October 20, 2007

This presentation is not a form of solicitation, nor is it intended to be a recommendation to purchase or sell any investments. This presentation is merely intended as a form of sharing of research to the AAII-SIG. As an investment advisor, I may own and control, long or short, any of the companies mentioned in this handout. We currently indirectly probably have close to 15% to 20% of our portfolios, long in the manufactured housing and/or finance industry. Banks that will be mentioned today may include Countrywide Financial, Downey Savings and First Federal Financial. We covered our short positions during the 3rd quarter of 2007.

Countrywide as an example, what went wrong? What might occur?

A. Let’s start simple. To avoid confusion, I am going to present hopefully simple and generic concepts. Countrywide as an example, is not so simple, yet I think the “layperson approach” will be effective for this procedure.

B. Traditionally, a bank collects money from depositors. The bank will pay the depositor a specific rate. The bank will then loan that money to say a home purchaser via a mortgage, at a higher rate. The higher rate is predicated on profit (net interest margin), a risk factor to the bank and future servicing costs.

Mortgage rate bank collects	8%
Deposit rate bank pays out	4%
Profit	4%

C. Bank has collected short-term deposits, and loaned out money over the long term. In the interim the bank will need liquidity. They need to turn on the lights, pay employees, etc. The bank can try to get this liquidity from investors, or they can sell some of the loans they are collecting 8% for the next 30 years.

D. This is where it starts getting confusing. Think of it this way. We are in business together. We each put up $1,000,000. We loan someone money at 10%, for a 30 year fixed mortgage. Each month we collect principal and interest. Each year we put in a new $100,000 and loan it out at 10% fixed for 30 years. We also start loaning out the interest and principal collected. We have no fears of not collecting, as we have hired Vince B. and Steve P. as our “credit collection enforcers.” After 20 years, we have each put in at least $6.4M. We are now collecting a tidy some. We can walk away any time and collect all the money owed to us, and we are receiving 10% interest. We just might have difficulty making 10% ROI in the future. At no time did we ever carry too much debt, if any that would ever injure our net worth.

What Countrywide did (and many other banks)?

A. Lets pretend they started with $1M from investors.

Description	Debit	Credit

Cash	1,000,000
Shareholder Equity		1,000,000

B. We got a million dollars baby! What should we do? One officer says, “ Can I sell my shares now?” Oh, I digress. Let me get back on subject….. We loan out $1,000,000 at 8% interest. Here is the Journal Entry:

Description	Debit	Credit

Loan Receivable	1,000,000
Cash		1,000,000

Our Balance Sheet looks like this:

Description	Debit	Credit

Loan Receivable	1,000,000
Shareholder Equity		1,000,000

In one year we collect $100,000 in Interest (lets forget the principal here.) Our Balance sheet now looks like this.

Description	Debit	Credit

Cash	100,000
Loan Receivable	1,000,000
Shareholder Equity		1,100,000

If bank wants to fund more loans, they need to generate cash

We have no cash, yet we want to still generate loans. We are collecting 8%, and we like those safe returns. Angelo CEO says, “we can sell our loans receivable. We won’t hold them as investments anymore. Also, when they are “Loans Held For Sale”, they get put on the balance sheet at Fair Value.”

The selling of these loans is known as “securitizations.” This is where the difficulty starts.

In the examples above, the only income you ever generate is “Interest Income.” Countrywide will now sell these loans (as long as there are buyers) via “securitizations”.

Now I will discuss leverage. Countrywide, as of their most recently reported financial statements 6/30/07, had an Asset to Equity Ratio of 15:1. First lets look at the Balance Sheet I presented above:

Description	Debit	Credit

Cash	100,000
Loan Receivable	1,000,000
Shareholder Equity		1,100,000

Lets say, we also “marked to market.” Let’s assume our Loans Receivable, became impaired by 20%. If that were to occur, our Balance sheet would be reduced by 200,000. We are still quite solvent. A disappointing, yet manageable Net Worth of 900,000. That is because the asset to equity ratio was 1:1.

Description	Debit	Credit

Cash	100,000
Loan Receivable For Sale	800,000
Shareholder Equity		900,000

Let’s use an example like Countrywide and impute an Asset to Equity ratio of 15:1.

Description	Debit	Credit

Cash	100,000
Loan Receivable For Sale	15,000,000
Debt		14,100,000
Shareholder Equity		1,000,000

Then I will reduce the held for sale assets by not 20%, but by only 8%, lets see what happens. Loans receivable would be impaired by $1,200,000. The Balance sheet would now look like this.

Description	Debit	Credit

Cash	100,000
Loan Receivable For Sale	13,800,000
Debt		14,100,000
Shareholder Deficit	200,000

The company directly above is insolvent. It is insolvent because of leverage.

What was and is concerning with Countrywide?

1. I actually was one who frequently was vocal on the insider selling at Countrywide. I asked about a simultaneous Corporate buy back, with, at the same time, material amounts of shares being sold by the CEO.

2. You would see all or most of our concerns at our webpage. http://rbcpa.com/companies/CFC_notes.html

3. Compensation packages to CEO are obscene.

4. I discussed “securitizations.” What I didn’t mention is that all securitizations for Countrywide were recorded as “Gain on Sale Income.” Gain on Sale Income has been in excess of 200% of reported net income for most of the last 4 fiscal years. Very generically, “gain on sale” is booking much of the future profits. Hence, a bank can no longer rely on interest income to earn money. They must now sell these loans.

5. It is of my belief that contrary to popular opinion, banks are not taking the “big bath” in 3Q07. I have heard that these “loans held for sale” are getting bids of 20 and asks of 90. What do you mark that at?

6. Option arm loans created income, created portfolio growth (as it added to loans receivable when lack of payment was merely added to the mortgage loan balance)

What am I doing now about investing in banks?

1. Really just waiting and learning. Waiting for clarity. If Countrywide marked conservatively or in a bad case scenario, I believe they would be deemed insolvent. Not to mention covenant breakages, commitments, etc.

2. I am going to spend a bit of resources digging deeper into bank valuation. Be ready to pounce when I could assess reasonable understanding of bank value, assets, skeletons in the closet, and assessment of continuity, without any type of reorganization.

3. I wouldn’t be surprised to see the following scenario for Countrywide,

“When rumors were going around about CFC and Buffett, I would often think about it. I knew that Mozilo and Buffett didn't seem right. But, I thought that Berkshire could lay claim to the assets and ownership of CFC , via Wells Fargo, BAC or USB. Ultimately, I think that Berkshire in some fashion will own a bit of CFC (probably indirectly via BAC, or perhaps a future consortium, which could include WFC and USB. I am sure that WEB would be fine with BAC (whom I just am not familiar with, but just think of them like WFC, and I do that with really no knowledge of BAC philosophy etc.)

I think that current balance sheet wise, we could see that CFC is actually insolvent. Yet, couldn't BAC make a deal, say, buy the remaining (80% or > ) of CFC for say $4B. They could do this by negotiating with the creditors, banks, investment houses and investors of the paper that CFC owes. In turn, if BAC or like, were to take over, they do it with an arrangement with current creditors, that gives them some remuneration ( a lot less than planned, and ultimately an awful investment for those investors). Meaning if CFC sold a securitized high rated pool of Alt A Option Arms, for say 1.03, well maybe BAC says, we will pay you as though you paid 0.75. At the same time BAC says, "no problemo securitizer asset loaded to the rim dude, we will just split this scene, and you could get substantially less than what we are offering. Take it or leave it, to be blunt, we don't care."

Hence, I am thinking a BAC type could take over the servicing section of CFC and own the very large and I am sure, when structured conservatively, look to the long term, severe profit streams. They could also absorb the current $200b of assets, but only absorb them at their "mark to market" that buyer ( conduit of Berkshire) is comfortable with. This is where Berkshire comes in. They could probably price these vehicles to own as good as anyone. Yet, they can be generous on their stress factors, which would minimize the price they would buy these "marked down assets." Once they own it, a few years go by, and the "mark" of distress is lifted, and BAC (Berkshire) would secure a profitable future revenue stream, with the typical Berkshire lower risk profile. What I mean is that on all mortgages and assets bought by BAC (synonymous for Berkshire conduit), there is a certain price, that includes reasonable stress levels. Reasonable stress levels, like hurricane insurance after Katrina and such, would have greater than normal uncertainties, and on the pricing of these assets, conduit buyer take advantage of low prices, and at the same time show reasonable attempt to give a fair price to current owners and creditors of CFC and related debts. Maybe there is a way to deal with the buyers of these "bankruptcy remote qSPE's"

Summing it up Mozilo and Buffett, do not seem like a fit. CFC is better off without the leaders (even the founder) that pay such great personal compensation packages, used incompetent judgment in their business model, etc, etc. But, BAC and WFC have that expertise, and we could see a means where indirectly WEB takes over an entity, by use of a conduit subsidiary or material investment where they have an influence on (WFC), BAC or USB , for now). Buffett wouldn't come in and run the place ala Salomon, but he could have a company that already is a leader in the industry do it.

They can save the world ;-)”