What’s Inside America’s Banks?
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.
An Iv-B economy is like a poker game, people win by being secretive and deceptive. When the I-O police are weak this is like poker where people use marked cards, deal from the bottom of the deck, etc as well. When the game itself is untrustworthy people cannot afford to use bluffing in it.
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.
A stimulus on Iv-B businesses is like putting fertilizer on weeds in the hope they will turn into trees. They continue to grow secretively and deceptively, then collapse when the resources are wastefully used up. With this color imbalance the V-Iv parts of the economy might still have enough money to buy themselves out of trouble, this is like a Y-Oy empire like the Roman Empire able to get enough wealth from the colonies to cow them into submission for more pillage.
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.
Surely, one would assume, Wells Fargo’s assets would mostly reside on Level 1, with perhaps a small amount on Level 2. It’s just a simple mortgage bank, right? And it seems inconceivable that Wells Fargo would be loaded with Level 3 investments long after regulators have supposedly purged the banks of toxic assets and nursed them back to health.
Yet only a small fraction of Wells Fargo’s assets are on Level 1. Most of what the bank holds is on Level 2. And a whopping $53 billion—equivalent to more than a third of the bank’s capital reserves—is on Level 3. All three categories include risky assets that might lose value in the future. But the additional concern with Level 2 and Level 3 assets is that banks might have errantly recorded them at values that were inflated to begin with. There is no way to check whether reported values are accurate; investors have to trust the bank’s managers and auditors. Scholarly research on Level 3 assets suggests that they can be misstated by as much as 15 percent at any given time, even if the market is stable. If Wells Fargo’s estimates are that far off, the bank could be sitting on billions of dollars of hidden losses.
This is the Iv-B part of many businesses, stimulus in the economy is more likely to revive these mutated assets in a bubble but it cannot turn them into balanced Biv assets to give reliable growth.
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.
These also mutate to avoid the i-O regulators then grow exponentially when there is money available.
In the decades following the 1929 crash, banks were understandable. That’s not because they were financially simple—that era had its own versions of derivatives and special-purpose entities—but because the banks’ disclosures were more straightforward and clear. That clarity sprang from the fear of consequences. The law, as Oliver Wendell Holmes Jr. said, is a prediction of what a court will do. And the broadly scoped laws of that time gave courts wide latitude.
Going to jail for financial fraud was a real risk back then, and bank executives worried that their reputations would be destroyed if a judge criticized what they had done. Richard Whitney, a broker who had been the president of the New York Stock Exchange, was sent to Sing Sing prison in 1938 for embezzlement. “Sunshine Charlie” Mitchell, the president of National City Bank, the predecessor to Citibank, was indicted for tax evasion after the 1929 crash and was also the first of many bankers to testify before the famous Senate Pecora Committee in 1933. The Pecora investigation galvanized public opinion, and helped usher in the landmark banking and securities laws of 1933 and 1934. The scrutiny and continuing threat of prosecution convinced many bank executives that they should keep their business simple and transparent, or worry about the consequences if they did not.
When the economy became Roy the O criminal police cleaned up much of this Oy-R fraud then. In the mainly Biv economy after the GFC the fraud has been mainly treated as a civil matter by I.
In an important call to arms this past summer, Andrew Haldane, the Bank of England’s executive director for financial stability, laid out the case for an international regulatory overhaul. “For investors today, banks are the blackest of boxes,” he said. But regulators are their facilitators. Haldane noted that a landmark regulatory agreement from 1988 called Basel I amounted to a mere 18 pages in the U.S. and 13 pages in the U.K. Likewise, disclosure rules were governed by a statute that was essentially one sentence long.
Basel II, the second iteration of global banking regulation, issued in 2004, was 347 pages long. Documentation for the new Basel III, Haldane noted, totals 616 pages. And federal regulations governing disclosure are even longer than that. In the 1930s, a bank’s reports to the Federal Reserve might have contained just 80 entries. Yet by 2011, Haldane said, quarterly reporting to the Fed required a spreadsheet with 2,271 columns.
Iv-B economies are much more complex, this compelxity can also be used to confuse and hide deception as well as wear out V-Bi opponents.
The banks provide “a ton of disclosure,” Ackman notes. There are a lot of pages and details in any bank’s annual report, including Wells Fargo’s. But “it’s what you can’t figure out that’s terrifying.” In the gargantuan derivatives-trading positions, for instance, he says, “you can’t figure out whether the bank has got it right or not. That’s faith.”
A combination of clearer, simpler disclosure and stronger enforcement would help clean up the system, just as it did beginning in the 1930s. Not only would shareholders better understand banks’ businesses, but managers would have the incentive to run their businesses more ethically. The broad cultural failure on Wall Street has arisen in part because disclosure rules encourage the banks to be purposefully opaque. Today, their lawyers don’t judge whether statements are clear and meaningful but rather whether they are on the bleeding edge of legality. If bank managers faced real consequences when their descriptions proved inaccurate or incomplete, they would strive to make those descriptions as clear and simple as Strunk and White’s The Elements of Style.
Perhaps there is a silver lining in the loss of sophisticated investors’ trust. The disillusionment of the elites, on top of popular outrage, could foment change. Without such a mobilization, all of us will remain in the dark, neither understanding nor trusting the banks. And the rot will spread.