What’s In Your Bank?

Economist - Banksters (2)In one of the most insightful articles I’ve read about Big Banks from the Great Depression to the present, authors Frank Partnoy and Jesse Eisinger, writing in the Jan/Feb 2013 issue of The Atlantic, discuss why America’s big lending institutions are no safer today, than the months leading up to the 2008 collapse of the financial markets. [See,“What’s Inside America’s Banks?”]

After recounting the events of 2012, the ‘Year of the Rat’ in terms of bank scandals,[1] the authors decided to focus on Wells Fargo’s annual statement, since the bank “…is widely regarded as the most conservative of the nation’s biggest banks.” However, after several pages of discussion about what they found, it becomes clear that the only difference between Wells Fargo and some of its peers, is not that it shuns high risk bets – just that it appears to shun less of them than others.  And the glue that binds all Big Banks together is actually worse today than years past – a lack of transparency – they are, in the words of the authors, “black boxes.”

Herewith are some snippets from this article, to support the authors’ compelling story:

  • The $6 billion London Whale fiasco suffered by Jamie Dimon, JPMorgan’s CEO, considered one of the best of the best, was an eye-opener.  If it could happen at one of the best run and most risk-prudent banks, it could happen anywhere – and for much larger losses.

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 is common knowledge that rank and file Americans have little or no trust in the Big Banks. But what about industry insiders?

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.

  • The authors explain the different types of risk Big Banks carry on their books and why much of it is impossible to measure by people both inside and outside the bank.  What follows is an explanation of how Wells Fargo reports the fair value of the securities it holds:

Like other banks, Wells Fargo uses a three-level hierarchy to report the fair value of its securities. Level 1 includes securities traded in active, public markets; it isn’t too scary. At Level 1, fair value simply means the reported price of a security. If Wells Fargo owned a stock or bond traded on the New York Stock Exchange, fair value would be the closing price each day.

Level 2 is more worrisome. It includes some shadier characters, such as derivatives and mortgage-backed securities. There are no active, public markets for these investments—they are bought and sold privately, if at all, and are not listed on exchanges—so Wells Fargo uses other methods to figure out fair value, including what it calls “model-based valuation techniques, such as matrix pricing.” At Level 2, fair value is what accountants would charitably describe as an “estimate,” based on statistical computer models and what they call “observable” inputs, such as the prices of similar assets or other market data. At Level 2, fair value is more like an educated guess. [Emphasis added.]

Level 3 is hair-raising. The bank’s Level 3 estimates are “generated primarily from model-based techniques that use significant assumptions not observable in the market.” In other words, not only are there no data about the prices at which these types of assets have recently traded, but there are no observable data to inform the assumptions one might use to generate prices. Level 3 contains the most-esoteric financial instruments—including the credit-default swaps and synthetic collateralized debt obligations that became so popular and prevalent at the height of the housing boom, filling the balance sheets of Bear Stearns, Merrill Lynch, Citigroup, and many other banks.


At Level 3, fair value is a guess based on statistical models, but with inputs that are “not observable.” Instead of basing estimates on market data, banks use their own assumptions and internal information. At Level 3, fair value is an uneducated guess. [Emphasis added.]

And harking back to the off-balance sheet accounting days of Enron, in 2001 with its “special-purpose entities,” we learn that Well Fargo’s accountants are still using the ruse, but under a different name:

There is an even lower circle of financial hell. It is populated with complex financial monsters once known as “special-purpose entities.” These were the infamous accounting devices that Enron employed to hide its debts. Around the turn of the millennium, the Texas energy-trading firm used these newly created corporations to borrow money and take on risks without recording the liabilities in its financial statements. These deals were called “off-balance-sheet” transactions, because they did not appear on Enron’s balance sheet.

Suppose a company owns a slice—just a small percentage—of another company that has a lot of debt. The first company might claim that it doesn’t need to include all of the second company’s assets and liabilities on its balance sheet. Let’s say we owned shares of IBM. We aren’t suddenly on the hook for all of the company’s liabilities. But if we owned so many IBM shares that we effectively controlled it, or if we had a side agreement that made us responsible for IBM’s debts, common sense dictates that we should treat IBM’s liabilities as our own. A decade ago, many companies, including Enron, used special-purpose entities to avoid common sense: they kept liabilities off the balance sheet, even when they had such control or side agreements.

As in a horror film, the special-purpose entity has been reanimated, and is now known as the variable-interest entity. In the alphabet soup of Wall Street, the acronym has switched from SPE to VIE, but the idea is the same. Big companies create these entities to borrow money and buy assets, but—like Enron—they do not include them on their balance sheets. The problem is especially worrisome at banks: every major bank has substantial positions in VIEs.

As of the end of 2011, Wells Fargo reported “significant continuing involvement” with variable-interest entities that had total assets of $1.46 trillion. The “maximum exposure to loss” it reports is much smaller, but still substantial: just over $60 billion, more than 40 percent of its capital reserves. The bank says the likelihood of such a loss is “extremely remote.” We can hope.

However, Wells Fargo acknowledges that even these eye-popping numbers do not include its entire exposure to variable-interest entities. The bank excludes some VIEs from consideration, for many of the same reasons Enron excluded its special-purpose entities: the bank says that its continuing involvement is not significant, that its investment is temporary or small, or that it did not design or operate these deals. (Wells Fargo isn’t alone; other major banks also follow this Enron-like approach to disclosure.)

Conclusion.  The authors recite the increasing complexity of laws as contributing to the inability of regulators to actually regulate.  I would second that, but add that the problem does not end there.  There is a symbiotic relationship between regulators and the regulated.  The banking and investment industry is a fertile source of employment for ex-regulators.  One does not want to burn bridges, so the kid gloves stay on the regulators.

Moreover, the Big Bank lobby has proven masterful in diluting laws with regulations that gut the spirit of the law, creating loopholes to game the system.

The Glass-Steagall Act of 1933 [which prohibited bank from engaging in investment activities],*** was perhaps “the single most influential piece of financial legislation of the 20th century,” was only 37 pages. In contrast, 2010’s Dodd-Frank law was 848 pages and required regulators to create so many new rules (not fully defined by the legislation itself) that it could amount to 30,000 pages of legal minutiae when fully codified.

The “Volcker Rule,” is a case in point.

The rule is an attempt to ban banks from being able to make speculative bets if they also take in federally insured deposits. The idea is straightforward: the government guarantees deposits, so these banks should not gamble with what is effectively taxpayer money.

Yet, under constant pressure from banking lobbyists, Congress wrote a complicated rule. Then regulators larded it up with even more complications. They tried to cover any and every contingency. Two and a half years after Dodd-Frank was passed, the Volcker Rule still hasn’t been finalized. By the time it is, only a handful of partners at the world’s biggest law firms will understand it.

My only disagreement with the authors is what I believe to be a Pollyannaish solution offered to deal with the problem of Big Bank Opacity – write simpler laws. Over my 40 years of law practice, I have never seen regulations move from the complex to the simple.  Nice, but about as unlikely as seeing remorse on the face of Lance Armstrong, or embarrassment on the face of Anthony Weiner.  It seems to be the natural order of things to move from the simple to the complex.

Moreover, there are too may stakeholders who profit from complexity in the banking system.  Politicians like Messrs. Dodd and Frank, needed to pass a sweeping law to create the appearance they were on the right side of the debate[2]; lobbyists need to lobby, which means writing loop-holes for their clients; lawyers need to obfuscate for their clients in order to explain to the regulators that “no laws were broken.” [It’s hard to obfuscate simple and easy-to-understand laws]; and accountants need complexity in order to finesse GAAP, so Big Bank annual reports can continue their opacity.  In short, “simple” doesn’t work for these stakeholders – “complex” does.

[1] I will not recount them here in this post.  They are regaled in prior posts, here, here, here, here, and here.  For a rabid anti-Big Bank Blogger like myself, the lending and finance industries have been the gift that keeps on giving.

[2] They weren’t – they used the banking industry like a sucker fish uses a shark, symbiotically, drawing contributions and currying favor. See my discussion here.