The harder they fall

The revelation that Wells Fargo employees had opened millions of accounts without the knowledge of their customers has come like thunder in a bright blue sky.

Here was the most respected of the big US banks seemingly behaving as the reviled Wall Streeters, after it had touted its plain vanilla business and earned Warren Buffett’s confidence and admiration[1]!

Of course, not everybody cried, as Congressional critics were quick to point out that they had been right all along: big banks were out to trick their customers rather than serve them, and their staff would stop at nothing to earn fat bonuses.  It also provided a timely boost to the controversial Consumer Financial Protection Bureau which uncovered the problem.

Still, the bank has given them ample ammunition:

-         The scope of the fraud, close to two million accounts and credit cards,

-         That some 5,300 employees and managers were fired, hardly “a few isolated bad apples”,

-         That the leader of the unit where the shenanigans had taken place chose that time to retire with US$125 million in stocks, options and retirement benefits, a large chunk of which had been accumulated during her stewardship of the consumer banking unit,

-         Finally, that the bank CEO squarely blamed employees but didn’t name any high ranking executives among those responsible and was vague as to his own accountability.

At the same time, it should be noted that the actual financial damage inflicted on the bank customers was light: some 14,000 accounts incurred an average of US$28 each, and, in total, US$5 million was refunded which works out to less than US$5 per client[2].  This explains why, by today’s standards, the fine was a very modest US$185 million.

Nevertheless, I expect that the final cost to the bank will be much higher.

To begin with, the bad publicity will bite all the more so that Wells Fargo had such a good reputation.  Negative sentiment will weigh on the stock price.

The bank will need to spend hundreds of millions on better internal controls and training.  The decision-making will likely be slowed down as transactions will need to go through lengthier and slower approval processes.  Risk taking will probably diminish, and with it profits as staff will be wary of making career-ending decisions.

This scandal will likely take a bigger toll on top management than we have seen to-date.  Let’s face it, when thousands of employees feel so pressured to reach their goals that they resort to fraud, either (1) they were poorly trained and/or of uncommonly bad character, or (2) the top down pressure was so intense and widespread that it was no accident.  Either way, management is at fault.

Having worked for a large bank, I for one believe that corporate culture determines how business is conducted; it is critical in guiding managers’ and employees’ behavior and decision making.  In this instance, and from anecdotic evidence, I believe that there was a corporate cultural problem.  Setting the appropriate culture IS the responsibility of top management, under the supervision of the board of directors.

A key Wells Fargo strategy toward growth and profitability has also been called into question: the much advertised effort to deepen and broaden the relationship with customers by selling them ever more products.  Yet in recent years, while the goal had been set at 8, they had plateaued just north of 6.  If 6 rather than 8 is the effective ceiling, how will the bank make up for this setback, especially since cross-selling will be under closer scrutiny?

Some have compared this crisis to the JP Morgan “London Whale”.  JPM was punished much more harshly, even though its victims were its own shareholders rather than its customers.  With its “fortress balance sheet”, JPM recovered relatively quickly although it is likely that its future profitability suffered because of rising compliance expenses and lower risk tolerance.

Wells Fargo has in my view a bigger problem: besides incurring greater compliance expenses and dialing back risk-taking, it faces a greater strategic challenge and it may suffer from upheaval in its top management ranks.

For all these reasons, I wouldn’t be surprised if its stock price were to drift down toward book value, i.e. US$36 vs. US$47 today, reflecting a loss of premium valuation and lower future earnings.

Although it is no excuse, I think that the current financial context of quasi-zero interest rates keeps exerting ever stronger pressure on banks’ net interest margins, and Wells Fargo is the latest but by no means last victim.

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[1]  Buffett’s Berkshire Hathaway owns 9.7% of Wells Fargo, a stake worth US$21 billion.

[2]  In the absence of further details, such average number is difficult to interpret.  My own hunch is that some customers were charged fees of about US$30 while others incurred no charges.

2102 revisited: stock commentaries

We reviewed a few stocks this year.  So far, our take has been mostly right.  Our current scorecard is provided at the top of each section.

YPF (+33%) and Telecom Argentina (+16%)

Last April we noted that the nationalization of YPF and the expropriation of its then controlling shareholder, the Spanish multinational Repsol, was part of a long standing pattern of misbehaving by the Kirchner governments. 

Last month, with surprise developments affecting its unrestructured sovereign debt (impounding of the frigate Libertad in Ghana, adverse New York court judgment), with massive street demonstrations against the Kirchner government and the evident difficulties that YPF had in closing joint-venture deals with the likes of Chevron and others, we surmised that change may soon become inevitable and we started to invest in Argentina, just a little.  We thought that YPF would be a good start, with Telecom Argentina as a less speculative second choice.  At the time, their ADR prices were $10.46 and $9.82 respectively.

Today, they are $13.90 and $11.41.  While Repsol’s legal pressure is continuing, the Spanish government has made it known that it was in regular contact with its Argentine homologue and that a resolution of the dispute was likely.  After initial difficulties, YPF was able to raise substantial sums by issuing bonds on the local market; ironically, the repressive financial controls made YPF bonds the best deal in town.  It also helped that the government could force its Social Security system to buy half of the company’s debt offerings.

Negotiations seem to be continuing with Chevron and now Bridas, and they are very difficult: how could it be otherwise given the Repsol expropriation precedent and the unrealistic energy pricing system?  In the end, I think that Argentina has no choice but to pay Repsol for its stake in YPF and to adopt economically sensible oil and gas prices.  After all, its shale deposits are among the richest in the world, it will control and benefit their exploitation and it doesn’t want to be too dependent on Bolivia and Brazil for its energy needs.

Even though it gears to become the energy national champion (by taking control of Metrogas and with its expected bid for Petrobras Argentina),YPF continues to be priced for disaster (see peer comparisons in our September post). I do believe that the current strategy consisting in copying the Brazilian energy model is wrong and terribly costly; but even then, if the Repsol dispute is settled, as I expect it will, the YPF stock should rise very appreciably.

Telecom Argentina is well managed, profitable and carries a large net cash position.  Price controls and high inflation have squeezed its profit margin, but it too is priced for disaster.  Its stock may not pop up as much as YPF’s, but it is offers lower risks.

The other big risk factor for US investors is the continued listing of these companies’ ADRs in New York, as this provides liquidity and attractive economics given the overvaluation of the Argentine peso.  One would think that, unable to tap international bond markets, Argentina would be anxious to maintain access to international equity markets. 

JP Morgan Chase (+19%)

In May, I commented on the London Whale travails of JP Morgan which had pushed its stock price down to $36.96 on the day of my post.  I advised prudence, cautioned that the loss on its derivatives could well exceed the initial estimate of $2 billion (it did) but took the view that buying below $36 would result in a profitable trade.  The stock price spent two months below that level, bottoming at $30.70.  Today it is $42.81.

The bank management was extensively reshuffled.  Yet markets have responded without enthusiasm.  Although the stock price should appreciate further next year, my view of the company has evolved.  I have come to the conclusion, partly through personal experience and partly through industry review, that the bank has grown too big and diversified to provide superior customer products and services and to be effectively controlled. 

Warren Buffett once said that he wanted to invest in businesses that even fools couldn’t sink, because sooner or later fools would be in charge.  JP Morgan’s top management is very smart, even if it may suffer from some hubris; but I wouldn’t want to own the stock if fools were at the helm.  Admittedly, this is a remote possibility in the case of JPM.

Standard Chartered plc (-6%)

Last August, I wrote about Standard Chartered plc.  I expressed disbelief with their decision to continue doing business with Iran through their US facilities despite clear prohibition imposed by their host country.  I questioned the bank’s decision-making and the oversight exercised by its Board of Directors.  I also felt that its market value failed to reflect the inherent risks of its business model.  I elected to pass and wait for another day to invest.  The stock price then was 1,418.5p; today it is 1,497p.

Since then, little has changed. Of its twenty-one Directors, only two new have joined the Board following disclosure of the Iran saga.  No top or senior manager has paid the price for this fiasco.  The bank settled the outstanding charges with the US federal authorities for $327 million.   However, its latest quarterly results were satisfactory and, had I bought the stock back then, I would have made a 6% gain to-date.  I remain a skeptic but I admit that I may have been wrong.

 

Apple (+26%) and Research in Motion (+87%)

Last September, I argued that Apple was not a cheap stock despite its modest p/e multiple, the reason being that such multiple resulted from a very high gross margin.  I noted that reverting to 2006 gross margin levels would push the p/e above 23, even after deducting Apple’s large cash balances from its market value.  I also expressed some doubt that Apple could maintain its growth rate and gross margins by targeting emerging markets such as China.  Interestingly, Apple’s latest quarterly results showed a small drop in margins which the company put on the concurrent launches of new products.  The stock price, which was $691 on the day of our initial writing, has now fallen to $510. 

Irrespective of its fundamentals, Apple, once buoyed by client adoration and investor exuberance, seems to have lost some of its magic:  Steve Jobs passed away; it stumbled with its handling of Google Maps and Youtube; it continues to rankle with its refusal to support Adobe Flash; Apple TV remains an undefined possibility.  That said, relative to its peers, it remains a unique company; it is just very difficult to keep beating extraordinary expectations and to have to add $50 to $70 billion a year to justify current market valuation.   

On September 28^th, I argued that Research in Motion, the maker of the Blackberry, was a buy as it was priced for extinction, which didn’t seem likely. Today, a consensus has emerged that its new Blackberry 10 will come to market early next year.  Carriers and large corporate clients are testing it.  Besides its reported merits, the BB10I is benefitting from telephone carriers wanting to break the Apple/Android duopoly.  On the other hand, RIMM is faced with patent litigation from Nokia and has a very steep hill to climb in Europe and North America to regain market share. 

How will RIMM look like in two years, will it have succeeded in regaining critical mass, I don’t know.  But it has a sporting chance thanks to a meaningful client base (80 million), strong technology and good finances.  Back on 9/28/12 the stock price was $7.50.  Today, even at $14.05, its stock price continues to discount a somber future.

We should remind ourselves that extrapolating in a straight line is always dangerous; that was true when I wrote about these stocks back then and that is true now.  Market valuations are right most of the time, but when consensus reaches 90% or more, it is usually worth our while to investigate.

 

A few thoughts on JP Morgan’s hedging loss

JP Morgan announced yesterday that its Chief Investment Office had incurred a loss of $2 billion on derivative trading undertaken for the purpose of hedging its loan portfolio.  This loss in turn had been partially offset by $1 billion of realized gains in regular trading.  JPM’s Jamie Dimon further warned that the CIO loss could rise or fall substantially until the derivative positions were undone.

As a shareholder, I was surprised by the announcement and I am not happy.  In the charged regulatory and political climate of Washington, we can expect all kinds of theater; Congress has already announced hearings on the matter; the SEC and the New York State Attorney have announced inquiries.  While the stock has fallen 9% already, it could fall further.

There some troubling aspects to this loss:  (1) how could these derivative positions lose so much money in so little time? (2) market rumors of excessive position building seem to have preceded JPM’s top management awareness of the magnitude of the problem, (3) how could anyone believe that building a position, big enough so as to be illiquid, be a good way to hedge a portfolio? (4) if indeed the short hedges lost money, there should have been a commensurate gain on the asset side JPM balance sheet.

Beyond the above questions, there are some more fundamental issues: (1) is this incident evidence that JPM has become too big to manage, even for as detailed-oriented a manager as Mr. Dimon, or is this proof that even the best falter sometimes? (2) there have been reports, unconfirmed so far, that those responsible for hedging at CIO had recently been expected to show a profit as well; (3) old-time bankers like me remember when the kind of derivatives JPM used didn’t exist, yet banks tried to protect against portfolio losses by having ample capital and  building general loan loss reserves in good times; shouldn’t regulators and banks take another look at these remedies?

I will close with two observations:  having pulled through the crisis unscathed, JPM has not been bashful about its prowess.  Its CEO can come across as arrogant at times, and I can see how many officers at the bank, by assimilation, could consider themselves as the new masters of the banking universe; hubris can be as dangerous, in its own way, as lack of competence.  Although it is purely a personal speculation of mine, I believe that the huge cost of litigation and regulation is pushing banks to make up for lost profits in every nook and cranny, in the case of JPM in what used to be a hedging activity.  Ironically, Congress and state attorney generals have some paternity in the JPM loss.

Clearly, JPM has built huge derivatives positions that it can’t easily close.  Market participants will quickly figure out which these are, if they don’t know already, and bid against JPM.  This is why Mr. Dimon warned about volatility and his determination to use his balance sheet not to be forced into untimely liquidation.  Consequently, it is prudent, in the absence of detailed information which is unlikely to be aired publicly, to assume that JPM could incur a bigger loss than the above gross $2 billion.

Even if the gross loss number were doubled to $4 billion, or about $1.05/share , pre-tax, the tangible book value at the end of the year is likely to be close to $36 [1] per share.  I would think that buying below that level would represent an interesting opportunity.  After all, the bank is well diversified, has plenty of capital and, despite this embarrassing loss, well managed.

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[1] $34.5 tangible book at 3/31 + $4.7 of earning - $2.1 of net loss - $1.2 of dividends.  Book value would rise to $49.1.  I have assumed no net share buyback for the rest of the year.