Talk about the past coming back to haunt you…
Way back in the 1990s, banks uncovered a novel way to save money on taxes and employee benefits by – get this – betting on their employees dying.
I’m not joking.
An obscure investment known as bank-owned life insurance (BOLI) made it all possible. The banks simply purchased life insurance on their employees in bulk, and named themselves as the beneficiaries.
So if an employee dies, the bank profits.
I know. Nothing could possibly go wrong with such an arrangement, right?
Of course, it did.
And now, some 20 years later, the involvement of one of the world’s largest financial institutions in these “dead money” investments is making its stock… well, a “dead money” investment, too.
As you’ll find out in a moment, though, it’s anything but.
Better Off Dead
The way BOLIs work is pretty straightforward…
A bank purchases life insurance on employees. However, they don’t actually pay the premiums to an insurance company. Instead, they keep the money in a designated fund and invest it on their own. Hence, the bank-owned part.
If you know anything about how insurance companies invest premiums, you’ll immediately recognize what a coup the banks pulled off.
Instead of premiums being socked away in stodgy, low-return, low-yield investments – like cash and U.S. Treasuries – banks can be more risky with the capital to generate higher returns.
They get to keep all the profits, too. Not to mention, they pocket a payout upon an employee’s death.
Now, the banks can’t spend this money any way they want. It must ultimately be used to cover expenses for employee benefits. However, all the premiums invested, as well as any capital appreciation, aren’t taxed.
So BOLIs are essentially a tax shelter and cheap funding source for banks. No wonder they’re so popular, even today. (It’s estimated that almost 4,000 banks own $140 billion in BOLIs.)
There is a downside to BOLIs, however: If banks invest the premiums poorly, they’re on the hook for the losses.
In our world of never-ending financial innovation, though, it shouldn’t surprise you that banks found a way to eliminate that risk, too. And therein lies the problem…
No Such Thing As “No Risk”
The financial wizards over at JP Morgan (JPM) devised a way to assume much of the downside risk on BOLIs – for a fee, of course – using a derivative product known as a “stable-value wrap.”
Don’t worry about learning the ins and outs of another esoteric investment. All you need to know is this…
Other major banks followed JP Morgan’s lead into this market. And now, thanks to recent changes in regulations (Basel III), they’re required to set aside more capital to cover the liabilities created by these long-term derivatives.
As Martin Zorn, Chief Operating Officer at the risk management firm, Kamakura Corp., says, “Times have changed: There are a lot of long-term derivatives on financial institutions’ balance sheets that have become very costly today, and will stay that way.”
Granted, these derivatives only account for a small percentage of the megabanks’ investment portfolios. But the point is, the increased capital they have to set aside comes with an opportunity cost.
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In other words, since the money is just providing collateral, it can’t be allocated elsewhere to generate actual profits.
The situation can’t simply be unwound, either. Most of these derivatives are unique, so they’re not easily priced. They don’t trade regularly on exchanges. And there’s a limited pool of potential buyers.
Think about it… Banks aren’t exactly going to rush out to buy other banks’ long-term derivatives if they’re looking to unload their own.
Add it all up, and since the liabilities extend out for decades, banks are stuck with them. Or as Morgan Stanley (MS) Chief Executive, James Gorman, declared at the company’s annual meeting, these positions are “dead money.” Indeed!
Three More Risks Facing JP Morgan
JP Morgan is the biggest issuer of these derivatives, accounting for upwards of 30% of the market. In turn, it’s the most capital constrained. And if you’re in charge at JP Morgan, that’s not an ideal situation.
Not with the economy on the mend and interest rates rising.
We’re essentially on the cusp of entering the sweet spot of the economic cycle for banks and financial institutions. Yet the company can’t take full advantage of it.
That’s not the only reason the stock is a “dead money” investment, though.
Richard Bove, a well-known banking analyst at Rafferty Capital, sees “three clear risks” to JP Morgan’s earnings potential: lower investment-banking fees, slower payment systems profits and rising litigation costs.
Accordingly, he lowered his rating on the stock to a “Hold.”
My response? When will Wall Street analysts ever get a pair?
We all know their “Hold” is merely a euphemism for “Sell.” And that’s exactly what I think you should do if you own JP Morgan. There’s too much downside risk and too little upside potential.
If you need a suitable alternative, consider Bank of America (BAC). As I shared earlier in the year, it boasts strong fundamentals and a compelling valuation. But the tale of the tape pretty much says it all.
In the last year, JP Morgan is up about 40%, whereas Bank of America is up 80%. In more recent weeks, the divergence appears to be intensifying.
Since July 10, JP Morgan is down almost 6%, compared to an 8% rally for Bank of America.
Bottom line: If you’re looking for the lowest-risk, highest-return trade in mega-cap banking stocks, dump JP Morgan and buy Bank of America.
If you want to mitigate the market risk altogether, consider putting on a pairs trade: Divide the capital you plan to invest in two. Then use half to sell short JP Morgan, and use the other half to buy Bank of America.
Rest assured, regardless of which option you choose, it promises to be a much better alternative than sticking with a “dead money” investment.
Ahead of the tape,