Bruce Berkowitz on the Exceptional Value in the Financial Sector
Bruce Berkowitz is the founder and manager of the $20 billion Miami-based Fairholme Fund, which last year celebrated its tenth anniversary. Along with Charles Fernandez, he runs the fund’s portfolio management team. Mr. Berkowitz was named the US stock-fund manager of the year for 2009 and the US stock-fund manager of the decade 2001-2010 by Morningstar. We interviewed him on February 16.
In last year’s interview, you said that one should never play Russian roulette no matter how good the odds, but given the dependence of the financial system now on government support both here and abroad, aren't you playing Russian roulette with approximately 80% of the Fairholme Fund’s holdings in the financial sector?
We stayed away until we thought the Russian roulette element was over. The Russian roulette part was at the initial stage of the financial crisis, before the government became involved. That part ended once it was clear that capital would be given to the banks and what the objectives of the Fed and the Treasury were, and once enough time went by. By enough time, I'm referring to the further seasoning of potential bad loans, most of which originated in the 2007-2008 period.
At that time, you no longer could kill the companies, but there was still a question as to how much they could make in a more normal time. You really can't kill all of them or you would kill the entire economy.
So if Bank of America was required to return to mark-to-market accounting, would that change your investment opinion of their common stock?
They have had significant mark-to-market accounting changes, which have represented tens of billions of dollars. For real estate loans, the bank rules are quite specific as to how they have to be treated if they are not accruing. In other words, if someone stops paying you then you have an issue; it needs to be marked to the market.
Loans created and underwritten since 2009, or even at the very tail end of 2008, are good loans, well documented, with better credit quality, better yields, and better fees. You have this digestive period of bad loans, and at the same time you have the ingestion of good loans. You have a sense about how long it takes, with a given year of issuance, for a loan to burn off, the average length of a loan, and what the probabilities are when loans go bad.
What I'm getting at is enough time has gone by for seasoning. The banks have better balance sheets than I can remember.
Let me ask another question along the lines of the real estate lending. When you purchased your positions in banking stocks, did you anticipate the legal issues regarding foreclosures? Do the recent court rulings impact your appraisal of the value of those businesses?
I did not expect it to be as big an issue as it is. I did understand the nature of no-doc loans, liar loans and so on. The market values of banks and institutions that supposedly got involved in this have been more than adequately marked down for such potential liabilities. You are starting to see their true exposure now, based upon settlements with Freddie Mac and Fannie Mae, settlements beginning with MBIA, and every quarter in the footnotes and 10-Qs of the banks.
Speaking of MBIA, Warren Buffett pulled out of the municipal insurance business because he did not think the risk-reward tradeoff was favorable enough to be in that business. I am wondering whether you have read Meredith Whitney's report on the fiscal condition of the states and, if so, how that affects your investment in MBIA. Is your investment an indication that you agree with Mr. Buffett or Ms. Whitney?
Well, let's get the timeline right here. Let's start with Warren Buffett. I would hate to disagree with him, but MBIA is not writing new municipal bond insurance. It’s been over a year since Warren Buffett said it wouldn't write new insurance.
I don't know if he has changed his mind based upon what the rates are. MBIA isn’t writing any business right now because they are in the final stages of the legal challenge to the restructuring of the company. Right now it's a moot point; there is no writing.
Meredith Whitney? I have not read her report. She hasn't been nice enough to send it to me.
Whether it’s the banks, brokers, municipal bond insurers, or the property and casualty insurance companies, one of the great revenges of getting old is that you've seen it before, if not exactly the same way. I remember MBIA and worrying about it going bust, just as I did with Freddie and Fannie. Of course they are different institutions, and they made the mistake of trying to go into different businesses that were the functional equivalent of picking up pennies in front of a steamroller, but I’ve seen similar mistakes with Citigroup and the banks many times.
More specifically with respect to MBIA, will there be instances of bankruptcies? Yes. Will the federal government allow states to go bankrupt on a wholesale level? No. States elect senators, who will see to it that doesn’t happen.
I really want to be more positive. I look at the glass half full: that as the municipalities rebuild their balance sheets, they will more than ever need a company like MBIA. Some question exists as to whether or not there will be a need for municipal bond insurance after what has happened, but there is still a significant value in having an MBIA insurance guarantee. In fact, I believe MBIA stood by every one of its insurance policies, even though they think that the underlying issuers may have not have been less-than-perfect in their representations and warranties.
MBIA has franchise value. If you believe its management, it has a liquidation value significantly higher than where it is trading today. Because they have paid everyone, they have a franchise value that will allow them to charge a reasonable rate to insure municipalities. Given what has happened in the past, initially I don't see them overreaching for business by not charging the correct rate.
When the rates for municipalities were too low it meant mono-line insurers started to insure other areas, such as securitization of various assets. That is where the real trouble started.
Back to the financial sector, does the exit of employees at Goldman Sachs who have gone to set up hedge funds on their own have a meaningful impact on the company's value?
No, I don't believe so. That's the history of Goldman Sachs. When Goldman Sachs was a partnership, the only way you could get a reasonable amount of money out was to retire. For a very long period of time, the average age for partners retiring from Goldman Sachs was under 45, because that was the only way the person could actually get at some money given the policies they had in place for partners of the firm. So the answer to that is no on that basis.
But it is also a question of how the world evolves. Goldman Sachs has done a reasonably good job of evolving with the economy. Goldman Sachs brings tremendous value. Goldman Sachs, for example, is our eyes and ears in Asia. The Fairholme fund now has roughly 10% of its assets in life insurance companies focused in fast-developing economies. We would not feel comfortable if we didn't have Goldman Sachs on our side on the issues, especially considering our life insurance holdings in China.
When you talk to long-term investors, they rave about Goldman Sachs. Many consider it to be head-and-shoulders above most of its competitors. Will there be a business despite the smart, talented, experienced, and high-integrity people who go to work with mutual funds or other funds? Absolutely. Goldman is a high-value-added, high-profit business. In fact it's a very high-profit business when the firm's capital isn't at risk.
How do you handicap the risk to your investments in financial firms arising from the intransigence of French and German governments that are reluctant to expand the EU bailout funds?
If you ask financial services firms, including some of the best firms in the world, they will be needed to continue to resolve the remaining issues in the United States and in Europe. Of course, the European Union is behind on the timeline compared to the United States. I wouldn't be too surprised if the situation in Europe plays out the way the situation in the United States has. After all, what is the alternative?
The alternative would be to go the way of Argentina.
Argentina has survived, and the financial institutions working with Argentina have survived. Of course, you'd have to look at the exposures on the balance sheets of the institutions today. There are some very good European institutions. For instance, we have a relationship with Banco Santander, which is a very impressive organization.
What everybody is worried about today is not what is going to get you. It's what people aren't worried about.
Is there a scenario in Europe that particularly scares you?
No. There isn't, given the companies. The investment process is having an understanding of the securities you've purchased and the cash flows that security can generate from beginning to end, and then comparing that to other securities and comparing it to the price you have to pay for that security.
The prices that we paid had a significant margin of safety, and they were priced to continue to fall, and they are not priced for any kind of normalcy. The risk is it takes longer than I thought for it to return to normalcy, but I can't predict the future. Our purchases were priced to take into account that it could take longer.
I don't think it is an "if" situation of normalcy – it's just "when." And when you take those factors I just mentioned into account, I'm not too worried. No one is perfect, and the day I think I am 100% correct on everything will probably be the day before we will fail. So that's one of the reasons why we keep a tremendous amount of cash. Fairholme has $5.5 billion of cash.
Speaking about margin of safety, last year you allowed that real estate deflation had eroded your margin of safety for Sears, in which you are invested. Housing prices appear to be still on the decline. Are you concerned that this decline could impact that investment?
The point was that housing prices did erode the initial value that I had on Sears’ real estate. Its price is starting to bump around the bottom. Eddie Lampert has done a fairly good job of improving the balance sheet. We are moving off-balance-sheet pension fund liabilities and starting to close down unprofitable stores, while at the same time trying a few new ideas.
It wasn’t that long ago when everyone thought Apple was about to go down the tubes. Except Sears has a much better balance sheet now than Apple did at that time.
I'm not too worried. In fact, I'm quite confident that Sears has the wherewithal to wait and prepare for an upturn in housing, which their business is very heavily tied to. Then we shall see. From watching it for the last few years, Sears has become a real win-win, in that if Eddie Lampert does what most people expect he can do – improve the retailing of Sears – the stock will fly high and recognize that. If he can't, the stock price will continue to be volatile, very depressed at times, less depressed at other times, and eventually he'll have one share and we'll have one share, and there will only be two shares.
Going back to the insurance business, are reinsurance rates declining? And if so, isn't that bad for the cash flow, the combined ratio, and potentially for losses at AIG?
When insurance rates are declining, it's bad for AIG. When reinsurance rates are declining, it would probably be good for AIG, because they would go to reinsure some of their books. They have been accused of charging too little. They just came out with peer reserve studies that show that is not the case for the period they are accused of. Of course it's an estimate. That can change.
When you are growing, it is much easier to cover up poor reserving. When you are shrinking, it is very difficult to cover up under-reserving. I insure everything I have with AIG, and I pay more for insurance now than I have ever paid before. That is not a sufficient data point to say they are charging me the right price, but given deductibles and their due diligence, they are doing a really good job.
AIG is interesting, in that 10 years ago it was considered one of the great companies in the United States, able to compete on an international basis, with an unbelievable model and run by one of the smartest guys in US business. Today people consider it to be a disaster. Maybe it wasn't as good at the top, and maybe it is not as bad as that at the bottom.
The nice thing about the banks and the insurers today – AIG, Citigroup, Bank of America – is that because of central assistance there has been more transparency and more information published on the financial health of these companies than at any time before. Whether you talk about the Senate Congressional oversight panel, the GAO, New York’s attorney general’s office, or the normal Securities and Exchange Commission auditors, there have been tremendous amounts of information published about the financial health of the organizations.
I do admit it is quite complex, but AIG still has a global brand, and they are making money. They are rising from the ashes of a very difficult period. They had a couple of businesses that really didn't represent that much of the overall enterprise, such as securities lending and credit default swaps. The company has paid a huge price, but they still have an intact Chartis and an intact Sun America, and there are many valuable investments still embedded in the company.
A number of well respected market commentators have claimed that higher-quality large-cap stocks offer better relative value than lower-quality small-cap stocks. I know that you pick individual securities and I am not asking you for a market call, but I'm wondering if your bottom-up work sheds any light on where one might look for value.
The holdings in our portfolio would tell you that we agree, with one proviso: The Fairholme fund is now at $20 billion, and a small-quantity idea is not going to push the performance needle. We need big ideas. But that is the reason why we created the allocation fund. It is relatively small, and if we do find small-quantity ideas, one or two can make a real difference.
It makes more sense for Fairholme to look at large-cap stocks just because we have limited bandwidth and we need to put large amounts of money to work. Thankfully, that is not a bad place to be today as the world rebuilds. But, clearly, while the sun is shining and everybody is happy and going out to dinner and telling all their friends about how much money they've made in the stock market again, there are going to be many opportunities. There will be a point in time when we are going to have to close the doors, maybe give back money, and reassess the environment. But clearly what got Fairholme from zero to $400 million would not have gotten it from $400 million to $12 billion.
Our firm has to go through periods of what I'll call creative disruption, and we have to evolve with the environment and with our size. If we put ourselves in the shoes of our shareholders, we will get it right.
Would you be able to talk about any of your investing mistakes and why you made them, and what you learned from them?
We’ve made a lot of investing mistakes. General categories have included when we trusted but didn’t verify, overestimated the ability of management, or underestimated their integrity. Has that cost us a lot? No. The big mistakes Fairholme made in the last few years would've been that we stayed focused on becoming a manager of people rather than investments, and we owned too many positions and did not have the time to focus on what we owned.
Of course there is always a danger of just being plain wrong, but you are never perfectly right or 100% wrong. There are always hundreds of elements that interact with each other, but a difficult environment does make it easy for you, because a difficult environment usually goes hand-in-hand with a pessimistic price for securities, especially those securities for companies that are generally hated by the population.
I’ve stayed off the topic of St. Joe, because of your involvement with the board of that company. But I see today that you’ve nominated former Florida Governor Charlie Crist to serve on its board. Maybe you can comment on what Crist said today and what bearing that has on your investment.
The story of St. Joe is going to be a very positive story. It started out with us years ago recognizing that there was a tremendous amount of valuable land in the Florida Panhandle. The great recession did not help valuations, and as shareholders we were able to slowly start to get to know the company and get to 20%, then they allowed us to get to 30% and everything was fine.
When we started buying the company, the purchase was attacked by David Einhorn, which, to be honest with you, I wasn't even aware of, and much more recently the process started again with David. Dave is a smart guy, and there was much that I didn't disagree with, but there was much that I did disagree with.
I tried to help the board. Charlie Fernandez and I were invited onto the St. Joe’s board, effective January 1. We went on the board and it was obvious to us that there were just a handful of things that could be done that would make a positive difference, and we just couldn't get anything done. So we recently resigned, and we decided that we will try to get things done by being a shareholder and moving the ball forward for all shareholders.
St. Joe continues to have very valuable assets. You just need to have the right group of directors and management to increase the intrinsic value of the assets of the firm. That's what we are going to try for. There is no reason in the world why a company St. Joe's size should be spending the kind of money it's spending on compensation and legal issues. It makes no sense.
That huge waste of tens of millions of dollars every year could, over a long period of time, greatly diminish its assets or force it to sell assets when the time isn't right. So we've come up with a slate, and we want to get rid of directors and install a board that sets examples, install a compensation system where executives are allowed to make a good living when they make shareholders money. You can't get a big bonus for just showing up.
I recognize that our 500,000 shareholders own the Fairholme Fund. The directors and managers of St. Joe have to understand their shareholders own the company, and they have to feel the pain and joy of their shareholders. It's very simple and it's a positive story. It's going to be a win-win for shareholders and a win-win for Florida with a new board and new management. The bleeding will stop.