The consensus seems to be that Obama’s proposal to limit the operations of the banks to lending and securities underwriting, and not proprietary trading and hedge fund investing, if enacted, would be bad for banks and bank shareholders. Many pointed to the so-called Volcker rule to explain last week’s market sell-off. Like Ritholtz, I’m not quite sure I buy that explanation. I second Barry’s view that the Journal is getting sloppy and politicized, but there is another, much bigger reason why the sell-off makes no sense: The Volcker rule would actually be good for bank investors. (And as we all know the market is efficient.)
Here’s why: Despite banks recent experience with souring loans, lending and deposit taking is generally a more stable business than say proprietary trading or hedge fund, or private equity fund, investing. In theory, the shares of companies with more stable revenue and earnings streams should get higher valuations. Investors can trust those earnings and revenue more, so they pay up.
What this means for bank shares is that the more money the company makes from the boring business of lending and the less from those volatile trading and principal investing operations, the higher their p/e multiple is going to be. And in practice, that is exactly how it works. Even before the financial crisis, the valuations of Wall Street financial firms were falling as those companies added more and more risky businesses.
Take Goldman Sachs. For the much of the first few years after Goldman went public in 1999, the stock traded with a p/e ratio in the mid-to-high teens. It reached a p/e of 20 in early 2001. Then the Blankfein era commenced, which really started when the movie buff got the job as Goldman’s No. 2 in 2004. Lloyd ramped up Goldman’s already trading heavy culture. Last year, for instance, the company was risking as much as $240 million in the market everyday, or about 10 times what it gambled a decade ago. As a result, Goldman’s earnings soared, but its p/e multiple plummeted. By early 2007, well before most people were talking financial crisis, Goldman’s p/e had dropped to 9. Today, even as Goldman is posting stunning profits, the company’s trailing p/e is just under 8.
Now say the Volcker rule went into place, and Goldman was forced to drop its prop trading. Would shareholders be better or worse off? Let’s do the math. Goldman says about 10% of its revenue comes from trading for its own account. It’s probably much higher than that. David Hendler of CreditSights believes Goldman’s prop trading exposure could be as high as 40% of Goldman’s revenue. And given that trading is much more profitable and less labor intensive than say giving M&A advice, my guess is that prop trading even makes up a larger share of earnings. So lets say Goldman gets a wild, but possible, 50% of its earnings from prop trading. What would a non-prop-trading, Volcker-compliant Goldman have earned last year? About 11.00 a share. Apply a 17.5 p/e multiple–the mid-range of where the stock traded BB (before Blankfein)–and you have a Goldman stock price of $192.50, or about $35 higher than where the stock trades today.
So you see, even if you don’t think the Volcker rule addresses the problems that caused the financial crisis, any rational bank investor should see that it is good for their portfolio. That seems like a pretty good first step to me.
