1.25 billion per year. Tier 1 means they can leverage it up by about 10 to 1 if they want. The 5% preferred dividend is lot better deal than the 10% GE and GS had to pay Berkshire Hathaway (BRK) and I don't think WFC should have much trouble earning better than 5% on this new capital. Current return on equity is running a little over 15%. 9% is a much tougher threshold if they can't buy it back before the rate jumps in five years.

WFC also needs to issue warrants. 15% of the $25 billion is $3.75 billion. Counting back from today the 20-day trailing average comes to $33.98 per share. That would be a little over 110 million new shares or about 3.3% dilution. But, exercising the warrants would bring in the additional $3.75 billion of fresh capital.

Overall, this looks pretty good for WFC. I haven't seen any news releases, but expect they'll try to go ahead with the capital raise planned as part of the Wachovia deal to get the option to buy the preferred back. However, the gov't money will probably set a ceiling for the terms of any new offering and they may not be in any hurry to buy the Treasury preferred back. It will be interesting to see if that offering goes forward, how it's structured, how much they raise, and whether or not they buy back the gov't preferred. The current dividend yield on WFC common is just under 5%, so the only real advantage to bringing in private money is to take some of the warrants out. If they raised $25 billion, half the warrants come back.

The biggest downside to shareholders I see is possible limits on dividend increases or share buybacks. We're at the mercy of gov't regulators there and have to hope WFC management can make a good case if business conditions warrant a dividend hike or buyback program. Or just do a capital raise for a little over $6 billion and buy the preferred back from Treasury.

Treasury could have pushed for higher rates and better terms on the warrants, but that would have made subsequent capital raises more challenging and might have done more harm than good in getting capital into the credit markets. It also would have discouraged the stronger banks from playing. As it is, the gov't is borrowing 5-year money at 2.5 - 3% and earning 5% plus upside potential on the warrants. Not great, but probably a better deal for the taxpayer than paying a premium for mortgage paper and hoping it goes up in value.

On 25 September, GE released lower earnings guidance. They followed that on 1 October with an announced capital raise issuing $3 billion of preferred stock and warrants for $3 billion of common stock exercisable at $22.25 to Berkshire Hathaway along with a $12 billion public common stock offering priced at $22.25. The preferred stock issued to Berkshire Hathaway pays 10% and is redeemable after three years at a 10% premium.

As a shareholder, I was hoping GE would shed some light on why they felt they needed to raise capital. They did explain the reasons behind it, but not why they did it in a placement with BRK rather than a rights offering or other approach. SVP, Vice Chairman and CFO Keith Sherin stated, "We had a liquidity plan that said we were going to get our bank lines plus our cash equal to our CP [commercial paper] by the end of the year. After our earnings call last week -- or the preannouncement, we said that may not be fast enough and we went right to work on -- well, how do you accelerate that? That's why we did the equity offering. We have accelerated today our bank lines plus our committed cash are greater than our CP." Essentially, GE bought an insurance policy against a credit market lock-up. A prudent move even if it was an expensive insurance policy.

Given all the talk about credit markets tightening, I thought this statement by Mr. Sherin was very interesting, "...the debt markets have been volatile, but we are still funding ourselves without any issues. If you look at CP, in fourth quarter '07 the average cost of our commercial paper program where we had higher balances was about 5%. In the third quarter of '08 the average cost was 2.5%; and that is the same average cost for the last couple of weeks." According to this statement, GE is not only able to borrow in the commercial paper market, they're doing it at a lower cost than a year ago. Make your own conclusions about the severity of the credit crisis we keep hearing so much about.

GE has reduced outstanding CP to $88 billion and plans to reduce it below $80 billion by the end of the year. With the recent capital raise, cash plus bank lines exceed outstanding commercial paper. They're also investigating the recent Federal Reserve announcement of a commercial paper facility as an additional back-up funding source.

The knock on GE has been fears about the financial side of the business. During the 25 Sep guidance release, GE indicated they expected to earn about $2 billion from financial services and GE met that lowered target.

The presentation provides some additional color on the assets behind GE Capital Finance. There are $413 billion of commercial assets and $209 billion of consumer assets with broad diversification across type of asset and geography. 59% of commercial and 79% of consumer assets are outside the US. There are no SIVs, CDOs or CDS exposure on the books. Delinquencies and non-earning assets are up and do not appear to be leveling off. However, GE has been increasing loss provisions faster than write-offs for four consecutive quarters. There were $451 million of loan losses this quarter and $762 million was added to loss reserves. From the transcript, it sounded like total loss provisions are expected to be $6.6 billion by the end of the year, but the statement wasn't clear.

GE includes a chart of historical loan losses in the earnings call presentation. The estimated loss for 2008 is 1.2%. The highest loss rate shown was during the 1990 - 91 recession at 2.0%. GE believes they have a higher quality, more diversified loan portfolio than they did in '90-'91 and that they won't see that level of losses this time. It would have been interesting to see the chart run back to the late 1970's. GE lists a globally oriented portfolio, smaller average loan size, and a 70% average loan to value on real estate as some of the advantages today's portfolio has over '90-'91.

Outside of the finance business, things look pretty good. Energy infrastructure (energy, oil/gas) had a 32% increase in revenue and 31% increase in profit compared to the year ago quarter. Technology infrastructure (aviation, healthcare, transportation) had revenues up 9%, profit up 2%. NBC Universal revenues were up 35%, profits up 10% largely on strong results from Olympics coverage.

Summary/Opinions

The advantage of GE's diversified business model is that something will always be working. The disadvantage is that something will always be struggling. Even with the weakness in the financial business, it still accounted for nearly 45% of GE profits this quarter. The quarterly earnings of 45 cents per share don't leave a lot of cushion to cover the 31 cent quarterly dividend. Management was confident the dividend was safe, but we've heard that from other companies before.

The $3 billion of preferred stock sold to BRK represents a $300 million or 3 cent per share annual expense GE didn't have before. Since the new capital is intended to raise cash for defense against a tight commercial paper market, there won't be any new income associated with that money. Similarly, $12 billion of new shares will also be entitled to dividend payments that will total $670 million per year at the current rate.

Mr. Buffet's warrants and the new offering put a smart money price of $22.25 on GE shares. Investors interested in adding GE should look for a significant discount to that price to make buys.

TARP and the new Fed commercial paper facility may offer some advantages to GE going forward, but there's no way to quantify that possibility.

I believe shareholders would have been better off with a dividend cut to preserve capital over the preferred issue to BRK. Cutting the dividend from .31 to .23 per quarter would have saved more than the $3 billion over the course of one year. A one-quarter dividend suspension would also have saved more than $3 billion. In either case, shareholders would have taken a short term hit to income, but wouldn't be saddled with the annual bleed from the preferred.

The company is taking prudent steps to maintain a high credit rating and protect against tight credit markets. But further weakness in their loan portfolios or a fall off in the industrial businesses would make it very difficult to maintain the dividend.

As a shareholder, I feel like it's too late to sell and too early to buy more. If the price jumps much above the $22.25 smart money target, I'll probably lighten up and look to buy back at a lower price. A drop below $18 would be low enough to look attractive even with a possible dividend cut. Those buying GE today will probably be happy five years from now. Those who wait for a better price or average in will be even happier.

Anyone buying because Warren Buffet bought needs to recognize they aren't getting the same deal Warren was able to negotiate. If Berkshire has any regrets and would like to sell a slice of that preferred with warrants at cost, let me know.

Questions I wish analysts had asked:
Why did you do the placement with BRK over other capital raising alternatives?
What other options did you consider?
How much is currently set aside for loan loss reserves?
You list a 70% average loan to value for your real estate loan portfolio. Is that based on values at origination or current values?

I'll shoot an e-mail to investor relations and share the answer when I get it.

Monday, 28 July Merrill Lynch (MER) announced they were raising $8.5 billion of new capital in a stock offering and selling off a portfolio of CDO securities for $6.7 billion.

Particularly disturbing in this case is that the CEO had stated that Merrill was in good shape and wasn't going to need to raise capital fairly recently.

Analysts expect MER to return to profitability next quarter, however MER has under performed expectations for the last two quarters. Yahoo shows 1.53 billion shares outstanding and the company listed tangible assets of a little over $16 billion at the end of Jun. Factoring in the new capital raise and loss on the CDO sale announced in July, tangible assets would bump up to about $20 billion. The share count appears to include the dilution. That gives a tangible book value of $13 per share and would have MER trading at a price-to-tangible book value ratio of 1.3. I believe Merrill's assets are in better shape than many other financial firms because they did go ahead and sweep out a lot of the trash; that doesn't mean the trash is all gone.

MER is paying a high yielding dividend, but if they don't start logging profits soon the payout will need to be cut.

If I did the math right, MER is trading at a premium for a company with uncertain prospects. Financials that are weathering the credit crunch well and are positioned to make fire sale acquisitions deserve premium valuations; I don't think MER is in that category. At the other end of the spectrum, MER is too expensive to attract high risk, speculative investors or deep value hunters.

Bottom line, I think MER is expensive for a company with an uncertain future. I also don't like that they announced the last capital raise so soon after Mr. Thain had publicly stated they wouldn't need one. The smart money track records in financials have not been good to date, so I'd like to see either some profitable quarters or a much larger discount to Temasek's purchase price before considering joining them as a MER shareholder.

Edited to add: Never mind; disregard this post. Just saw the news that BAC is buying MER for the ridiculous price of $29 per share. Overpaid for Countrywide, now over paying for Merrill Lynch.

The turmoil from the bailout ('scuse me government assisted program) of FNM and FRE was worth a look to see if things might be overdone. Given the huge number of unknowns, there's no way to come up with a solid valuation, but the problem can be bounded to add some color to the risk/reward potential of scooping up some cheap shares.

To summarize what we know:
- Treasury is buying a new class of super senior preferred shares for $1 billion.

- The common stock and preferred stock dividends have been eliminated.

- The deal comes with warrants good for shares representing 80% of the common stock, the exercise price of the warrants is one-thousandth of a cent each, so there's no more money coming when the warrants get exercised.

- Treasury has the authority to purchase mortgage backed securities (MBS) from FNM and FRE. They will be purchasing $5 billion now and have authority to buy up to $100 billion.

- The plan establishes a direct secured credit facility for FNM and FRE at the Treasury.

- FNM closed at about $7 on Friday before the deal was announced.

- As of 30 June, FNM reported net tangible assets of $41.2 billion on the balance sheet and long-term assets of $774 billion.

- The trading range on Mon 8 Sep was $0.65 - $2.05 with a close of $0.73.

What we don't know:
- How much of the long term assets will be written off.

- What the book value would be if everything was valued at market prices.

- Whether this is the last capital injection and share dilution by Treasury.

- Unknown unknowns.

Defining the lower bound is simple. The stock is still trading, but if business deteriorates to the point where there's another capital injection, share value will quickly approach zero.

There are a couple of approaches to an upper price range.

The only thing that's changed since Friday's closing price is the bailout plan. At $7 per share, the market cap was about $7 billion. Treasury's plan brings the diluted share count to four billion shares. $7 billion/4 billion shares = $1.75 per share for one plausible stock valuation. Friday's closing price would have included some risk discount for a possible gov't wipeout of the common stock.

Another company with heavy mortgage exposure and questions about its future is Washington Mutual. As of 30 June, WM reported net tangible assets of $18.5 billion which works out to a P/B value of 0.38 based on Monday's closing price of $4.12. Applying that P/B value to FNM using the fully diluted share count would value FNM at $3.65 per share.

Anyone with other valuations on FNM, please feel free to comment.

In addition to massive dilution, the gov't intervention takes several measures that should help FNM business prospects going forward. Treasury's authority to buy MBS provides a market for those securities that didn't exist before, the credit facility offers financing at low spreads and the gov't action to back FNM and FRE debt should improve demand and lower spreads for their regular debt auctions.

The gov't intervention's impact on the housing market is unknown, but lower rates and an improved credit market should help stabilize the market, even if it just slows the rate of price declines. Any stabilization of housing prices helps limit foreclosures and should reduce the amount of write downs FNM will need to take.

IF (there aren't big enough letters for this if) FNM can survive without further dilution of the common or massive loss of tangible book value, buy back the gov't super preferred and move to a private sector company; it's reasonable to assume it could eventually trade at P/B of something like 2. That would be a way in the future, everything's wonderful share price of $19 based on the 30 June net tangible book.

On the downside, it would only take a little more than a 5% write down of the assets to totally wipe out the net tangible book. That's a big charge-off number, but well within the realm of possibility.

This doesn't look bad as a very, very high risk investment or a trade. At 73 cents a share, there's a plausible near term upside of between 140 and 400% if the market decides Friday afternoon's value for the company was reasonable or gives it a multiple similar to WM. Longer term, the upside is huge IF all that stuff listed above happens. Of course, there's a strong possibility of a total or near total loss of the investment.

I tried this today with a small piece of my virtual portfolio at Marketocracy and am well under water with it (entry point ~1.22). After running the numbers, I'm considering it with a tiny slice of my real portfolio, but will most likely leave this to the pros.