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The Big Banks: Truth, Trust In Short Supply

"What's Inside America's Banks"
The Big Banks: Truth, Trust In Short Supply
GUESTFrank Partnoy, professor of law and finance, University of San Diego

CAVANAUGH: Every year in January, banks release annual disclosure statements. You may have received one from your bank. And if you did, you probably did not read it! But it may not have made much difference if you did! A leading expert on modern finance says the statements are too complex, unclear, and perhaps deliberately misleading. Professor Frank Partnoy used to work creating complex financial instruments on Wall Street. He recently coauthored a thorough examination of what banks disclose and what they don't in an article called "What's Inside America's Banks." Welcome back to the show. PARTNOY: Great to see you again. CAVANAUGH: Your article takes us back to the financial crisis of 2008 when we started hearing about huge financial institutions collapsing. One reason that no one wanted to lend or trade with banks during that time, you say, is that no one, not even investors could understand what risks the banks were taking. Why couldn't they understand that? PARTNOY: In part because the banks didn't want them to understand it. So the financial statements were opaque, and all these financial instruments people now know about, are these crazy sympathetic debt obligations and complex derivatives and swaps, a lot of that was hidden from people. So one of the things Jesse Eisinger and I wanted to understand, is how much things have changed over the last five years. Trust in banks is at an all-time low, and the average person doesn't have any reason to trust banks. One of the things we wanted to understand is what are the people who are really in the know, who are experts about the banks, what do they think based on the minutia? So it's perfectly understandable that someone listening to this program who owns a few shares of JP Morgan stock would throw the detailed annual report in the trash. But what about the people who manage billions and billions of dollars? What do they think? CAVANAUGH: What do they think? PARTNOY: The same thing we do! They don't trust the banks. They use words like uninvestable. Because they wade through all of the financials and try to understand risk. And one of the things we found just in the last year is that banks are often announcing these huge surprise losses. JP Morgan just last year in a supposedly safe part of the bank announced it first had lost $2 billion, the CEO called it a tempest in a teapot, and then later said, oh, no, are sorry, it was $6 billion. And we still don't know what the real size of the loss is. And it's leading the most sophisticated investors to say we really can't trust the banks, so we're not going to invest in them either. CAVANAUGH: They can't trust them because they don't know what's going on in them? PARTNOY: Yes, and because they don't know what the worst case scenario is. Before the crisis, no one understood if real estate prices go down 30%, they're insolvent. Now people say, what if houses prices go down again, what will that do to the banks? And they look at their financial statements and they don't see answers. They see eye-popping numbers, trillions of dollars of derivatives, these crazy entities called variable interest entities or VIEs which are very similar to the complex entities that were at the center of the complex of Enron, and they see Enron inside these banks and say I'm not investing. CAVANAUGH: Your article points to a fact that is truly shocking, that the situation may be so complicated that a financial institution might not even really understand what's going on in other departments of that institution, as perhaps happened at JP Morgan with the CEO, Jamie Diamond, came out with that underestimation of how much the bank had lost because he perhaps was not familiar with the chief investment office of his own JP Morgan! PARTNOY: That's absolutely right. And the CEOs of these banks now are shaking in their shoes. They have massive institutions that they don't understand. And people know this about JP Morgan because JP Morgan was in the news, and they've heard similar stories about Morgan Stanley or bank of America. But one of the things that we wanted to do in this piece in the Atlantic was to try to understand the most conservative bank, the most trusted bank, the bank where Warren buffet owns 8% of the stock. Of the bank whose stock is worth more than any other bank. And this is a bank where I have my checking account. Wells Fargo. So far one of the things we wanted to do in this piece was to dive deep into Wells Fargo's financial statements to see if we could understand them. CAVANAUGH: And you tell us that it starts out very happily, quite understandably with stories. PARTNOY: And the beginning of these annual reports are beautiful! They're glossy photos of happy complaints and cowboys out in the west, echoing Wells Fargo's venerable tradition, the old stagecoach protecting our gold, and everyone is smiling, and there's glowing descriptions of the amount of money Wells fearing makes. And let's be clear, Wells Fargo makes a lot of money! And over the last year, they've done very well. But one of the things that happens after the first 20 pages is that there's what we call I Dante descent into hell, where you really can't understand any of the details. And buried in footnotes are a $377 million loss on a collateralized debt obligation. Maybe we don't care about that, but it's astonishing it was never reported in the media, that people don't care about it, that it simply disappeared. $377 million year, and $377 million there, you're talking about serious money. CAVANAUGH: You asked Wells Fargo about some of the things that you couldn't understand in their disclosure statement. What answers did you get in PARTNOY: Yes, we wanted to talk to people at Wells Fargo, to talk to their CEO and CFO, so we asked them, would they talk to us, and they said, no, submit a detailed list of questions, which we did, and we asked them about lots of specifics. And instead of answering the questions, one of the things they did was point us back to the financial statements. We would ask them about a pair graph that was unclear, and they would respond by saying well, why don't you read that paragraph? So we didn't get very far with Wells Fargo, and in fact one of the interesting things that happened after the Atlantic article came out was that on the quarterly conference call, the CEO was asked, hey, I read this 9,400-word article in the Atlantic. What's going on? And he answered in a very dismissive way, saying that this is a pretty plain vanilla business, and that their disclosures are as good as they ever have been, which made me wonder just how much the leaders of these large financial institutions know about what's buried in the footnotes of their own financial statements. CAVANAUGH: So the point you're making as I understand, as it goes toward Wells Fargo, and other bank disclosures, even with this most conservative bank, the amount of trading, what that trading is, are the amount of leveraged assets is something you really can't figure out by reading this disclosure statement; is that right? PARTNOY: That's exactly right. And there is this trading, and there are more than a trillion dollars of derivatives, and more than $2 trillion of these variable interest entities at Wells Fargo. And so one of the questions that we have is if we don't trust these banks, and the edifice is rotting away, it's a dry rot. And right now, this year, everything might be fine, and next year everything might be fine. But if the foundation and the structure of these banks is being eaten away, and there are these risks that we don't understand, then the structure might become less stable. And then there will be another storm! We will confront another financial storm, and our concern is that if we don't understand the details, maybe these banks all will be blown down then. CAVANAUGH: What about all the reforms that were put into place after the financial meltdown of 2008? Hasn't that helped to make the disclosure statements more comprehensible or what's going on in banks more transparent? PARTNOY: It's a great question. And unfortunately, the reforms were aimed in other directions so that disclosures haven't really changed that much. A lot of people who are critical of the rules that were enacted think that it didn't do enough. And the other problem of course is that this mountain of regulations hasn't been enacted, and some of what has been has been whittled away. But the question of having the banks come clean and tell us what their risks are, that wasn't part of the reform. So it really shouldn't be all that surprising that the banks are still so opaque. CAVANAUGH: I remember when the bank crisis was at its height, people were talking about the pressure on banks to make larger and larger profits and therefore invest more and more heavily in all types of things. Is that pressure still on? These stockholder-owned banks to completely increase their profit margin? PARTNOY: Absolutely. In fact, the pressure has mounted. Banking is a tough industry N. Some ways, it's a dying industry. There are layoffs all over the world. The profits are being squeezed, the kinds of really plain vanilla businesses that banks historically have engaged in, things like deposits or just lending money to businesses, the margins on those businesses are much lower than they used to be. So banks are forced to stretch even more. And that means they're stretching down to retail. So a lot of people listening might have been offered complex products from their banks because the most you can earn just putting your money in the bank is a fraction of 1%. So they might come along with some fancy instrument with bells and whistles on it and say oh, you could earn much more with this. So I think average people need to be aware that banks really do have incentives to stretch right now. MAUREEN CAVANAUGH: And I think one of the most sobering things in this article, are what's inside America's bank, is the fact that this is not just a problem here in the United States. This is a problem globally. PARTNOY: This is clearly a global problem: For us, it's a serious problem here. For the last year or so, we have been sanguine about our basics. Banks did well. We looked abroad at Greece and Spain and Italy now, which just had another scandal hit, and I think we became a little passive in the U.S., thinking that this is a global problem. And you're certainly right that it is. But one of the things we wanted to point out in this article is that even for the most conservative U.S.-based institutions, it remains a problem, that we thought that things would get better after the financial crisis. And in some ways, they have, in some limited ways they have, but the core of what caused the collapse of the banking system and nearly wiped out the financial system in 2007 and 2008, the core of that problem with transparency, that problem still remains in the U.S. CAVANAUGH: What is the problem? Could you explain what is the problem to the overall U.S. economy? If high-powered investors, reading these financial disclosure statement, say I don't really know what's going on with this bank so I'm not going to put into money into it, why does this create a problem for the U.S. economy? PARTNOY: Ultimately, what it does is create a long-term structural problem in terms of the stability of the banking system. In the short-term, it's unlikely that there'll be a major collapse. But in the long run, for our economy to grow, we need the banks to play this very important role of putting together people who need people and people who have money. That fundamentally is what banks are there to do. And it's a hugely important role, and there are plenty of great people inside all of the banks who are doing this. But the problem is as long as the banks remain unclear and aren't transparent, that basic function could be put at risk. Just like at JP Morgan, this office that was thought to be low-risk that wasn't involved in the traditional banking business suddenly has lay $6 billion loss. If there's a lot of that going on, it could be that if we have some butterfly fluttering its wings in the future, any decline in housing prices or changes in foreign exchange or interest rates, that could put the entire bank at jeopardy. So the idea is that we need for there to be trust in the financial system. And even if average people like you and me and people listening, even if those people don't trust the banks, if the sophisticated investors trust them, that could be enough to hold them up. But the problem is even the most sophisticated people don't trust the banks anymore. CAVANAUGH: Is there a quick fix to this? Could there be a couple of regulations passed in Washington that would basically turn this around and force the banks to be more transparent? PARTNOY: There are two things that we could do, and historically, they're what we did in the aftermath of the last financial crisis after the 1929 market crash. And we have hopefully a new SEC commissioner coming in who's very skilled and smart, and the two things are this disclosure issue we've been talking about. For the securities and exchange commission to say you need to disclose all of these risks, you need to tell investors what the worst case scenarios are, and you need to do it in plain English. They aren't doing that right now. That's No. 1. And that was pillar No. 1 of our financial system from the 1930s until recently. CAVANAUGH: Shouldn't they be doing that right now though? Aren't there laws on the books basically telling them to disclose that kind of information? PARTNOY: They should be doing it. But the laws enable them to disclose certain information but not the information that really matters. And in some ways, we've been strung up by our own regulatory structure that allows them to comply with the law without actually telling us what we need to know. CAVANAUGH: Exactly. PARTNOY: And the second piece is enforcement. We used to have rigorous enforcement of the securities laws, and people went to the jail in the aftermath of the 1920 crisis! If you ask people what really should have happened after this crisis, it's that! That's the thing that makes a lot of average people angry. No senior executive has gone to jail for the conduct at the core of the crisis. That's really the second pillar that came out of the 1930s laws that held up our economy for so long, there was this threat that you would go to jail if you did something wrong. And there isn't that threat right now. CAVANAUGH: My last question to you, you mentioned the CEO of Wells Fargo sort of was rather dismissive about this article. Have you gotten any other feedback from this article? PARTNOY: Not from Wells Fargo. [ LAUGHTER ] PARTNOY: Which made us very happy, actually, because it confirms that everything in the article was accurate. And we were pain staking about the detail in the article. And the Atlantic is a tremendous, tremendous magazine, and they were very, very focused on the details. But the feedback we've gotten from other banks is -- in particular from one bank I just learned of in the last few days was inside the bank the CFOs and controllers have gone told read this article, and I want you to tell me, do we have any of these shenanigans happening inside our bank? Because the smaller banks, they shouldn't be doing any of this stuff. And some of them are. And so we've gotten very positive feedback within the institution, saying this is a roadmap for what we should not do, and if we're doing, it we should stop.

There's a very scary story in the January/February of Atlantic Magazine.

"What's Inside America's Banks," by University of San Diego School of Law professor Frank Partnoy and ProPublica's Jesse Eisinger, details evidence of hidden monsters -- high-risk trades, misleading information and made-up numbers -- that could gobble up the financial system once again. And scariest of all, they find no way to get at the truth.

The bottom line is that we have no idea what the bottom line is.


The unprecedented efforts since 2008 to save the financial industry, clean up banking practices and reform regulations simply haven't worked, says Partnoy. American banks such as Wells Fargo, Bank of America and JP Morgan are bigger than ever and more opaque than ever. Some are under civil or criminal investigation.

Public trust in banks is in the cellar. In the late 1970s, three out of five Americans said they trusted big banks "a great deal." Now only one in four admits to trusting banks at all.

The bigger problem is that investors don't trust them either. Reading a bank's annual report, where all information on worth, risk, types of practices and financial instruments should be found, is an exercise in translating outright guesswork and working through layers of obfuscation.

If investors think banks are "uninvestable," banks can't attract capital. Without capital, they will weaken and die.