I regard banks and other financial institutions as black boxes. These firms are too complex to understand as executives, let alone as outside investors. Insiders have a hard time keeping track of their many regulations and contracts that these organizations have to honor. Outside investors have a worse task: they have to try to understand material changes in the company without detailed, proprietary information that is available to management.
The complexity of these businesses makes them very dangerous to investors and management. Sometimes there is forewarning of issues that become huge scandals and management misses it. New reports about JPMorgan Chase's (NYSE:JPM) proprietary trading scandal reveal some forewarning by regulators. Sometimes the problems are widespread in an organization, as was the case in HSBC's (HBC) money laundering investigation and settlement. The risks of these firms cannot be quantified or even described until after they surface in the news.
The prevalence of these scandals demonstrates that financials are truly speculative bets.
SEC Warnings Before JPMorgan's Loss
Almost a year before JPMorgan Chase lost $6.2 billion due to derivative positions, the SEC (Securities and Exchange Commission) was already pressing the bank for adequate disclosures to investors regarding its proprietary trading and principal transactions revenue.
The SEC wrote JPMorgan's CFO Douglas Braunstein asking for the above-mentioned information, according to correspondence between the agency and the company communicated between June 15th and February 17th of last year. A provision contained in the Dodd-Frank Act known as the Volcker rule restricts proprietary trading - bets or trades executed by the banks using their own money, as distinguished from those it trades on behalf of its clients.
SEC Assistant Director of Corporation Finance Suzanne Hayes disclosed, "It is not clear how much of this revenue was generated from your proprietary-trading business, hedge-fund activity and private-equity funds that would be affected by the Volcker rule," referring to JPMorgan's disclosure in a previous filing that the proprietary holdings in its equities unit were already liquidated and another JPMorgan's assertion that a credit derivatives portfolio, a bet against U.S. companies' creditworthiness, was not a proprietary bet but a hedge against a weak economy.
JPMorgan's more than $6.2 billion loss for the three quarters, which was executed through the bank's (chief investment office) CIO, is being looked into by the U.S. Senate Permanent Subcommittee on Investigations who called the transactions a 'textbook' example of why the Volcker rule should be enhanced. Pension funds, led by the Ohio Public Employees Retirement System are suing JPMorgan for using the CIO as a 'secret hedge fund' and claiming the bets are supposed to mitigate risk.
In a July 1st response to the SEC, Braunstein disclosed that proprietary trading represented a "de minimis portion of the revenues and earnings of the investment bank." He revealed that the bank is also investing its own money in commodities, fixed-income and equities within its investment bank division, while the CIO is in charge of the operational risks associated with foreign currencies and interest rates. The letter explained further that the activities "are designed to mitigate the firm's structural risk and preserve the firm's longer-term capital value through economic cycles and, as such, are clearly distinguishable from proprietary trading activity."
In its correspondence with the SEC, JPMorgan asked for confidentiality. Its spokesman Mark Kornblau refused to comment on the exchanges that were recently made public.
HSBC entered into a $1.92 billion settlement with the U.S. Department of Justice over money laundering. HSBC's violations were many. The bank failed to comply with anti-money laundering review, which allowed hundreds of millions of dollars of Mexican illegal drug money to pass through U.S. bank accounts. In addition, HSBC allowed about $660 million in prohibited transactions to move through U.S. financial institutions from Cuba, Iran, Libya, Sudan, Burma and other countries with economic sanctions. Investigators also identified 2,300 transactions from March 2004 to June 2010 amounting to $430 million that violated economic sanctions imposed against Cuba, Libya, Iran, Sudan and Burma. The bank's lax oversight and failure to implement adequate programs and anti-money laundering procedures left dangerous gaps that drug dealers and other criminals readily exploited.
The Senate investigation uncovered that HSBC also facilitated 'U-turn transactions' through American financial institutions from Iran to non-U.S. banks by altering transaction records to hide information about its real clients. A Deloitte audit revealed 25,000 transactions with Iran worth around $19.4 billion were processed, 90% of these passing through the U.S.
The firm's operations are capable of handling settlement fines. Although a total of $1.5 billion, $800 million of which was made this third quarter, had been earmarked as provision to cover for a possible settlement, additional costs such as the $700 million for "know-your-customer" review, etc. would reduce the planned savings to be generated for this year. HSBC Group Chief Executive Stuart Gulliver seeks to improve profits by cutting costs of $2.5 billion to $3.5 billion and selling assets to re-focus towards emerging economies where it has bigger market share, and predicts he will achieve those savings by the end of next year.
Pride Investments Group's Chief Investment Officer Lewis Wan noted that the settlement removed an uncertainty blocking Gulliver's plans, but it does not completely clear the path for HSBC since regulators are now watching the bank more closely and the bank itself will strengthen compliance and spend time and money on this change.
Searching for Cheap Bets
It's perfectly fine to abstain from financials altogether. However, many investors refuse to quit them cold turkey. For these risk-seekers, the question is whether scandal-embroiled stocks are cheap relative to their peers based on this scandal. Consider these price multiples:
The Royal Bank of Scotland
Bank of America
Mitsubishi UFJ Financial
PNC Financial Services
Wells Fargo & Company
Bank of Montreal
The Toronto-Dominion Bank
The Bank Of Nova Scotia
Canadian Imperial Bank of Commerce
HSBC's stock is not cheap based on price-to-book, price-to-sales, or price-to earnings multiples when compared to its peers. JPMorgan Chase stock is cheaper, though there are cheaper stocks out there. Neither stock is a screaming deal at current price levels. Speculators should look elsewhere for cheap bets.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.