Bair's Restricted Borrowing Approach: Sensible Banking?

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

Sheila Bair published her memoir Bull by the Horns one year after stepping down from her position at the FDIC. In her book, she calls for banks to be restricted to borrowing half of what they can currently against equity.

Her motivation in calling for these changes is to make the banking system safer. The current implementation of new U.S. banking regulations fell short of her vision, and are being rendered meaningless by financial engineering. Individual banks remain speculative investments and are considered here only as small positions to add to a portfolio.

Bair's Prescription for Safer Banking

Sheila Bair's envisioned deleveraging may sound like an overzealous regulatory change, but it is actually a sensible move away from currently ridiculous leverage. For perspective, banks can currently borrow 25 times their equity but with the new regulation suggested by Bair that would be dropped down to 13 times their equity. Bair also supports the conclusions of the Basel Committee on Banking Supervision. This committee not only wants to change how much banks can borrow, they also want to change what the banks are allowed to define as capital. With less qualifying capital to use as leverage, the largest banks in the world would need to raise about $100 billion in new capital approved under the new rules.

The current required ratio in the U.S. is only 4% and is an even lower 3% in many developed countries. Since current capital ratios use a broader definition of assets as collateral, implementing stricter definitions would require well-capitalized banks to find more collateral which would meet the higher standards. With the new way of calculating the leverage ratio, the largest bank in the U.S., JPMorgan Chase (NYSE: JPM) would only have a ratio of 5.8%. This ratio would be unacceptable under Sheila Bair's proposed capital requirements.

The international banking community is ridiculing the 8% leverage ratio that Bair and the Basal Committee endorse.

Bair's Insight and Bank Stocks

Sheila Bair is absolutely correct in her assessment. Market crashes in real estate and mortgages subordinated to that real estate can correlate across geographies. This can ultimately wipe out banks with the most cautious risk measures which assume some level of diversification.

Moreover, the idea that an investor could value a firm which has only 3% to 4% equity capital is unrealistic. Such thin capitalizations are easily within the margin of errors of analysts and investors. If your estimates for loan values have a margin of error of 20%, (which would be a great margin of error) you would still not know if a bank firm's equity is worth more or less than nothing.

There are ultimately two outcomes that can happen in the banking sector. If leverage is effectively tightened, then banks will have lower annual returns on equity but will make more money in the long-term because they will not blow up as frequently. If leverage is not effectively tightened, then business as usual will continue. Banks will be able to report earnings as they have in the past and will blow up on occasion.

Recent Reforms Can Be Circumvented

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 "collateral transformation" process has investors concerned that it will hide risk, rather than avoid it.

The invention of "collateral transformation" as a way to maneuver around tightening capital control should not surprise economists. It is merely an example of "creative response," 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.

This new trick is a way of maintaining high leverage under more regulation. Investors should realize that such tricks do not change the economics of banks: they remain speculative investments. At the same time, this regulatory work-around allows banks to collect extra fees.

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.

Banks as Cheap Bets

Financial metrics were used to compare the firms that offer collateral transformation services in order to find the best risk-reward propositions for speculators. Some of the financial services companies that are planning on offering this service include: JPMorgan ChaseBank of America (NYSE: BAC)State Street (STT)Goldman Sachs (GS),Barclays (NYSE: BCS), and Bank of New York Mellon (BK).

<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> <td> <p><strong>D/E</strong></p> </td> </tr> <tr> <td> <p>BAC</p> </td> <td> <p>Bank of America</p> </td> <td> <p>USA</p> </td> <td> <p>10.13</p> </td> <td> <p>1.65</p> </td> <td> <p>0.43</p> </td> <td> <p>7.1</p> </td> <td> <p>2.66</p> </td> </tr> <tr> <td> <p>BCS</p> </td> <td> <p>Barclays</p> </td> <td> <p>UK</p> </td> <td> <p>17.68</p> </td> <td> <p>1.3</p> </td> <td> <p>0.50</p> </td> <td> <p>0.97</p> </td> <td> <p>16.61</p> </td> </tr> <tr> <td> <p>GS</p> </td> <td> <p>The Goldman Sachs Group</p> </td> <td> <p>USA</p> </td> <td> <p>17.78</p> </td> <td> <p>1.68</p> </td> <td> <p>0.79</p> </td> <td> <p>3.63</p> </td> <td> <p>6.05</p> </td> </tr> <tr> <td> <p>BK</p> </td> <td> <p>The Bank of New York Mellon</p> </td> <td> <p>USA</p> </td> <td> <p>12.73</p> </td> <td> <p>7.6</p> </td> <td> <p>0.8</p> </td> <td> <p>68.48</p> </td> <td> <p>0.92</p> </td> </tr> <tr> <td> <p>JPM</p> </td> <td> <p>JPMorgan Chase</p> </td> <td> <p>USA</p> </td> <td> <p>9.66</p> </td> <td> <p>2.68</p> </td> <td> <p>0.83</p> </td> <td> <p>2.02</p> </td> <td> <p>3.68</p> </td> </tr> <tr> <td> <p>STT</p> </td> <td> <p>State Street</p> </td> <td> <p>USA</p> </td> <td> <p>11.38</p> </td> <td> <p>6.61</p> </td> <td> <p>1.01</p> </td> <td> <p>6.05</p> </td> <td> <p>1.04</p> </td> </tr> </tbody> </table>

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.

Holistically, Bank of America offers the most attractive valuation multiples with a relatively low debt-to-equity ratio. Investors who are looking to bet on the financial sector should start by considering Bank of America stock.

Know What You Own

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BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Bank of America and 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.

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