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.
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.
Consider JPMorgan’s widely scrutinized trading loss last year. Before the episode, investors considered JPMorgan one of the safest and best-managed corporations in America. Jamie Dimon, the firm’s charismatic CEO, had kept his institution upright throughout the financial crisis, and by early 2012, it appeared as stable and healthy as ever.
One reason was that the firm’s huge commercial bank—the unit responsible for the old-line business of lending—looked safe, sound, and solidly profitable. But then, in May, JPMorgan announced the financial equivalent of sudden cardiac arrest: a stunning loss initially estimated at $2 billion and later revised to $6 billion. It may yet grow larger; as of this writing, investigators are still struggling to comprehend the bank’s condition.
The loss emanated from a little-known corner of the bank called the Chief Investment Office. This unit had been considered boring and unremarkable; it was designed to reduce the bank’s risks and manage its spare cash. According to JPMorgan, the division invested in conservative, low-risk securities, such as U.S. government bonds. And the bank reported that in 95 percent of likely scenarios, the maximum amount the Chief Investment Office’s positions would lose in one day was just $67 million. (This widely used statistical measure is known as “value at risk.”) When analysts questioned Dimon in the spring about reports that the group had lost much more than that—before the size of the loss became publicly known—he dismissed the issue as a “tempest in a teapot.”
Six billion dollars is not the kind of sum that can take down JPMorgan, but it’s a lot to lose. The bank’s stock lost a third of its value in two months, as investors processed reports of the trading debacle. On May 11, 2012, alone, the day after JPMorgan first confirmed the losses, its stock plunged roughly 9 percent.
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 gets worse. Federal prosecutors are now investigating whether traders lied about the value of the Chief Investment Office’s trading positions as they were deteriorating. JPMorgan shareholders have filed numerous lawsuits alleging that the bank misled them in its financial statements; the bank itself is suing one of its former traders over the losses. It appears that Jamie Dimon, once among the most trusted leaders on Wall Street, didn’t understand and couldn’t adequately manage his behemoth. Investors are now left to doubt whether the bank is as stable as it seemed and whether any of its other disclosures are inaccurate.
The JPMorgan scandal isn’t the only one in recent months to call into question whether the big banks are safe and trustworthy. Many of the biggest banks now stand accused of manipulating the world’s most popular benchmark interest rate, the London Interbank Offered Rate (LIBOR), which is used as a baseline to set interest rates for trillions of dollars of loans and investments. Barclays paid a large fine in June to avoid civil and criminal charges that could have been brought by U.S. and U.K. authorities. The Swiss giant UBS was reportedly close to a similar settlement as of this writing. Other major banks, including JPMorgan, Bank of America, and Deutsche Bank, are under civil or criminal investigation (or both), though no charges have yet been filed.
Libor reflects how much banks charge when they lend to each other; it is a measure of their confidence in each other. Now the rate has become synonymous with manipulation and collusion. In other words, one can’t even trust the gauge that is meant to show how much trust exists within the financial system.
Accusations of illegal, clandestine bank activities are also proliferating. Large global banks have been accused by U.S. government officials of helping Mexican drug dealers launder money (HSBC), and of funneling cash to Iran (Standard Chartered). Prosecutors have charged American banks with falsifying mortgage records by “robo-signing” papers to rush the process along, and with improperly foreclosing on borrowers. Only after the financial crisis did people learn that banks routinely misled clients, sold them securities known to be garbage, and even, in some cases, secretly bet against them to profit from their ignorance.
Together, these incidents have pushed public confidence ever lower. According to Gallup, back in the late 1970s, three out of five Americans said they trusted big banks “a great deal” or “quite a lot.” During the following decades, that trust eroded. Since the financial crisis of 2008, it has collapsed. In June 2012, fewer than one in four respondents told Gallup they had faith in big banks—a record low. And in October, Luis Aguilar, a commissioner at the Securities and Exchange Commission, cited separate data showing that “79 percent of investors have no trust in the financial system.”
When we asked Dane Holmes, the head of investor relations at Goldman Sachs, why so few people trust big banks, he told us, “People don’t understand the banks,” because “there is a lack of transparency.” (Holmes later clarified that he was talking about average people, not the sophisticated investors with whom he interacts on an almost hourly basis.) He is certainly right that few students or plumbers or grandparents truly understand what big banks do anymore. Ordinary people have lost faith in financial institutions. That is a big enough problem on its own.
But an even bigger problem has developed—one that more fundamentally threatens the safety of the financial system—and it more squarely involves the sort of big investors with whom Holmes spends much of his time. More and more, the people in the know don’t trust big banks either.
After all the purported “cleansing effects” of the panic, one might have expected big, sophisticated investors to grab up bank stocks, exploiting the timidity of the average investor by buying low. Banks wrote down bad loans; Treasury certified the banks’ health after its “stress tests”; Congress passed the Dodd-Frank reforms to regulate previously unfettered corners of the financial markets and to minimize the impact of future crises. During the 2008 crisis, many leading investors had gotten out of bank stocks; these reforms were designed to bring them back.
And indeed, they did come back—at first. Many investors, including Warren Buffett, say bank stocks were underpriced after the crisis, and remain so today. Most large institutional investors, such as mutual funds, pension funds, and insurance companies, continue to hold substantial stakes in major banks. The Federal Reserve has tried to help banks make profitable loans and trades, by keeping interest rates low and pumping trillions of dollars into the economy. For investors, the combination of low stock prices, an accommodative Fed, and possibly limited downside (the federal government, needless to say, has shown a willingness to assist banks in bad times) can be a powerful incentive.
Yet the limits to big investors’ enthusiasm are clearly reflected in the data. Some four years after the crisis, big banks’ shares remain depressed. Even after a run-up in the price of bank stocks this fall, many remain below “book value,” which means that the banks are worth less than the stated value of the assets on their books. This indicates that investors don’t believe the stated value, or don’t believe the banks will be profitable in the future—or both. Several financial executives told us that they see the large banks as “complete black boxes,” and have no interest in investing in their stocks. A chief executive of one of the nation’s largest financial institutions told us that he regularly hears from investors that the banks are “uninvestable,” a Wall Street neologism for “untouchable.”
That’s an increasingly widespread view among the most sophisticated leaders in investing circles. Paul Singer, who runs the influential investment fund Elliott Associates, wrote to his partners this summer, “There is no major financial institution today whose financial statements provide a meaningful clue” about its risks. Arthur Levitt, the former chairman of the SEC, lamented to us in November that none of the post-2008 remedies has “significantly diminished the likelihood of financial crises.” In a recent conversation, a prominent former regulator expressed concerns about the hidden risks that banks might still be carrying, comparing the big banks to Enron.
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.
A disturbing number of former bankers have recently declared that the banking industry is broken (this newfound clarity typically follows their passage from financial titan to rich retiree). Herbert Allison, the ex-president of Merrill Lynch and former head of the Obama administration’s Troubled Asset Relief Program, wrote a scathing e-book about the failures of the large banks, stopping just short of labeling them all vampire squids. A parade of former high-ranking executives has called for bank breakups, tighter regulation, or a return to the Depression-era Glass-Steagall law, which separated commercial banking from investment banking. Among them: Philip Purcell (ex-CEO of Morgan Stanley Dean Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch), and John Reed (former coâ€‘CEO of Citigroup). Sandy Weill, another ex-CEO of Citigroup, who built a career on financial megamergers, did a stunning about-face this summer, advising, with breathtaking chutzpah, that the banks should now be broken up.
Bill Ackman’s journey is particularly telling. One of the nation’s highest-profile and most successful investors, Ackman went from being a skeptic of investing in big banks, to being a believer, and then back again—with a loss of hundreds of millions along the way. In 2010, Ackman bought an almost $1 billion stake in Citigroup for Pershing Square, the $11 billion fund he runs. He reasoned that in the aftermath of the crisis, the big banks had written down their bad loans and become more conservative; they were also facing less competition. That should have been a great environment for investment, he says. He had avoided investing in big banks for most of his career. But “for once,” he told us, “I thought you could trust the carrying values on bank books.”
Last spring, Pershing Square sold its entire stake in Citigroup, as the bank’s strategy drifted, at a loss approaching $400 million. Ackman says, “For the first seven years of Pershing Square, I believed that an investor couldn’t invest in a giant bank. Then I felt I could invest in a bank, and I did—and I lost a lot of money doing it.”
A crisis of trust among investors is insidious. It is far less obvious than a sudden panic, but over time, its damage compounds. It is not a tsunami; it is dry rot. It creeps in, noticed occasionally and then forgotten. Soon it is a daily fact of life. Even as the economy begins to come back, the trust crisis saps the recovery’s strength. Banks can’t attract capital. They lose customers, who fear being tricked and cheated. Their executives are, by turns, traumatized and enervated. Lacking confidence in themselves as they grapple with the toxic legacies of their previous excesses and mistakes, they don’t lend as much as they should. Without trust in banks, the economy wheezes and stutters.
And, of course, as trust diminishes, the likelihood of another crisis grows larger. The next big storm might blow the weakened house down. Elite investors—those who move markets and control the flow of money—will flee, out of worry that the roof will collapse. The less they trust the banks, the faster and more decisively they will beat that path—disinvesting, freezing bank credit, and weakening the structure even more. In this way, fear becomes reality, and troubles that might once have been weathered become existential.