Certain Habits

As reported by the Wall Street Journal today, the countries largest banks appear to have been systematically masking the levels of debt they maintain in their quarterly filings to the SEC.

When are the trials for fraud, you ask? It turns out what they’re doing is completely legal, and may have been standard operating procedure for many years.

SEC filings document the bank’s balance sheet at a particular point in time: the end of the quarter. So, if you were an enterprising big bank CEO with a bonus tied to your stock performance, what would you do? Well, knowing that a key input in the value function for your stock is the amount of debt (read: risk) that you carry, you would sharply curtail your overnight borrowing just prior to having to report earnings. Then you could resume feeding at the trough of the Fed’s overnight counter the next day.

Here is how the Wall Street Journal described it:

Major banks have masked their risk levels in the past five quarters by temporarily lowering their debt just before reporting it to the public, according to data from the Federal Reserve Bank of New York. A group of 18 banks—which includes Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Bank of America Corp. and Citigroup Inc.—understated the debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods, the data show. The banks, which publicly release debt data each quarter, then boosted the debt levels in the middle of successive quarters.

While this “repo” borrowing is just a small percentage of a bank’s total activities, it substantially increases the leverage that their trading desks employ. And because these are often a bank’s riskiest assets, and because poorly understood, highly-levered, high-risk trading assets can wipe out a bank’s equity with alacrity should the market move against them, understanding the size of these positions is critical to investors. Again, the Wall Street Journal:

The data highlight the banks’ levels of short-term financing in the repurchase, or “repo,” market. Financial firms use cash from the loans to buy securities, then use the purchased securities as collateral for other loans, and buy more securities. The loans boost the firms’ trading power, or “leverage,” allowing them to make big trades without putting up big money. This amplifies gains—and losses, which were disastrous in 2008.

This is story contains lessons beyond those for individual investors contemplating purchasing banks again. It also provides a lesson in the number of ways that big bank complexity can doom efforts to regulate the financial sector. If there is any group of people more likely than bank strategists to game a regulatory system (trial lawyers excepted), I don’t know who they are.

The only solution for the systemic risks endemic to large, complex financial institutions is a limitation on bank size and leverage in all its forms.

While we should be making “too big to fail” financial institutions “small enough to fail”, we’ve done the opposite. And we’ve piled too-big-to-fund government liabilities on top of them. While this may postpone the day of reckoning, it doesn’t change the basic fact of life: that which cannot continue, at some point won’t.

Reforms that would shrink the biggest banks and let bad banks fail would cause a double-dip recession. They will almost certainly make money more expensive in the short term and reintroduce some transactional inefficiencies. But those efficiencies are purchased on hidden credit in the form of unpredictable, and asymmetrically damaging, systemic risks. If we prove unable to learn the lessons of the pain we’ve experienced the last two years, we have no one to blame but ourselves.