Unsexy banks sail through crisis

JPMorgan Chase gets a pat on the back for avoiding the credit calamity that has plagued its competitors. Investors have lowered their standards for financial services, even though other companies are less risky and offer solid performance.

Bank of New York Mellon and State Street skated through the crisis nearly unscathed because of their minimal exposure to the securities that caused the pain. These companies profit from the boring business of asset custody, so it's easy to overlook them in favor of firms with more sizzle, like Citigroup , Goldman Sachs and JPMorgan, whose investment banking divisions add rocket fuel to their earnings and risk profiles.

Custody banks are far from exciting, and they won't make good conversation topics at a dinner party, but they're stronger bets than the big-name banks. Bank of New York has generated an operating margin of 19 per cent for the past 12 months, while State Street posted an impressive 32 per cent. These numbers crush those of the investment banks that have seen revenues crumble amid capital market turmoil.

Bank of New York and State Street, which report third-quarter results tomorrow, benefit from the steady stream of income they get for providing services such as record keeping, performance analysis and trade execution. The stock has a forward price-to-earnings ratio of 12, compared with 27 for the industry.

These services haven't resulted in blockbuster share growth. Bank of New York's shares have fallen 2.2 per cent this year, while State Street's have climbed 35 per cent. Goldman Sachs shares have more than doubled, and JPMorgan stock has soared 49 per cent.

The stocks haven't achieved the fabulous returns of Citigroup, Goldman Sachs or JPMorgan this year, but they've only lost 5.5 per cent annually, on average, in the past three years. If you were to create a portfolio that favors Goldman and JPMorgan over the poorly performing Citigroup, the custody banks would beat the investment banks by more than 6 per cent.

If an investment is worth the discounted value of future cash flows, then what's driving the valuation of these banks? During Citigroup's heyday, the shares yielded about 4 per cent in dividends, on par with big companies such as General Electric. Investors must have factored in profits not paid out in dividends, but this money is going toward bonuses to top employees, enriching them at the expense of shareholders.

For investors suffering from slashed dividends, it must be infuriating to see the investment banks pay millions of dollars to the very people that caused the loss of income. The economic incentives are out of whack at these banks. While State Street and Bank of New York must pay top brass well, the scale of the payout isn't on the same level as the big investment banks.

State Street and Bank of New York won't hit the moon on a hot trading streak like others, but they won't blow-up on the launch pad. Investors who rode Goldman and JPMorgan share back from the dead might feel validated, but those stocks could have easily suffered a prolonged slump like Citigroup shares.

Risk certainly has its place, but more emphasis should be placed on the likes of State Street and Bank of New York.