The Banks' Broken Model
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
JPMorgan's (NYSE: JPM) on-going trading snafu under-scored in my mind that the relationship between shareholders and many large banks is deeply flawed, leaving large investment banks, like Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS), and many money-center banks uninvestable.
The Problem
Large money-center and investment banks make their money in a variety of ways: fees from customers, the spread on loans, market-making, trading, etc. Most of these earnings are hard to increase quickly. Customers routinely look to avoid fees, while increasing the spread made from loans requires taking on riskier loans. Additionally, market making spreads continue to fall as more products move to electronic exchanges. Trading remains one area where banks can increase earnings relatively easily (sustainably increasing trading earnings is still very hard, but at least in this business, banks have a fighting chance).
With this in mind, we turn to the culture of Wall Street. The earnings blinders with which Wall Street sees the world drives investors away from an important metric when analyzing banks: risk-adjusted earnings (I sympathize with analysts as determining risk-adjusted earnings for banks is all but impossible). When investors judge and compare banks solely on earnings, managements (fearing under-performance and losing their jobs) focus on beating previous and competitor earnings. In a business that should grow at a moderate pace, managements are forced to juice earnings to appease Wall Street analysts. Often, the only way to do this is by taking more credit risk or trading risk. As the pressure to beat and raise earnings persists, banks pass the threshold of manageable risk and look down only to see their spinning legs a good ways from the edge of the cliff. Thus, we see the fundamental flaw of the publicly-traded bank: pressure toward out-sized risk taking. Moreover, as we saw in 2008, the fallout in such situations is disastrous for shareholders.
Unfortunately, I do not believe enough changes were made to prevent this cycle from playing out in the future (JPMorgan's Jamie Dimon believes its current bad trade would have been allowed under the proposed Volcker Rule). Moreover, tying executive compensation to longer-term performance only helps if the amount of money the executive loses in the long-term is more than the amount he or she loses if fired for bad short-term performance. Ultimately, the fragmented and uneducated (very few people are educated enough to properly understand all of the risks involved in many of the products traded today) shareholder bases prevent banks from being judged on much more than the bottom line, leaving the flawed relationship between shareholders and large banks intact.
Because of the flawed incentives managements at banks face, a different perspective on corporate governance is needed. For example, even though Goldman Sachs' and Morgan Stanley boards are overwhelmingly comprised of independent directors (8 of 10 and 10 of 12, respectively) and the boards' committees are entirely composed of independents, I do not believe these boards can properly represent long-term investors. When the banking cycle hits full-stride and Wall Street's earnings expectations go higher and higher, I doubt the boards ability and predilection to distinguish between good returns and good risk-adjusted returns.
The Way Forward
Many people, however, need to invest in some financials. The sector represents a large portion of the S&P 500 and since we remain close to the bottom of the banking cycle, any upturn in the economy would cause those avoiding banks to massively under-perform. For those looking for financial exposure via banks, I recommend looking at regional banks and banks owned by Berkshire Hathaway.
Most regional banks do not "gamble" in the capital markets. Instead they focus on fee and loan-margin growth. Again, however, one must be careful as regional banks can increase earnings by making more risky loans. Although the risk involved with loans is more transparent than with trading, one need look no further than 2008 to see examples of risky AAA securities.
In my opinion, the safest way to invest in banks for the long-term is to coat-tail Berkshire Hathaway. Banks that Berkshire has a sizable stake in, while not immune to the banking cycle, I believe are better able to fight off the pressures of perpetually increased risk-taking. These banks offer investors a large, well-educated shareholder that is focused on long-term risk-adjusted returns. Moreover, because of Warren Buffett's status, he is all but guaranteed access to management to voice his opinion. For these reasons, I believe long-term investors looking for banking exposure should look to US Bancorp (NYSE: USB), where Berkshire has a 3.61% stake, or Wells Fargo (NYSE: WFC), where Berkshire has a 7.44% stake. Currently, both banks get less than 5% of their revenue from trading activities, and I believe pressure from Berkshire will keep it this way.
dtlly has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase & Co. and Wells Fargo & Company and has the following options: short APR 2012 $21.00 puts on Wells Fargo & Company, short APR 2012 $29.00 calls on Wells Fargo & Company, short OCT 2012 $33.00 puts on Wells Fargo & Company, and short OCT 2012 $36.00 calls on Wells Fargo & Company. Motley Fool newsletter services recommend Goldman Sachs Group and Wells Fargo & Company. 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.
