The limitations of Return on Equity
In his Financial Times column on Tuesday ("Banks would profit by taking measures beyond ROE"), Patrick Jenkins mentioned a downside of ranking bank performance mainly by Return on Equity (ROE) -- the incentive to goose ROE by taking on more leverage and risk:
Within the past few days, Brady Dougan, chief executive of Credit Suisse (CS), and [Bob] Diamond [CEO of] Barclays (BCS) both stubbornly stood by ROE targets of 15 per cent and 13 per cent, respectively, despite little sign of being able to achieve them without either miracles or financial jiggery-pokery. As the pre-crisis years showed, the trick to boosting ROE was to keep equity cushions super-thin and to grow rapidly using debt -- all fine, until the lending risk backfired and the meagre equity was eaten up.
Complementing ROE with a risk metric
To complement ROE with a risk metric, I used to Fidelity's stock screener to pull up a list of banks with returns on equity in the top quintile in their industry, and I pulled up their GovernanceMetrics International Accounting and Governance Risk (AGR) ratings as well. AGR ratings vary from "Very Conservative" (companies scoring in the top 5%) to "Very Aggressive" (bottom 5%). I didn't find any banks rated "Very Conservative", but the table below shows 2 high-ROE banks with the next-highest AGR rating, "Conservative", along with 2 with "Very Aggressive" AGR ratings.
Hedging high ROE banks
The table below lists these 4 stocks, along with the costs of hedging them against greater-than-20% declines over the next several months, using optimal puts.
For comparison purposes, I've also included the costs of hedging Credit Suisse (CS) and Barclays (BCS) against the same decline (neither stock had an ROE high enough to appear on the screen). In addition, I included the SPDR S&P 500 ETF, (SPY). First, a reminder about what optimal puts are, and why I've used 20% as a decline threshold; then, a screen capture showing the current optimal puts to hedge the comparison ETF ((NYSEARCA:SPY)).
About Optimal Puts
Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.
In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below. Essentially, 20% is a large enough threshold that it reduces the cost of hedging, but not so large that it precludes a recovery.
The Optimal Puts For SPY
Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of SPY against a greater-than-20% drop between now and June 15, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.
(Click to enlarge)
Why There Were No Optimal Contracts For CS or BCS
In some cases, the cost of protection may be greater than the loss you are looking to hedge against. That was the case with Credit Suisse (CS) and Barclays, PLC (BCS). On Tuesday, the cost of protecting them against a greater-than-20% decline over the next several months was itself greater than 20%. Because of that, Portfolio Armor indicated that no optimal contracts were found for them.
Hedging Costs as of Tuesday's Close
The hedging data in the table below is as of Tuesday's close, and is presented as a percentage of position value. Neither Credit Suisse nor Barclays appeared on the screener, as they didn't have top-quintile ROEs. There is no AGR score for Barclays, but Credit Suisse is rated "Very Aggressive".
|(INDB)||Independent Bank Corp.||8.36%**|
|(NBTB)||NBT Bancorp, Inc.||8.90%**|
|Very Aggressive AGR|
|(NYSE:PNC)||PNC Financial Services Group||6.78%**|
|(WFC)||Wells Fargo & Co.||6.03%*|
|(CS)||Credit Suisse||No Optimal Contracts|
|(BCS)||Barclays||No Optimal Contracts|
|(SPY)||SPDR S&P 500||3.60%***|
*Based on optimal puts expiring in April 2012.
**Based on optimal puts expiring in May 2012.
***Based on optimal puts expiring in June 2012.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.