This is not an editorial. Editorials come too late. They usually come after the fact. This is an article for those investors who have decided they don't want hedge funds inside the banks they invest in.
If AIG (NYSE:AIG) was the volcano when it comes to derivatives disasters, then JPMorgan (NYSE:JPM) is the unwelcome aftershock. We are told that JPMorgan has a huge balance sheet, and the loss is trivial, but AIG's shareholder equity dropped from $95 billion to $52 billion in one year.
The problem with proprietary trading (that is, trading for the bank's own account) is that it can bring down banks and hedge funds at a moment's notice. Nick Leeson brought down Barings Bank (founded in 1762), Britain's oldest merchant bank in 1995. Jérôme Kerviel brought Société Générale (OTCPK:SCGLF) trader to its knees in 2007. And now Bruno Iksil has brought whale-sized notoriety to Chase with losses of perhaps $5.8 billion (the numbers keep changing). So for some investors it does not matter how large Chase's stockholder equity is - there are traders on the loose. What investors need to know is which banks engage in proprietary trading, and who does not.
Serious investors recognize that the term "hedge fund" is more of that semantic legerdemain that comes from Madison Avenue. A lot of the time no one is hedging anything. A farmer hedged a possible loss by selling his crop for what he knew was a good price before it came in. Most of this "trading" is un-hedged, that is, out and out gambling. So, a more appropriate title for this piece would really be "No Casino Funds Inside Banks."
Investors were reassured that managers like Jamie Dimon were geniuses of risk management, especially noted for discovering a large sub-prime risk in Chase's portfolio, and excising a lot of it, calling up managers all over the planet, and having them come to a meeting to deal with this. It was reassuring. But now we learn that JPMorgan Chase had a "whale" in London who was making rather out-sized un-hedged bets.
There is nothing wrong with proprietors gambling with their own money. The problem with proprietary trading is that it is using, in a sense, the credit of the government to run out-sized risks because the proprietors know that if they are large enough, the government will bail them out. Sort of the Donald Trump proposition: if you are a small lender, the bank owns you, but if you are a large lender, you own the bank. In this sense, banks know they own the government. They will be bailed out, and if there are enough of them in this predicament, the Federal Reserve will grant them automatic profits - low interest rates that do not even need to put back into the economy, they can just buy bonds with them, and clip the coupons. The Federal Reserve grants them this profit concession so their balance sheets will be restored, and to re-establish financial stability.
But for investors these actions may be too late to protect their investment. Bernanke is a public servant who is not concerned with bank profits except as they effect the economy as a whole. Thus Citicorp (C) stock, which saw a 90% haircut after the crash, has never really recovered, even if the Treasury under Hank Paulson bought preferred shares and the Federal Reserve helped to restore its balance sheet and protect depositor's money with cheap money. Citicorp stock holders can take no consolation in the protection of these government back-stops. They are out of luck.
Nor will Bank of America (BAC) stockholders, who saw a similar haircut.
Understand, it is fine for the managers who take these out-sized risks. No one is asking Charles Prince or Robert Rubin or Sandy Weill for a return of compensation. They are not going to prison for crimes against their investors. That is why shareholders would do best to avoid these banks no matter what kind of face they put on it, nor how sensible the management appears to be, like Jamie Dimon.
Of course, everyone knows that Goldman Sachs (GS) is basically a hedge fund, or casino fund, except when it needs to be a depositary bank to take advantage of cheap money, that's the kind of Jekyll and Hyde monster it is. But if you want to invest with brilliant traders, then you want to invest in Goldman Sachs. I've been reading about partners' bonuses long enough to know they're pretty good at it. But you must remember that the partners run the business for themselves, as has become more evident in recent years. Customers, the government, even its own shareholders, are all considered counterparties. So, you know that shareholders are not primary. You're betting that the partners will let some money pass through their sticky hands into the shareholders hands.
The Volker Rule is supposed to impose rules about proprietary trading. Banks will be permitted true hedging. They will be permitted trading to make markets, but probably not the kind of trading of Jamie Dimon's whale in London. Nevertheless, Jamie Dimon, the sharpest critic of the Volker Rule, has argued vociferously that proprietary trading is important in making markets and so on, but those of us who have watched All the President's Men know that we should follow the money, and we conclude that Dimon feels he can only justify his lofty pay package by making enormous un-hedged bets and out-sized profits, but all of this based on the image of risk control.
The fact that Dimon is the sharpest critic of the Volker Rule is damning enough, it means that he does not have confidence that he can generate substantial profits from normal banking, where banks take in deposits and make loans that actually have something to do with the economy, like lending for homes and factories and bridges and hospitals. Perhaps he is not equal to the task of running a profitable normal type bank. We suggest he that maybe he would be happier running a "hedge" fund. Though such funds can also end up in disasters. I think of Amaranth Advisors and Long Term Capital Management.
The five biggest banks control 56% percent of all the banking in the U.S. The government is responsible for a lot of this current concentration of banking from using existing banks to funnel losing banks, which is a reasonable enough strategy, but it compounds a condition that puts the nation's financial resources at risk. There is still no derivatives' clearing house, and no way of knowing what kind of nasty stuff is lurking out there in financial swamps. The best way out for investors is either to embrace a swamp-master like Goldman Sachs, or avoid them. But certainly one will want to steer clear of banks that seem to stand for one thing, like brilliant risk management and normal banking, but which are nothing of the kind.
JPMorgan Chase, Bank of America, and Citibank are all engaged in proprietary trading, and are best avoided by investors who want to invest in normal deposit and loans banks.
Of the larger banks, PNC says that as of January 22, 2010 it has no proprietary trading desk. And Wells Fargo also seems to have it right. Perhaps Wells Fargo (WFC) does do some trading, but it has a conservative bent, and CEO John Stumpf said that proprietary trading did not figure within Wells' "vision and values." The stock trades within the vicinity of its pre-2008 crash price. No 80% or 90% stock haircuts here. Truly good investors of the Warren Buffett variety, who has owned Wells Fargo for years, don't wait for editorials or government hearings to know about risky investments. The chart shows it is within its trading range and can be bought and held.
Banco Santander, S.A. (SAN) has taken a ratings beating because of Spain's problems and Europe's problems, but they have been minding the store for years, and half their profits come from Latin America. So, I'm going the other way on this one. The news is bad and this stock has been under the gun, but great investors need to put their money in when others are afraid. That's the discipline. This stock is at the bottom end of its 10 year trading range, and the bank's earnings have fallen 36% in 2011. But they are not chasing the market into Asia; in fact, they are going into mature markets by buying Abbey National in the U.K, and buying Sovereign Bancorp in the U.S. CEO Emilio Botin believes in what was called "plain-vanilla" and "bread-and-butter" banking in a Fortune (3/23/12) article.
Here you are getting a resourceful banker who does not believe he has to tweak earnings with risky derivatives trades. But that does not mean Botin is sitting on his haunches. He is a hunter and has grown a regional bank into Spain's biggest through adroit acquisitions. Here is your chance to hunt the hunter and get a bargain if you have the nerve.
J.P. Morgan Chase - steer clear, CEO biggest advocate of proprietary trading/gambling
Citibank - steer clear, still needs to pare down
Bank of America - steer clear, trader (think Merrill Lynch)
PNC Bank - all clear signal, no proprietary trading desk as of 1/22/10
Goldman Sachs - for the Vegas crowd only
Wells Fargo - conservative leanings, a normal lender, though there is some trading.
Banco Santander, S.A. - normal lender with international exposure hurt by Spain
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.