In the world of banks, risk-taking is so 2007.
Ten days ago, Moody's downgraded 15 global banks that actively trade securities and have other big capital markets operations. The ratings service explained that these activities expose them to a danger of "outsized losses" that are inherent in those businesses.
Then came reports last week that one of the 15, JPMorgan Chase & Co., may have lost as much as $9 billion on a bad derivatives trade -- which just proves Moody's point.
The mass downgrade leaves just one big banking company at Aa3 as rated by Moody's: U.S. Bancorp, a heartland company located a world away in its business strategy.
Minneapolis-based U.S. Bank, the fifth-largest American bank, makes money in consumer and business banking and by running big service businesses like trust and payment processing. It tells its investors that it is happy leaving capital markets activities to others, whether or not the markets are hot.
Maybe more telling than being Moody's top-rated big bank is that investors have pushed borrowing costs for U.S. Bank to the lowest by far among big banks. Its stock over the past two years has been the top performer without a close second among a peer group of 10 major banks, up 31.5 percent. Being boring is proving to be a sustainable competitive advantage through cheaper capital.
U.S. Bank vs. peers is a case study in one of the fundamental ideas of investing: transparency and predictability in future cash flow drive value. To predict cash flow you need to see how a company makes its money. And the big capital markets banks like JPMorgan are black boxes when it comes to earnings. You can see the profits but can't see clearly into the box at how they were made.
David P. Goldman, principal of Macrostrategy LLC in New York and former global head of fixed income research for Bank of America, said an investor traditionally would examine the loans, securities and mortgage servicing portfolios, and make estimates based on what could be seen.
"Then there's all of this stuff left over that you can't make sense of," he said, referring to proprietary securities trading and other activities. "Stuff that you can't get a good explanation for. And if you can't make sense of it and you can't get a good explanation for it, then you have to assume the worst."
He said JPMorgan's credit-default derivatives mess is just that -- a shocking disclosure in a nonbanking unit followed by an unconvincing explanation from Chief Executive Jamie Dimon. Goldman said he concluded that it wasn't a sloppily executed hedge at all, as Dimon argued, but an intentional trade to boost earnings. He characterized that strategy as "delusional."
No analyst says delusional when discussing the strategy of U.S. Bank Chairman and CEO Richard Davis. "Boring" is their favorite word. "That's his role at that bank, and that's really his ambition, to be boring," said Nancy A. Bush, a longtime bank analyst and a contributor to SNL Financial, an industry data provider.
U.S. Bank gets just 2 percent of its revenue from the exciting and headline-producing activities of trading, brokerage, investment banking and equity investments, vs. an average of 11 percent for a group of nine peer banks. Banks in that group on average get only 4 percent of their revenue from the repeatable and predictable business of managing payments, and for U.S. Bank it is 17 percent.
Corporate trust is another snooze. It largely entails getting paid to act in the interest of bondholders and other investors. While that is not always easy, like when a bond issue sinks into default, trust is hardly a volatile business. U.S. Bank's market share in domestic corporate trust grew from 8 percent in 2007 to 24 percent in the first quarter of 2012. U.S. Bank since the first quarter of 2008 has acquired $1.1 trillion in trust assets of all kinds under administration.
U.S. Bank's story about trust and its other businesses is getting through to investors. Debt investors are all but jumping in the boat.
U.S. Bank issued five-year notes in May at a rate of 1.65 percent. In real terms, which considers the impact of inflation in interest rates, that money was more or less free. No wonder certificate of deposit rates are low, if the bank can attract $1.25 billion at a 1.65 percent rate in one morning.
Morgan Stanley is among the research firms that track "credit spreads," meaning the premium in returns over Treasury notes corporate borrowers have to pay to attract debt capital. As of this week, Morgan Stanley reported that U.S. Bank had by far the cheapest borrowing cost of a group of large banks. Its credit spread was less than half of JPMorgan's on five-year debt.
All of this recognition from the investment community would seem fun to discuss, but U.S. Bank executives declined to comment for this column. Just speculating here, but perhaps coverage of Moody's downgrades and JPMorgan derivatives trading seems like a perfect opportunity to remain silent.
It is also true that Moody's has had U.S. Bank on "negative" outlook since March 30, 2009. Liquidity, capital cushion, revenue and net income are all up since the first quarter of 2009, but Moody's has said its view of the banking sector remains cautious. A ratings downgrade this summer by one notch would not be surprising.
Besides, it is not hard to learn what Davis thinks. On his first-quarter call in April with investors, analyst Michael Mayo from Crédit Agricole pressed him a bit, asking "are you leaving money on the table" by not adding more capital markets businesses.
"OMG, no!" Davis responded. "We only do what we understand and that we can control. And as trite as it sounds, I really like the consistent, predictable, repeatable business we've given you all."
No argument here.
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