NEW YORK (AP) — It’s an old idea with a new twist: Banking is
about the return on your money, and the return of your money.

Dave Ellison, chief investment officer of The FBR Equity Funds,
remembers hearing it early in his career. “It’s probably one of the
things that’s most important to remember,” he says, “and now we’re
all working on the ‘of’ part and it’s not working out so well.”

Ellison, who has specialized in financial stocks since 1985, is
the portfolio manager of FBR Small Cap Financial Fund (FBRSX) and
FBR Large Cap Financial Fund (FBRFX). He says banks are still
paying the price for lowering their lending standards during the
housing boom.

He shared his thoughts on financial services companies in a
recent interview with The Associated Press.

Q: We’re seeing a mix of positive and negative signs regarding
the economic recovery. Where’s your head at in terms of the big
picture?

A: My head is drooped. If you look at the big picture you can
find many good things and many bad things. Of course now it seems
like there are more bad than there are good, because the economy
has seemed like it was going up at a good rate, now it’s
slowed.

Housing sales boomed, and then they leveled off. Car sales
boomed, and then they leveled off. Unemployment hasn’t gotten
better. So the improvement has slowed to a point where it’s almost
unnoticeable now.

I think underneath it all if you look at the companies, talk to
the companies, there’s a tremendous amount of work being done.
They’re grinding through foreclosures, reorganizing or resetting
the loan policies.

The crisis hit, and so I tend to say, “let’s get into the mud.”
Let’s see what’s going on, and let’s buy the companies that are
working through the issues with the appropriate speed and the
appropriate safety and soundness. And if the economy does stay the
same, these companies will get a little better because they’re
working through their troubles. If the economy gets worse they’re
probably in better shape because they’ve started to heal.

Q: What should an average investor do?

A: There are times you need to listen to what people are saying
and times you need to watch what people are doing. And this is a
time you have to watch what people are doing — because if you
listen, it’s not a happy time.

My advice would be to find a manager who is experienced, who has
a track record, and stay with that. I wouldn’t try to buy one
financial stock or two financial stocks. You need to take the group
hug approach. Because there are many things that are wrong — many
types of loans that are bad, many things that regulators are trying
to do. But this also means there are many ways to make money in
this recovery.

Q: You manage both a small-cap and a large-cap financial fund.
What are the key distinctions between them?

A: The small cap fund is more complicated because there are
different types of companies. The larger financial companies have
been aided more thoroughly and more significantly by the
government, and that has helped them to be ahead of the little
guys.

They also have a lot of non-loan related income, such as
investment banking, sales and trading. You know JP Morgan may make
half of its money on lending money, while the little guys make 100
percent of their money on lending money. So the larger banks are
able to use the other 50 percent to mark those loans down sooner
and get back to normalcy. Which is why you see the bigger companies
have higher valuations. You look at Wells Fargo, JP Morgan, they’re
all trading well above book value. And you don’t see that with the
smaller guys because they haven’t had the time to recover yet.

Q: How do you categorize the companies in the small-cap
fund?

A: I look at the smaller groups as sort of four buckets, and
they aren’t necessarily mutually exclusive. You have those that are
well run, that haven’t had a lot of troubles and are now feeding on
the FDIC’s yard sale. They’re buying their troubled neighbors for
very little.

The second bucket would be those who have had credit issues that
are significant that they’re working through. And the valuations
are such that if you can see your way clear to the end of the
ditch, the stock has a lot of upside because earnings have a lot of
upside.

The third group would be the second group in worse shape. Now
you’re taking more risk on regulatory changes, so they’re more
risky but then the upside becomes very large.

And then the fourth group would be those that are tangentially
related, the homebuilders, the real estate investment trusts, the
property insurers, the commercial real estate brokers — that kind
of stuff.

Q: With so many small banks failing in the last few years, what
lessons did you learn?

A: The overriding lesson is that there are four things that
drive the industry. It’s credit, interest rates, regulatory changes
and accounting changes. And they drive profitability, drive
sustainability, drive the risk level, etc.

But the thing that really creates a loss of wealth on a
permanent basis, or allows you to recover wealth, is credit, the
cycle of credit. It’s not rates, it’s not the other three.

Putting it simply, when credit starts to go bad, get out. When
credit starts to improve, get back in.

Q: So interest rates aren’t the most essential element?

A: Everyone always worries about rates, but that’s been the one
thing that’s good. At the moment, I think rates are too low. I
think the biggest mistake was driving the rates too low.

To keep the math simple, if you’ve got a million dollars in the
bank and you’re earning 1 percent, that’s $10,000. If rates are 3
percent then you’re making $30,000, plus social security and maybe
some other money — so it’s possible to earn a living. But with such
low rates it’s as if I’m earning nothing. So it’s forcing people
either to save more or spend less. At the same time the government
is encouraging us to spend, saying they want us to go out and buy a
car.

But people say “I can’t” because they don’t want to eat into
principal. Because if I eat into principal and end up with no money
in 10 years, “Are you going to come and bail me out?” I don’t think
so.

And everybody can’t live in a trailer park 100 miles south of
Orlando. There’s just not enough land for that.