Banking Sector Investors Beware: Losses Come With The Territory

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The market is overreacting to investigations of prominent financial companies. The possibility of such activities going on behind the scenes should have been priced into financial stocks before specific problems arose. Furthermore, the likelihood of more allegations and legal issues coming to light is roughly the same as it was before. As an investor, there is no reason to punish financial stocks that got caught since there is no way to know who will get caught next. The valuation differences that exist in the news can be exploited to make smart bets on banks that attract irrational hatred.

Banks as Black Boxes

Financial companies are not transparent: they embrace risks that defy prediction. Mark-to-model accounting and high-failure modification programs cast dispersions on the valuations of bank assets. Trading desks and “risk management” are frequently the source of headline losses, so frequently that investors should be used to them by now. In the last decade Credit Suisse (NYSE: CS), Société Générale, UBS (NYSE: UBS), Morgan Stanley (MS), and most recently JPMorgan (NYSE: JPM) have been implicated in scandals.

The JPMorgan Mess

JPMorgan is being investigated by a U.S. Senate panel led by Carl Levin. So far this panel has extensively questioned executives from many banks, including HSBC Holdings (HBC) and Goldman Sachs (GS). Unidentified sources have stated that Levin's Permanent Subcommittee on Investigations is looking for testimony from people who worked in JPMorgan's investment office. The London branch of this office lost almost $6 billion earlier this year on failed derivative positions, an unexpected loss which shook the markets and caused JPMorgan shares to plunge.

The inquiry is challenging JPMorgan’s version of events that led to this huge loss, and JPMorgan has stated publicly that its own internal review has found that traders may have tried to hide the full amount of losses on their transactions.

JPMorgan’s market value has fallen more than $22 billion, and during the first six months of 2012, the bank lost almost $6 billion on trades, and has stated that it could lose over $7 billion in total. In May 2012, Ina Drew, JPMorgan’s chief investment officer resigned, and then offered to pay back part of the compensation she had earned with the company. Jamie Dimon, the company's chief executive officer has recently overhauled the division and replaced many executives. The bank has stated that Craig Delany is now its new chief investment officer and will report directly to the new co-chief operating officer Matthew Zames. An internal memo stated that Delany will now manage the bank’s mortgage servicing rights.

The bank has also stated that the three London managers and traders who were responsible for the bad trades are not with the firm any longer, and the bank will attempt to recoup their pay. Levin's senate panel is known to be extremely thorough in their investigations and will often spend years checking documents, interviewing witnesses, and issuing subpoenas. The same panel investigated Wall Street for two years after the 2008 financial crisis, which resulted in a report that was over 600 pages in length and put much of the blame for the crisis on large banks.

UBS Trader Trial

Ex UBS trader Kweku Adoboli is also about to go on trial, accused of illegal trades that cost over $4 billion. He is charged with false accounting and fraud in one of the highest profile banking cases in London’s history. The trial is scheduled for criminal court and is expected to last about eight weeks. Adoboli is charged with tampering with exchange-traded fund transaction records and other accounting documents, he is also charged with fraud and abusing his position as a senior trader. In the U.K. you can spend a maximum of 10 years in jail if you are found guilty of fraud, and seven years for false accounting. Adoboli is currently facing two counts of each charge.

Richard Morton, a spokesman for UBS has stated that UBS is not involved in the case and has no comments. Regardless, this case has been a blow to the reputation of UBS. Adoboli was employed by the Delta One, a Zurich based investment bank, and UBS has stated that the loss has not affected any of their clients.

London's finance industry has been the center of many recent scandals. Recently, Barclays (BCS) settled with regulators for over $460 million because they rigged interest rates. Standard Chartered settled allegations by New York's banking regulator for more than $300 million after being accused of money laundering, and HSBC Holdings is currently being investigated for handling cash for sanctioned nations.

Cheap Bets

Assuming investors are capable of learning, they can react in one of two ways to the conundrum of investing in financial companies. One defensible way to act on this knowledge is to abstain from investing in financials. Another way is to keep investments in financial companies small, and only when they are trading at compelling discounts which can justify taking on risks.

Consider the following valuations:

<table> <tbody> <tr> <td> <p><strong>Ticker</strong></p> </td> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Country</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>P/S</strong></p> </td> <td> <p><strong>P/B</strong></p> </td> <td> <p><strong>P/FCF</strong></p> </td> </tr> <tr> <td> <p>(BAC)</p> </td> <td> <p>Bank of America</p> </td> <td> <p>USA</p> </td> <td> <p>9.7</p> </td> <td> <p>1.58</p> </td> <td> <p>0.41</p> </td> <td> <p>6.8</p> </td> </tr> <tr> <td> <p>(MS)</p> </td> <td> <p>Morgan Stanley</p> </td> <td> <p>USA</p> </td> <td> <p>13.5</p> </td> <td> <p>0.93</p> </td> <td> <p>0.52</p> </td> <td> <p>1.26</p> </td> </tr> <tr> <td> <p>(CS)</p> </td> <td> <p>Credit Suisse</p> </td> <td> <p>Switzerland</p> </td> <td> <p>52.64</p> </td> <td> <p>1.19</p> </td> <td> <p>0.76</p> </td> <td> <p>0.93</p> </td> </tr> <tr> <td> <p>(JPM)</p> </td> <td> <p>JPMorgan Chase</p> </td> <td> <p>USA</p> </td> <td> <p>9.39</p> </td> <td> <p>2.61</p> </td> <td> <p>0.8</p> </td> <td> <p>1.96</p> </td> </tr> <tr> <td> <p>(UBS)</p> </td> <td> <p>UBS</p> </td> <td> <p>Switzerland</p> </td> <td> <p>17.3</p> </td> <td> <p>2.63</p> </td> <td> <p>0.8</p> </td> <td> <p>0.53</p> </td> </tr> <tr> <td> <p>(HBC)</p> </td> <td> <p>HSBC Holdings</p> </td> <td> <p>UK</p> </td> <td> <p>10.94</p> </td> <td> <p>2.79</p> </td> <td> <p>1.03</p> </td> <td> <p>NA</p> </td> </tr> <tr> <td> <p>(WFC)</p> </td> <td> <p>Wells Fargo</p> </td> <td> <p>USA</p> </td> <td> <p>11.46</p> </td> <td> <p>3.73</p> </td> <td> <p>1.24</p> </td> <td> <p>11.46</p> </td> </tr> </tbody> </table>

Wells Fargo was added as a contrast to this list since it is a bank which is considered “safe.”

Bank of America, Morgan Stanley, and Credit Suisse are at price-to-sales, price-to-book, and price-to-free cash flow multiples that are near or under one half of those of Wells Fargo. Notice that JPMorgan shares and UBS shares would have to drop in price to rival these valuations even though they are currently suffering headline risk.

If an investor seeks exposure to financial companies, they should accept that $7 billion losses come with the territory. At the very least, Bank of America, Morgan Stanley, and Credit Suisse make for cheap speculation.

BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

blog comments powered by Disqus