Michael Durante Western Reserve 1Q029 review

1. First Quarter 2009 Review April 6, 2009
“Radical chic invariably favors radicals
who seem exotic and romantic…”
- Tom Wolfe
Dear Partners,
Western Reserve Master Fund, LP (the “Fund”) closed out a roller-coaster first quarter down
approximately 13% versus our closest comparables – S&P financial related indexes down an
average 34%. Stocks were first driven essentially by fear and uncertainty over the new
concentration of power in Washington and then by ‘shock and awe’ over the hurried magnitude
of radical legislative and fiscal policy ambition. Once the ‘shock’ was discounted, stocks
stabilized near the end the quarter off deep depression-era values.
Investors remain numb, though not comfortably so…
From the inflection point in the election last October to the recent lows, stocks and the economy
posted their largest and swiftest decline since the late eighteen-fifties or at the eve of the Civil
War. They were led down by the horror of rabid and unfounded bank nationalization fear.
More than two-thirds of the declines in both stocks and jobs lost in this downturn have occurred
since October, when polls all but insured an imbalance of power in the offing. We believe this
frightened both investors and business owners alike. It’s at this point the economy simply “fell
off a cliff” as Warren Buffett recently surmised. Never before in our lives has politics influenced
investing so dramatically and we all have been reluctantly pulled-into the body politic. Wall
Street, it would seem, has temporarily moved due south by approximately 204 miles.
The good news is that the displacement of the market as measured either by a short train ride or a
far more immodest journey into panic, spells opportunity. A record $10 trillion of M2 (cash and
equivalents) now sits on the sidelines and much is parked atop the balance sheets of the nation’s
banks. Our banking system is much maligned these days amid rampant populism. It has
spawned the previously unthinkable such as neo-terrorist groups like “Bank Bosses are
Criminals”.

2. All the same, our financials presently sit on their largest store of liquidity in history. Money is
made whence capital flows and our financial system has hoarded much of our country’s capital.
Conversely, investment demand for gold now represents nearly 60% of all global mine
production (a record) and the percentage of it physically delivered is at levels last seen in 1982 or
the onset of the greatest bull stock market of all-time.
Make no mistake. This is the worst and most sudden swan dive in the economy in our lifetime
and we hardly are bullish for a swift recovery. However, we do believe the discounts in equities
are prodigious. And the resilience of our uniquely self-reliant denizens and business stewards can
and will work around Washington until “gridlock” returns.
“Radical chic” will wear out its favor and majority prudence will restore confidence; as a result
the economy and stock market will begin to rise again over a protracted period. This is the time
of our lives as investors.
The “Chaotic” Case for Financial Stocks
Western Reserve has written extensively the past few years about the inherent flaws in mark-to-
market accounting (MTM), and its “negative feedback loop” effect on banking and our economy.
Not to mention, the underlying problems for accountants who have misapplied “fair value” to the
new, unregulated and highly speculative credit default swaps (CDS). For a long time, trees
falling in a forest were more than just metaphor. Now, we hear even retroactive recoveries are
potentially in the offing from badly needed revision to MTM.
It’s promising we now see these tightly correlated issues aired out on television and on Capitol
Hill on a daily basis by a growing legion of fervent agreement and more constructive
disagreement. The restructuring of MTM is inevitable now and so is the strict regulation of CDS
to require offsetting assets and/or material equity investment. It’s actually the CDS issue that
makes MTM so flawed as the lack of asset or equity backing caused inefficient price discovery.
In combination, their restructuring likely has set a floor on financial stocks in our view and the
healing can begin…
“I just don’t get that we should treat credit default swaps as like the Delphic
Oracle of any kind. It’s the most easily manipulated and broadly manipulated
market that there is.”
- Jeff Immelt, CEO of General Electric
We didn’t get it either Jeff. We pulled our GE short off too soon as a matter of fact.
Arguably, we were too early on these issues and found ourselves too far out in front (noting two
former Fed Chairmen below, we were in good company). We pulled our financial shorts off
prematurely as a result. We mistook chaos as mere misinformation that would correct itself in
feasible time and totally missed the Congressional flip-flop on TARP. We didn’t expect rational
beings to take so long figuring out MTM and CDS. And we frankly were blindsided by the class
warfare targeting of the banking industry.

3. Paul Volcker on Mark to Market Accounting
Former Fed Chairman, Paul Volcker, Chairman of the Group of Thirty, Consultative
Group on International Economic and Monetary Affairs, Inc., just released a study with
recommendations on financial reform.
Recommendation #12 on Fair Value Accounting reads as follows:
a. Fair value accounting principles and standards should be reevaluated with a view to
developing more realistic guidelines for dealing with less liquid instruments and
distressed markets.
b. The tension between the business purpose served by regulated financial institutions
that intermediate credit and liquidity risk and the interests of investors and creditors
should be resolved by development of principles-based standards that better reflect
the business models of these institutions . . . ."
Alan Greenspan on Mark to Market Accounting
On November 1, 1990, Federal Reserve Chairman, Alan Greenspan, in a 4-page letter to
Richard Breeden, Chairman of the Securities and Exchange Commission, said, in part:
"The Board believes that market value accounting raises a substantial number of
significant issues that need to be resolved before considering the
implementation of such an approach in whole or in part for banking organizations.
Accounting methodology should be developed to measure the results of a particular
business purpose or strategy; it is not an end in itself. For an institution whose
business purpose is to trade marketable financial assets on an intra-day basis, for
example, closing daily market values would measure the success or failure of that
particular business purpose. An end of the day balance sheet, marked to market, is clearly
the appropriate accounting procedure in the example.
Generally, the business strategy of commercial banks, on the other hand, is to employ
their credit insights on specific borrowers to acquire a diversified portfolio of essentially
illiquid assets held to term. The success or failure of such a strategy is not measured by
evaluating such loans on the basis of a price that indicates value in the context of
immediate delivery. Clearly, one aspect of value in an exchange is the period of delivery.
But the appropriate price for most bank loans and off-balance sheet commitments-is the
original acquisition price adjusted for the expectation of performance at maturity. It is
only when that price differs from the book value of the asset that an adjustment is
appropriate. A reserve for loan losses is such an adjustment. To mark such an asset to
a market price intended to reflect the value of a loan were it liquidated
immediately is interesting, but not a relevant measure of the success of
commercial banking."

4. The good news is that we have made no fundamental mistakes (have had to take no permanent
losses long) and prices just got better and better, thus lowering our average cost and increasing
the upside. Chaos brings with it both short term and long term opportunities. There was a great
opportunity chasing a “short all the financials” bubble. We looked at MTM and CDS, saw the
flawed pricing, and didn’t draw the fundamental case to chase the short trade far enough. The
“populism” that erupted into the bank nationalization panic during the quarter was a wild card
(read: blind luck).
This financial crisis is different in one significant way than the one we witnessed as banking
regulators in the early nineties. In the S&L Crisis, the accounting lagged the poor underwriting
decisions of many banks and it had to be altered after-the-fact. The current crisis also involves
some ridiculously poor underwriting by some lenders, but it was isolated to certain types of
mortgages and in the absence of MTM and lax CDS regulation, we believe it would have begun
and ended there. In this crisis, MTM and CDS were the agents of spreading credit concerns to
unnecessary levels and across uncorrelated asset classes. This go ‘round, we are forced to
unwind perhaps well intended but hastily crafted and deeply flawed accounting after-the-fact.
The investment opportunity is the same however…gloomily under valued financial stocks, which
should lead the recovery.
Opining about the financial crisis which concluded in the early 1990’s, value investor David
Dreman writes in Contrarian Investment Strategies, “A full-fledged panic in financial stocks
began during the Gulf Crisis, in August of 1990. Banks, S&L's, insurance companies and other
financial stocks, already down sharply because of real estate problems, went into a free fall. Fears
were now voiced about the viability of the banking system itself, and doubts were expressed as to
whether it could withstand the shock of trillion-dollar losses in real estate. From the beginning of
the year to the end of September of 1990, money center and regional banks dropped 50%. Some
financial stocks fell by as much as 80% from their previous highs."
“Crisis investing opens the door to large profits. But you had better don your
general’s hat and flak jacket. To make this killing you have to charge ‘into the
valley of death’ while overreaction is roaring and thundering all around you.”
- David Dreman, Contrarian Investment Strategies, 1998
Dreman continues his analysis of this period by pointing out that many bank stocks fell to
substantially below book value, observing the same principles that Western Reserve has written
about extensively in our prior quarterly client letters. As Dreman qualifies more articulately than
we, in times of crisis, pricing becomes as distorted as public opinion. Negative opinion and
negative events cycle back and forth or what Western Reserve has described as a “negative
feedback loop,” which dominates market sentiment and overwhelms reason.
Dreman observes, “In a crisis or panic, the normal guidelines of value disappear. People no
longer examine what a stock is worth; instead they are fixated by prices cascading ever lower.
The falling prices are reinforced by expert and peer opinion that things must get worse.” Dreman
adds, “Further, the event triggering the crisis is always considered to be something new; nothing
in our experience shows us how to cope with the current catastrophe.”
Few investors understood this period for what it was. Namely, a historic buying opportunity with
a great likelihood for extraordinary returns as hadn’t been seen in a long time. Western Reserve
views the current environment in very much the same way. Warren Buffett viewed the market

5. for financial stocks similarly as Dreman in 1990. The following is a brief (and condensed) excerpt
from the Berkshire Hathaway 1990 year-end letter to investors.
“Our purchases of Wells Fargo in 1990 were helped by a chaotic market in
bank stocks. The disarray was appropriate: Month-by-month the foolish loan
decisions of mismanaged banks were put on public display. As one huge loss
after another was unveiled -- often on the heels of managerial assurances that all
was well -- investors understandably concluded that no bank's numbers were to
be trusted. Aided by their flight from bank stocks, we purchased…Wells Fargo
for…less than five times after-tax earnings. A year like that -- which we
consider a phenomenon -- does not distress us….fears of a real estate disaster
caused the price of Wells Fargo stock to fall almost 50% within a few months.
Though we had bought some shares at prices before the fall, we welcomed the
decline because it allowed us to pick up many more shares at the new, panic
prices.”
Source: Berkshire Hathaway, 1990 Investor Letter
The performance of the NASDAQ Bank Index versus the S&P 500 from November 1990 to April
1998 is illustrated in the chart below. During this period and based on daily price at closing, this
broad index of regional banking stocks returned approximately 887% versus a return of
approximately 200% in the S&P 500. Dreman and Buffet were dead-on.
0%
100%
200%
300%
400%
500%
600%
700%
800%
900%
November 1990 - April 1998
NASDAQ Bank Index
S&P 500
Western Reserve offers additional insight that supports the strong likelihood of a sharp
recovery in financial company earnings (and stock prices) in advance and in excess of the
broader market over the next several years.

6. The substantial historical out performance of financials following a credit-induced crisis lies
in the fact that financial services firms’ profits recover ahead of most product and industrial
companies due to five dynamic “profit accelerators” that are unique to financial services
firms’ business models and their accounting not found in other industries.
Loan Loss Provision Expense
Loan loss provision expenses are non-cash deductions from capital and currently
represent more than 85% of banking profit declines. These loan loss provisions are very
pro-cyclical non-cash charges which peak long before the economy begins to recover and
often become grossly overstated due to “double upping”. As a result, the banking
industry will see profit relief from lower loan loss provisions early in an economic
upswing. This is an accounting-related phenomenon. In downturns, banks transfer capital
to their loan loss reserve accounts by reducing retained earnings (by making non-cash
charges against earnings). This is not a transfer of cash or a “cash flow exercise,” it is a
balance sheet transfer from the capital account (retained earnings) into a contra-asset
account (loan loss reserve). Therefore, bank earnings are significantly reduced during
periods of heightened credit losses because most banks expense their current loan losses
without corresponding reductions of their loan loss reserve balances causing the expense
to be a “double up”. After loan loss provisions peak, such as at or near the bottom of a
recession, banks see their earnings recover suddenly as the loan loss reserve “spigot” gets
turned off and reported profits "jump" quickly back in line with underlying cash flows.
This gives Wall Street the appearance of a very sudden and rapid acceleration in the
earnings power of banks, while a bank contemporaneously is over-reserved for future
losses.
Release of Excess Loss Provisions
New accounting standards governing bank loan loss reserving practices were
implemented following the last recession and exacerbate the over-reserved aspect of the
aforementioned “double up”. These new standards require banks to “reverse out” any
excess loan loss reserves by “releasing” them back through future earnings periods. This
creates a levered boost to earnings power as the economy stabilizes. First, new loan loss
provisions are eliminated or get dramatically reduced as discussed in the previous
paragraph. Second, the excess reserves are released back through the earnings statement.
The result is that bank earnings are grossly under stated during downturns and overstated
during up turns. “Double ups” become “double dips”… Our research using CAMEL or
regulatory insight is the driver of our research combing over the carnage looking for
banks that will have very quick recoveries in credit related expenses.
Transaction-related earnings as “money flows” return
The economy now is sitting on a record $10 trillion in cash and cash equivalents (defined
as “M2” by the Federal Reserve). Most of this cash is currently custodied within the
financial services industry. As the economy begins to stabilize and investors begin to
accept more risk by moving out of cash, financial services firms realize early and strong
revenue growth acceleration because they are, at their core, transaction processing-
oriented businesses that generate fees from moving, loaning, servicing and transacting
these cash flows.
Financial services firm revenues accelerate first in a recovery as money starts to “move
around” again. This is true both of monies moving back into debt and equity capital

7. markets and out of money markets, as well as retail-oriented transactions driven by the
acceleration of credit and debit card purchases. Merchant (investment) banks and
custodial focused banks tend to move first followed by more traditional commercial
banks.
Slope of Yield Curve
Like the Greenspan Fed in the early nineties, it’s highly likely the Bernanke Fed will
leave short term interest rate targets low for a protracted period of time to help the
banking industry “earn” it’s way through higher credit costs. This proved very
instrumental in aiding the recovery of banks in the after-math of the S&L Crisis. The
effect is to allow bank net interest margins (lending spreads) widen and stay wide for an
extended period.
Record levels of capital and liquidity
As financial firms have cash and capital hoarded per usual in this credit crisis, the
industry is sitting on the largest store of capital and liquidity in history. As a whole, banks
have three times the relative level of capital today than they had during the depths of the
S&L Crisis. The average bank now carries regulatory capital above 12%, or almost three
times the minimum level required to meet standards for being considered “well
capitalized.” Any retroactive recoveries from MTM amendments will only further boost
capital levels. We do not expect any surprises from the current “stress tests” on-going; as
“impairment accounting” which governs 80% or more of bank held assets is timely and
effective and our CAMEL approach to analyzing banks is in step with the regulators.
While non-performing loan levels are still rising and we expect them to continue for
some time, they remain well below those experienced during other credit crises such as
during the period from 1988 through 1992, and significantly below the level experienced
during the Great Depression. Many banks are trading at levels below their net cash-on-
hand (excluding core deposit “match funded” loan portfolios), so the extraordinary levels
of liquidity and capital are not credited in stock prices. Such remarkable levels of capital
and liquidity mean that banks are “under-loaned” and have excess cash and deposits on
hand. At the point the potential fiscal economic stimulus and obvious “easy” monetary
policy effectively grabs-hold, banks will be extraordinarily well-positioned to lend into
an economic recovery. This increased lending activity is expected to result in a steady
and early increase in the banks income-producing assets which will bolster their net
interest margins and profitability. Traditional banks, especially smaller regional banks,
will flourish and their valuations climb sharply. In addition, excess capital and liquidity
likely will usher-in another extensive merger boom such as we saw in the latter parts of
that near 900% climb in the financials between 1990 and 1998.
According to First Call average analyst estimates for the S&P Financials Index,
Percent change year over year in earnings-per-share
1Q09 -37%
2Q09 -40%
3Q09 +264%
4Q09 >+500%
2010 >+350%
Source: First Call (These are First Call and Western Reserve estimates)

8. By comparison, the average earnings progression for the S&P 500 excluding Financials is far less
attractive coming out of this downturn as a result of the aforementioned “profit accelerators”.
1Q09 -36%
2Q09 -32%
3Q09 -27%
4Q09 -17%
2010 +2%
Source: First Call (These are First Call and Western Reserve estimates)
Conclusion - Financial firm earnings “snap-back” will attract investors on a relative basis into the
coming recovery, propelling their shares faster and higher than the overall stock market.
The ‘shock and awe’ of the liberal agenda no longer is a surprise to anyone, so the economy
is showing some modicum of stabilization. However, its a stabilization at very depressed
levels and recovery will be slow, arduous and lumpy. This is one reason why equities will
start to outperform other asset classes and already may have begun. We have record cash on
the sidelines in the economy. It eventually has to move off the fence. The economy will be
an L-shaped recovery, but stocks will lead and have a U-shaped recovery as a public stock
can move ahead of fundamentals whereas a building or land or private equity cannot. Keep
in mind that public equities, particularly financials, already trade below private market value
as folks have had to see them marked monthly in their account statements, prompting them to
sell public stock emotionally. They see their stocks down and sell and live in denial of their
private holdings liquidation values. The opposite is true at troughs.
Regards,
Michael P. Durante
Managing Partner