What You Should Be Investigating Before Investing In A Bank Stock

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 |  Includes: C, GS, JPM, MS
by: Martin Lowy

Reading articles on banking and related comments on Seeking Alpha, I have been surprised by investors’ relatively low level of understanding of how banks do or do not make money. Here is a summary of the aspects of a banking business that an investor should look into before buying a bank stock. And if you own a bank stock and have not yet looked into these aspects, then this is a good time to evaluate whether you should continue to own it in 2012.

We can divide banking into five spheres: payments system, lending, trading, underwriting/broking, and trust company functions.

Payments System Business

The payments system is a fundamental banking function. It could be done without banks, but only if the government took it over entirely. Government conduct of the payments system might be a good thing, since as now constituted, it requires government guarantees and could be done entirely electronically. But large banks can make money with little risk based on their payments system functions. A bank with offices around the world, a high level of demand deposits, and a sound capital base that makes it a sought-after counterparty has a sound base of profitability in its payments business.

Lending

Lending is the most dangerous part of banking. Although lending is apparently a fundamental banking function, bad loans are the most usual cause of bank failures. Small banks usually have to rely on real estate as collateral, so they tend to be at the mercy of the ups and downs of the real estate market, as we saw clearly in 2008-2009. Larger banks that lend to large businesses have to compete with the capital markets for that business and, therefore, often end up charging interest rates that are barely higher than the banks’ marginal cost of funds. Insured deposits can come to the bank’s rescue here because they are both lower-cost and “sticky”. A bank that is funded largely by insured deposits is more likely to be able to make money on its lending business. Therefore, to evaluate a bank’s long-term ability to make money from lending, one should look at the liability side of the balance sheet rather than the asset side.

But a bank that is not well capitalized also is unlikely to make money from lending over the long term. This is because, in a recession, loan loss reserves are never adequate, and if capital also is inadequate, a bank is prone to failure unless it is TBTF—but even a TBTF bank can be a bad investment because the common stockholders are not the ones who get bailed out.

Trading

Trading is not a part of traditional commercial banking or, at scale, traditional investment banking. Goldman and Bear were known as trading houses back in the early 1980s--but they did not have scale. Bear went public to gain scale for its trading (in 1985). Several other investment banks/brokers went public to gain scale for trading later in the decade, including Morgan Stanley (NYSE:MS), J.P. Morgan (NYSE:JPM), and Salomon Brothers (later acquired by Citi (NYSE:C)). Goldman (NYSE:GS) went public in 1999. Lehman gained scale by being acquired by AmEx (NYSE:AXP), then became public in 1992 when AmEx spun it off. Many other traditional investment banking firms consolidated or were acquired by “universal” European banks. The scaling up and selling out often was undertaken in order to trade like the few large European banks, such as Deutsche (NYSE:DB) and Credit Suisse (NYSE:CS).

Trading had not been a significant part of American banking, either underwriting/broking or commercial, until after Nixon repudiated gold in 1971. That action changed banking—and the entire financial world—more than I think anyone foresaw at the time. At first, it merely opened up the foreign exchange market, since it made the dollar a floating currency. But in fairly rapid succession, loan securitizations and various other kinds of derivative instruments, such as interest rate swaps and futures, led to trading markets where the most savvy could make money simply by knowing more about market action than participants outside the markets could know.

This insider's market flourished in the 1980s and through the 1990s. But competition from agile hedge funds and too many competitors chasing the same trades ate into the profitability of the trading business after 2000. With the bloom off the rose, Dodd-Frank stripped commercial banks of the right to engage in “proprietary trading”, whatever that ends up meaning when the Fed’s regulations become final and the banks end playing the salami game.

Proprietary trading is a zero sum game. Not everyone can make a profit. Therefore, for all but a very few banks, this prohibition is a good thing for investors (although not for the bankers’ bonuses). So no matter how much the bankers wail, except in a few cases, possibly such as Goldman Sachs, the loss of proprietary trading probably is beneficial long-term.

Trading on behalf of customers, which banks are still allowed to do, is profitable business that utilizes the traditional insider knowledge of a market maker. It is not zero sum, and a bank that has a large book of this business is well-placed for long-term profitability, so long as it does not overstep its bounds and sell snake oil to its customers. Look out for the bank that rewards short-term profitability.

Underwriting/Broking

Underwriting/broking is a separate business that commercial banks were barred from by Glass-Steagall from 1934 onward. In various steps, culminating in 1999, Glass-Steagall was significantly eroded. (I have never been a fan of the Glass-Steagall prohibitions. I made money from them as one of the early experts on the subject, but I have never thought that the Glass-Steagall provisions had a sound policy basis.) Underwriting/broking actually is a fairly safe business, so long as traditional principles are followed. But when brokers become traders at scale, they take on risks. E.g., most recently, MF Global (OTC:MFGLQ). And if underwriters eat their own cooking (as opposed to selling out the deal before they actually close it), as they did with CDOs in 2005-2007, then underwriting can be dangerous, too, as Merrill and Citi proved. (First Boston showed that "bridge loans" were another way to screw up one's balance sheet in the late 1980s.)

Few banks can be major underwriters. But those banks that can be major underwriters—and that create local cultures that eschew the excessive greed that leads to trouble—can make money over the long term.

Trust Company Functions

Trust company functions require scale in order to be profitable. Although they do not usually expose the bank to significant credit or interest rate risks, they do involve substantial costs that have to be spread over many dollars under management. Thus, few banks are highly profitable through trust company operations, and a high proportion of these are banks that specialize in this area.

What Should a Bank Be Allowed To Do?

Whether, as a policy matter, all these functions should be permitted in a single entity should be questioned because the government provides substantial subsidies to banks, including deposit insurance, the Fed discount window, accounts at the Fed, TBTF etc. Subsidies also include various regulatory exemptions for banks that make it hard - or in some cases impossible - for non-banks to compete. These are in both federal law and state laws. Should entities that have such subsidies be treated as if they were private corporations? Or are they not, rather, quite like the public/private structure of Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC) that failed largely because of such confusion?

What a Bank Investor Should Look For

But these public policy questions are not on the front burner, so investors need not worry about them yet. A bank investor should look for:

1. A culture that rewards long-term profitability.

2. A high level of capital. (Pay no attention to bankers complaining about capital requirements. They are complaining to protect their bonuses, not their stockholders.)

3. A high percentage of the balance sheet funded by insured deposits.

4. A focus on the businesses that make money long-term.

In my judgment, J.P. Morgan Chase (JPM) may be the only bank that meets these criteria.

Happy New Year to all.

Disclosure: I am long GS, JPM.