Blackwall Partners 2011 Outlook January 20, 2011

“No matter how we arrive at the latest financial conclusion,

we always seem to be preparing ourselves for the last thing that happened…”

- Peter Lynch

A New “Golden Age” for U.S. Financials Blackwall Partners believes that the financial crisis ended some time ago and we are entering a new “golden age” for financial equities similar to the post Savings & Loan Crisis (“SLC”) approximately twenty years ago. The recent crisis was grossly exaggerated via a number of contributing factors, which position the current recovery to be perhaps even more powerful than the recovery experienced in the nineties. The implementation of new accounting rules (“mark-to-market”) in 2007-2008 resulted in an up-front over-stating of the credit problems in this cycle, which has resulted in record excess capital and reserve builds. These excessive capital stores will have to be unwound and redeployed in the coming years, ushering-in the most aggressive capital management strategies that U.S. banks have ever deployed. Investors will be the direct beneficiaries.

Financials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisis

Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500

Financials Soared 900% off of Last Credit Crisis

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November 1990 - April 1998

NASDAQ Bank Index S&P 500

Source: Thompson Reuters

Politically speaking, this credit cycle was also exacerbated by a populist outcry (ironically) against the huge success of the Troubled Asset Relief Program (“TARP”). This misinformed outcry prompted a politically motivated legislative reaction which has created a steady overhang in valuations. However, the new rules are vague and the regulatory power has shifted away from government agencies towards the independent Federal Reserve. The Fed, a pro-growth and pro-bank regulator, will implement the new rules far more favorably for financial stock investors than the current deeply depressed market valuations would have one believe. We recognize this as the best investment opportunity in financial and banking stocks in generations. In our opinion, this is no less of an opportunity since the days of the bargains in the era of the Resolution Trust Corporation (“RTC”). Blackwall Partners believes a period of rapid internal capital generation already is well underway across the financial services industry. We even see a respite to the politically driven ‘bank bashing’, which has held the sector at as much as a 70% discount to the broader stock market. At the very least, the mid-term elections have delivered a more favorable political climate for the group - gridlock. We recognize a similar dynamic in financial stocks today to what we witnessed in the sector from 1992 to 1998 coming out of the SLC. This post SLC period was a time of stabilization, recapitalization and re-growth in financial industry net credit revenue as well as in its earnings and book values. This drove a substantial rally in the sector (See Chart- page left). In the nineties, Salomon Brothers’ (my alma mater) senior money center banking analyst Tom Hanley used to call it “bank stock

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heaven.” It was a period of benign credit and generally favorable monetary policy coupled with excess liquidity and capital which was deployed at a steadily increasing pace. Most Mondays, we awoke to a slew of bank mergers whose premiums seemed to endlessly rise throughout this era. The table is set similarly today and we suspect that the next decade should be a repeat of “bank stock heaven”. "There's so much cash in some of the banks in the United States that they're actually selling at below their cash value per share. For example, Citigroup, Bank of America, Bank of New York, State Street, Northern Trust. They all sell at below their cash per share. What that means is these companies now have a tremendous amount of liquidity which ultimately can be put to use to generate further earnings growth. And I think for the next 2-3 years what you will see, is that banks will actually increase their earnings at about a 20% rate per year, which will be far faster than what you're going to see from the industrial averages. Banks have more capital as a percentage of assets since anytime since 1934."

-veteran banking analyst Dick Bove, 2011

The table below speaks volumes for how inexpensive valuations are currently… By our estimates, leading financial firms are priced at <3x cash flow; 30% below equity plus adjusted loan loss reserves and yes – less than net cash-on-hand. This, of course, is absurd.

Select Valuations

Price

Book Value

Adj Book1

PTPP2

Price/AdjBook

Price/ PTPP

JP Morgan

$42

$41

$51

$13

82%

3.2x

Wells Fargo 31 24 30 8 100 3.7

Citigroup 5 7 8 2 63 2.5

PNC Fin. 61 63 71 17 86 3.6

BankofAmerica 13 27 31 6 42 2.2

Capital One 42 57 66 16 64 2.6

Regions Fin. 7 11 13 3 54 2.8

Average 70% 2.9x

1Stated book value plus loan loss reserve drawn down to 1% of loans with excess taxed at 40% tax rate through 2012 estimated earnings

2Pre-tax, pre-provision net earnings at normalized credit loss provision rate

In large part, we believe many portfolio managers struggle with financial firm analysis and accounting as it differs from all other sectors, contributing to the perhaps not so obvious under valuation. Lack

of understanding also creates fear and hesitancy, explaining the lowest relative exposure to financials in decades across most portfolios. Extremely low valuations also place financials at their lowest weighting in the S&P 500 in nearly forty years. At the market peak in 2007, financials represented as much as 1/3 of the value of the S&P 500. Today, it’s closer to half that due to under ownership. Based on our analysis, even the highest quality financial stocks trade below 5x cash flow (with some below 3x) while the broader market simultaneously trades at 11x cash flow representing an astonishingly low 30% relative valuation for financials versus the historic norm ranging from 60% to 80%. These depressed multiples in the financials are despite tremendous improvement in credit (the main driver of earnings recovery) and earnings visibility; this is in addition to the industry sitting atop record levels of both liquidity and capital, the driver of earnings acceleration.

Estimated Earnings Growth

Sector

4Q10 2010 2011

Consumer Discretionary 13% 44% 15%

Consumer Staples 2% 6% 11%

Energy 25% 49% 14%

Financials >200% 158% 37% Health Care 5% 10% 7%

Industrials 10% 24% 18%

REITs 7% 6% 1%

Technology 13% 41% 10%

Telecom 13% 0% 13%

Utilities -3% 4% -1%

S&P 5003 12% 28% 9%

3Excludes financials Source: Thompson Reuters

As the table outlines, the financials have the strongest prospects for earnings growth over the next few years. Yet, this has gone broadly unrecognized.

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Regime Change was Agonizing, but Now Largely Neutralized for Financials Discounting the change in administrations from President Bush to President Obama was challenging for financials in 2009 and 2010. In late 2008, we entered into a period of unprecedented anti-capitalist sentiment emanating from Washington and financial firms found themselves an easy target for populist expediency. One would have anticipated a less than friendly attitude towards bankers and business in general from the new administration, but the unbridled and incessant attacks on bankers made Mr. Smith Goes to

Washington seem like a light hearted comedy. Capitol Hill turned into a “Kabuki theater” including dozens of Congressional hearings which had but one obvious goal – “paint” all bankers as villains for political gain.

The real victim of this attack on the financiers was the economy. Nevertheless, hope springs eternal and the recent mid-term elections set a new tone, marking an end to the “bank bashing bonanza” of late 2008-2010. Political winds, however uncomfortable they are to endure at times; they do

matter and they have shifted more positively for bank stock investors. In contrast to the last congress and current President, the apolitical Federal Reserve has promoted a pro economic growth agenda. Their monetary policy has laid the foundation for a more sustained economic recovery now that political headwinds have subsided. The financials clearly stand to benefit. Note the very steep shape of the yield curve and the low cost of capital via interest rates (See Charts- bottom left).

Credit Improvement Opens-up Capital and Tightens Earnings Confidence; M2M Unwind is Dramatic

As previously mentioned, mark-to-market (“M2M”) accounting was integral in the manifestation of this most recent financial crisis and is key to understanding why credit improvements are coming far faster than many had expected. We published on this topic aggressively throughout 2007 and 2008. These accounting rules grossly over stated the loss potential across most credit verticals, including serious problems in residential real estate. "It's fascinating that the not-so-tiny matter of a $30 billion loss comes down to accounting arcana, but it does."

-Wall Street Journal, May 2009

Source: William Isaac, Chairman LECG Global Financial Services

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There never was $3 trillion or $4 trillion in losses via abstracts like synthetic credit default swaps as prognosticated by most banking analysts and economists. They were a figment of momentum trading in credit derivatives and never materialized in the cash (real) market. The prior chart (above) originally was provided in testimony by former FDIC Chairman Bill Isaac (FDIC Chairman during the SLC), who testified to the House Financial Services Committee on the inaccuracy and danger of M2M. It highlights the gross overstatement of losses by M2M. The overstatement was tenfold!

Nonperforming Loans4

4Federal Reserve Bank of St. Louis study of all U.S. commercial banks; Loans past due 90 days plus nonaccrual loans to total loans. Source: Federal Reserve Bank of St. Louis

This wasn’t even the S&L Crisis - While securitized loans across all credit types were mauled by M2M inaccuracies, banks with more traditional “portfolio” lending or “whole loan” accounting also were trampled inefficiently as the credit panic overshot the reality. The chart above via the Federal Reserve Bank of St. Louis illustrates the reality after the peak in problem loans. This most recent credit cycle witnessed peak nonperforming loans 48% below that which topped the SLC. So, it was an unnecessary panic in 2007-2009. The resulting excessive build-up of capital and reserves now is a benefit to bank stock investors.

As the data from the Federal Deposit Insurance Corporation (FDIC) below suggests, cumulative losses from 2008 to date are running ONLY about $500 billion and have begun to significantly decline in 2010. A fraction of what was projected at the height of the panic.

The conventional “wisdom” in 2008 called for banks to be unprofitable through 2012…this mantra was ubiquitous and also it was patently wrong. The insured banking universe returned to profitability as early as the first quarter of 2009 and has seen profit recovery largely improve with each subsequent quarter. Clearly, M2M and the conclusions drawn from it were somewhere between deeply “flawed” and ridiculous. The problem was not with the desire to mark loans and securities backed by loans to “like” securities. We tend to agree with such logic as long as the credits were also either impaired or their holding period sufficiently short term. Rather, it was the use of inefficiently priced derivatives like credit default swaps as “proxies” that caused the accounting to so grossly miss the mark on credit. Implementing derivatives as proxies were the main driver of this recent panic. This inefficiency now is materially positive for investors to take advantage of, yet most have no idea what really happened and financial stocks remain wildly under-valued and under-owned as a result.

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The chart below illustrates the excessive levels of capital and reserve builds generated as a function of M2M.

Common Tier 1 Capital (“CT1”) is Inordinately High for U.S. Banks

B3M5 = Basel III Minimum risk-based capital standard expected to be implemented by a global regulators roundtable known as the Basel Committee on Banking Supervision. Source: Company reports; Blackwall Partners LLC estimates

US banks hold capital levels that materially exceed even the future expected higher minimums for “well capitalized” institutions (See above: B3M5) that international bank regulators are considering in the Basel III accords. A similar build-up of excess capital had followed the SLC in the early 1990’s. This resulted in a decade long period of heightened dividend payouts, stock repurchases and a fervent merger and acquisition boom. By comparison, the M2M blunder has created a much larger surplus of excess capital and reserves than the SLC. Therefore, we believe an even more significant period of shareholder friendly capital management from U.S. financial firms is ahead; even more so than the “bank stock heaven” days of the post SLC period.

6Morgan Stanley bank research coverage universe; average net-charge-offs to average loans Source: Morgan Stanley & Company

We anticipate material improvement in credit in 2011 and near zero credit costs in 2012. We fully expect to see banks and other financial firms continue to “release” excess loan loss reserves back into their earnings at an accelerated pace in 2011-2014. In addition to providing significant earnings re-acceleration, this makes substantial capital available for dividends, stock buy-backs and acquisitions, which will drive-up valuation multiples. The combination of a strong rise in earnings aside multiple expansion is the same recipe that drove the material outperformance for financials in the post SLC period.

B3M5

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Source: Keefe, Bruyette & Woods; Blackwall Partners LLC

The chart above tracks reported earnings (GAAP) versus pre-tax, pre-provision (“PTPP”) or “free cash flow.” The gap between the black and blue lines illustrates the reality of the “non-cash hole” that M2M blew through the earnings (and capital) of financial firms in 2007-2008 and illustrates the inevitable earnings reacceleration that we predict. This is what the vast majority of investors and portfolio managers are missing… the recovery in reported earnings will be swift and epic…these lines will converge!

Provision Reduction Impact Significant

Our Per Share Impact

Street 2012e EPS

Impact %

C $0.30 $0.47 64%

STI 1.20 2.79 64%

PNC 3.10 8.67 36%

JPM 1.75 5.09 35%

BAC 0.70 2.41 29%

RF 0.17 0.71 24%

WFC 0.95 3.93 24%

KEY 0.15 0.70 21% Median 33%

Source: Thomson Reuters; Blackwall Partners LLC estimates

Further depicting this from a bottom-up perspective, please note the table above. Our own analysis suggests that the impact on just loan loss provision expense abatement adds 21% to 64% to 2012 earnings for leading banks. Many will be forced (by tax law) to provide no provisions by 2012, as they no longer will be able to justify their reserves to their auditors. Any acceleration in earnings owed to an improved economy and thus loan growth (net interest income) and fee income growth by 2012 is additional earnings power not currently baked-in financial stock valuations. Yet, we expect banks to again grow their balance sheets by 2012.

Extraordinary Popular Delusions & the Madness of Crowds…

…is a book written about popular folly by the renowned Scottish writer and journalist Charles Mackay. The text was first published in 1841 and it chronicles abstract responses by humans under either intense despair and/or intense euphoria. The subjects of Mackay's debunking include economic

bubbles, alchemy, crusades, witch-hunts, prophecies and fortune-telling, as well as trivial subjects such as the shape of the beards of the day. Purportedly, these factors influenced politics and even religion “in the day”. Given recent events, the book is not outdated despite being quite old and worth a revisit by any investor.

iPad or Kindle Alert

We were fortunate enough to have been invited to a global central banking summit co-hosted by the Federal Reserve and the Bank of England last year. The current President of The Federal Reserve Bank of Dallas’ Richard Fisher lauded Mackay’s text. Fisher referred to it as a modern day reminder of all things “empirically unpredictable, erstwhile inexplicable and politically expedient by men of sound judgment and good intentions” (and others neither too sound nor too good). We agreed with President Fisher. I had long since forgotten about this book (since college economics) and I would recommend one download a copy onto their Kindle or iPad.

What the US (and global) economy and especially our financial system have endured over the past few years would make a very good chapter addition to Mackay’s ageless text. The growing scores of books that we have examined about the ‘Financial Crisis’ are devoid of both

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conclusive fact and clever cognizance alike. None come anywhere close to Mackay’s brilliance.

“Recency Bias” - The reason for referencing MacKay’s work is that we believe currently overly depressed valuations in financial stocks are a result of what psychologists refer to as “recency bias.” This is the tendency for people to myopically obsess or focus on what has happened lately when evaluating something instead of empirical and/or historical precepts. For example, it is not rational for banks with improving credit and strengthening balance sheets to trade at or below book value or at or below cash-on-hand. Yet, many currently do. Many investors today weight very short term performance of stocks much more heavily than they do fundamentals and valuations. This is causing what we believe to be one of the widest dislocations in the financial sector in decades, perhaps since the Great Depression.

We have posed the challenge of updating Mackay’s master work to our friend and special advisor former President of the Federal Reserve Bank of Dallas and Federal Open Market Committee member, Bob McTeer. Bob’s “My Mark-To-Market Nightmare” blog is a must read and certainly conclusive enough for us. One can follow Bob at www.bobmcteer.com.

Though quite biased we admit, we find Bob’s insight on the economy; banking and the Federal Reserve’s actions indispensible. Bob blogs in plain English (not Fed ‘E’s’ so we all can follow along) and he is short and to the point (brevity being among the greatest of virtues). Once referred to as the Fed’s “Maverick”, Bob was well out in front of the M2M issue and he helped shape current legislative initiatives to correct the flaws of M2M. These changes will make market-based accounting work much more in-step with real world banking practices and thus more realistic outcomes. Hopefully, a repeat of the M2M induced panic will be avoided in the future as a result.

In addition, we also would recommend downloading “Senseless Panic”, a book penned in 2010 by our friend and former FDIC Chairman Bill Isaac. We found Bill’s book to be the only one we

have seen which accurately ties M2M to the depth of the financial crisis. Bill explains this most recent financial crisis in comparison to the SLC which he actually had to manage as head of the agency.

We have no economic interest in Bill’s book, so please take our recommendation as “good faith”. If you wish to understand what happened in this most recent financial crisis; his book is the very best on this topic in our view.

iPad or Kindle Alert

Unfortunately Mackay is not with us today to take advantage of the extravagant price dislocations provided by a maddening crowd fueled by M2M.

One major Wall Street firm’s regional banking analyst recently opined – “a new paradigm of price-to-tangible book value multiples [is likely]. Consequently, we believe more normal multiples for the sector may range well below the historical multiple.” First, no stocks trade on book value for very long. They trade on cash flow. And secondly, there has never been a new paradigm that we have witnessed “stick” either. We suspect the analyst just has a bad case of the “recency bias”. It can be “catching”.

Considering Mackay’s observations on human behavior and economic outcome, it is not surprising

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that few modern investors have yet to take advantage of the current lunacy in financial stock valuations. This is good for us of course.

Learn to Embrace Low Valuation Volatility…

While many market pundits have argued that markets again are fully priced; we would argue that from a bottom-up perspective many equities remain in a delusional price dislocation funk (bank stocks at or below cash per share e.g.). A “funk” like a “mania” creates a vacuum of “strong hands” where ‘fast money’ can push prices around with relative ease. This can create a self-fulfilling prophesy for a period of time which is not based in fundamental reality. Extreme volatility is the manifestation of this of course. But not all volatility is the same and one must always be cautious what one wishes for… While the current volatility of equities, especially financials, has driven away investors or has altered the strategies for investing in them to tilt more towards less return in exchange for less volatility, we view the situation far more opportunistically. Volatility does not disrupt our investment strategy of going long good companies whose shares are uncharacteristically cheap and to short the expensive and unsustainable. Rather, it enhances it, but at the expense of more movement in interim portfolio returns than normal. However, we view the practice of altering one’s strategy merely to avert volatility as being short sighted. Especially when return potentials are as considerably large as is the case with such low valuations today.

While capturing the inefficiency of excess volatility isn’t easy, we note stalwart Wells Fargo (WFC) in the chart (bottom left) courtesy of Hedgeye. This is one of the most well managed and profitable banks in the world. Yet, its shares, as Hedgeye’s statistical wonks astutely pointed out to us, are traded as though Wells is as risky as a high yield bond like some third world banana republic’s sovereign debt. This doesn’t make sense to pure fundamental stock pickers like us. Wells Fargo is not Kazakhstan. Why wouldn’t we (or any investor) want to take advantage of such a fundamental dislocation? In this case, volatility is a gift.

Volatility does not disrupt the reality of fundamentals in the long-term of course. It’s a short term problem. So, we find it perplexing that low valuation volatility (recovery from a deep bear market) has carried such negative sentiment and has altered asset allocations and driven the ultra-low volatility portfolio construction fad. Though, this also is good for us. It’s the high valuation markets with heightened volatility (e.g. 1999) that would cause us to be cautious. To others however, high valuation volatility often spurs greed and overconfidence. Low valuation volatility simply makes possible the lowering of our cost basis.

The recent aversion to volatility has shown-up in clear performance dislocations like banks versus Real Estate Investment Trusts (REITs). The two groups generally are well correlated to one another as both share a common underlying asset – real estate. Yet, as the charts on the following page

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suggest, REITs are materially outperforming financial stocks. We believe this is due to a risk aversion trade which is focused on current income. REITs have gotten “hot” being used as bond substitutes for equity fund managers amid a growing current income bubble.

REITs (ICF) v. Regional Banks (RKH) 2002-Present

Source: Chart Analytics

The preference to avoid volatility when it exists and to seek out volatility when it is nowhere to be found can only be attributed to the irony of the human psyche. We believe this is evidenced in the yield

hungry mob which has overtaken current investment strategy popularity. Despite REITs holding the same underlying collateral risks as banks and therefore having a high historic correlation to banks; the REIT industry’s ability to continue to pay dividends has attracted buyers and has thus bid up the sector. We view these current valuations as highly unattractive. The disconnect, of course, is due to the regulators having artificially and temporarily precluding too many banks from paying normal dividends. The

decoupling is a function of a short term investment strategy preference and is not fundamentally-driven. Financial firms actually have stronger fundamentals and cash flows and are in better position to return more capital to investors than REITs presently. However, this requires a little investor patience.

REITs (ICF) v. Regional Banks (RKH) Last 12 Months

Source: Chart Analytics

REITs have outperformed banks by approximately 100% since 2002 and by 30% over the past twelve months. Today, capitalization rates for REITs are at or near record lows. These levels were last seen pre-crisis during a period of intense buying by private equity firms. Currently, the spread over the ten year Treasury note is near zero (percent) as opposed to the historical yield spreads of 200 basis points. We believe that this yield spread disequilibrium is not sustainable and that many equity fund managers are simply attempting to avert volatility by “masking” their portfolios as virtual bond funds. We view them as being engrossed in a “crowded trade.” We suspect this trend could have a sharp reversal as the economy improves and interest rates begin to rise once again.

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The Case for Financials Out-Performing

Blackwall is quite bullish on the broader services sector, especially financial services. We are not just focused on the larger capitalization stocks either; it is approaching the time to reach back to include some of the smaller regional banks, financial technology and non-bank financial services companies. The risk-reward pendulum has begun to favor such a shift. We would point to a few bullet points which may alter your perspective… if you have been a subscriber to the consensus opinion that U.S. financials are in some sort of new paradigm “funk” and are thus destined to lag both the broader U.S. and global markets forever:

Source: Morgan Stanley & Company

• At the market peak of 2007, the S&P Financials Index traded at 2.2x book value and approximately 14x earnings. Historically speaking, these were not “rich” multiples. The peak in 1998 (post SLC rally) was in excess of 3x book and over 20x earnings. Today, U.S. financials are at or below stated book value (1x) for most names and when one adjusts for excessive capital and reserves as previously outlined; the multiples are well below book and in the low single digits on current “PTPP” or earnings power/cash flow.

To assume multiples are efficient today is empirically insupportable. By contrast, we anticipate a protracted period for the expansion of multiples and for such expansion off overly depressed levels currently to be a material driver of stock performance for the sector just as it did in the 1990’s coming out of the SLC. We actually think the chart (Morgan Stanley’s multiple expansion outlook for the sector) is very conservative by historical precepts and both current untapped earnings power and excess capital leverage in the sector.

• This most recent market crash caused a drop in the financial index by some 84% or the worst pummeling of any major index in history (the Internet collapse included). Thus explaining why confidence in the sector has caused its lag and historic low weighting in the S&P 500 (i.e. few own financials yet). The extremely low sector weightings in large funds alone suggests portfolio managers will need to more than double their current exposure to the group at some point.

• About three-fourths of that unheard of 84% decline in the financials came after the November 2008 election results. So, there was a significant political factor that played a role in the sector’s unprecedented decline. The recent 2010 mid-term elections should materially affect the negative momentum of the 2008 election for the financial industry.

• Today, the larger financial sector remains approximately 89% to 115% below a retracement to their 2007 high depending upon which index you track.

• By our calculations and estimations, with a return to a valuations peak of 2007, the sector would RISE some 230% based on

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current PTPP (cash flow); and a repeat of the post SLC multiples would mean a RISE of >400% when conservative growth in earnings and book values are fully discounted out over the next 5 years.

• Historically speaking, the fundamental underpinnings of the financial sector survivors get stronger and more profitable following every credit shake-out; this most recent crisis leaves the industry’s elite atop the largest stores of liquidity; capital and reserves in history (Bove says since 1934).

• So, the “best-in-class” financial firms now have more market share than ever and have more capital than at any other time in history. Yet, they are priced for some new paradigm which includes little or no premium to tangible book or cash-in-hand? This assumes banks have no “franchise value” whatsoever… (often expressed as a “deposit premium.”)

• The elites in this cycle were able to use the crisis, including TARP and FDIC loss guarantees to make highly accretive acquisitions at scales we have never seen before. All this accretion lies ahead for these companies. They are akin the Resolution Trust Corporation (“RTC”) auction buyers of yore. And they saw wild returns on invested capital as a refresher. We see it again only on a more concentrated and thus larger scale across a relatively small number of select institutions. These institutions just happened to be in great condition at the right moment in history for regulators to lean on them for help in cleaning-up the mess.

• On a more broad view, the amount of idle cash sitting on the sidelines of the economy is at or near record levels – approximately $10 trillion. Much of this is held by financial firms in one form or another and will spur new growth in lending as credit is where most excess liquidity gets deployed /

invested. And with cash earning very little these days, it will get reinvested. Banks and other financial intermediaries will benefit directly from credit expansion.

• This same type of combination of industry and economic leverage and multiple expansion is what led financials to rise 900% from the trough of the SLC.

Financials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisisFinancials soar from last banking crisis

Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500Bank Index vs. S&P 500

Financials Soared 900% off of Last Credit Crisis

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November 1990 - April 1998

NASDAQ Bank Index S&P 500

Source: Thompson Reuters

• How easy it is to forget history even as it repeats itself before our own eyes!

Even Better this Time This most recent financial crisis was handled quite differently than the SLC. TARP largely was designed to mop up the mess created by the confluence of ridiculously poor residential mortgage underwriting and the ill-advised application of derivatives as proxies for M2M. TARP successfully averted what would have been a sloppy and protracted clean-up in the style of the RTC strategy applied approximately twenty years earlier. Instead of inefficient asset auctions like the RTC, the Federal Reserve and the other bank regulators effectively auctioned off troubled banks in whole through TARP and smaller clean-ups of entire banks were handled via the FDIC implementing loss sharing agreements. This resulted in a far more efficient and expeditious clean-up effort which, as noted, provided enormous

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accretion to the banks that participated in these purchases. TARP or FDIC assisted acquisitions – we fully anticipate a significant merger boom to ensue within the financial sector when an economic recovery gets further substantiated and multiples start their ascendancy. The seeds of ascendance are already sown as the need to leverage record capital levels already is weighing on returns on capital. There is a small fraternity of best-in-class banks at the height of this most recent crisis that took down a king’s ransom in terms of fully accretive acquisitions. Thus, they are ahead of the curve. The largest deal of this type was WFC buying Wachovia with Tier 1 eligible TARP. By our estimation, Wells Fargo affectively doubled its assets and free cash flow with the Wachovia acquisition. However, it only incurred a 23% final share count dilution via the new capital raised to exit TARP as part of the Fed’s Supervisory Capital Assessment Program (“SCAP”). So, WFC doubled its cash flow for only a 23% increase in shares…wildly accretive! The second largest deal was JP Morgan (JPM) with its purchase of Washington Mutual. This too had a very favorable accretion as in the Wells-Wachovia merger. Other notably accretive larger TARP deals included PNC Financial (PNC) absorbing National City; Bank of America acquiring Merrill Lynch; US Bancorp (USB) for Downey Financial and Capital One (COF) taking-down Chevy Chase. All were arranged by the banking regulators and all materially accretive to the acquiring banks. Smaller regional banks taking advantage of TARP included the likes of First Niagara (FNFG), which doubled its size at huge leverage to the capital infusion required to absorb such growth. Smaller, non-TARP deals were orchestrated by the FDIC. This was done whereby the FDIC sold the troubled bank by offering credit guarantees on acquired assets. One which we found of particular interest was East West Bancorp (EWBC). The Pasadena-based EWBC had its share of problem mortgages in the fallout in California, but they took steps to

shore-up their balance sheet in early 2008. They took action before the credit crunch took hold and thus they were well positioned to buy-up their closest rivals, who were slower to react to the housing crisis. The FDIC loss sharing agreements guaranteed up to as much as 80%, so EWBC virtually doubled its size with very limited added capital-at-risk. It now is the largest Chinese American focused bank in the country. Survivors, Barely – while the accretion machines previously mentioned are obviously very attractive opportunities; both large multi-national and mid-tier regional banks in recovery are just as attractive from a risk-reward standpoint. In some cases, these are financials that we believe averted the crisis and have remained undervalued simply as a function of their near death experience. This particular play is more in-line with the type of strategy one would have employed quite successfully coming out of the SLC. “Survivors-barely” which have CAMEL rated (regulatory risk analysis) handsomely by our investment discipline include Citigroup (C); Bank of America (BAC) in the multi-national or complex bank holding company category. Also regional banks like Synovus Financial (SNV); Huntington Bancorp (HBAN); Regions Financial (RF) and Zions Bancorporation (ZION) also CAMEL well based on our proprietary fundamental scoring model. All are absurdly under-valued. Capital to burn return… C and BAC are unique situations which we have discussed in great detail in the past. Thanks to the overstatement of losses courtesy of M2M, one compelling aspect - displayed in the next chart – C and BAC are so over capitalized now that they could return to investors a substantial percentage of current market values. For example, we estimate BAC could return 85% and C 60%. Quite attractive for two companies trading at just net cash-on-hand!… One sell-side bank analyst recently opined “…much of the capital that has been raised has been chewed up by provision expense rather than used to position the industry for longer-term growth.” We couldn’t disagree more and we are not speculating. Bank

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accounting is pretty simple, yet often not understood. A bank provides to a loan loss reserve by expensing against the income statement, but the provision (expense) is not cash. It’s a non-cash accounting treatment used to divert retained earnings into a contra asset account known as a loan loss reserve. It is still “capital”. The accounting technique is meant to give the investor a more realistic view of capital assuming all of the reserve indeed is necessary, but for banks that survive a crisis, the reserve is never used-up and most often is excessive and must, in large part, be returned back to the standard capital account through retained earnings. This reversal is called a “reserve release’ and we already are seeing these take place in size across many financial firms as credit costs have peaked. This is why the chart below shows such substantial excess capital available to be returned to investors. It mimics the post SLC period only far greater in magnitude this cycle due to M2M inaccuracy in predicting real credit losses.

Potential Capital Returned to Investors as a

Percent of Market Value is HIGH

Source: Morgan Stanley & Company; Blackwall Partners LLC estimates

The following table (See: top right) is our own estimates regarding dividend payout ratios and current yields implied on 2012 payouts over a wide range of financial institutions. This is the result of the high volume of bank holding companies petitioning to reinstate their dividends and initiate large stock repurchase programs given their record excess capital. We expect the Federal Reserve to

initiate a SCAP-like test for the industry and then approve these capital management initiatives en

mass sooner rather than later in 2011.

Expected Dividend Payout Ratios & Implied Yields

Payout Ratio 2011e

Payout ratio 2012e

Dividend Yield 2012e

AXP

23%

25%

3.0%

BAC 10% 25% 5.5% BBT 33% 35% 4.3% BK 28% 30% 4.0% C 5% 25% 4.0% FITB 15% 25% 3.5% JPM 15% 30% 4.5% KEY 15% 33% 3.5% PNC 25% 33% 5.5% RF 15% 33% 4.5% STI 15% 33% 3.7% USB 30% 35% 4.5% WFC 20% 35% 5.5%

Median

30%

4.5% Source: Blackwall Partners LLC estimates

As touched upon earlier, from a relative valuation perspective, bank holding company stocks carry a much higher dividend yield than like Treasury (10 Year T-Note yields under 3%) and REITs (also sub 3% yields). As the larger market begins to recognize this rationally, a rotation out of over-bought bonds and yield-oriented equities (REITs) and into banks should ensue.

Regional Banks (RKH) v. S&P 500 Last 5 Years

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Source: Chart Analytics

The SB (“survivors-barely”) regionals all have a similar attribute – dirt cheap valuations relative to primary capital (equity plus reserves); improving credit trends and balance sheet rebuilds behind them. The regional SB’s either move a lot higher or they will be acquired. Meanwhile, each can return substantial capital to patient investors either through dividends or stock repurchases sooner rather than later. Yield Spread Power Players – credit cards are one of the most attractive areas because the yields on assets remain very high, while funding costs remain very low and credit costs have begun to fall. Despite persistent high unemployment, credit quality has continued to improve on credit card portfolios quarter in and quarter out now for over a year. The missing element is portfolio growth as the consumer has been steadily deleveraging. This has kept the public market valuations very low. However, credit card issuers have rate flexibility and thus will benefit from a recovering economy by offsetting rising funding costs with higher portfolio yields. Inevitably, the consumer will return to expanding their borrowing and the credit card companies have little or no interest rate risk in what will most likely be a rising rate environment. Capital One (COF), American Express (AXP) and Alliance Data Systems (ADS) are elite names in the card space and each is cranking out highly attractive free cash flow amid the yield spread arbitrage. C, BAC and JPM also have large credit

card portfolios and likewise are experiencing the same economic advantages of wide spreads and declining credit costs. Rising Tides Lift Some Boats More – as asset values and transaction volumes steadily improve from everything from the stock market, to private equity, to consumer spending; we believe the purveyors of custody and transaction services will tend to shine brightly. In mergers and acquisitions, Goldman Sachs (GS) and Lazard (LAZ) are the best-in-class. As record cash hoards that we have mentioned get put back to work, these two branded investment bankers will rake-in the fees. In asset custody, we are hard pressed to find better values than the trust banks like State Street (STT) and Bank of New York Mellon (BK). As two of the three largest securities custodians in the world, rising asset prices just means rising fees for them. And because they are banks, they are a lot cheaper than pure asset price plays like mutual fund companies. STT and NTRS trade at less than half the valuation of say – T. Rowe Price Group (TROW). In fact, we find the mutual fund company stocks good hedges against the rest of the asset price and transaction velocity rising tide related financials at these disjunctive valuations. The same is true of the world’s most formidable bourse – NYSE-Euronext (NXT) and most traded – Nasdaq OMX Group (NDAQ). Along with an improving economy and rising asset values, trading volumes also will rise. And while one must remain alert to the poorly thought out legislation levied on the consumer transaction processing industry by the financial regulatory reform law last year – namely the “Durbin Amendment.” The global consumer spending trends greatly favor brands like Visa (V) and MasterCard (MA). They are direct beneficiaries of increased electronic payments globally; direct growth from emerging market consumers and a gradual return to domestic spending growth normalcy. We suspect the current interpretation of the law favoring merchants over acquirers on so-called “interchange fees” at the point-of-sale using debit and credit cards will moderate under Federal Reserve oversight. The

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stocks have over discounted a worst case scenario in our view.

Financial Regulatory Reform Has Less Bite than Advertised! Regarding all of the drama surrounding the “sound bite” amendments at the core of financial regulatory reform; we expect less rather than more in terms of impact on sector revenue. These include – the “non-definable” (by its own namesake) “Volcker Rule”, its politically expedient cousin “the Blanche Lincoln amendment”, the potpourri of “audit the Fed amendments”, the debit card interchange fees (that supposedly caused the housing bubble) etc. Some of these “populist” reforms may even be attacked by sea-changes in the Congress as they increasingly are seen more accurately as anti-economic growth. Ultimately, we would anticipate as each of these “reforms” will fall under the full purview of the Federal Reserve for final interpretation and implementation. Consequently, they will be implemented pragmatically and the concerns about them will end with an anti-climactic whimper. And if we’re wrong, then financial firms will just charge all of us more for some other service. Never underestimate Wall Street’s ability to reinvent itself. The great compromise/resolution in the financial regulatory rules overhaul of 2010 is that the appropriate regulator got more power – The Federal Reserve. The independent Fed has no political agenda; only an economic one. Government acquiescing to the Federal Reserve is a good thing. At the heart of the legislation is a de facto need for an update to the Federal Reserve Act 13-3 (“FRA 13-3”) and the Bank Holding Company Act of 1956 (“BHC Act”). This reform is necessary and a positive change as most of the failures of the last several financial crises have been linked to weak government regulators and poor congressional oversight. It’s never publically noted, but the Fed has never lost money on a Discount Window loan in its history. Granted, one can make the argument that we are totally biased (former Fed bank regulator),

but they are the best in the business and the true independence of the Federal Reserve is a big part of what makes the “meat” of this reform actually quite positive for the economy and the financial industry. “Too Big To Fail” is resolved by updating both of these laws governing Federal Reserve regulatory oversight. Updating the BHC Act to expand the Fed’s regulatory purview to include the “shadow banking” industry solves for both the next 30 to 1 levered Wall Street “wire house” catastrophe and the next AIG. Our preference would be for the Fed to also assume oversight authority regarding Fannie Mae (FNMA) and Freddie Mac (FMCC). However, we suspect that this will remain conspicuously absent from conversation for the near term, but not forever. The more formalized use of FRA 13-3 (emergency lending powers) also helps to clarify for the market the circumstances which will surround an institutions access to the lender of last resort. Thus, the ability to be “unwound” in the next crisis, of which one certainly will come (generally about every 20 years or “generational”). Uncertainty over how these new massive reforms will be interpreted and implemented is what the market is trying to handicap. This is what has held financial stock valuations well below their historic norm relative to the broader market. Given our confidence in the Fed, we would identify this as “over-discounted.” Market participants should anticipate seeing the Fed apply these new rules with reason, ration and clarity of purpose – as the Fed’s mission is what best benefits a safe and sound banking system. A similar regulatory issue via the Federal Reserve occurred in 2009. The Fed was required by law to interpret and apply new credit card legislation known as the CARD Act. Initially, the market sold-off credit card issuers with the concern that the legislation was too harsh and thus would materially damage revenues. Only later did market participants recognize the fact that the Fed consciously employed pragmatic and “workable” rules for issuers that (are and were) effectively revenue neutral. The same will be true of the potential

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“comprehensive” financial reform. More “sound bite” than bite…

Mortgage “Put-Back” Risk Over Focused Upon There has been much consternation regarding risk to banks with large mortgage operations. The concern being the “put back” risk to loans securitized during the mortgage bubble between 2005 and 2007. This concern has caused many fund managers to remaining under-weighted financials and has given short sellers some “headline risk” to trade upon. BAC recently settled with the two dominating mortgage agencies – FNMA and FMCC for a relatively nominal $3 billion (considering the $trillions that the two GSE’s hold). We believe this settlement will be in-line with what will transpire via the feeding frenzy of class-action style suits over “private-label” (non-GSE-backed) securitizations. The BAC settlement was materially below the levels for which BAC had reserved and will not be an issue for them. We think this issue is being driven by a surplus of lawyers “trolling” for what they hope would be a quick settlement and politicians looking for some populist headlines. The actual risk to banking industry capital is nominal as most of these cases are specious. Even in the recent zany Massachusetts high court ruling against WFC and USB in single foreclosure cases, the court held - "There is no dispute that the mortgagors of the properties in question had defaulted on their obligations, and that the mortgaged properties were subject to foreclosure.” So, even the most liberal of potential court rulings has not threatened much in terms of precedence to the “put-back” mania lawsuits. We suspect that they will have very little traction. The GSE settlement itself covers a significant percentage of such claims in dollar terms. On balance, we believe that the “overhang” from this issue just creates attractive entry points in those commensurate stocks namely – JPM, BAC and WFC. The general lack of understanding and clarity

regarding proposed regulatory reforms and other issues like the “put-back” lawsuits merely procrastinate the financial sector’s profound and historical underinvestment by fund managers. This gives investors one more opportunity to get involved at these highly attractive valuations. Even sell-side banking analysts can’t seem to agree on the impact of these largely phantom concerns. (See: Chart: Top-Right)

Wide Range for Earnings Estimates is an Opportunity

Their opinions run the gamut on earnings estimates for financials. This makes little sense given the clear strong and stable growth in PTPP the industry is throwing-off for now eight consecutive quarters. PTPP (cash flow) is an easy guidepost to forward reported profits. The key fundamental drivers of earnings are evident – improving credit; rising fee revenue; and early signs of loan growth. Everything else is “noise” at this stage of what we see as a long, steady recovery in profits and higher returns on capital, aided by substantial capital management opportunities.

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Credit Cards: Early Indicator of Recovery

EOP Loans

Purchase Volume

% Change

NCOs

LLR

% Released

BAC $141 $54 2% 9% 10% 3%

JPM 136 80 7% 9% 10% 10%

C 111 66 - 9% 10% 0%

COF 61 27 4% 8% 8% 11%

AXP 57 179 14% 5% 8% 11%

DFS 45 24 5% 8% 8% 5% NCO – Net charge-offs as a % of average loans LLR – Loan loss reserve as a % of EOP loans Source: Company reports; Blackwall Partners LLC

The table above outlines major credit card portfolios at the end of the 3Q10. Unsecured credit is a very good “tell” on general economic and credit trends as credit cards are used both as a pure payment tool and credit tool by consumers. The data clearly suggest a very steady recovery is well underway. Consumer purchase volume, while still subdued, has turned up across all the major issuers and credit has not only stabilized, but has begun to improve. Now, credit issuers are “releasing” reserves, a sign they see the improvements in credit in their early stage delinquency trends. AXP’s higher purchase volume growth indicates that the recovery is top-down the income spectrum as one would expect in the earliest part of an economic recovery. In short, the data indicates what is taking shape is rather normal and should encourage investors.

Undoubtedly, it has been a bumpy ride for fundamental-based investing for the last number of years. That being said, we view the mid-term election cycle as a major turning point for financial stocks as at the very least it has reinstituted “grid-lock” in Washington. The epic untapped liquidity, capital and earnings power of the U.S. financial industry is in place coupled with still near historically low stock prices. This is pure fuel for financial stocks moving much higher and we suspect any headwinds are fading fast. We believe volatility should not be averted during such unusual and opportunistic times, but rather embraced for what it is – time to buy! Regards,

Michael P. Durante Managing Partner Blackwall Partners LLC