In the recent edition of The Atlantic, Frank Partnoy (law & finance professor at the Univ. of San Diego who recently wrote Wait: The Art and Science of Delay) and Jesse Eisinger (a journalist with ProPublica and columnist for the New York Times DealBook) authored What’s Inside America’s Banks?. They present an extensive analysis of the public disclosures made by major banks. The centerpiece of the article was an effort by Partnoy and Eisinger to unpack and understand the annual statement of Wells Fargo, a large bank that has been less associated with complex derivatives and trading activities than firms such as JP Morgan, Citi, and Goldman Sachs. They conclude that the public securities disclosure makes it impossible to understand adequately the risk-taking of even a more “traditional” large bank.
Frank agreed to engage in the following e-mail q&a on the article:
Q: You paint a pretty bleak picture of opaque disclosure and potential hidden time bombs lurking in the balance sheets of big banks. How does this problem compare to the toxic assets hidden in Japan’s zombie banks in the 1990s after their real estate bubble collapsed?
A: It’s a great comparison, and the degree and type of opacity are very similar. For example, I wrote in F.I.A.S.C.O. about the AMIT deals we were selling to Japanese banks back then, and looking back from today I think that the games played during the real estate bubble echo the games played in Japan during the 1990s. (And the zombie point is also a good one; we actually used that word in an early draft of the piece.)
Q: Is this a post-crisis phenomenon? Is it a function of banks trying to hide bad assets from before the bubble burst? Did the problem start there?
A: Yes, and I think it’s a friendly amendment to Charles Kindleberger’s work on crises, or even Hyman Minsky’s. As the bubble builds, credit expands, and risk increases, and inevitably the banks at the center of the expansion increasingly hide their risky assets. The assets aren’t necessarily bad – at least not at first – but they are hidden because they are risky. Then there is a dislocation and a panic as the assets “become” bad and ultimately the losses are disclosed.
Q: Is the opaque disclosure a sign that the United States runs the risk of a zombified banking sector like Japan’s?
A: That remains unclear. Bank stocks have performed well recently, in part because of the faith in the implicit U.S. government guarantee. Japanese banks weren’t as fortunate. But we think the risk is a real one, and it was a major reason why we wanted to write the piece. I don’t know if the right metaphor is zombie or rot or something else, but historically opacity has been at the center of major financial problems, especially over the long term.
Q: Do you have a sense whether the problem is as acute for large banks overseas – the Barclays, UBSs, and Deutsche Banks of Europe?
A: The gap between disclosure and reality is not nearly as wide in Europe, though banks there have plenty of other problems. For example, European regulators and bankers continue to rely heavily on credit ratings; that is a huge ongoing problem and will almost certainly result in massive misallocation of capital and future crises.
Q: You don’t seem to have much confidence in the ability of regulators or even bank management to understand the risks these banks are taking despite having nonpublic information. Is there other evidence of this besides the London Whale tale of JP Morgan?
A: Oh, there are so many. Regulators have failed to comprehend the risks at banks over and over during the previous two decades. My book Infectious Greed documents many of those incidents from the 1980s through 2003. As for more recent examples, the recent revelations about what Fed officials thought in 2007 is notable. So are the regulators’ positions about risks at Citigroup in late 2007 and early 2008. I attended several conferences with regulators during 2007-08 and was surprised by how little they knew about Structured Investment Vehicles. And so on. Kids, you really need to get out more.
Q: Why did Warren Buffett invest in banks after the crisis? What could he figure out that you (or other investment fund managers you interviewed) couldn’t? Did he have special access? Why is Berskshire Hathaway still invested in Wells Fargo if the disclosure is so opaque?
A: Buffett obviously has special access and his bet turned out to be a good one last year. He’s experienced investing in companies with opaque derivatives exposure, going back to General Re, and while sometimes he is warning that derivatives are financial weapons of mass destruction he is also often profiting from them. The key to Buffett’s investing style has always been timing – he is a genius at managing delay, waiting for the “fat pitch,” and I suspect he’ll know when it’s the right time to unload bank stocks so that he doesn’t get burned again. He understands that just because something is a black box doesn’t necessarily mean you should avoid it. Even buying into a pyramid scheme can be very profitable if you get the timing right.
Q: Why wouldn’t the market address this? Wouldn’t one large bank collect new investors and be able to sell equity above book value by offering better disclosure?
A: Oh, you’re right – how silly of me. The market addresses all such problems. Never mind.
(But seriously, imagine what our economy would look like today if the markets actually had worked. What if all of the major banks had failed in 2008 and Google, Microsoft, Amazon, and Walmart had stepped in to provide basic financial functions?)
Q: If this opacity scares away equity investors, why isn’t it also scaring away the creditors and derivative counterparties of these big banks? Why aren’t they demanding more margin or collateral or higher effective interest rates? Do these counterparties assume that the problem would have to be large enough to threaten the big bank?
A: Implicit government guarantees. And even so, they are demanding more collateral and clearer contractual arrangements, which are creating another set of problems. Also, there is some truth to the notion that the banks are so large and diversified today that creditors and counterparties probably aren’t at huge risk of failure. Catastrophe yes, but maybe nothing so big to cause insolvency. JPMorgan’s $6 billion loss was a nit.
Q: You offer a detailed indictment of Levels 2 and 3 of fair value accounting. What did you make of the outcry during the financial crisis that mark-to-market accounting was exacerbating the crisis by causing fire sales? Might some of the reforms you suggest, including improving fair value disclosure, have nasty procyclical effects?
A: No, quite the opposite. The outcry during the crisis was about marking down assets to more realistic levels – obviously bank managers didn’t want to do that. But if managers had understood they would be required to mark assets down immediately when they declined in value, they would have been less likely to buy them during a bubble – hence, an anti-cyclical effect. The smartest investors and managers say that if you can’t mark something every day, you shouldn’t buy it. Period.
Q: Your analysis of Wells Fargo’s “customer accommodation” trading focuses on some of the fudged language in the disclosure, namely that this trading might not be driven by actual customer demands, but “expected” customer order flow. You also write that
“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 make a profit.”
Does this mean that you are skeptical of the Volcker rule’s effectiveness in reducing risk-taking because the built-in statutory exceptions to proprietary trading are too easily manipulable?
A: Absolutely. I use the metaphor of a piece of Swiss cheese with holes that get bigger and bigger – until it is gone.
Q: Are you really limiting your proposed fixes to better disclosure and more vigorous securities enforcement? Or are you saying, as Felix Salmon blogged, that banks need to become much simpler? Do you agree with his assessment that moving back to a simpler age of banking or a simpler age of disclosure is quixotic?
A: I think getting simpler would be a result of better disclosure and enforcement. And I have very little confidence that regulators could draft a set of “simplicity rules” to pare down what banks are permitted to do and what they are not, especially in the face of the financial services lobby. I don’t think ex post adjudication in a principles-based regime is quixotic. If anything it’s a more sophisticated way of impounding market information in regulatory decisions. But good use of the word “quixotic.”
Q: Doesn’t disclosure still have the “you can lead a horse to water…” problem? Would even sophisticated investors demand or make use of the disclosure you envision? How do you know?
A: True. Some of the reception to our piece has made me wonder whether some supposedly “sophisticated” investors are in fact not wearing any clothes. On the Wells Fargo earnings call after our piece was published, one person asked about it, but the various investors and analysts seemed placated by the CEO’s response that Wells Fargo is “pretty plain vanilla” and “I’ve never seen us be more transparent.” There’s been virtually no follow-up about the bank’s Variable Interest Entity disclosures, for example. But I think there are enough truly sophisticated investors out there, and they have huge amounts of wealth under management – as long as they drink, the other horses eventually should come along. And the most sophisticated investors tend to pile on very effectively once even one of their ilk has made a good case. Which is why managers hate (and fear) them so much.
Q: Are you coming out in favor of principles in the old rules vs. principles debate on accounting standards? Aren’t simple, broad standards also subject to gamesmanship?
A: Yes, I am. It is much more difficult to game broad standards when they are adjudicated ex post. This after-the-fact element is just as important as rules vs. principles.
Q: How much promise do you think technology offers in improving the quality of disclosure (for example, the SEC’s XBRL initiative)? [Editorial note: this is my latest research project]
A: It’s a fantastic project, and I wish you the best with it. In theory, technology can vastly improve the quality of disclosure. But one problem with systematizing disclosure is that you can miss crucial angles that are “outside-the-box” or more like narrative. What would XBRL have done with Enron’s footnote 16?
Q: If you were to offer a few concrete suggestions for the new SEC Chair on improving disclosure and enforcement, what would they be?
A: Keep it simple and be willing to be vague. Single out financial firm disclosure as a hot topic, and make it clear that banks must make better disclosures of risks and worst-case scenarios, or face consequences. Get the board members of the major banks to sign on to these initiatives, through a series of early meetings and then a highly-publicized roundtable. Keep trying to win “should have known” cases, especially against employees of financial firms. Good luck!
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