Thoughts on Big Banks and Volcker Rule
After reading a recent Fortune piece on the Volcker Rule, I had a couple of thoughts and observations to share. The article explains that major banks in the U.S. are again asking for an extension before complying with the Volcker Rule, needing more time before divesting their illiquid assets. It also discusses the size of the assets that fall under the Volcker Rule that Goldman Sachs (
GS
), Morgan Stanley (
MS
), and JPMorgan (
JPM
) currently own.
http://hvst.co/2aYSq4c
I understand the banks' unwillingness to go through any painful experience right now. Net interest margin has been compressed as the Fed has artificially kept interest rates low. After the six-year bull market we are currently experiencing, the outlook for bank activity levels could soon be slowing and in hindsight, it may have been better to go through this pain years ago. Furthermore, the low-interest rate environment has produced an environment where risk taking and valuations have been rewarded, so this may be an opportune time to sell these assets, if the banks act quickly.
I have two qualms about banks’ unwillingness to comply. It has been ten-plus years since they began to get the U.S. (and global economy) into a crisis with over extending the mortgage and securitization business and over-leveraging themselves and other financial institutions with products like CDOs. Frankly, I do not believe the banks felt enough pain and re-emerged from the crisis too quickly, without fully resolving issues, including the Volcker Rule, which in some ways is a Glass-Steagal “light” rule set. It makes the most business sense to tie off loose ends from these illiquid and principal investing businesses. The continuing conflict with regulators and legislators is not improving the banks’ standing with the public, Washington, or investors by not resolving this already.
Per the article, Goldman Sachs (GS) has $7 billion in real estate, hedge funds, and other illiquid investment positions, Morgan Stanley (MS) has $3.2 billion, and JP Morgan (JPM) has $1.0 billion. Meanwhile, the market capitalizations are approximately $67 billion, $56 billion, and $236 billion, respectively (as of August 12, 2016). The value of investments to divest represents 10% (GS), 6% (MS), and 0.4% (JPM) of their market caps. I argue that this won’t affect their valuations significantly. In the worst case scenario, even discerning buyers should offer dimes to quarters on the dollar, not pennies. Goldman would be the hardest hit by the Volcker Rule implementation and built the best franchise of the three in the principal investing space, but this is far from a major event. By way of comparison, the London Whale scandal of JP Morgan was an approximately $6 billion loss, per the July 13, 2012 announcement. According to a CNN Money article ( http://hvst.co/2aYRooH ), JPM lost $25 billion since it revealed the initial loss but then surged 6.0% on July 13, 2012. It should be noted that the JPM juggernaut earned net income of $5.0 billion in Q2, including the trading loss. The one day move was approximately worth $7.7 billion to JPM’s market cap. One month later, the market had shrugged off the effect of the loss and was up 8.7% since July 12, 2012, or $11.2 billion. Over this same one month period, the iShares financial sector ETF (IYF) was only up 1.6%. The point being, a franchise like JP Morgan can get past this type of potential write-down quickly - I have no doubt Goldman Sachs’ and Morgan Stanley’s franchises will remain intact, like JP Morgan’s. With a typical Wall Street classification of the illiquid investment sale as a restructuring and one-time expense, investors may ignore any hit to book value and expenses to accomplish the divestiture of illiquid assets.
My suggestion is for these firms is one of two courses of action: (1) to create new public companies and complete IPOs for them or, (2) to spin-off the assets and give shares in the new company to existing shareholders (spin-off). While the differences between the two are small, in both cases they will have to create a prospectus and make substantial disclosures exposing them to sharing which contracts and investments have been made, as well as further detail on how they are valuing them. Under the IPO option, the bank will be the sole selling shareholder and additional capital could be raised for the new entities. The banks may even directly, or indirectly, receive some compensation for their services as underwriters to soften the blow, although I think receiving such fees is egregious in this case. The total book value of approximately $11 billion from the three aforementioned firms should not be an issue for the market to absorb given the dearth of recent financial IPOs, demand for yield, and the low-interest rate environment. The market for alternative asset managers such as Carlyle, Blackstone, KKR, and Ares is fairly robust, with multiples between 1.0x and almost 3.0x book value. The banks would also receive cash to deploy strategically for buybacks / dividends, to shore up capital (though the largest banks are seen by many as overcapitalized right now), or to deploy into existing operations for growth.
The spin-off is largely the same, but could be a faster process without needing to find new shareholders, and not receiving cash from the assets. The headline value with the spin-off may also be higher as it may be able to be done at a value closer to book value, rather than the possible haircut the IPO investors may offer. With Goldman’s portfolio being the largest of the three, it may make sense for them to split it into two asset class properties such as real estate and hedge funds. If the banks are holding out hope that they will find a few strategic buyers, or private financial institutions, to acquire these assets at a premium, they run the risk that buyers may see their position as weakness, not participate in the IPO, and sully the opinion on the assets. Public investors would be much less likely to bid if the smartest buyers on Wall Street (firms like JC Flowers, Baupost, Oakmark, Fairfax, or strategic real estate investors like Brookfield, Boston Properties, Equity Residential, and so on) passed on the opportunity.
CCM has shied away from some of the largest commercial and investment banks because they are too large, have legacy business that is difficult to model and understand, and is subject to higher risk and volatility. However, we would support either of these paths and be buyers of the spin-offs, particularly at a significant discount to any reported Net Asset Value and where sufficient disclosure has been provided to form our own opinion on an estimated fair value. With the spin-off, there may be a shift of the shareholder base and downward pressure share early on (shareholders who only want to own the banking business will sell the illiquid asset manager stock). This could certainly make a more attractive entry point and provide a larger margin of safety. Considering how long we have been waiting for banks to comply with the Volcker Rule and move on, we do not expect these alternatives to be completed in 2016, but would certainly welcome the opportunity if management acted quickly.
Disclosure: CCM did not receive compensation for this article. CCM nor its clients hold direct positions in the securities mentioned herein does not plan to within the next 72 hours. Investments are inherently risky, please conduct appropriate due diligence before investing and consult with a financial professional, accountant, or lawyer. Past performance is not a guarantee of future results.
Written by Carlos Sava, Founder and Portfolio Manager, Clarendon Capital Management LLC
I understand the banks' unwillingness to go through any painful experience right now. Net interest margin has been compressed as the Fed has artificially kept interest rates low. After the six-year bull market we are currently experiencing, the outlook for bank activity levels could soon be slowing and in hindsight, it may have been better to go through this pain years ago. Furthermore, the low-interest rate environment has produced an environment where risk taking and valuations have been rewarded, so this may be an opportune time to sell these assets, if the banks act quickly.
I have two qualms about banks’ unwillingness to comply. It has been ten-plus years since they began to get the U.S. (and global economy) into a crisis with over extending the mortgage and securitization business and over-leveraging themselves and other financial institutions with products like CDOs. Frankly, I do not believe the banks felt enough pain and re-emerged from the crisis too quickly, without fully resolving issues, including the Volcker Rule, which in some ways is a Glass-Steagal “light” rule set. It makes the most business sense to tie off loose ends from these illiquid and principal investing businesses. The continuing conflict with regulators and legislators is not improving the banks’ standing with the public, Washington, or investors by not resolving this already.
Per the article, Goldman Sachs (GS) has $7 billion in real estate, hedge funds, and other illiquid investment positions, Morgan Stanley (MS) has $3.2 billion, and JP Morgan (JPM) has $1.0 billion. Meanwhile, the market capitalizations are approximately $67 billion, $56 billion, and $236 billion, respectively (as of August 12, 2016). The value of investments to divest represents 10% (GS), 6% (MS), and 0.4% (JPM) of their market caps. I argue that this won’t affect their valuations significantly. In the worst case scenario, even discerning buyers should offer dimes to quarters on the dollar, not pennies. Goldman would be the hardest hit by the Volcker Rule implementation and built the best franchise of the three in the principal investing space, but this is far from a major event. By way of comparison, the London Whale scandal of JP Morgan was an approximately $6 billion loss, per the July 13, 2012 announcement. According to a CNN Money article ( http://hvst.co/2aYRooH ), JPM lost $25 billion since it revealed the initial loss but then surged 6.0% on July 13, 2012. It should be noted that the JPM juggernaut earned net income of $5.0 billion in Q2, including the trading loss. The one day move was approximately worth $7.7 billion to JPM’s market cap. One month later, the market had shrugged off the effect of the loss and was up 8.7% since July 12, 2012, or $11.2 billion. Over this same one month period, the iShares financial sector ETF (IYF) was only up 1.6%. The point being, a franchise like JP Morgan can get past this type of potential write-down quickly - I have no doubt Goldman Sachs’ and Morgan Stanley’s franchises will remain intact, like JP Morgan’s. With a typical Wall Street classification of the illiquid investment sale as a restructuring and one-time expense, investors may ignore any hit to book value and expenses to accomplish the divestiture of illiquid assets.
My suggestion is for these firms is one of two courses of action: (1) to create new public companies and complete IPOs for them or, (2) to spin-off the assets and give shares in the new company to existing shareholders (spin-off). While the differences between the two are small, in both cases they will have to create a prospectus and make substantial disclosures exposing them to sharing which contracts and investments have been made, as well as further detail on how they are valuing them. Under the IPO option, the bank will be the sole selling shareholder and additional capital could be raised for the new entities. The banks may even directly, or indirectly, receive some compensation for their services as underwriters to soften the blow, although I think receiving such fees is egregious in this case. The total book value of approximately $11 billion from the three aforementioned firms should not be an issue for the market to absorb given the dearth of recent financial IPOs, demand for yield, and the low-interest rate environment. The market for alternative asset managers such as Carlyle, Blackstone, KKR, and Ares is fairly robust, with multiples between 1.0x and almost 3.0x book value. The banks would also receive cash to deploy strategically for buybacks / dividends, to shore up capital (though the largest banks are seen by many as overcapitalized right now), or to deploy into existing operations for growth.
The spin-off is largely the same, but could be a faster process without needing to find new shareholders, and not receiving cash from the assets. The headline value with the spin-off may also be higher as it may be able to be done at a value closer to book value, rather than the possible haircut the IPO investors may offer. With Goldman’s portfolio being the largest of the three, it may make sense for them to split it into two asset class properties such as real estate and hedge funds. If the banks are holding out hope that they will find a few strategic buyers, or private financial institutions, to acquire these assets at a premium, they run the risk that buyers may see their position as weakness, not participate in the IPO, and sully the opinion on the assets. Public investors would be much less likely to bid if the smartest buyers on Wall Street (firms like JC Flowers, Baupost, Oakmark, Fairfax, or strategic real estate investors like Brookfield, Boston Properties, Equity Residential, and so on) passed on the opportunity.
CCM has shied away from some of the largest commercial and investment banks because they are too large, have legacy business that is difficult to model and understand, and is subject to higher risk and volatility. However, we would support either of these paths and be buyers of the spin-offs, particularly at a significant discount to any reported Net Asset Value and where sufficient disclosure has been provided to form our own opinion on an estimated fair value. With the spin-off, there may be a shift of the shareholder base and downward pressure share early on (shareholders who only want to own the banking business will sell the illiquid asset manager stock). This could certainly make a more attractive entry point and provide a larger margin of safety. Considering how long we have been waiting for banks to comply with the Volcker Rule and move on, we do not expect these alternatives to be completed in 2016, but would certainly welcome the opportunity if management acted quickly.
Disclosure: CCM did not receive compensation for this article. CCM nor its clients hold direct positions in the securities mentioned herein does not plan to within the next 72 hours. Investments are inherently risky, please conduct appropriate due diligence before investing and consult with a financial professional, accountant, or lawyer. Past performance is not a guarantee of future results.
Written by Carlos Sava, Founder and Portfolio Manager, Clarendon Capital Management LLC
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