Why The Overpriced Dealer Banks Look Cheap: Financial Creativity Has Gone Missing

by: Kurt Dew


Banks are different from other companies.

They live on their wits, not their efforts.

Lately, there has been a shortage of ideas among dealer banks.

It is this, not government regulation, that is making dealer bank stocks cheap.

What determines the value of a financial institution? For excellent analysis of dealer bank valuation based on the bank's reported numbers, see SA articles from IP Banking Research such as "Citigroup CCAR 2016: The Fed Is Taking The Heat Off The Big Banks." This article provides particular insight into the dealer banks' current frame of mind.

While the methods analysts use to determine the value of a financial institution are fairly straightforward - revenue figures, asset values, risk exposure and the like - the reality is that investors should think of financial institutions differently from, for example, car manufacturers.

Why? Because car manufacturers start their business with something real (steel, plant and equipment and the like) and end with something real (cars). Financial institutions, rightly managed, avoid these things. When you strip a financial institution of the things it should be avoiding, such as real estate ownership, what you really have is the contribution of the employees to the profitability of other firms and investors.

A loan or a derivatives transaction is itself of little value to bank customers. A loan in an amount exceeding that provided by other financial institutions, based on the judgement of the banker and perhaps the banker's advice about the proper deployment of the borrowed money, creates value for a customer on the asset side of the business. If that judgement is correct, the bank is repaid, and that creates value for the bank's depositors and shareholders.

Similarly, if a bank has a way of slicing and dicing, or alternatively repackaging, boring ordinary assets to create liabilities that are more enticing to its liability-side customers; that can also produce rewards for bank stockholders.

The essential factor that distinguishes a bank from a coal mining company is that only ideas create banking value. More importantly - they must be relatively new ideas. Because once ten banks understand the initial idea, the value of the idea goes to zero as soon all ten banks are up to speed in providing that service. So banking without creativity is a zero value activity. Without creativity, the value of a bank's stock is simply the accumulated value of the bank's past ideas. And that, I submit, is the case for Bank of America (NYSE: BAC), Citigroup (NYSE: C), Goldman Sachs (NYSE: GS), JPMorgan Chase (NYSE: JPM) and Morgan Stanley (NYSE: MS).

The dealer banks this year are pretenders to financial creativity. When creativity is real, creative companies trade at premiums to standard analysis of valuation.

The dealer banks compete for top graduates with Silicon Valley. But Alphabet's (NASDAQ: GOOG) market to book exceeds four, while JPMorgan Chase's rests just under one. The implication is that much of the talent hired by the dealer banks is going to waste.

There have been times when a financial institution's executive skills have been so dominant that investors tore up their 10-Qs, and bought on reputation. When I have that thought, my mind turns to Michael Milken and Drexel Burnham during the 1980s.

Financial engineering is an apt description of what most Quants working for banks do. Engineers use existing theories of the way things work, applying them to the situation at hand. Which in the banking business is necessary to maintain solvency, but not enough to create profitability.

That is not what Milken did, and it is not what creates profitability of the kind he created for Drexel.

Michael Milken

Milken was not a financial engineer. He was a financial creator. His reputation is tarnished, in some minds, by the fact that he went to prison for securities violations. But not in the minds of those who understand humanity, finance and law.

A few things are certain about Milken.

  1. His career in finance was, at least in part, the result of the fact that he listened to his finance lecturer, who pointed out that high yield bonds, risky when considered alone, were - when considered as part of a portfolio of other high yield bonds - not very risky. To his lecturer, that was the result of statistical analysis. To Milken, it was pure gold.
  2. His genius was to recognize that this piece of sterile textbook statistics would make him the archetypal financial creator. And make him one of the people that were more important to his firm's valuation than their 10-Qs.

But the process that created Milken is broken.

Milken is an example of someone who, by virtue of his understanding of finance, created rents for his firm for a decade. Imitation, it is said, is the sincerest form of flattery. But it is not the path to creation of the kind of corporate value that Milken provided.

The pretense of the dealer banks is that they, through their dominance of derivatives and securities trading, are Milken's intellectual heirs. Nothing could be further from the truth. Today, the dealer banks are counting on relief from the Federal Reserve's capital requirements under the Fed's Comprehensive Capital Analysis and Review (CCAR).

The dealer banks await the Fed's go-ahead to permit them to improve the value of their shares through accelerated stock repurchase.

Consider the implication of stock repurchase. It is one of two ways a company signals its stockholders that the stock is underpriced. It says "The most effective way this bank can reward its stockholders is to buy the stock at its current undervaluation." When a company (Apple (NASDAQ:AAPL) comes to mind) sits on an ocean of cash that it could not possibly plow into its existing operations at returns exceeding the current ones, I get that policy. It's something like a dividend with slightly different tax implications.

There is nothing in what Milken was doing that made stock repurchase a good idea. The free cash at Drexel was best employed by throwing it into the strategy. But then Milken's idea, like every other idea in finance, was finally overdone. Drexel missed the moment when the plug needed pulling, because there was no next idea.

It is wise of the dealer banks' managers to realize, as the declining volume figures suggest they do, that OTC derivatives were ideas with a finite shelf life. The financial crisis made that obvious. Are bank analysts catching on? If so, they see a second reason financial institutions have for buying back their stock. Until the banks come up with the "next big thing," the shareholders have better ways to use their money.

Disclosure: I/we 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.