Thrifty Investing

"By the time the S&L crisis was over, by the early 1990s,
it was by most measures the most expensive financial
collapse in American history."

— David Mason, Financial Historian

Mason calculates that between 1980 and 1993, 1,307 S&Ls
with more than $603 billion in assets went bankrupt, at a
cost to taxpayers of nearly $500 billion. The reputation of
S&Ls had plunged. Once seen as the humble local
institutions of ‘It’s a Wonderful Life’ fame, they now
conjured up the image of Charles Keating in handcuffs and
became symbols of greed and corruption.

Into this mess stepped Peter Lynch, then the manager of
Fidelity Magellan, and on his way to compiling one of the
most amazing track records in the history of investing.
Lynch took the reigns at Magellan in May of 1977, when the
Dow was at 899 — and headed to 801. He left in May 1990. If
you had put $10,000 with Lynch in 1977 and just left it
there, you would have had over $250,000 when Lynch retired
in 1990. That’s an average annual return of 29.2%.

Among his favorite stocks were S&Ls. At one point, he owned
over 150 of them. As he writes in his book Beating the
Street, "Once, I confessed to the Barron’s panel that I’d
invested in 135 of the 145 thrifts whose prospectuses
landed on my desk. The response from Alan Abelson [Barron’s
editor, long known for his wit] was typical: ‘What happened
to the others?’"

Lynch bought S&Ls when they were still among the
untouchables of the investment world. Yet there were many
S&Ls that survived the debacle of the early 1980s. Lynch
also noted that in terms of financial strength, as measured
by the equity-to-asset ratio, there were many S&Ls that
were stronger than the strongest bank in country, then J.P.
Morgan.

Lynch had his own schema for separating S&Ls. He had the
"bad guys," who perpetuated the fraud. Most of the frauds,
Lynch notes, were privately owned (Charles Keating’s
Lincoln Savings and Loan being an exception) and would not
have survived the scrutiny of being a public company. Then
there were the "greedy guys," who couldn’t leave well
enough alone. In their thirst for greater profits, they
followed the old hackneyed measure of borrowing as much as
they could and putting it to work in risky ventures.

The last of the lot were the "Jimmy Stewarts," as Lynch
called them. They were the no-frills, low-cost neighborhood
thrifts that concentrated on making old-fashioned mortgage
loans.

Lynch loved these S&Ls. As he explains it, he bought them
in such large quantities because they were often small and
Magellan was so large, such that "to get nourishment out of
them, I had to consume large quantities, like the whales
that are forced to survive on plankton." One reason he
loved them was the unique way in which they go public.

Mutual companies, such as thrifts, can’t issue stock to
raise capital. Sometimes the easiest and best way for a
growing thrift to add capital is to go public. This process
is called a thrift conversion, because the thrift converts
from an organization of mutual ownership to one of public
ownership. There are other reasons a thrift may want to
convert to a public company.

For example, the institution may feel it is necessary to
attract employees and executives, since it must compete
with banks that often award such hired hands with lucrative
stock options. Another reason a thrift may convert is to
facilitate acquisitions, which are more easily handled with
common stock ownership than in a mutual company
arrangement.

At year-end 2004, there were 1,345 thrifts operating in the
United States. Of these, 47% were publicly held companies,
and the remaining 53% were still mutual thrifts (that is,
they remained owned by depositors).

The current mutual-to-stock conversion process for a thrift
was established in 1976. After a 13-year moratorium, the
Federal Home Loan Bank Board began to permit conversion.
This process created a favorable investment situation.

Lynch describes it this way: "Imagine buying a house and
then discovering that the former owners have cashed your
check for the down payment and left the money in an
envelope in a kitchen drawer, along with a note that reads:
‘Keep this, it belonged to you in the first place.’"

When Lynch learned about the "hidden cash in the drawer"
rebate, early in his Magellan career, he bought almost
every S&L that he could get his hands on. While the
environment today is different than it was then, these
conversions still present value opportunities.

Not every thrift is a slam-dunk, of course, and each thrift
has to be evaluated on its own merits. Even when you buy at
a discount, you still bear the risks that come with
investing in stocks — management can blow it, competitors’
actions are unpredictable, etc.

Back then, S&Ls were widely unpopular. Not so today. But if
you look hard enough, there’s still plenty of value out
there. In fact, I think many of these recent thrift
conversions may be the last relatively safe plays in the
banking world.

We’re getting paid for saving again! The real interest rate
is back above zero for the first time in nearly three
years.

We start with a nominal interest rate – the street level
rate. Everbank has a 3-month dollar CD going for 3.22% or
you could use a floating rate, like the yield on 13-week
U.S. Treasurys, which was 2.84% at close last night.

Then you need to adjust for inflation, and this is
important, it has to be expected future inflation, not
historical CPI. We calculate this by comparing the yield on
10-year Treasurys with 10-year TIPS (inflation protected
government securities) and taking the spread.

For the last three years, saving has cost money. The reward
for saving is still pretty poor, but in times like these,
where everything’s up and bargains are hard to find, 3.27%
starts to look appetizing.