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Exposed: What’s Inside America’s Banks? – Part 1/3
Posted by Stephen Cook on January 4, 2013 / Comments Off
Category: World Banking Changes
Tags: Bankers' Fraud, New System Needed
Jamie
Dimon, JPMorgan’s CEO, testifying last summer before the House
Financial Services Committee about his bank’s sudden $6 billion loss.
(Jacqueline Martin/AP)
Exposed: What’s Inside America’s Banks? – Part 1 of 3
Stephen: Last year saw much deception and fraud uncovered within
the global banking sector – the Libor scandal, money laundering, illegal
foreclosures and so much more.
This is an incredibly detailed and well-researched mainstream magazine expose from The Atlantic,
looking at what’s really going on with the banks. It also offers some
surprising solutions. It may focus on the US, but it’s applicable
worldwide… Although some of it is not new to some of us, it is
enormously rewarding and refreshing to see such material making it into
the wider public domain. It is lengthy, so I will break it into three
parts for your weekend leisure reading. Thanks to Bob.
About the Authors – Frank Partnoy is a law and
finance professor at the University of San Diego and the author of Wait:
The Art and Science of Delay. Jesse Eisinger is a senior reporter at
ProPublica and a columnist for The New York Times’ Dealbook section.
What’s Inside America’s Banks?
By Frank Partnoy and Jesse Eisinger, The Atlantic – January/February 2013
http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/2/?single_page=true
Some four years after the 2008 financial crisis, public trust in
banks is as low as ever. Sophisticated investors describe big banks as
“black boxes” that may still be concealing enormous risks—the sort that
could again take down the economy. A close investigation of a supposedly
conservative bank’s financial records uncovers the reason for these
fears—and points the way toward urgent reforms.
The financial crisis had many causes—too much borrowing, foolish
investments, misguided regulation—but at its core, the panic resulted
from a lack of transparency. The reason no one wanted to lend to or
trade with the banks during the fall of 2008, when Lehman Brothers
collapsed, was that no one could understand the banks’ risks. It was
impossible to tell, from looking at a particular bank’s disclosures,
whether it might suddenly implode.
For the past four years, the nation’s political leaders and bankers
have made enormous—in some cases unprecedented—efforts to save the
financial industry, clean up the banks, and reform regulation in order
to restore trust and confidence in the American financial system. This
hasn’t worked. Banks today are bigger and more opaque than ever, and
they continue to behave in many of the same ways they did before the
crash.
Consider JPMorgan’s widely scrutinized trading loss last year. Before
the episode, investors considered JPMorgan one of the safest and
best-managed corporations in America. Jamie Dimon, the firm’s
charismatic CEO, had kept his institution upright throughout the
financial crisis, and by early 2012, it appeared as stable and healthy
as ever.
One reason was that the firm’s huge commercial bank—the unit
responsible for the old-line business of lending—looked safe, sound, and
solidly profitable. But then, in May, JPMorgan announced the financial
equivalent of sudden cardiac arrest: a stunning loss initially estimated
at $2 billion and later revised to $6 billion. It may yet grow larger;
as of this writing, investigators are still struggling to comprehend the
bank’s condition.
The loss emanated from a little-known corner of the bank called the
Chief Investment Office. This unit had been considered boring and
unremarkable; it was designed to reduce the bank’s risks and manage its
spare cash. According to JPMorgan, the division invested in
conservative, low-risk securities, such as U.S. government bonds. And
the bank reported that in 95 percent of likely scenarios, the maximum
amount the Chief Investment Office’s positions would lose in one day was
just $67 million. (This widely used statistical measure is known as
“value at risk.”) When analysts questioned Dimon in the spring about
reports that the group had lost much more than that—before the size of
the loss became publicly known—he dismissed the issue as a “tempest in a
teapot.”
Six billion dollars is not the kind of sum that can take down
JPMorgan, but it’s a lot to lose. The bank’s stock lost a third of its
value in two months, as investors processed reports of the trading
debacle. On May 11, 2012, alone, the day after JPMorgan first confirmed
the losses, its stock plunged roughly 9 percent.
The incident was about much more than money, however. Here was a bank
generally considered to have the best risk-management operation in the
business, and it had badly managed its risk. As the bank was coming
clean, it revealed that it had fiddled with the way it measured its
value at risk, without providing a clear reason. Moreover, in
acknowledging the losses, JPMorgan had to admit that its reported
numbers were false. A major source of its supposedly reliable profits
had in fact come from high-risk, poorly disclosed speculation.
It gets worse. Federal prosecutors are now investigating whether
traders lied about the value of the Chief Investment Office’s trading
positions as they were deteriorating. JPMorgan shareholders have filed
numerous lawsuits alleging that the bank misled them in its financial
statements; the bank itself is suing one of its former traders over the
losses. It appears that Jamie Dimon, once among the most trusted leaders
on Wall Street, didn’t understand and couldn’t adequately manage his
behemoth. Investors are now left to doubt whether the bank is as stable
as it seemed and whether any of its other disclosures are inaccurate.
The JPMorgan scandal isn’t the only one in recent months to call into
question whether the big banks are safe and trustworthy. Many of the
biggest banks now stand accused of manipulating the world’s most popular
benchmark interest rate, the London Interbank Offered Rate (LIBOR),
which is used as a baseline to set interest rates for trillions of
dollars of loans and investments. Barclays paid a large fine in June to
avoid civil and criminal charges that could have been brought by U.S.
and U.K. authorities. The Swiss giant UBS was reportedly close to a
similar settlement as of this writing. Other major banks, including
JPMorgan, Bank of America, and Deutsche Bank, are under civil or
criminal investigation (or both), though no charges have yet been filed.
Libor reflects how much banks charge when they lend to each other; it
is a measure of their confidence in each other. Now the rate has become
synonymous with manipulation and collusion. In other words, one can’t
even trust the gauge that is meant to show how much trust exists within
the financial system.
Accusations of illegal, clandestine bank activities are also
proliferating. Large global banks have been accused by U.S. government
officials of helping Mexican drug dealers launder money (HSBC), and of
funneling cash to Iran (Standard Chartered). Prosecutors have charged
American banks with falsifying mortgage records by “robo-signing” papers
to rush the process along, and with improperly foreclosing on
borrowers. Only after the financial crisis did people learn that banks
routinely misled clients, sold them securities known to be garbage, and
even, in some cases, secretly bet against them to profit from their
ignorance.
When we asked Ed Trott, a former Financial Accounting Standards Board
member, whether he trusted bank accounting, he said, simply,
“Absolutely not.”
Together, these incidents have pushed public confidence ever lower.
According to Gallup, back in the late 1970s, three out of five Americans
said they trusted big banks “a great deal” or “quite a lot.” During the
following decades, that trust eroded. Since the financial crisis of
2008, it has collapsed. In June 2012, fewer than one in four respondents
told Gallup they had faith in big banks—a record low. And in October,
Luis Aguilar, a commissioner at the Securities and Exchange Commission,
cited separate data showing that “79 percent of investors have no trust
in the financial system.”
When we asked Dane Holmes, the head of investor relations at Goldman
Sachs, why so few people trust big banks, he told us, “People don’t
understand the banks,” because “there is a lack of transparency.”
(Holmes later clarified that he was talking about average people, not
the sophisticated investors with whom he interacts on an almost hourly
basis.) He is certainly right that few students or plumbers or
grandparents truly understand what big banks do anymore. Ordinary people
have lost faith in financial institutions. That is a big enough problem
on its own.
But an even bigger problem has developed—one that more fundamentally
threatens the safety of the financial system—and it more squarely
involves the sort of big investors with whom Holmes spends much of his
time. More and more, the people in the know don’t trust big banks
either.
After all the purported “cleansing effects” of the panic, one might
have expected big, sophisticated investors to grab up bank stocks,
exploiting the timidity of the average investor by buying low. Banks
wrote down bad loans; Treasury certified the banks’ health after its
“stress tests”; Congress passed the Dodd-Frank reforms to regulate
previously unfettered corners of the financial markets and to minimize
the impact of future crises. During the 2008 crisis, many leading
investors had gotten out of bank stocks; these reforms were designed to
bring them back.
And indeed, they did come back—at first. Many investors, including
Warren Buffett, say bank stocks were underpriced after the crisis, and
remain so today. Most large institutional investors, such as mutual
funds, pension funds, and insurance companies, continue to hold
substantial stakes in major banks.
The Federal Reserve has tried to help banks make profitable loans and
trades, by keeping interest rates low and pumping trillions of dollars
into the economy. For investors, the combination of low stock prices, an
accommodative Fed, and possibly limited downside (the federal
government, needless to say, has shown a willingness to assist banks in
bad times) can be a powerful incentive.
Yet the limits to big investors’ enthusiasm are clearly reflected in
the data. Some four years after the crisis, big banks’ shares remain
depressed. Even after a run-up in the price of bank stocks this fall,
many remain below “book value,” which means that the banks are worth
less than the stated value of the assets on their books.
This indicates that investors don’t believe the stated value, or
don’t believe the banks will be profitable in the future—or both.
Several financial executives told us that they see the large banks as
“complete black boxes,” and have no interest in investing in their
stocks. A chief executive of one of the nation’s largest financial
institutions told us that he regularly hears from investors that the
banks are “uninvestable,” a Wall Street neologism for “untouchable.”
That’s an increasingly widespread view among the most sophisticated
leaders in investing circles. Paul Singer, who runs the influential
investment fund Elliott Associates, wrote to his partners this summer,
“There is no major financial institution today whose financial
statements provide a meaningful clue” about its risks. Arthur Levitt,
the former chairman of the SEC, lamented to us in November that none of
the post-2008 remedies has “significantly diminished the likelihood of
financial crises.” In a recent conversation, a prominent former
regulator expressed concerns about the hidden risks that banks might
still be carrying, comparing the big banks to Enron.
A recent survey by Barclays Capital found that more than half of
institutional investors did not trust how banks measure the riskiness of
their assets. When hedge-fund managers were asked how trustworthy they
find “risk weightings”—the numbers that banks use to calculate how much
capital they should set aside as a safety cushion in case of a business
downturn—about 60 percent of those managers answered 1 or 2 on a
five-point scale, with 1 being “not trustworthy at all.” None of them
gave banks a 5.
A disturbing number of former bankers have recently declared that the
banking industry is broken (this newfound clarity typically follows
their passage from financial titan to rich retiree). Herbert Allison,
the ex-president of Merrill Lynch and former head of the Obama
administration’s Troubled Asset Relief Program, wrote a scathing e-book
about the failures of the large banks, stopping just short of labeling
them all vampire squids.
A parade of former high-ranking executives has called for bank
breakups, tighter regulation, or a return to the Depression-era
Glass-Steagall law, which separated commercial banking from investment
banking. Among them: Philip Purcell (ex-CEO of Morgan Stanley Dean
Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO
of Merrill Lynch), and John Reed (former co‑CEO of Citigroup). Sandy
Weill, another ex-CEO of Citigroup, who built a career on financial
megamergers, did a stunning about-face this summer, advising, with
breathtaking chutzpah, that the banks should now be broken up.
Bill Ackman’s journey is particularly telling. One of the nation’s
highest-profile and most successful investors, Ackman went from being a
skeptic of investing in big banks, to being a believer, and then back
again—with a loss of hundreds of millions along the way.
In 2010, Ackman bought an almost $1 billion stake in Citigroup for
Pershing Square, the $11 billion fund he runs. He reasoned that in the
aftermath of the crisis, the big banks had written down their bad loans
and become more conservative; they were also facing less competition.
That should have been a great environment for investment, he says. He
had avoided investing in big banks for most of his career. But “for
once,” he told us, “I thought you could trust the carrying values on
bank books.”
Last spring, Pershing Square sold its entire stake in Citigroup, as
the bank’s strategy drifted, at a loss approaching $400 million. Ackman
says, “For the first seven years of Pershing Square, I believed that an
investor couldn’t invest in a giant bank. Then I felt I could invest in a
bank, and I did—and I lost a lot of money doing it.”
A crisis of trust among investors is insidious. It is far less
obvious than a sudden panic, but over time, its damage compounds. It is
not a tsunami; it is dry rot. It creeps in, noticed occasionally and
then forgotten. Soon it is a daily fact of life. Even as the economy
begins to come back, the trust crisis saps the recovery’s strength.
Banks can’t attract capital. They lose customers, who fear being tricked
and cheated. Their executives are, by turns, traumatized and enervated.
Lacking confidence in themselves as they grapple with the toxic
legacies of their previous excesses and mistakes, they don’t lend as
much as they should. Without trust in banks, the economy wheezes and
stutters.
And, of course, as trust diminishes, the likelihood of another crisis
grows larger. The next big storm might blow the weakened house down.
Elite investors—those who move markets and control the flow of
money—will flee, out of worry that the roof will collapse. The less they
trust the banks, the faster and more decisively they will beat that
path—disinvesting, freezing bank credit, and weakening the structure
even more. In this way, fear becomes reality, and troubles that might
once have been weathered become existential.
At the heart of the problem is a worry about the accuracy of banks’
financial statements. Some of the questions are basic: How do banks
account for loans? Can investors accurately assess the value of those
loans? Others are far more complicated: What risks are posed by complex
financial instruments, such as the ones that caused JPMorgan’s massive
loss? The answers are supposed to be found in the publicly available
quarterly and annual reports that banks file with the Securities and
Exchange Commission.
The Financial Accounting Standards Board, an independent
private-sector organization, governs the accounting in these filings.
Don Young, currently an investment manager, was a board member from 2005
to 2008. “After serving on the board,” he recently told us, “I no
longer trust bank accounting.”
Accounting rules have proliferated as banks, and the assets and
liabilities they contain, have become more complex. Yet the rules have
not kept pace with changes in the financial system. Clever bankers,
aided by their lawyers and accountants, can find ways around the
intentions of the regulations while remaining within the letter of the
law. What’s more, because these rules have grown ever more detailed and
lawyerly—while still failing to cover every possible circumstance—they
have had the perverse effect of allowing banks to avoid giving investors
the information needed to gauge the value and risk of a bank’s
portfolio. (That information is obscured by minutiae and legalese.) This
is true for the complicated questions about financial innovation and
trading, but it also is true for the basic questions, such as those
involving loans.
At one point during Young’s tenure, some members of the Financial
Accounting Standards Board wanted to make banks account for loans in the
same way they do for securities, by recording them at current market
values, a method known as “fair value.”
Banks were instead recording the value of their loans at the initial
loan amount, and setting aside a reserve based on their assumptions
about how likely they were to get paid back. The rules also allowed
banks to use different methods to measure the value of the same kind of
loans, depending on whether the loans were categorized as ones they
planned to keep for a long time or instead as ones they planned to sell.
Many accounting experts believed that the reported numbers did not give
investors an accurate or reliable picture of a bank’s health.
After bitter battles, turnover on the board, worries about acting in
the middle of the financial crisis, and aggressive bank lobbying, the
accounting mandarins preserved the existing approach instead of
switching to fair-value accounting for loans.
Young believes that the numbers are even less reliable now. “It’s gotten worse,” he says.
When we asked another former board member, Ed Trott, whether he trusted bank accounting, he said, simply, “Absolutely not.”
Part 2 Tomorrow…
Exposed: What’s Inside America’s Banks? Part 2/3
Posted by Stephen Cook on January 5, 2013 / Leave a Comment
Category: World Banking Changes
Tags: Bankers' Fraud, New System Needed
Exposed: What’s Inside America’s Banks? Part 2/3
Stephen: This is the second installment of a groundbreaking major mainstream media expose of the US banking system by The Atlantic magazine. Again, thanks to Bob.
Part 1 is here: http://goldenageofgaia.com/2013/01/exposed-whats-inside-americas-banks-part-13/
By Frank Partnoy and Jesse Eisinger, The Atlantic – January/February 2013
http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/2/?single_page=true
Part 2: The problem extends well beyond the opacity
of banks’ loan portfolios—it involves almost every aspect of modern bank
activity, much of which involves complex investment and trading, not
merely lending.
Kevin Warsh, an ex–Morgan Stanley banker and a former Federal Reserve
Board member appointed by George W. Bush, says woeful disclosure is a
major problem. Look at the financial statements a big bank files with
the SEC, he says: “Investors can’t truly understand the nature and
quality of the assets and liabilities. They can’t readily assess the
reliability of the capital to offset real losses. They can’t assess the
underlying sources of the firms’ profits. The disclosure obfuscates more
than it informs, and the government is not just permitting it but seems
to be encouraging it.”
Accounting rules are supposed to help investors understand the
companies whose shares they buy. Yet current disclosure requirements
don’t illuminate banks’ financial statements; instead, they let the
banks turn out the lights. And in that darkness, all sorts of unsavory
practices can breed.
We decided to go on an adventure through the financial statements of
one bank, to explore exactly what they do and do not show, and to gauge
whether it is possible to make informed judgments about the risks the
bank may be carrying. We chose a bank that is thought to be a
conservative financial institution, and an exemplar of what a large
modern bank should be.
Wells Fargo was founded on trust. Its logo has long been a strongly
sprung six-horse stagecoach, a fleet of which once thundered across the
American West, loaded with gold. According to the firm’s official
history, “In the boom and bust economy of the 1850s, Wells Fargo earned a
reputation of trust by dealing rapidly and responsibly with people’s
money.” People believed Wells Fargo would keep their money safe—the
bank’s paper drafts were as good as the gold it shipped throughout the
country.
For a century and a half, Wells Fargo stock was also like gold, which
is what led Warren Buffett to buy a stake in the bank in 1990. Since
then, Buffett and Wells Fargo have been inextricably linked. As of fall
2012, Buffett’s firm, Berkshire Hathaway, owned about 8 percent of Wells
Fargo’s shares.
Today, Wells Fargo still prominently displays the stagecoach logo at
branches, in advertising, on the 12,000-plus ATMs that dot the country,
and even at the bank’s museum stores. There, visitors can buy wholesome,
family-friendly items: a stagecoach night‑light; stagecoach salt and
pepper shakers; a hand-painted ceramic stagecoach pillbox. These are
more than tchotchkes. They are emblems of the bank’s honest and
honorable mission.
Buffett’s impeccable reputation has rubbed off on the bank. Wells
Fargo is widely regarded as the most conservative of the nation’s
biggest banks. Many investors, regulators, and analysts still believe
its financial reports reflect a full, fair, and accurate picture of its
business. The market value of Wells Fargo’s shares is now the highest of
any U.S. bank: $173 billion as of early December 2012. The enthusiasm
for Wells Fargo reflects the bank’s good reputation, as well as one
seemingly simple fact: the bank earned solid net income of nearly $16
billion in 2011, up 28 percent from 2010.
To find out what’s behind that fact, you have to read Wells Fargo’s
annual report—and that is where we began our adventure. The annual
report is a special document: it is the place where a bank sets forth
the audited details of its business. Although banks also submit
unaudited quarterly reports and other periodical documents to the SEC,
and have conference calls with analysts and shareholders, the annual
report gives investors the most complete and, supposedly, reliable
picture.
(Today, big banks have to answer to a dizzying litany of
regulators—not only the SEC, but also the Federal Reserve, the Office of
the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, the Commodity Futures Trading Commission, the newly created
Consumer Financial Protection Bureau, and so on. The disclosure regimes
vary, adding to the confusion. Banks confidentially release additional
information to these regulators, but investors do not have access to
those details. That regulators have these extra, confidential
disclosures isn’t much comfort: given the inability of regulators to
police the banks in recent years, one of the only groups that investors
trust less than bankers is bank regulators.)
Wells Fargo’s most recent annual report, covering 2011, is 236 pages
long. It begins like a book an average person might enjoy: a breezy
journey through a year in a bank’s life. On the cover, that stagecoach
appears. The first page has a moving story about a customer. The next
few pages are filled with images of guys in cowboy hats, a couple
holding hands by the ocean, cupcakes, and solar panels.
In bold 50‑point font, Wells Fargo reports that it contributed
$213.5 million to nonprofits during the year, and it even does the math
to make sure we appreciate its generosity: “$4.1 million every week or
$585,000 every day or $24,000 every hour.” The introduction’s capstone
is this: “We don’t take trust for granted. We know we have to earn it
every day in our conversations and actions with our customers. Here’s
how we try to do that.”
The sheer volume of “trading” at Wells Fargo suggests that the bank is not what it seems.
Fortunately for Wells Fargo, most people do not read past the
introduction. In the pages that follow, the sunny faces of satisfied
customers disappear. So do the stories. The narrative is replaced by
details about the bank’s businesses that range from the incomprehensible
to the disturbing.
Wells Fargo told us it devotes “significant resources to fulfilling
all reporting requirements of various regulators.” Nevertheless, these
disclosures wouldn’t earn anyone’s trust. They are littered with
language that says nothing, at length. The report is riddled with
progressively more opaque footnotes—the financial equivalent of Dante’s
descent into hell. Indeed, after the friendly introduction, the report
ought to bear a warning to the inquisitive reader intent on truly
understanding the bank’s financial positions: “Abandon all hope, ye who
enter here.”
The first circle of Wells Fargo’s version of the Inferno, like
Dante’s Limbo, merely hints at what is to come, yet it is nonetheless
unsettling. One of the main purposes of an annual report is to tell
investors how a company makes money. Along these lines, Wells Fargo
splits its businesses into two apparently simple and distinct
parts—“interest income” and “noninterest income.” At first blush, these
two categories appear to parallel the two traditional sources of banking
income: interest from loans and customer fees.
But here the descent begins. Suddenly, this folksy mortgage bank
starts showing signs of a split personality. It turns out that trading
activities, the type associated with Wall Street firms like Goldman
Sachs and Morgan Stanley, contribute significantly to each of Wells
Fargo’s two categories of income. Almost $1.5 billion of its “interest
income” comes from “trading assets”; another $9.1 billion results from
“securities available for sale.”
One billion dollars of the bank’s “noninterest income” are “net gains
from trading activities.” Another $1.5 billion is income from “equity
investments.” Up and down the ledger, abstruse, all-embracing categories
appear: “other fees earned from related activities,” “other interest
income,” and just plain “other.” The income statement’s “other”
catchalls collectively amounted to $6.6 billion of Wells Fargo’s income
in 2011. It will take the devoted reader 50 more pages to find out that
the bank derives a big chunk of that “other” income from, yes, “trading
activities.” The sheer volume of “trading” at Wells Fargo suggests that
the bank is not what it seems.
Some bank analysts say these trading numbers are small relative to
the bank’s overall revenue ($81 billion in 2011) and profit (again, $16
billion in 2011). Other observers don’t even bother to look at these
details, because they assume Wells Fargo is protected from trading
losses by its capital reserves of $148 billion. That number, assuming it
is accurate, can make any particular loss appear minuscule.
For example, buried at the bottom of page 164 of Wells Fargo’s annual
report is the following statement: “In 2011, we incurred a $377 million
loss on trading derivatives related to certain CDOs,” or collateralized
debt obligations. Just a few years ago, a bank’s nine-figure loss on
these sorts of complex financial instruments would have generated major
headlines. Yet this one went unremarked‑upon in the media, even by top
investors, analysts, and financial pundits. Perhaps they didn’t read
all the way to page 164. Or perhaps they had become so numb from bigger
bank losses that this one didn’t seem to matter.
Whatever the reason, Wells Fargo’s massive CDO-derivatives loss was a
multi-hundred-million-dollar tree falling silently in the financial
forest. To paraphrase the late Senator Everett Dirksen, $377 million
here and $377 million there, and pretty soon you’re talking about
serious money.
Even conservatively run banks can be risky, as George Bailey learned
in It’s a Wonderful Life. But the Bailey Building and Loan Association
did not earn money from trading. Trading is an inherently opaque and
volatile business. It is subject to the vagaries of the markets. And yet
in the past two decades, as profits from traditional lending and
brokering activities have been squeezed, banks have turned more and more
to trading in order to make money.
Today, banks’ trading operations involve more leverage, or borrowed
money, than in the past. Banks also obtain a form of leverage by
promising to pay money in the future if some event doesn’t go their way
(much like an insurance company must pay out a lot of money if a house
it covers burns down). These promises come in the form of derivatives,
financial instruments that can be used to hedge against various
risks—like the possibility that interest rates will rise or the
likelihood that a company will default on its debts—or simply to place
bets on those same possibilities, hoping to profit. Because many of
these bets are both large and complex, trading carries the potential for
catastrophic losses.
The cryptic way Wells Fargo describes its trading raises many
questions. The bank breaks what it calls “net gains from trading
activities”—which doesn’t cover all of its trading income, but is an
important part—into three subcategories, leaving the annual-report
reader to play a kind of shell game.
Look first at “proprietary” trading—activity a firm undertakes to
make money for its own account by buying or selling stocks, bonds, or
more-exotic financial creations. Self-evidently, this activity might
involve big risks. When this shell is lifted, the bank’s exposure seems
reassuringly inconsequential: the reported loss is just $14 million.
Still, there may be more under this shell than meets the eye: that $14
million might not be indicative of the bank’s true exposure. Was Wells
Fargo just lucky to finish slightly down after a roller-coaster year of
wild gambling with much bigger gains and losses? Without more
information about the size of the bank’s bets, it is impossible to know.
A second subcategory is “economic hedging.” An activity labeled
“hedging” might sound soothing. Wells Fargo says it lost an
inconsequential $1 million from economic hedging in 2011. So maybe there
is nothing to worry about under this shell, either. In its pure form,
hedging is supposed to reduce risk. A person buys a house and then
hedges the risk of a fire by purchasing insurance. But hedging in the
world of finance is more complex—so much so that it requires advanced
mathematics and computer modeling, and still can be little better than
guesswork. It is difficult to anticipate how a portfolio of complicated
financial instruments will respond as variables like interest rates and
stock prices go up and down.
As a result, hedges don’t always work as intended. They may not fully
eliminate large risks that banks think they’ve taken care of. And they
may inadvertently create new, hidden risks—“unknown unknowns,” if you
will. Because of all this complexity, some traders can disguise
speculative positions as “hedges” and claim their purpose is to reduce
risk, when in fact the traders are purposely taking on more risk to try
to make a profit. That is what the traders within JPMorgan’s Chief
Investment Office appear to have been doing. Was Wells Fargo’s “economic
hedging” like buying straightforward insurance? Or was it more like
speculation—what JPMorgan did? Do the reported numbers suggest low risk
when in fact the opposite is true? The bank’s disclosures don’t answer
these questions.
Finally we come to a third shell—and there’s unquestionably something
to see under this one. It carries an innocuous label: “customer
accommodation.” Wells Fargo made more than $1 billion from
customer-accommodation trading in 2011. How did it make so much money
merely by helping customers? This should be a plain-vanilla business: a
broker sits between a buyer and a seller and takes a little cut of the
transaction. But what we learned from the 2008 financial crisis, and
what we keep learning from incidents such as the JPMorgan scandal, is
that seemingly innocuous activities that appear highly profitable can be
dangerous to a bank’s health—and to our economy.
Don’t look to the annual report for clarity. Here is the bank’s
definition: “Customer accommodation trading consists of security or
derivative transactions conducted in an effort to help customers manage
their market price risks and are done on their behalf or driven by their
investment needs.”
That might seem safe, but the report notably fails to explain why
this activity would be so profitable. In fact, at many large banks,
customer accommodation can be a euphemism for “massive derivatives
bets.”
For Wells Fargo, the subcategory of “customer accommodation, trading
and other free-standing derivatives” included derivatives trades of
about $2.8 trillion in “notional amount” as of the end of 2011, meaning
that the underlying positions referenced in the bank’s derivatives were
that large then. By way of explanation: if we were to make a bet with
you about how much the price of a $70 share of Walmart would change this
year—we pay you any increase, you pay us any decrease—we’d say the
“notional amount” of the bet is $70.
Wells Fargo doesn’t expect to gain or lose $2.8 trillion on its
derivatives, any more than we would expect the payment on our Walmart
bet to be $70. Bankers generally assume that the likely risk of gain or
loss on derivatives is much smaller than their “notional amount,” and
Wells Fargo says the concept “is not, when viewed in isolation, a
meaningful measure of the risk profile of the instruments.” Moreover,
Wells Fargo reports that many of its derivatives offset each other, as
yours might if you placed several wagers that Walmart stock would go up,
along with several other bets that it would go down.
Yet, as investors in bank stocks learned in 2008, it is possible to
lose a large portion of the “notional amount” of a derivatives trade if a
bet goes terribly wrong. In the future, if interest rates skyrocket or
the euro unravels, Wells Fargo might sustain huge derivatives losses,
just as you might lose the full $70 you bet on Walmart if the company
went bust. Wells Fargo doesn’t tell investors how much of the $2.8
trillion it could lose in a worst-case scenario, nor is it required to.
Even a savvy investor who reads the footnotes can only guess at what the
bank’s potential risk exposure to derivatives might be.
One reason Wells Fargo is trusted more than other big banks is that
its notional amount of derivatives is comparatively small. At the end of
the third quarter of 2012, JPMorgan had $72 trillion in notional amount
on its books—about five times the size of the U.S. economy. But even at
Wells Fargo levels, the numbers are so large that they lose their
meaning. And they put Wells Fargo’s seemingly immense capital
reserves—$148 billion, you’ll recall—in a rather different light.
How much risk is the bank actually taking on these trades? For which
customers does it place a requested bet, then negate its risk by taking
an exactly offsetting position in the market, so that it is essentially
acting as an agent simply taking a commission? And for all these trades,
what risk is Wells Fargo taking on its customers? Many of these bets
involve the customers’ promises to pay Wells Fargo depending on how
certain financial numbers change in the future. But what happens if some
of those customers go bankrupt? How much money would Wells Fargo lose
if it “accommodates” customers who can’t pay what they owe?
We asked Wells Fargo officials if we could talk to someone at the
bank about its disclosures, including those concerning its trading and
derivatives. They declined. Instead, they suggested we submit questions
in writing, which we did.
In response, Wells Fargo public-relations representatives wrote, “We
believe our disclosures on the topics you raised are comprehensive and
stand on their own.” In answering our written questions about the annual
report, the representatives simply pointed us back to the annual
report. For example, when we inquired about the bank’s trading
activities, Wells Fargo responded: “We would ask you to refer to our
discussion of ‘Market Risk-Trading Activities’ on pages 80–81 in the
Management Discussion and Analysis section of the Wells Fargo 2011
Annual Report.”
Yet it was precisely those pages that generated our questions about
the bank’s various categories of trading. When we specifically asked
Wells Fargo to help us quantify the risks associated with
customer-accommodation trading, its representatives pointed us to those
same pages. But those pages don’t answer that question. Here is the most
helpful of the bank’s disclosures related to customer-accommodation
trading:
in annual reports. So why did they use the word expected in discussing
customer order flow in that last sentence? Is Wells Fargo speculating
based on what one of its traders “expects” a customer to do, instead of
responding to what a customer actually has done? The language the bank
pointed to for answers to our questions only raises more questions.
Wells Fargo’s annual report is filled with similarly cryptic
declarations, but not the crucial information that investors actually
need. It doesn’t describe worst-case scenarios for
customer-accommodation trades, or even include any examples of what such
trades might involve. When we asked straightforward questions—such as
“How much money would Wells Fargo lose from these trades under various
scenarios?”—the bank’s representatives declined to answer.
Only a few people have publicly expressed concerns about
customer-accommodation trades. Yet some banking experts are skeptical of
these trades, and suspect that they hide huge risks. David Stockman,
who was the federal budget director under President Reagan, an
investment banker at Salomon Brothers, and a partner at the
private-equity firm Blackstone Group, calls the big banks “massive
trading operations.” Stockman has become so disillusioned by America’s
financial system that he is now regarded, in some quarters, as a
wild-eyed heretic, but his expertise is undeniable. He recently told
reporters for “The Gold Report,” an online newsletter, “Whether they
called it customer accommodation or proprietary is a distinction without
a difference.”
Part 3 tomorrow.
Thanks to: http://goldenageofgaia.com
Posted by Stephen Cook on January 4, 2013 / Comments Off
Category: World Banking Changes
Tags: Bankers' Fraud, New System Needed
JamieDimon, JPMorgan’s CEO, testifying last summer before the House
Financial Services Committee about his bank’s sudden $6 billion loss.
(Jacqueline Martin/AP)
Exposed: What’s Inside America’s Banks? – Part 1 of 3
Stephen: Last year saw much deception and fraud uncovered within
the global banking sector – the Libor scandal, money laundering, illegal
foreclosures and so much more.
This is an incredibly detailed and well-researched mainstream magazine expose from The Atlantic,
looking at what’s really going on with the banks. It also offers some
surprising solutions. It may focus on the US, but it’s applicable
worldwide… Although some of it is not new to some of us, it is
enormously rewarding and refreshing to see such material making it into
the wider public domain. It is lengthy, so I will break it into three
parts for your weekend leisure reading. Thanks to Bob.
About the Authors – Frank Partnoy is a law and
finance professor at the University of San Diego and the author of Wait:
The Art and Science of Delay. Jesse Eisinger is a senior reporter at
ProPublica and a columnist for The New York Times’ Dealbook section.
What’s Inside America’s Banks?
By Frank Partnoy and Jesse Eisinger, The Atlantic – January/February 2013
http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/2/?single_page=true
Some four years after the 2008 financial crisis, public trust in
banks is as low as ever. Sophisticated investors describe big banks as
“black boxes” that may still be concealing enormous risks—the sort that
could again take down the economy. A close investigation of a supposedly
conservative bank’s financial records uncovers the reason for these
fears—and points the way toward urgent reforms.
The financial crisis had many causes—too much borrowing, foolish
investments, misguided regulation—but at its core, the panic resulted
from a lack of transparency. The reason no one wanted to lend to or
trade with the banks during the fall of 2008, when Lehman Brothers
collapsed, was that no one could understand the banks’ risks. It was
impossible to tell, from looking at a particular bank’s disclosures,
whether it might suddenly implode.
For the past four years, the nation’s political leaders and bankers
have made enormous—in some cases unprecedented—efforts to save the
financial industry, clean up the banks, and reform regulation in order
to restore trust and confidence in the American financial system. This
hasn’t worked. Banks today are bigger and more opaque than ever, and
they continue to behave in many of the same ways they did before the
crash.
Consider JPMorgan’s widely scrutinized trading loss last year. Before
the episode, investors considered JPMorgan one of the safest and
best-managed corporations in America. Jamie Dimon, the firm’s
charismatic CEO, had kept his institution upright throughout the
financial crisis, and by early 2012, it appeared as stable and healthy
as ever.
One reason was that the firm’s huge commercial bank—the unit
responsible for the old-line business of lending—looked safe, sound, and
solidly profitable. But then, in May, JPMorgan announced the financial
equivalent of sudden cardiac arrest: a stunning loss initially estimated
at $2 billion and later revised to $6 billion. It may yet grow larger;
as of this writing, investigators are still struggling to comprehend the
bank’s condition.
The loss emanated from a little-known corner of the bank called the
Chief Investment Office. This unit had been considered boring and
unremarkable; it was designed to reduce the bank’s risks and manage its
spare cash. According to JPMorgan, the division invested in
conservative, low-risk securities, such as U.S. government bonds. And
the bank reported that in 95 percent of likely scenarios, the maximum
amount the Chief Investment Office’s positions would lose in one day was
just $67 million. (This widely used statistical measure is known as
“value at risk.”) When analysts questioned Dimon in the spring about
reports that the group had lost much more than that—before the size of
the loss became publicly known—he dismissed the issue as a “tempest in a
teapot.”
Six billion dollars is not the kind of sum that can take down
JPMorgan, but it’s a lot to lose. The bank’s stock lost a third of its
value in two months, as investors processed reports of the trading
debacle. On May 11, 2012, alone, the day after JPMorgan first confirmed
the losses, its stock plunged roughly 9 percent.
The incident was about much more than money, however. Here was a bank
generally considered to have the best risk-management operation in the
business, and it had badly managed its risk. As the bank was coming
clean, it revealed that it had fiddled with the way it measured its
value at risk, without providing a clear reason. Moreover, in
acknowledging the losses, JPMorgan had to admit that its reported
numbers were false. A major source of its supposedly reliable profits
had in fact come from high-risk, poorly disclosed speculation.
It gets worse. Federal prosecutors are now investigating whether
traders lied about the value of the Chief Investment Office’s trading
positions as they were deteriorating. JPMorgan shareholders have filed
numerous lawsuits alleging that the bank misled them in its financial
statements; the bank itself is suing one of its former traders over the
losses. It appears that Jamie Dimon, once among the most trusted leaders
on Wall Street, didn’t understand and couldn’t adequately manage his
behemoth. Investors are now left to doubt whether the bank is as stable
as it seemed and whether any of its other disclosures are inaccurate.
The JPMorgan scandal isn’t the only one in recent months to call into
question whether the big banks are safe and trustworthy. Many of the
biggest banks now stand accused of manipulating the world’s most popular
benchmark interest rate, the London Interbank Offered Rate (LIBOR),
which is used as a baseline to set interest rates for trillions of
dollars of loans and investments. Barclays paid a large fine in June to
avoid civil and criminal charges that could have been brought by U.S.
and U.K. authorities. The Swiss giant UBS was reportedly close to a
similar settlement as of this writing. Other major banks, including
JPMorgan, Bank of America, and Deutsche Bank, are under civil or
criminal investigation (or both), though no charges have yet been filed.
Libor reflects how much banks charge when they lend to each other; it
is a measure of their confidence in each other. Now the rate has become
synonymous with manipulation and collusion. In other words, one can’t
even trust the gauge that is meant to show how much trust exists within
the financial system.
Accusations of illegal, clandestine bank activities are also
proliferating. Large global banks have been accused by U.S. government
officials of helping Mexican drug dealers launder money (HSBC), and of
funneling cash to Iran (Standard Chartered). Prosecutors have charged
American banks with falsifying mortgage records by “robo-signing” papers
to rush the process along, and with improperly foreclosing on
borrowers. Only after the financial crisis did people learn that banks
routinely misled clients, sold them securities known to be garbage, and
even, in some cases, secretly bet against them to profit from their
ignorance.
When we asked Ed Trott, a former Financial Accounting Standards Board
member, whether he trusted bank accounting, he said, simply,
“Absolutely not.”
Together, these incidents have pushed public confidence ever lower.
According to Gallup, back in the late 1970s, three out of five Americans
said they trusted big banks “a great deal” or “quite a lot.” During the
following decades, that trust eroded. Since the financial crisis of
2008, it has collapsed. In June 2012, fewer than one in four respondents
told Gallup they had faith in big banks—a record low. And in October,
Luis Aguilar, a commissioner at the Securities and Exchange Commission,
cited separate data showing that “79 percent of investors have no trust
in the financial system.”
When we asked Dane Holmes, the head of investor relations at Goldman
Sachs, why so few people trust big banks, he told us, “People don’t
understand the banks,” because “there is a lack of transparency.”
(Holmes later clarified that he was talking about average people, not
the sophisticated investors with whom he interacts on an almost hourly
basis.) He is certainly right that few students or plumbers or
grandparents truly understand what big banks do anymore. Ordinary people
have lost faith in financial institutions. That is a big enough problem
on its own.
But an even bigger problem has developed—one that more fundamentally
threatens the safety of the financial system—and it more squarely
involves the sort of big investors with whom Holmes spends much of his
time. More and more, the people in the know don’t trust big banks
either.
After all the purported “cleansing effects” of the panic, one might
have expected big, sophisticated investors to grab up bank stocks,
exploiting the timidity of the average investor by buying low. Banks
wrote down bad loans; Treasury certified the banks’ health after its
“stress tests”; Congress passed the Dodd-Frank reforms to regulate
previously unfettered corners of the financial markets and to minimize
the impact of future crises. During the 2008 crisis, many leading
investors had gotten out of bank stocks; these reforms were designed to
bring them back.
And indeed, they did come back—at first. Many investors, including
Warren Buffett, say bank stocks were underpriced after the crisis, and
remain so today. Most large institutional investors, such as mutual
funds, pension funds, and insurance companies, continue to hold
substantial stakes in major banks.
The Federal Reserve has tried to help banks make profitable loans and
trades, by keeping interest rates low and pumping trillions of dollars
into the economy. For investors, the combination of low stock prices, an
accommodative Fed, and possibly limited downside (the federal
government, needless to say, has shown a willingness to assist banks in
bad times) can be a powerful incentive.
Yet the limits to big investors’ enthusiasm are clearly reflected in
the data. Some four years after the crisis, big banks’ shares remain
depressed. Even after a run-up in the price of bank stocks this fall,
many remain below “book value,” which means that the banks are worth
less than the stated value of the assets on their books.
This indicates that investors don’t believe the stated value, or
don’t believe the banks will be profitable in the future—or both.
Several financial executives told us that they see the large banks as
“complete black boxes,” and have no interest in investing in their
stocks. A chief executive of one of the nation’s largest financial
institutions told us that he regularly hears from investors that the
banks are “uninvestable,” a Wall Street neologism for “untouchable.”
That’s an increasingly widespread view among the most sophisticated
leaders in investing circles. Paul Singer, who runs the influential
investment fund Elliott Associates, wrote to his partners this summer,
“There is no major financial institution today whose financial
statements provide a meaningful clue” about its risks. Arthur Levitt,
the former chairman of the SEC, lamented to us in November that none of
the post-2008 remedies has “significantly diminished the likelihood of
financial crises.” In a recent conversation, a prominent former
regulator expressed concerns about the hidden risks that banks might
still be carrying, comparing the big banks to Enron.
A recent survey by Barclays Capital found that more than half of
institutional investors did not trust how banks measure the riskiness of
their assets. When hedge-fund managers were asked how trustworthy they
find “risk weightings”—the numbers that banks use to calculate how much
capital they should set aside as a safety cushion in case of a business
downturn—about 60 percent of those managers answered 1 or 2 on a
five-point scale, with 1 being “not trustworthy at all.” None of them
gave banks a 5.
A disturbing number of former bankers have recently declared that the
banking industry is broken (this newfound clarity typically follows
their passage from financial titan to rich retiree). Herbert Allison,
the ex-president of Merrill Lynch and former head of the Obama
administration’s Troubled Asset Relief Program, wrote a scathing e-book
about the failures of the large banks, stopping just short of labeling
them all vampire squids.
A parade of former high-ranking executives has called for bank
breakups, tighter regulation, or a return to the Depression-era
Glass-Steagall law, which separated commercial banking from investment
banking. Among them: Philip Purcell (ex-CEO of Morgan Stanley Dean
Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO
of Merrill Lynch), and John Reed (former co‑CEO of Citigroup). Sandy
Weill, another ex-CEO of Citigroup, who built a career on financial
megamergers, did a stunning about-face this summer, advising, with
breathtaking chutzpah, that the banks should now be broken up.
Bill Ackman’s journey is particularly telling. One of the nation’s
highest-profile and most successful investors, Ackman went from being a
skeptic of investing in big banks, to being a believer, and then back
again—with a loss of hundreds of millions along the way.
In 2010, Ackman bought an almost $1 billion stake in Citigroup for
Pershing Square, the $11 billion fund he runs. He reasoned that in the
aftermath of the crisis, the big banks had written down their bad loans
and become more conservative; they were also facing less competition.
That should have been a great environment for investment, he says. He
had avoided investing in big banks for most of his career. But “for
once,” he told us, “I thought you could trust the carrying values on
bank books.”
Last spring, Pershing Square sold its entire stake in Citigroup, as
the bank’s strategy drifted, at a loss approaching $400 million. Ackman
says, “For the first seven years of Pershing Square, I believed that an
investor couldn’t invest in a giant bank. Then I felt I could invest in a
bank, and I did—and I lost a lot of money doing it.”
A crisis of trust among investors is insidious. It is far less
obvious than a sudden panic, but over time, its damage compounds. It is
not a tsunami; it is dry rot. It creeps in, noticed occasionally and
then forgotten. Soon it is a daily fact of life. Even as the economy
begins to come back, the trust crisis saps the recovery’s strength.
Banks can’t attract capital. They lose customers, who fear being tricked
and cheated. Their executives are, by turns, traumatized and enervated.
Lacking confidence in themselves as they grapple with the toxic
legacies of their previous excesses and mistakes, they don’t lend as
much as they should. Without trust in banks, the economy wheezes and
stutters.
And, of course, as trust diminishes, the likelihood of another crisis
grows larger. The next big storm might blow the weakened house down.
Elite investors—those who move markets and control the flow of
money—will flee, out of worry that the roof will collapse. The less they
trust the banks, the faster and more decisively they will beat that
path—disinvesting, freezing bank credit, and weakening the structure
even more. In this way, fear becomes reality, and troubles that might
once have been weathered become existential.
At the heart of the problem is a worry about the accuracy of banks’
financial statements. Some of the questions are basic: How do banks
account for loans? Can investors accurately assess the value of those
loans? Others are far more complicated: What risks are posed by complex
financial instruments, such as the ones that caused JPMorgan’s massive
loss? The answers are supposed to be found in the publicly available
quarterly and annual reports that banks file with the Securities and
Exchange Commission.
The Financial Accounting Standards Board, an independent
private-sector organization, governs the accounting in these filings.
Don Young, currently an investment manager, was a board member from 2005
to 2008. “After serving on the board,” he recently told us, “I no
longer trust bank accounting.”
Accounting rules have proliferated as banks, and the assets and
liabilities they contain, have become more complex. Yet the rules have
not kept pace with changes in the financial system. Clever bankers,
aided by their lawyers and accountants, can find ways around the
intentions of the regulations while remaining within the letter of the
law. What’s more, because these rules have grown ever more detailed and
lawyerly—while still failing to cover every possible circumstance—they
have had the perverse effect of allowing banks to avoid giving investors
the information needed to gauge the value and risk of a bank’s
portfolio. (That information is obscured by minutiae and legalese.) This
is true for the complicated questions about financial innovation and
trading, but it also is true for the basic questions, such as those
involving loans.
At one point during Young’s tenure, some members of the Financial
Accounting Standards Board wanted to make banks account for loans in the
same way they do for securities, by recording them at current market
values, a method known as “fair value.”
Banks were instead recording the value of their loans at the initial
loan amount, and setting aside a reserve based on their assumptions
about how likely they were to get paid back. The rules also allowed
banks to use different methods to measure the value of the same kind of
loans, depending on whether the loans were categorized as ones they
planned to keep for a long time or instead as ones they planned to sell.
Many accounting experts believed that the reported numbers did not give
investors an accurate or reliable picture of a bank’s health.
After bitter battles, turnover on the board, worries about acting in
the middle of the financial crisis, and aggressive bank lobbying, the
accounting mandarins preserved the existing approach instead of
switching to fair-value accounting for loans.
Young believes that the numbers are even less reliable now. “It’s gotten worse,” he says.
When we asked another former board member, Ed Trott, whether he trusted bank accounting, he said, simply, “Absolutely not.”
Part 2 Tomorrow…
Exposed: What’s Inside America’s Banks? Part 2/3
Posted by Stephen Cook on January 5, 2013 / Leave a Comment
Category: World Banking Changes
Tags: Bankers' Fraud, New System Needed
Exposed: What’s Inside America’s Banks? Part 2/3Stephen: This is the second installment of a groundbreaking major mainstream media expose of the US banking system by The Atlantic magazine. Again, thanks to Bob.
Part 1 is here: http://goldenageofgaia.com/2013/01/exposed-whats-inside-americas-banks-part-13/
By Frank Partnoy and Jesse Eisinger, The Atlantic – January/February 2013
http://www.theatlantic.com/magazine/archive/2013/01/whats-inside-americas-banks/309196/2/?single_page=true
Part 2: The problem extends well beyond the opacity
of banks’ loan portfolios—it involves almost every aspect of modern bank
activity, much of which involves complex investment and trading, not
merely lending.
Kevin Warsh, an ex–Morgan Stanley banker and a former Federal Reserve
Board member appointed by George W. Bush, says woeful disclosure is a
major problem. Look at the financial statements a big bank files with
the SEC, he says: “Investors can’t truly understand the nature and
quality of the assets and liabilities. They can’t readily assess the
reliability of the capital to offset real losses. They can’t assess the
underlying sources of the firms’ profits. The disclosure obfuscates more
than it informs, and the government is not just permitting it but seems
to be encouraging it.”
Accounting rules are supposed to help investors understand the
companies whose shares they buy. Yet current disclosure requirements
don’t illuminate banks’ financial statements; instead, they let the
banks turn out the lights. And in that darkness, all sorts of unsavory
practices can breed.
We decided to go on an adventure through the financial statements of
one bank, to explore exactly what they do and do not show, and to gauge
whether it is possible to make informed judgments about the risks the
bank may be carrying. We chose a bank that is thought to be a
conservative financial institution, and an exemplar of what a large
modern bank should be.
Wells Fargo was founded on trust. Its logo has long been a strongly
sprung six-horse stagecoach, a fleet of which once thundered across the
American West, loaded with gold. According to the firm’s official
history, “In the boom and bust economy of the 1850s, Wells Fargo earned a
reputation of trust by dealing rapidly and responsibly with people’s
money.” People believed Wells Fargo would keep their money safe—the
bank’s paper drafts were as good as the gold it shipped throughout the
country.
For a century and a half, Wells Fargo stock was also like gold, which
is what led Warren Buffett to buy a stake in the bank in 1990. Since
then, Buffett and Wells Fargo have been inextricably linked. As of fall
2012, Buffett’s firm, Berkshire Hathaway, owned about 8 percent of Wells
Fargo’s shares.
Today, Wells Fargo still prominently displays the stagecoach logo at
branches, in advertising, on the 12,000-plus ATMs that dot the country,
and even at the bank’s museum stores. There, visitors can buy wholesome,
family-friendly items: a stagecoach night‑light; stagecoach salt and
pepper shakers; a hand-painted ceramic stagecoach pillbox. These are
more than tchotchkes. They are emblems of the bank’s honest and
honorable mission.
Buffett’s impeccable reputation has rubbed off on the bank. Wells
Fargo is widely regarded as the most conservative of the nation’s
biggest banks. Many investors, regulators, and analysts still believe
its financial reports reflect a full, fair, and accurate picture of its
business. The market value of Wells Fargo’s shares is now the highest of
any U.S. bank: $173 billion as of early December 2012. The enthusiasm
for Wells Fargo reflects the bank’s good reputation, as well as one
seemingly simple fact: the bank earned solid net income of nearly $16
billion in 2011, up 28 percent from 2010.
To find out what’s behind that fact, you have to read Wells Fargo’s
annual report—and that is where we began our adventure. The annual
report is a special document: it is the place where a bank sets forth
the audited details of its business. Although banks also submit
unaudited quarterly reports and other periodical documents to the SEC,
and have conference calls with analysts and shareholders, the annual
report gives investors the most complete and, supposedly, reliable
picture.
(Today, big banks have to answer to a dizzying litany of
regulators—not only the SEC, but also the Federal Reserve, the Office of
the Comptroller of the Currency, the Federal Deposit Insurance
Corporation, the Commodity Futures Trading Commission, the newly created
Consumer Financial Protection Bureau, and so on. The disclosure regimes
vary, adding to the confusion. Banks confidentially release additional
information to these regulators, but investors do not have access to
those details. That regulators have these extra, confidential
disclosures isn’t much comfort: given the inability of regulators to
police the banks in recent years, one of the only groups that investors
trust less than bankers is bank regulators.)
Wells Fargo’s most recent annual report, covering 2011, is 236 pages
long. It begins like a book an average person might enjoy: a breezy
journey through a year in a bank’s life. On the cover, that stagecoach
appears. The first page has a moving story about a customer. The next
few pages are filled with images of guys in cowboy hats, a couple
holding hands by the ocean, cupcakes, and solar panels.
In bold 50‑point font, Wells Fargo reports that it contributed
$213.5 million to nonprofits during the year, and it even does the math
to make sure we appreciate its generosity: “$4.1 million every week or
$585,000 every day or $24,000 every hour.” The introduction’s capstone
is this: “We don’t take trust for granted. We know we have to earn it
every day in our conversations and actions with our customers. Here’s
how we try to do that.”
The sheer volume of “trading” at Wells Fargo suggests that the bank is not what it seems.
Fortunately for Wells Fargo, most people do not read past the
introduction. In the pages that follow, the sunny faces of satisfied
customers disappear. So do the stories. The narrative is replaced by
details about the bank’s businesses that range from the incomprehensible
to the disturbing.
Wells Fargo told us it devotes “significant resources to fulfilling
all reporting requirements of various regulators.” Nevertheless, these
disclosures wouldn’t earn anyone’s trust. They are littered with
language that says nothing, at length. The report is riddled with
progressively more opaque footnotes—the financial equivalent of Dante’s
descent into hell. Indeed, after the friendly introduction, the report
ought to bear a warning to the inquisitive reader intent on truly
understanding the bank’s financial positions: “Abandon all hope, ye who
enter here.”
The first circle of Wells Fargo’s version of the Inferno, like
Dante’s Limbo, merely hints at what is to come, yet it is nonetheless
unsettling. One of the main purposes of an annual report is to tell
investors how a company makes money. Along these lines, Wells Fargo
splits its businesses into two apparently simple and distinct
parts—“interest income” and “noninterest income.” At first blush, these
two categories appear to parallel the two traditional sources of banking
income: interest from loans and customer fees.
But here the descent begins. Suddenly, this folksy mortgage bank
starts showing signs of a split personality. It turns out that trading
activities, the type associated with Wall Street firms like Goldman
Sachs and Morgan Stanley, contribute significantly to each of Wells
Fargo’s two categories of income. Almost $1.5 billion of its “interest
income” comes from “trading assets”; another $9.1 billion results from
“securities available for sale.”
One billion dollars of the bank’s “noninterest income” are “net gains
from trading activities.” Another $1.5 billion is income from “equity
investments.” Up and down the ledger, abstruse, all-embracing categories
appear: “other fees earned from related activities,” “other interest
income,” and just plain “other.” The income statement’s “other”
catchalls collectively amounted to $6.6 billion of Wells Fargo’s income
in 2011. It will take the devoted reader 50 more pages to find out that
the bank derives a big chunk of that “other” income from, yes, “trading
activities.” The sheer volume of “trading” at Wells Fargo suggests that
the bank is not what it seems.
Some bank analysts say these trading numbers are small relative to
the bank’s overall revenue ($81 billion in 2011) and profit (again, $16
billion in 2011). Other observers don’t even bother to look at these
details, because they assume Wells Fargo is protected from trading
losses by its capital reserves of $148 billion. That number, assuming it
is accurate, can make any particular loss appear minuscule.
For example, buried at the bottom of page 164 of Wells Fargo’s annual
report is the following statement: “In 2011, we incurred a $377 million
loss on trading derivatives related to certain CDOs,” or collateralized
debt obligations. Just a few years ago, a bank’s nine-figure loss on
these sorts of complex financial instruments would have generated major
headlines. Yet this one went unremarked‑upon in the media, even by top
investors, analysts, and financial pundits. Perhaps they didn’t read
all the way to page 164. Or perhaps they had become so numb from bigger
bank losses that this one didn’t seem to matter.
Whatever the reason, Wells Fargo’s massive CDO-derivatives loss was a
multi-hundred-million-dollar tree falling silently in the financial
forest. To paraphrase the late Senator Everett Dirksen, $377 million
here and $377 million there, and pretty soon you’re talking about
serious money.
Even conservatively run banks can be risky, as George Bailey learned
in It’s a Wonderful Life. But the Bailey Building and Loan Association
did not earn money from trading. Trading is an inherently opaque and
volatile business. It is subject to the vagaries of the markets. And yet
in the past two decades, as profits from traditional lending and
brokering activities have been squeezed, banks have turned more and more
to trading in order to make money.
Today, banks’ trading operations involve more leverage, or borrowed
money, than in the past. Banks also obtain a form of leverage by
promising to pay money in the future if some event doesn’t go their way
(much like an insurance company must pay out a lot of money if a house
it covers burns down). These promises come in the form of derivatives,
financial instruments that can be used to hedge against various
risks—like the possibility that interest rates will rise or the
likelihood that a company will default on its debts—or simply to place
bets on those same possibilities, hoping to profit. Because many of
these bets are both large and complex, trading carries the potential for
catastrophic losses.
The cryptic way Wells Fargo describes its trading raises many
questions. The bank breaks what it calls “net gains from trading
activities”—which doesn’t cover all of its trading income, but is an
important part—into three subcategories, leaving the annual-report
reader to play a kind of shell game.
Look first at “proprietary” trading—activity a firm undertakes to
make money for its own account by buying or selling stocks, bonds, or
more-exotic financial creations. Self-evidently, this activity might
involve big risks. When this shell is lifted, the bank’s exposure seems
reassuringly inconsequential: the reported loss is just $14 million.
Still, there may be more under this shell than meets the eye: that $14
million might not be indicative of the bank’s true exposure. Was Wells
Fargo just lucky to finish slightly down after a roller-coaster year of
wild gambling with much bigger gains and losses? Without more
information about the size of the bank’s bets, it is impossible to know.
A second subcategory is “economic hedging.” An activity labeled
“hedging” might sound soothing. Wells Fargo says it lost an
inconsequential $1 million from economic hedging in 2011. So maybe there
is nothing to worry about under this shell, either. In its pure form,
hedging is supposed to reduce risk. A person buys a house and then
hedges the risk of a fire by purchasing insurance. But hedging in the
world of finance is more complex—so much so that it requires advanced
mathematics and computer modeling, and still can be little better than
guesswork. It is difficult to anticipate how a portfolio of complicated
financial instruments will respond as variables like interest rates and
stock prices go up and down.
As a result, hedges don’t always work as intended. They may not fully
eliminate large risks that banks think they’ve taken care of. And they
may inadvertently create new, hidden risks—“unknown unknowns,” if you
will. Because of all this complexity, some traders can disguise
speculative positions as “hedges” and claim their purpose is to reduce
risk, when in fact the traders are purposely taking on more risk to try
to make a profit. That is what the traders within JPMorgan’s Chief
Investment Office appear to have been doing. Was Wells Fargo’s “economic
hedging” like buying straightforward insurance? Or was it more like
speculation—what JPMorgan did? Do the reported numbers suggest low risk
when in fact the opposite is true? The bank’s disclosures don’t answer
these questions.
Finally we come to a third shell—and there’s unquestionably something
to see under this one. It carries an innocuous label: “customer
accommodation.” Wells Fargo made more than $1 billion from
customer-accommodation trading in 2011. How did it make so much money
merely by helping customers? This should be a plain-vanilla business: a
broker sits between a buyer and a seller and takes a little cut of the
transaction. But what we learned from the 2008 financial crisis, and
what we keep learning from incidents such as the JPMorgan scandal, is
that seemingly innocuous activities that appear highly profitable can be
dangerous to a bank’s health—and to our economy.
Don’t look to the annual report for clarity. Here is the bank’s
definition: “Customer accommodation trading consists of security or
derivative transactions conducted in an effort to help customers manage
their market price risks and are done on their behalf or driven by their
investment needs.”
That might seem safe, but the report notably fails to explain why
this activity would be so profitable. In fact, at many large banks,
customer accommodation can be a euphemism for “massive derivatives
bets.”
For Wells Fargo, the subcategory of “customer accommodation, trading
and other free-standing derivatives” included derivatives trades of
about $2.8 trillion in “notional amount” as of the end of 2011, meaning
that the underlying positions referenced in the bank’s derivatives were
that large then. By way of explanation: if we were to make a bet with
you about how much the price of a $70 share of Walmart would change this
year—we pay you any increase, you pay us any decrease—we’d say the
“notional amount” of the bet is $70.
Wells Fargo doesn’t expect to gain or lose $2.8 trillion on its
derivatives, any more than we would expect the payment on our Walmart
bet to be $70. Bankers generally assume that the likely risk of gain or
loss on derivatives is much smaller than their “notional amount,” and
Wells Fargo says the concept “is not, when viewed in isolation, a
meaningful measure of the risk profile of the instruments.” Moreover,
Wells Fargo reports that many of its derivatives offset each other, as
yours might if you placed several wagers that Walmart stock would go up,
along with several other bets that it would go down.
Yet, as investors in bank stocks learned in 2008, it is possible to
lose a large portion of the “notional amount” of a derivatives trade if a
bet goes terribly wrong. In the future, if interest rates skyrocket or
the euro unravels, Wells Fargo might sustain huge derivatives losses,
just as you might lose the full $70 you bet on Walmart if the company
went bust. Wells Fargo doesn’t tell investors how much of the $2.8
trillion it could lose in a worst-case scenario, nor is it required to.
Even a savvy investor who reads the footnotes can only guess at what the
bank’s potential risk exposure to derivatives might be.
One reason Wells Fargo is trusted more than other big banks is that
its notional amount of derivatives is comparatively small. At the end of
the third quarter of 2012, JPMorgan had $72 trillion in notional amount
on its books—about five times the size of the U.S. economy. But even at
Wells Fargo levels, the numbers are so large that they lose their
meaning. And they put Wells Fargo’s seemingly immense capital
reserves—$148 billion, you’ll recall—in a rather different light.
How much risk is the bank actually taking on these trades? For which
customers does it place a requested bet, then negate its risk by taking
an exactly offsetting position in the market, so that it is essentially
acting as an agent simply taking a commission? And for all these trades,
what risk is Wells Fargo taking on its customers? Many of these bets
involve the customers’ promises to pay Wells Fargo depending on how
certain financial numbers change in the future. But what happens if some
of those customers go bankrupt? How much money would Wells Fargo lose
if it “accommodates” customers who can’t pay what they owe?
We asked Wells Fargo officials if we could talk to someone at the
bank about its disclosures, including those concerning its trading and
derivatives. They declined. Instead, they suggested we submit questions
in writing, which we did.
In response, Wells Fargo public-relations representatives wrote, “We
believe our disclosures on the topics you raised are comprehensive and
stand on their own.” In answering our written questions about the annual
report, the representatives simply pointed us back to the annual
report. For example, when we inquired about the bank’s trading
activities, Wells Fargo responded: “We would ask you to refer to our
discussion of ‘Market Risk-Trading Activities’ on pages 80–81 in the
Management Discussion and Analysis section of the Wells Fargo 2011
Annual Report.”
Yet it was precisely those pages that generated our questions about
the bank’s various categories of trading. When we specifically asked
Wells Fargo to help us quantify the risks associated with
customer-accommodation trading, its representatives pointed us to those
same pages. But those pages don’t answer that question. Here is the most
helpful of the bank’s disclosures related to customer-accommodation
trading:
For the majority of our customer accommodation trading weBankers, and their lawyers, are careful about the language they use
serve as intermediary between buyer and seller. For example, we may
enter into financial instruments with customers that use the instruments
for risk management purposes and offset our exposure on such contracts
by entering into separate instruments. Customer accommodation trading
also includes net gains related to market-making activities in which we
take positions to facilitate expected customer order flow.
in annual reports. So why did they use the word expected in discussing
customer order flow in that last sentence? Is Wells Fargo speculating
based on what one of its traders “expects” a customer to do, instead of
responding to what a customer actually has done? The language the bank
pointed to for answers to our questions only raises more questions.
Wells Fargo’s annual report is filled with similarly cryptic
declarations, but not the crucial information that investors actually
need. It doesn’t describe worst-case scenarios for
customer-accommodation trades, or even include any examples of what such
trades might involve. When we asked straightforward questions—such as
“How much money would Wells Fargo lose from these trades under various
scenarios?”—the bank’s representatives declined to answer.
Only a few people have publicly expressed concerns about
customer-accommodation trades. Yet some banking experts are skeptical of
these trades, and suspect that they hide huge risks. David Stockman,
who was the federal budget director under President Reagan, an
investment banker at Salomon Brothers, and a partner at the
private-equity firm Blackstone Group, calls the big banks “massive
trading operations.” Stockman has become so disillusioned by America’s
financial system that he is now regarded, in some quarters, as a
wild-eyed heretic, but his expertise is undeniable. He recently told
reporters for “The Gold Report,” an online newsletter, “Whether they
called it customer accommodation or proprietary is a distinction without
a difference.”
Part 3 tomorrow.
Thanks to: http://goldenageofgaia.com
