Will "Collateral Transformation" Hide Risk, Or Avoid It?

By Bill Edson - September 25, 2012 | Tickers: BAC, BCS, GS, JPM | 0 Comments

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“Creative response” is the frustrating tendency of businesses and other market participants to circumvent regulation. Financial companies in particular are adept at defying rules in ways that are not always foreseen by regulators, politicians, or investors.

Recently, many financial firms are implementing “collateral transformation” as a way to maneuver around tightening capital controls. Investors should realize that such tricks make these firms speculative investments. At the same time, this regulatory work-around allows banks to collect extra fees. Financial metrics were used to evaluate which of the firms which offer collateral transformation services are the best risk-reward propositions.

Transforming Collateral

Beginning in 2013, new rules created to help prevent another financial meltdown will force traders to post U.S. Treasury bonds and other select holdings as collateral. Unfortunately for traders, this change is taking place at a time when treasuries offer low yields and banks need capital to rebuild their balance sheets. At least seven banks have come up with a solution, and will allow customers to temporarily swap their lower risky securities that don't meet required standards for a loan of Treasuries, or similar holdings that qualify. This process, called 'collateral transformation,' has investors concerned that it will hide risk, rather than avoid it.

Some of the financial services companies that are planning on offering this service include: JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), State Street (STT), Goldman Sachs (NYSE: GS), Barclays (NYSE: BCS), and Bank of New York Mellon (BK). A spokeswoman for JPMorgan Chase stated that this service is a type of short-term secured lending subject to tight rules and fully transparent to regulators, and therefore will not hide risk.

The new rules that inspired this service were passed in response to the 2008 financial crisis. This is a funny development because much of the blame for this crisis has been attributed to derivatives contracts that were not backed by enough collateral. For example, these temporary treasury swaps are reminiscent of Lehman’s cash repos. 

Risk and Valuation Discounts

Many of these firms trade at significant discounts to the accounting value of their equity:

The price-to-book ratio shows Bank of America and Barclays to have the cheapest valuations while the price-to-free cash flow metric shows Barclays and JPMorgan to be the cheapest. JPMorgan and Bank of America are the cheapest by the price-to-earnings ratio. Of these firms, the greatest leverage as captured by the debt-to-equity ratio is borne by Barclays. Goldman Sachs is a distant runner-up for the extent of its debt financing.

Clearly, the market is not using the simple debt-to-equity metric to gauge risk for these firms. Other factors must be at play.

Discounted for the Wrong Reasons

Instead, the market is punishing JPMorgan and Barclays for “news” scandals that it should come to expect from these firms. There is no excuse for this implied naivety and the dramatic overreaction in stock prices.  In fact, the recent price drops in JPMorgan might be attractive buying opportunities for bank investors.

Months ago JPMorgan made public that its bungled trading could cost more than $7 billion. The controversy over trades correlates to the bank’s decrease in market value. The gigantic loss felt by JPMorgan is largely due to Bruno Iksil, the “London Whale” so named because of his tendency to go big or go home on investments.  Iksil’s choice to put all his chips on U.S. corporate bonds expecting a big payout cost JPMorgan $5.8 billion, three times the bank’s estimated risk.

Several organizations, including SEC, the Justice Department, the Commodity Futures Trading Commission, and different Congressional committees are investigating JPMorgan Chase. In addition, Class action suits are being levied by public pension funds for causing these funds to sustain big trading losses. These cases rest on the fact that investors were given wrong information about the risk and financial condition of their investments.

Barclays has its own scandal. It has been accused of altering the interest rate at which it borrows money from other banks.  This estimate has affected the LIBOR (London Interbank Offer Rate), which in turn informs the rates at which trillions of dollars are borrowed and lent, affecting everything from high-yield corporate debt to mortgages and student loans.

Evidence suggests that Barclays has been fixing the LIBOR since 2005, underreporting its LIBOR numbers in order to appear to have better credit quality and less risk.  The scandal narrative alleges that cooking the books was especially important for Barclays to save face during the financial crisis that started in September 2007.  Since then, the media has questioned Barclays’ reporting integrity multiple times in recent years. Regulatory bodies have at different times investigated Barclays’ financial conduct including the New York Fed, the British Bankers’ Association, the Financial Services Authority, the Commodity Futures Trading Commission, the New York Federal Reserve Bank, and the U.S. Treasury. Between different regulation authorities in the UK and the U.S., Barclays has been forced to pay $471 million in fines.

Thus far, Barclays’ chief executive, chairman, and chief operating officer have resigned. Some of the higher-ups at Barclays who have retained their positions in the midst of this scandal have indicated that Barclays is not the only bank to have under-reported rates and that soon other falsified submissions from other banks will come to light.

These scandals are great at scaring investors, but they do not engender much more risk for JPMorgan or Barclays shareholders going forward. Financial companies which constantly innovate new derivative products cannot be distinguished as being more or less prone to release unexpected bad news. That’s right: unexpected bad news is not expected. Thus, there is no reason to price firms involved in yesterday’s scandals at considerably lower valuations than their peers.

Conclusion

Since JPMorgan’s trading scandal and not its debt-to-equity ratio explain its attractive valuations, investors should consider it as one of the more attractive financial service companies. In contrast, On the other hand, Barclays’ LIBOR scandal does not make up for its high leverage. Investors may be correctly pricing high perceived risk for Barclays stock for the wrong reasons.

Investors who are looking in the financial sector should consider JPMorgan and Bank of America stock as the best available sector bets.

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