Berkshire Hathaway Inc. said it will acquire the 77% of Burlington Northern Santa Fe Corp. it doesn’t already own in a cash and stock deal that values the railroad company at $34 billion and marks Warren Buffet’s largest acquisition.

The deal values Burlington Northern at $100 a share, a 31% premium to Monday’s closing price.

“Berkshire’s $34 billion investment in BNSF is a huge bet on that company, Chief Executive Matt Rose and his team, and the railroad industry,” Mr. Buffett said in prepared statement. Berkshire also will assume $10 billion of outstanding Burlington Northern debt.

“Most important of all, however, it’s an all-in wager on the economic future of the United States,” Mr. Buffett said. “I love those bets.”

The deal provides that each Burlington Northern share will be at the election of the shareholder to be converted into the right to receive either a cash payment of $100 or a variable number of Berkshire’s Class A or Class B stock.

The deal is expected to close in the first quarter.

Separately, Berkshire’s board approved a 50-for-1 split of its Class B stock. The company said a great majority of the stock issued by Berkshire in the acquisition would be its “A” shares, but “B” shares will also be needed to accommodate holders of smaller amounts of Burlington Northern’s shares who opt for a share of exchange rather than a cash payment.

Berkshire to Acquire Burlington Northern (WSJ)

The really interesting thing here is that Buffett is set to use Berkshire shares for the acquisition. I can’t remember the last time that he did this, I know he really regretted it with Dexter Shoe Co.:

In 1993, Berkshire paid $433 million for the Maine-based company. Rather than use cash, Buffett used Berkshire Class A stock to fund the purchase. That Berkshire stock is worth eight times more now, giving the Omaha, Nebraska-based insurance and investment company a $216 billion market value.

Dexter didn’t make it that long. It ended shoe production in the United States and Puerto Rico in 2001, and Berkshire folded what was left into its H.H. Brown Shoe Group unit.

“What I had assessed as durable competitive advantage vanished within a few years,” Buffett wrote on Friday. “By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6 percent of a wonderful business — one now valued at $220 billion — to buy a worthless business.”

“To date, Dexter is the worst deal that I’ve made,” Buffett went on. “But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: ‘I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.’”

Buffett calls Dexter Shoe his worst deal ever (Reuters)

I know some people think that the capital expenditures of railroad companies are likely to be limited in the future as much of the track has been already laid. Most capex would then go to maintenance, with the rest being gravy for the owner. This could be a big motivator for Buffett changing his mind on railroads and becoming so bullish.

Give it a read:

A Find in Freemont (PDF)

I’m going to start reading Fremont’s filings so I can get a better picture of the situation and make my own judgement.

Fremont is actually a company I’ve heard of before. Texas-based activist investor Harry Long has been lobbying for change there. Check out his whitepaper: Build Fremont (PDF).

I can’t be sure of whether Biglari agrees with Long, I know that the folks at Chanticleer have a different opinion of the company’s management. It will be an interesting company to watch though.

Also, there’s an article from Bloomberg on the talk:

Hedge-fund manager David Einhorn said JPMorgan Chase & Co., Bank of America Corp., Wells Fargo & Co. and Citigroup Inc. are among banks that the government should break up to ensure no company is “too big to fail.”

Einhorn said he’s buying gold to bet against the dollar because U.S. government and Federal Reserve policies may undermine the currency. Rather than buoying banks with bailouts, the U.S. should decide which lenders endanger the financial system and force them to shrink, he said.

“The lesson of Lehman should not be that the government should have prevented its failure,” Einhorn, who runs New York- based Greenlight Capital Inc., said in a presentation at the Value Investing Congress in New York. “The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system.”

Einhorn Says U.S. Should Make JPMorgan, Wells Shrink (Update3)

Key notes:

-There are periods of time, could be 2 or 3 years where it underperforms the market. People usually drop the formula if it does that. That prevents it from widely adopted.
-Over the last 5 years the magic formula is up 73% versus 3% for the market.
-Launching an investment fund to do all the work for investors.
-Not a fast trading strategy. Lost a little bit against the market last year. There are periods when it does not do well or can actually lose money.
-Not a great strategy for hedge fund managers. On average these plays do well over time, difficult to hedge out. That’s why it Greenblatt thinks it will continue to work.
-If you look specifically, you’ll pick reasons why you should not buy them individually. But if you buy as a basket it generally works out.

How do you gain a circle of competence with banks? Where do you start?

Keep it very simple. Banks or financial institutions are based around borrowing money and then lending it. So that’s going to be masked by all different types of weird funding mechanisms and odd assets (securities and lending structures). The accounting treatment and regulation will be tricky.

The learning curve especially with the crisis means it’s hard and always evolving. With that giant pot of knowledge you want to keep it very simple. Start out be looking at small micro banks, there are banks trading that might only have 10 branches that operate out of one geography. You can learn that one particular geography and all the macro idiosyncrasies of it. Plus, you can probably talk to management. Keep it simple, find banks that focus on just mortgage lending or commercial and industrial (C&I) lending and master that. Then if you master it you can branch out. If you master mortgages you can branch out to commercial real estate (CRE), then C&I.

Then you could do something like read a Bank of America 10K. They own every type of business within financials. So it might look confusing as a whole but if you think about it individually they are like separate monolines that are operating as a whole.

But yeah definitely start with the simpler banks at first.

What ratios are you looking at the most when examining banks? Do you use the Texas ratio at all given how it has helped signal banks that will need to raise cash in the past?

We don’t really use the Texas ratio specifically. The general ratios that the banks provide you are ok but obviously you can’t just go off of that. There’s much more investigative work. It all starts with a detailed look of the loan/securities portfolios, so type of loans and where they were originated in terms of geography. We look at the different delinquency buckets, non-performing assets, charge-off numbers and make assumptions. It’s a very macro-economic driven process.

Non-Performing Asset (NPA) ratios and charge-off ratios and the rates of their change are important but ultimately it’s the capital relative to the banks assets that’s most important. If a bank has a 4% capital ratio (TCE / TA) and the bank has 5% losses the equity is wiped out assuming they don’t earn their way out. Texas Ratio basically says if all non-performers lead to charge-offs then what percentage of tangible equity would be wiped out, so sort of the same thing.

Do you use any different metrics for regional banks?

No. I wouldn’t say we use any different metrics. Regional banks may not have as many loan categories as the bigger guys. There can be less to look at and obviously its specific to the region. If there is a large discrepancy between the general macro and the regions macro it can make a major difference (meaning a Florida bank may relatively underperform a bank in NJ)

Thomas Brown of Bankstocks argued that the charge-offs to loan reserve ratio had no meaning due to variations in accounting treatment. Can the analyst describe a better criteria for measuring loan reserve adequacy?

There’s some merit to his argument. I’ll give you a simple example: When a bank makes a credit card loan, the reserve to the loan should be higher in theory because it’s an unsecured loan. If it’s a mortgage you can afford to charge off less because there’s collateral backing it up and you’ll have some of the loan recovered in a sale. Obviously the severity is dependent on the economy (if home prices go down). Generally simple reserve ratios may not tell the whole story but when they are headed in one direction quarter after quarter it’s telling you something. If I recall correctly from the specific article where Brown discusses the topic he talks about FHN and how based on reserve ratio, reserves look inadequate but if you look at how those reserves are allocated it seems sufficient. Now you can try to be a hero and pick names that way and claim its thorough analysis but it doesn’t work so well in a banking crisis environment similar to the one we went through.

So should capital adequacy ratios factor in black swan events then?

See – no one knows what that correct capital adequacy ratio (CAR) number is. You don’t know what the severity of the next crisis will be. I’m in favor of keeping the reserve requirements higher than they have historically been. One of the reasons we got in trouble is because the system got way too levered.

How important do you view the funding of deposits? How do you incorporate sources of funding into your investing decisions?

Some people value banks based on deposits — I don’t. I don’t think anyone uses it as the end all valuation. Deposits can make or break a bank. They generally tend to be the stickiest and lowest cost source of funding. With wholesale funding, you’re waking up in the morning praying that some institution is going to keep lending to you. With deposits, you don’t have to worry about that as much.

You want growth in savings loans versus high yield CDs right?

Yeah — the type of deposits is important. If a bank sets them up with hot money CDs, it’s really no different than wholesale funding. GMAC did this. You don’t want a banking institution that does that. You want a depository that people trust and are willing to give you money interest free.

How do you value a bank? Most traditional investors look at things like DCF valuations or try to come up with a Ben Graham style assets-based valuation, but banks are different right?

It’s rare to see a bank analyst use a DCF. We mostly use an earnings model. We then attach a multiple, so what a lot of analysts are doing is attaching the historical 10-12x multiple to normalized earnings.

A simple way of getting an earnings number is by taking a ROA (Return on Assets) percentage and assuming some type of asset growth (negative or positive) and then multiplying the ROA times assets times the growth number. Then, take that number and divide it up by the shares outstanding to get some kind of an EPS figure.

A more detailed model assumes some earnings asset level and net interest margin (NIM) to get net interest income. To get non-interest income you just assume some growth rate off of the fee line items. Then, assuming something on provisions and expenses to get a net income figure. Thats the basic idea and it incorporates a lot of assumptions on the macro and regulatory environment.

During this crisis I think people looked at banks in this manner:

There is a credit/capital concern > people start looking at banks based on tangible book > the concern becomes whether capital is enough. You make your own stress test. If banks pass that you might want to invest in them. Obviously you have to net that against how ouch they will earn too. But trying to earn your way out didn’t really work for Japan.

Ulimately, normalized earnings will depend on GDP and unemployment. If it ends up being robust (so GDP growth rates are high and the unemployment rate goes down) then banks will win but the biggest risk to bank earnings going forward is the level of earning assets. If earning assets decline, normalized earnings will not be as high. The decline in loan balances is something I’m paying particularly close attention to this quarter.

So if a bank has 14% capital and they currently have losses of 3% you are probably in good shape assuming they are not lying or pushing losses into the future. But a bank of that sort might not be cheap either, which can make it a waste to invest in.

What kinds of things do you usually ask management on calls and visits?

Ask whatever you can’t get out of the 10Q and 10K. Understand the intricacies of the business. Find out about specific accounting treatments and things like granular details on their loan portfolios.

Also, trying to gauge how they see the macro-economic environment. The best thing to ask management is to ask what they see in their locale. Look at Case Schiller and see what a specific housing market is doing and then ask a bank there about it. They might say that even if house prices are going up, the unemployment situation still sucks so there’s no improvement.

In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?

It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.

So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.

So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.

Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE:CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.

So why did value investors get it wrong?

As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.

I think that some value investors refused to believe that this time it is different. Also, they just didn’t understand the risks involved with some of the intricacies in financials. Bruce Berkowtiz talks about how he didn’t understand AIG when he read about their derivatives and said pass.

I think that other value investors, especially the ones who decided that AIG was cheap let those risks pass by them. Or they looked at history and said “Okay, this bank trades at 1/2 book and based on history its never been cheaper.” They were wrong.

What would happen to banks in a hyper-inflationary scenario in which the 30-year Treasury yield goes to 15-20% or higher, as Julian Robertson has suggested?

In a hyper or super high rate environment, it will not be good for financials and equities.

The first step would be that asset sensitive banks where loans/securities re-price faster than their liabilities would win temporarily. If you read what SCHW has said, for every 100 bps rise in rates they generate 600 million in net revenues, which pretty much fall straight to the bottom line.

Eventually the dynamic that would kick in would be that depositors would demand higher rates. If rates are 15% depositors wont want 3% CDs. So right there, funding costs would go up.

For a bank to make money, it’s usually an 80/20 split. So, 80% comes from interest income and 20% from fees. Since banks typically generate income from net interest income, they’re going to have to make loans that are higher than their funding costs. The argument is, what homeowner wants to pay a 15% mortgage in a 10% unemployment environment? Credit card rates have already gone up — you’ve seen Wells Fargo and others already do this to try to protect against potential regulatory changes, so that they can keep ROEs closer to a historical level.

I’d argue though that loan demand would collapse. Unless it’s a necessity but I don’t think anybody can raise prices high enough to match that kind of rate environment. Would you pay $20 for a Starbucks coffee? I don’t think so.

So the basic idea here is that nobody will be able to afford those loans and the demand for credit will fall?

So yeah, when funding costs become elevated it’s tough for them to make loans higher than the funding cost. A coffee shop isn’t going to take a loan to buy an espresso maker when the rate is 15%. To make money above their 15% cost you would have to raise prices to the point where no one would purchase a latte. Will that espresso machine make a 15% return to make that a viable expense? I doubt it. Initially, when rates start to rise, asset sensitive banks will win.

So let’s say a bank out there has locked in 5% funding base for the next 10 years. If rates go to 20%, they’re safe with their 5% and they’ll be able to price loans above that easily. Or a bank can become the lender to the government, but if all you’re doing is funding the government that wont work in the long term, as the economy would collapse.

The trade in financials has largely been long large money center and short regional banks. Do you see that trend continuing going forward?

If you start from the beginning, that trade has worked relatively. The best trade was to just long the whole sector. Now I would say that trade is worth holding onto. Ultimately, what I see on the long side is truly diminishing. On the short side there is some stuff but its primarily valuation related.

I want to make clear though that the idea to go long money center banks has had the margin of safety diminish by a lot. I’ll give an example:

Smart and dumb analysts think that Bank of America (NYSE:BAC) is going to earn around $2.50 to $3.00 in 2011 or 2012. What happens if they’re dead wrong? What happens if they earn $0.90 cents? Then you are clearly overpaying for the price it is at today, $17. But when the stock was available at about $3 it was either trading at 3x or 1x. It was very cheap at both of those multiples.

It’s scary because everyone is betting on Bank of America and I don’t like to bet on a horse that everyone else is betting on. If there is a chain reaction of sells on that name it can contract quite a bit.

How worried are you about regionals with large commercial real estate (CRE) exposure as we progress through what seems to be the next set of fundamental problems? And on that note, which regionals would you be most afraid of here?

In the beginning of the year people thought about banks specifically on the basis of what are the banks with early credit stage issues – housing, consumer type loans (credit cards) versus banks with later stage issues like CRE.

So for example: If you see people moving onto land, they’ll build houses. And if companies see houses, they’ll build commercial real estate and expand their businesses there. So in theory, it’s consumer loans that go bad and then goes CRE and C&I. So for regionals, later stage issues are a larger portion of their loan portfolios. We haven’t seen that hit as much as the early stage credit stuff.

CRE is an interesting animal. 1. There’s a lot of weird accounting 2. The structure of the loan itself. So there are these mini-perm loans for example where on the third or fifth year, the principle balance of the loan is due. A lot of these loans were made between 2005-2007. You still have 2009-2011 where things will come due. But a lot of these mini perm loans get extended out a year. So instead of going to non-performing they just get extended out and to all of us we continue to think they are performing.

Fifth Third (NASDAQ:FITB) is one regional that I’m kind of worried about. In general, right, if you’re going to look for CRE issues there’s a few categories: retail, lodging, industrial, and multi-family. Multi-family probably won’t do as bad as other ones because it’s harder to get loans to buy a mortgage. So more people are going to move into apartments in theory but it will still be hit. That might not do as bad as the other types of loans. Retail will obviously take a hit with consumer spending dropping and unemployment levels elevated. Here are some numbers: a basket of regionals – CMA 22.4%, MTB 25%, Regions 21%, Synovus 28%, Zion 35%. If you look at Wells Fargo 10%. Citigroup it is 2% and for BoA it’s 5.75% of loan portfolio. So those guys are pretty diversified versus the regionals that have a ton of CRE exposure. So you have to drill down and figure out the type of CRE they have the geography of it.

So basically it’s a way for management to hide delinquencies using weird accounting treatments?

Exactly. I’d point to the FDIC bank failures. A lot of the failed banks had 2-4% delinquencies in CRE and then a quarter later delinquencies shot up to 30%!. So you don’t really see that in other categories as the increase is gradual Q/Q.

Will majors participate in open market M&A or wait for the FDIC gain deposit share?

A lot of consolidation you saw with PNC (NYSE:PNC) taking over Nat City, Wells taking over Wachovia, I would argue that that type of M&A is less likely in the near term. More of the FDIC bank seizure type will be common

What about straight up mergers/takeovers?

Banks are still worrying about filling holes in their capital base. Even though equity markets have opened up, these guys would likely have to raise money to take over a large-scale bank. Look at Wells Fargo. Once they put on all their off-balance sheet exposure they’ll have a TCE ratio closer to 3%. They’re already in the 4%-ish range. Some of these guys are already too big — a single bank cannot own 10% of the depositor base of the US. You can only do that if you grow the deposit base organically. Not through takeovers, though I think that rule wasn’t considered last year

Can you talk about how you think regulatory / compliance changes that are on the horizon will affect banks? Any key things to watch out for?

One thing that’s known by the industry that everyone is expecting is rules on new capital adequacy ratios. Capital ratios will go up, the system cannot lever as much as it did before. That’s one thing. Fees are going to get hit (think deposit fees, credit card fees). Who knows what will happen if the Consumer Protection Agency goes forward.

I think normalized earnings will go down because of this. I think provisioning rules will change too. When times are good, banks can’t build reserves too high. FASB will argue that that they’re trying to dodge taxes. Do you know how that works?

No I don’t — let’s go into that a bit.

Okay so, when you have to build your allowances for loan losses, it comes through the provision expense. So banks have a reserve set aside, Bank A has $1000 in reserves with $100 in charge-offs. $100 comes out and the reserve is $900 now. If you want to replenish you need to add $100 but if you want to over provide for that you need to add $101 or more, which all comes out of net income.

In good times, some banks might want to provide for more if they think a crisis is coming. The less they provide the higher their earnings will be. The more they earn, the more they pay in taxes. FASB doesn’t want them to build reserves to an amount they think is unnecessary.

It goes back to what Japan was worried about. Their loans stayed in trouble for a long time. I think 25% of Japan’s tax receipts came from financial reserves. So the government didn’t want them to provide for bad loans.

So yeah — it would severely dent tax revenues. So that’s the dynamic here, there’s this quirk in the accounting and regulatory situation.

Exactly. If a bank had foreseen the crisis, they would have had pressure to actually lower reserves. So I think that will change for the better now and that banks will be able build reserves at a higher rate than before.

How do you deal with the government interference and its skewing of natural competition among banks? (i.e.: having the entire mortgage market in 3-4 banks)

Yeah, so there’s always a stigma with government. I think that’s why banks got so depressed in January and March lows. There were a lot of nationalization fears and the stress test looming. Nat City always boggles me because they had 8.7% TCE ratio, they were one of the highest among peers/large banks. For some reason that bank had to basically be sold to PNC. It could have been a depositor’s run.

So you think the government overreacted in cases?

I don’t think government is good at running businesses. So if they start telling banks whom to originate to I wouldn’t want to be a shareholder of that bank. I do think it will have some implications on the lending business going forward.

One thing to add to that, some people are definitely giving the banks that have excessive intervention less of a multiple. Bank X might be worth 8x but Bank Y that paid back TARP might be worth 10x.

Do you agree with that?

Yeah I do. If government flexing their muscles influences operations, if it becomes very big, then yeah. I don’t think government will be as efficient although I don’t think management of banks themselves aren’t so competent or efficient.

Yeah I thought it was interesting that Citigroup had to sell Phibro, even though it’s a profitable and well-run business unit.

Yeah that’s one decent example. Another thing — if you have more programs or initiatives that relax loan standards. If you can’t pay 20% down you shouldn’t buy a house, no matter what the American dream entails. America’s sort of becoming one big bank. They’re doing subprime lending with the FHAs.

What’s your best long and short for the sector? Themes?

I currently ask two questions:
1. What financial institutions are pushing problems to the future?
2. What banks are trying to work through their issues right now and be prepared for an uncertain world?

So how do you tell that?

Find banks that are aggressive in marking down their books and aggressive in raising capital. Or banks that didn’t partake in this excess during the credit bubble. You’ll find these banks; they might not be very popular. Look for well-capitalized institutions that are ready to pick off credits from weaker institutions. It’s sad to say but look for well-connected management. Look at Goldman Sachs (NYSE:GS), a lot of people complain about Goldman, like with that Rolling Stones article. But if you think about it, all those negatives are reasons I’d want to own them at the right price.

So for management, look for guys that are liked by politicians and the public?

So if Warren Buffett were to fall tomorrow, a bunch of guys would be saying all these great things about the life he lived. Angelo Mozilo of Countrywide? Probably not so much. In banking, honesty is super important. It’s important everywhere but I mean — look at IndyMac’s CEO. He was so positive up till the bank collapsed. It’s very unfair and really tough. Some investors really relied on his word and it’s very sad. The good thing about having this period in history is that you can see what management teams handled it well. So if the problems get worse, you can use this period to see if they passed.

I would argue that future crises that come about are likely to be worse. With the way the US is acting these days, with the amount of debt they’re taking on, we’ll probably see more problems in the future.

Commerce Bancorp (formerly CBH) used to be a unique bank that had a different business model. If it were a standalone company now, would it have been affected the same way as most of the big banks? Also, would it have taken more market share from the likes of BoA and Citi.

The thing is, when you go through a system-wide crisis, even small banks are bound to be affected. People always praise Wells but I highly doubt that they picked off the best credits in California while Countrywide and IndyMac were left holding the crap. When you have that big of a loan portfolio, I doubt that whole number is good credits. Obviously it hasn’t been.

So Commerce, their model, Vernon Hill was definitely an innovator. Bank Atlantic tried to mimic it exactly, UMPQ is doing something similar. Ultimately though, it’s the type of loans you make that can bring you down. You can be the most innovative banker in the world but if you make bad loans you’ll go down. Commerce also benefited from having a geographic concentration in the Tri-state area.

Are there any banks in particular that stand out in doing new, innovative things? The future of banking will be different than it is today, which banks are going to be ready for that new future?

I’m sure people can disagree but I’d argue how innovative can you really get in a borrowing/lending model. The medium is changing. We’re seeing more Internet banking and maybe something happens in mobile. When is the last time you actually stepped into a bank branch? My parents do, but not so much the younger generations. There’s banks that offer iPhone apps, so that’s the type of innovation I see but nothing too big. You wont get credit for innovation when you’re in a banking crisis.

Mostly, innovations are used to get cheap deposits. If there is a bank that can innovate and do it correctly, then it can work well. Commerce is a great example of one that did achieve it. Their efficiency ratio was higher than most peers but that’s because they kept their bank open 7 days a week and they made it so you really wanted to visit their branches. They used nice colors, had super friendly tellers (they weren’t stuck behind bullet proof windows or a mini gate), and they didn’t make branches look like a post office or a jail cell.

Their whole idea was putting more money towards non-interest expense but they were able to charge less for deposits since they were more convenient. It definitely worked. If you could invest in safe assets you could earn a wider NIM than peers.

The thing about Vernon Hill was that he wasn’t in the banking business forever, he owned Burger King franchises so he brought over that customer-driven model to banking. But if you run into the storm like we did now, innovation is not a high priority on bank executives’ minds.

If you look at innovation from other areas, like tech, you’ll see guys in college who are really bright that are making websites trying to innovative banks.

Yeah I wanted to talk about that — I always see guys, especially from valley tech startups saying how we need to take the start up model to banking ad really innovate things on that end. Every time, I think this is a recipe for failure with all the regulatory hurdles and work involved.

That’s another good point. It’s a heavily regulated industry. So for someone in college or high school that has a bright idea for starting something in the financial sector, they’re going to go through more capital and regulatory barriers than someone trying to build something like Facebook or Twitter. The roadblocks are just a lot higher.

A lot of times when there’s innovation in financials, it usually comes from within the banking system itself. So it is some guy who has been there for 10 years who sees something and acts on it. But it’s almost never from guys on the outside that think of something one day while sitting in their college classroom.

I would argue that there’s simply a smaller number of brains devoted to thinking about new ideas in banking and it’s mostly limited to people who are already in the financial world because it is within their competence.

What about innovative companies within banking?

There’s definitely people like Dick Kovacevich of Wells Fargo who talks about cross selling at Wells Fargo. There are people who argue that it doesn’t work but to him it’s like the Holy Grail. I’d argue to some degree it has worked because Wells Fargo probably has the best funding out there. I don’t have much experience with their branches since I’m on the east coast but we’ll see how things go with this Wachovia integration.

One thing that a lot of value guys got wrong is that they focus too much on qualitative factors like culture and things on the surface of the business model too much. They focus so much on the positives that they aren’t looking at the risks looming. When you’re sitting there analyzing tech companies, a lot of tech companies have good balance sheets. You’re not trained to look at balance sheet risk. David Einhorn did better on financials than other guys, because they set themselves up to look more at downside. Tom Brown focused too much on culture / qualitative factors and didn’t consider the macro/quantitative reasons that could destroy a bank.

What are you reading right now?

I’m reading Just What I Said by Carrol Baum, a Bloomberg Economics columnist. It’s pretty basic. One thing I learned about banks is that macro matters so much more than you think with banks. You’re almost a macro investor, so on that note I’m also reading Alchemy of Finance by George Soros.

One more basic/beginners book that I really like is Peter Lynch’s One Up Wall Street, that was a book that had a big impact on how I looked at investing when I was younger.

Thank you very much for giving your time for this interview. I know that my readers are going to enjoy it.

I think that this person will be great for an interview, but I thought it might be even better to get questions from some of you guys. Typically, you’ll see value investors shy away from analyzing financials because of the complexity involved. This guy does it day in day out, so it might be the perfect time to get some questions answered.

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Oak Tree Capital: Memos from our Chairman 1990 – 2009 (PDF)
Source: Oaktree Capital