Relative value in financial services

Not every financial services sector company is a basket case destined for bankruptcy. There are many well-run lower risk organizations in the bunch. Moreover, let’s not blame the banking model for individual companies’ woes. The Economist had a good article this weekend highlighting the fact that it is not the universal banking model which is to blame f0r large writedowns at the likes of UBS and Citigroup.

Yet, tempting as it is to believe that changing business models would solve UBS’s problems, or those of the wider industry, the evidence of the credit crisis suggests otherwise. No single model has emerged from the turmoil either wholly vindicated or entirely discredited. Credit Suisse shares a city square in Zurich and a business strategy with UBS, but has come through the past 12 months in much better shape and continues to attract money into its wealth-management division. Citigroup’s version of the universal-banking model is one where it walks into every punch going; Britain’s HSBC has been more successful in blunting the impact of its American misadventures through decent earnings in emerging markets. Of the Wall Street investment banks, Goldman Sachs has survived with its reputation enhanced. Bear Stearns did not survive at all. Pure retail banks can blow up too: Northern Rock, which was nationalised by the British government after a humiliating run on it, had a simple enough product line.-No size fits all, Economist, 14 Aug 2008

While it is not a sure bet that Credit Suisse, Goldman and HSBC will continue to outperform their peers, it should be obvious that there are extreme differences in the risk profiles of different financial institutions n the same line of business.

Enormous losses were not a given for financial services companies. Those organizations with the greatest losses are the ones who took the largest risk. Their risk play has not paid off and they are reaping the consequences. Losses in the financial services sector are a direct result of individual institutions succumbing to the pressure for sustained profits in a low-return environment and making large bets on riskier assets just when the housing bubble burst. Other companies in the same sectors avoided these risks.

This got me to thinking about relative value plays in the financials. In that vein, let me suggest some financial institution relative value plays:

  1. Large U.S. Banks: Wells Fargo over Citigroup
  2. Large U.S. Banks: U.S. Bancorp over JP Morgan Chase
  3. Large U.S. Banks: Bank of New York Mellon over Bank of America
  4. Large U.S. Regional Banks: SunTrust over Wachovia
  5. Large U.S. Regional Banks: M&T Bank over Washington Mutual
  6. Britain: Lloyds over HBOS
  7. Switzerland: Credit Suisse over UBS
  8. Canada: Scotiabank over CIBC
  9. Germany: Commerzbank over Deutsche Bank
  10. Investment Banking: Goldman Sachs over Merrill Lynch
  11. Property and Casualty Insurance: Berkshire Hathaway over AIG

Why would you own the list of second names when you can own the first? Bottom-fishing is the only plausible reason I can come up with. But, in this credit crisis so far, bottom fishers have not done well. Expect more of the same going forward.

  1. Anonymous says

    I disagree with your conclusion. A lot of banks – such as Norther Rock – have problems because of over reliance on short term interbank borrowing (which has dried up). Not bad loans.

  2. Edward Harrison says

    Yes, that is true. Liquidity is a major concern. But recognizing that does not argue against the relative value of some financials over others. How do you disagree with my conclusions?

    As for Northern Rock, we are now seeing that Northern Rock’s loan book was not that good to begin with. Although they fell because of liquidity constraints, I would argue that they would be in dire straits today had they not failed in 2007 as the Chancellor’s additional funding has demonstrated.

  3. MAB says


    On a stand alone basis, I don’t think any financials are good risk adjusted investments here. That seems to fit well with your credit deflation thesis. As a paired trade though, identifying the bad and the not as bad could be a profitable stategy.

    That said, financial companies are black boxes. It’s hard to say what is lurking on or even off a balance sheet. Even WFC looks vulnerable as they have a huge exposure to California real estate via home equity loans. Their latest earning “beat” looked like smoke and mirrors to me – extending the term of delinquent to 120 days from 90 days.

  4. Edward Harrison says


    I wouldn’t touch financials with a barge pole. I think Laszlo Brinyi is right: ‘avoid financials.’ So, I agree with you – no financials. But, paired trades might be a way to reduce risk from going long or short.

    This sort of a relative-value hedge trade is the sort of thing hedge funds were invented to o. But, now it seems they are more bent on taking on risk.

    As for WFC, they seem mighty confident — dividend increase and all (not that I’d buy them outright here). Let’s see if there is any substance to that.

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