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Never Trust a Money Center Bank – And Never Buy One!

June 25, 2012 | About:

Joseph L Shaefer

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If I am doing right by our clients, subscribers, and online readers, it is my responsibility to advise what in my opinion should be avoided, as well as that which should be considered.

To wit: After repeated admonitions to all to avoid U.S. money center banks and brokerages, JPMorgan Chase (JPM) declared that, oh, whoops, we lost $2 billion of shareholders’ money on a “risk management” issue. The biggest risk is what takes place between the ears of big bank and brokerage senior leadership’s ears, and there is clearly no management of those functions whatsoever. Morgan would have you believe this is just a one-off event that could never happen again. Like Lucy and Charlie Brown with the annual football-kicking trick, somehow they get away with it!

All analysts and reporters, it seems, and too many investors as well, fall for it. The problem isn’t that they lost money. The problem is that they are playing with fire when they haven’t any clue how to tame it. Like kids who end up burning down a beautiful dry forest, they must actually believe at the time that they are in control and know what they are doing. The only alternative is that they know they don’t know what they are doing, which is too hard to believe because profits are huge, and they know the U.S. government will send the bill for restoration to the U.S. taxpayer. As that would be too cynical a perspective, I choose to believe they are simply stupid and not entirely venal. We all rationalize from time to time...

Maybe a better analogy than merely burning the forest down is kids digging around in the dirt and finding an unexploded land mine. It may be unarmed, the moisture and insects may have destroyed its ability to fire, or it may be a dud. I don’t want to be an alarmist and say that there must be another meltdown; I merely want to say that as long as the arrogant and cocksure play around with the potentially explosive, we continue to leave ourselves open to danger.

Back in 2003, when the kids were first digging in the dirt, the notional value of all derivatives outstanding, worldwide, was around $70 trillion. Apres le deluge in 2008, when the banks received a “strong letter of disapproval” (rather than a good caning, which is what they needed), notional values climbed to over $250 trillion. Boy, I guess that strong letter really slowed ‘em down.

I want to disbelieve the numbers in the chart below, from the United States Comptroller of the Currency, an independent bureau within the Treasury Department which exists to charter, regulate and supervise all national banks and federal branches and agencies of foreign banks in the U.S. Since they are not exactly some alarmist sky-is-falling blogger, I assume these guys know whereof they speak.

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I need to clarify that not all derivatives are bad. Listed options are also derivatives. Convertible bonds may be thought of as a type of derivative in that they represent a contract that must be met upon demand and exchanged into something else. One could even argue that life insurance policies are derivative in that a third party, the beneficiary, is involved and a known amount must be paid out when the derivative unwinds.

But the ones that are the most arcane and likely out-of-control derivatives which hold the greatest risk are often off-the-books and are “netted” against not-exactly-alike counter-hedges. (Think apples and oranges, only in this case the Imagineers who design these things put an orange rind around the apple so it looks like an orange. Hey, they’re both fruits, and it's profitable to fool oneself.)

The viability of the derivative markets is completely dependent upon what are called “netting benefits” by which the banks make themselves believe that their exposure to risk is almost perfectly balanced and almost perfectly hedged. Well, that’s what Bear Stearns and Lehman Brothers thought as well. The truth is, proven by 2008, netting benefits are illusory. They can disappear in a flash. When one big firm (let’s call it Lehman Brothers) makes a bet that proves to be, shall we say, unpropitious (that would be banker talk for a #*^$*& calamity), it typically creates a chain reaction that quickly reaches trillions of dollars. Such an event also actually occurred 10 years earlier, when we chose not to learn this lesson with the Long Term Capital Management fiasco.

Since we have not reined in the ability of banker/brokers to continue writing these contracts without regard to real capital structure, it is likely that similar events to Morgan’s recent $2 billion screw-up will occur or, worse, those similar to Long Term Capital Management (an ironic name for a moronic gamble by, among others, a couple Nobel Prize-winning economists — still think this is an easy business to figure out?) Or, devastatingly worse, Bear Stearns/Lehman/Step Right Up, Who’s Next?

Certainly, the rate of derivative growth continues unabated to this point. Notional values of derivatives now equal about 16 times our GDP, and growing at more than $100 billion per day. (The GDP itself is growing by only $41 billion per day.) While the Volcker Rules held the promise of removing some risk from derivatives (Paul Volcker, a former chairman of the Fed, a non-public banking regulator, clearly knows whereof he speaks), the bank and brokerage lobby was successful in watering it down significantly and delaying its implementation until the current crop of CEOs could buy their Gulfstreams and chateaux along the Loire, and hand the business over to someone else to take the fall. (Already, the bankers have been granted a July 2014 date to comply and have negotiated the ability to request three one-year extensions. Clearly, the regulators don’t understand the issue or have all their assets in a Swiss bank.)

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The larger issue here, of course, is the threat to the economic viability of the nation itself. To deal with that, I and our firm have acted more conservatively than those who have thrown caution to the wind, drank the Kool-Aid and said “Let’s party!” This has cost us the occasional client who wants to join in the fun but also gained us new clients who understand there be dragons here, whether they breathe fire this quarter or not. It is not encouraging that America seems content to churn out weapons of mass financial destruction rather than create meaningful jobs in meaningful manufacturing and service sectors. Again, we address that general issue by being wary of jumping in the deep end of the abyss.

To be more specific, avoid U.S. money center banks. They will always find a way to lose money for their shareholders and, via government largesse, for American taxpayers. There are plenty of other ways to, far more safely, participate in the economic strength of a nation, including our own. Buying other financials like the few well-run insurance companies that do not dally in the landmine-strewn fields of derivatives, or public mutual fund families or banks that remember what it is to be a banker.

One way we have chosen to participate in America’s economic future (a future hopefully untainted by another derivative blow-ups) is to buy smaller U.S. banks that serve their communities, states or regions. One we hold in our current portfolios is SIVBO, the SVB (Silicon Valley Bank) 7% preferred which we bought at $10 back in March of 2009 (currently $25.40) at which price it paid, and continues to pay, a stellar 17.5% per year in dividends.

The other more recent addition is First Trust NASDAQ ABA Community Bank (QABA.) This is an ETF that holds a very different mix of banks than the Citi, Goldman, BofA paper that most analysts recommend. It is a mirror of an index that selects the common stock of all NASDAQ-listed banks and thrifts or their holding companies that are designated as banks by the Industry Classification Benchmark but which excludes any of the 50 largest banks or thrifts and their holding companies based on asset size or any banks or thrifts classified as having an “international specialization” or a “credit-card specialization.”

In other words, this ETF owns banks — they take in deposits and make loans, mostly from local depositors to local businesses. They may not all be Bailey Savings and Loan (the bank in It’s a Wonderful Life), but they are a lot closer to that model than the wannabe pirates on Wall Street.

Each bank in the ETF must have a market capitalization of at least $200 million and a three-month average daily dollar trading volume of at least $500,000. In addition, they must meet certain operating history, solvency and financial statement requirements to remain eligible for inclusion in the index.

The index is rebalanced quarterly and reconstituted semi-annually. Its top 10 holdings may not be familiar to everyone, but if you live in one of the areas these banks serve, you probably know them well: BOK (the old Bank of Oklahoma) Financial. Zions Bancorporation, Commerce Bancshares, East West Bancorp, TFS Financial Corp, Signature Bank, our old favorite SVB Financial, Hancock Holding Company, Associated Banc-Corp and Fulton Financial.

On any general market malaise we will be buying more QABA. I want to invest in American entrepreneurs, not holding companies that don’t really know what they are that trade scraps of paper for teenies in nanoseconds. I’ll leave that to the Masters of the Universe wannabes. Let them juggle grenades. Me, I’ve thrown enough live grenades to know that I’d rather buy quality and watch it grow.

Disclosure: We are long SIVBO Pfd and QABA. We wouldn’t touch a U.S. money center bank unless it was selling for a dime on the dollar and even then we’d buy it only as a short-term trade.

The Fine Print: As Registered Investment Advisors, we see it as our responsibility to advise the following: we do not know your personal financial situation, so the information contained in this communiqué represents the opinions of the staff of Stanford Wealth Management, and should not be construed as personalized investment advice.

Past performance is no guarantee of future results, rather an obvious statement but clearly too often unheeded judging by the number of investors who buy the current #1 mutual fund only to watch it plummet next month.

We encourage you to do your own research on individual issues we recommend for your analysis to see if they might be of value in your own investing. We take our responsibility to proffer intelligent commentary seriously, but it should not be assumed that investing in any securities we are investing in will always be profitable. We do our best to get it right, and we "eat our own cooking," but we could be wrong, hence our full disclosure as to whether we own or are buying the investments we write about.


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