Punta del Este | As we head into Q4 2019 earnings this week, US financials have never been so expensive and risk indicators have never been so skewed. Just as last July we called the problems brewing in the short-term money markets in a discussion on CNBC’s Halftime Report with Mike Mayo of Wells Fargo (NYSE:WFC), today we want to put down a marker regarding the concealed credit risk inside US banks.
Our favorite bank portfolio holding, U.S. Bancorp (NYSE:USB), closed Friday at 1.87x book value, down about 5% from the peak in December just over $60 and 2x book. Still a little too rich to add more to our portfolio of USB common, but we continue to accumulate a number of bank preferred issues. With the number of profitless unicorns dying at an accelerating rate, steady cash flow has a certain appeal right about now.
More important, credit default swap (CDS) spreads for high quality issuers are also at all time lows. JPMorganChase (NYSE:JPM) is inside 40bp or around a “A” rating for the largest bank in the US. In 2015, JPM’s CDS was trading close to 120bp over sovereign swaps. Question is, does the market know, really, how much risk sits on Jamie Dimon’s books in the world of corporate CDS and more obscure credit products, like “transformation repo.” We think not.
For those not familiar with the wonders of OTC derivatives and collateral swapping, see our 2019 comment “HELOCs and Transformational REPO.” We wrote in March of last year: “The dealer bank trades corporate debt for cash (for a fee), but uses its own government or agency collateral to meet the margin call for the customer.
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