Most of us are familiar with Albert Einstein's famous insight on insanity: doing the same thing over and over again and expecting different results.
Perhaps investing is plagued by an ineradicable strain of insanity.
I say that because I see investors are again tempted to invest in big banks. They invest despite the banks' numerous transgressions – Latin American debt, biased research, risky commercial real estate lending, subprime mortgages – which seem to recur with remarkable regularity.
That the banks themselves repeatedly transgress suggests they, too, suffer from a touch of insanity.
JPMorgan Chase (NYSE:JPM) is the most recent example. The big New York bank reported a stunning $2-billion trading loss in mid-2012. That loss was subsequently trebled to $6 billion. Management initially explained that the loss was associated with “risk management,” but we soon learned it was associated with priority trading.
The January/February edition of The Atlantic, in a riveting exposé titled “What's inside America's Banks?”, tells us that the big banks remain “black boxes” to this day. Despite more regulation and a Federal Reserve bailout, they are still opaque trading houses that no analyst can reliably decipher.
How banks have changed. Traditional banking used to be about earning money on the spread between what a bank paid on deposits and the interest it charged on loans. The big banks today are more interested in what credit default swap will be trading next week than making a legitimate commercial loan.
Of course, there are banks that still practice traditional banking. The High Yield Wealth portfolio used to own two such banks – Community Trust Bancorp (NASDAQ:CTBI) and Cullen/Frost Bankers (NYSE:CFR) – that excelled at the pedestrian, but profitable, banking model of taking in deposits and making loans.
Not surprising, Community Trust and Cullen/Frost are located far from the dens of Wall Street and were inured to the financial chaos of 2008. Indeed, these banks continued to earn money and raise dividend payouts to their investors amid the crisis. And they continue to raise payouts to this day.
Banks used to be reliable sources of income, and many regional traditional banks like Community Trust and Cullen/Frost continue that tradition. The problem is that these banks are no longer exceptional income sources.
Business development corporations (BDCs), on the other hand, offer a high-yield, reliable income alternative for investors who want to invest in the pedestrian banking model of borrowing at a lower rate and lending at a higher one.
BDCs take in money by issuing equity and borrowing in the debt markets. They then lend these funds to middle-market companies, i.e., companies that provide basic services and goods. BDCs manage their risk by lending across many asset classes and industry sectors.
I see BDCs as being less risky than the big banks because, paradoxically, there are no regulators, no Federal Reserve, and no tax payers to bail them out. Knowing you must lend prudently to survive and prosper removes the moral hazard to act stupidly and recklessly.
What's more, BDCs are filling the void the big banks have left since their shift to trading houses. A recent study by the Federal Reserve Bank of New York found that smaller businesses view access to capital as their biggest barrier to growth. BDCs are stepping up to provide that needed capital.
More important from an income investor's perspective, BDCs offer safe yield and income two to three times that of traditional banks. For this reason, I traded out of traditional banks and into BDC investments.
The High Yield Wealth portfolio owns three BDCs yielding between 6.9% and 11.8%. One even pays its distributions monthly instead of quarterly. More importantly, all three BDCs have increased their distributions to investors within the past year.
Nobel Prize-winning economist George Stigler explicated “capture theory,” which is the propensity for the regulated to influence their regulators. This is exactly what the big banks do: they capture the regulators and continue with business as usual.
In other words, it's business as the big banks want it, and that means recurring financial crisis. In a pique of honesty, JPMorgan CEO Jamie Dimon mentioned that when his daughter asked him what a financial crisis is, he responded, “It’s the type of thing that happens every five, 10, seven years.”
So don't look for big-bank insanity to end. Fortunately, there are alternatives – the BDCs – that offer the reliable … and sane … income big banks used to offer when they were traditional banks.
Note: When I first considered a high-yield investing strategy, my goal was to devise a portfolio that yielded between 6% and 8% annually. To be sure, that's a worthy starting point. But years from now, I should expect to own a portfolio that yields 25%, 50% and even 100% on the cost basis of many of the investments in that portfolio.