Are the Banks Telling Us the Truth?

On the front page of the Financial Times this morning we read the disconcerting headlines, “’Tarp cop’ to investigate whether banks have ‘cooked their books.’” (See here) Neil Barofsky, special investigator-general for the Troubled Asset Relief Program (TARP), is “seeking evidence of wrongdoing on the part of banks receiving help from the fund.”

The game—“institutions applying for TARP money had to show they were fundamentally sound, potentially prompting them to misstate assets and liabilities.” Barofsky is quoted as saying, “I hope we don’t find a single bank that’s cooked its books to try to get money but I don’t think that’s going to be the case.”

Mr. Barofsky also said the Treasury’s expanded Term Asset-Backed Securities Loan Facility (TALF) was ripe for fraud.

The potential—fraudsters would be receiving indictments!

Two thoughts cross my mind when reading this. First, bankers in deteriorating situations tend to hide their heads in the sand when it comes to bad assets because they keep hoping that things will get better and the assets will recover their value. Having (successfully) completed several bank turnarounds I have found that this is one of the first things that becomes obvious when you initially investigate the loans and other assets of a troubled institution. Bankers, lenders, or portfolio managers continually think that ‘the economy will turn around’ or that ‘the company is getting its act in order’ or that some other event will come along that will result in the ‘asset gone bad’ becoming the ‘asset has become good again.’ And, so the asset is carried along but never comes back to life.

The problem with this is that these bad assets continually undermine the ability of the financial institution to right itself and become profitable again. The example is always there on the books of the banks and whether the executives or officers admit the fact, internally they know that things are not right and this drains efforts to instill a healthy culture to “do the right thing.” Managements that allow this unhealthy culture to continue are just perpetrating a bad situation, one that very rarely ever turns itself around.

The managements that participate in such a charade tend to be desperate and susceptible to moving to the next step when they are thrown a life boat like many financial institutions received in the past nine months or so.

Before following up on this point, let me just say that, historically, the bank either brings in someone to turn the institution around, or, a regulatory agency steps in and dissolves the organization. The American banking system has worked very well in the past with respect to “sick” banks. Contagion has been avoided through quick action connected with the swift resolution of problem assets. Financial institutions that were in trouble were taken care of—period!

But, that is not the case in the current situation. We have had a bailout. The banks have been tossed a life boat. However, financial institutions were supposed to be “fundamentally sound” in order to obtain TARP money. Here we get into the muddy waters of conducting a “general” bailout.

Let me just say that I have been suspicious from the start when government officials claimed that the need for the TARP funds was because the banks were facing “a liquidity problem” with respect to their troubled assets.
Again, my experience in doing bank turnaround’s is that the officers of the bank that claimed their assets were in trouble because of liquidity problems were attempting to cover up the real difficulties connected with the assets which were almost always associated with the issue of solvency.

It would not be much of a surprise to me to hear that the banks justified to the government that they were “fundamentally sound” because their asset problems were associated with liquidity issues rather than ones of solvency. This assessment could perhaps be supported if government officials only took a cursory glance at the assets. But, one could argue that this is the conclusion that government officials wanted to hear at that time.

Is this fraud? That is what Mr. Barofsky is going to have to find out.

Other than outright “cooking of the books”, in many cases the distinction between liquidity and solvency may fall back on an argument about “judgment”, about the “eye of the beholder.” Thus, Mr. Barofsky is going to have his problems proving his case.

In my opinion, many of the banks that received bailout relief had and still have a solvency problem and until the situation is handled that way the dislocations associated with the banking industry and the financial markets are going to continue. Consequently, I believe that Mr. Barofsky and others are going to find evidence that all along, the issue has been solvency and not liquidity. If so, then there is a real issue of whether or not that these institutions that received TARP money were “fundamentally sound.”

My second thought on this issue is a very simple one. If people inside the banks covered up the real issues related to solvency heads should roll. Those that committed fraud should be indicted! Those that knowingly misled should be dismissed!

And, top executives, even though they were not directly involved in fraud or in a cover up, should be removed from their positions as well. They have proven that they cannot manage their institutions with sufficient control to justify their ability to move those institutions on into the future. The “buck stops with the top position” and the argument that they didn’t know what was going on is insufficient. It was their responsibility to know what was going on!

Risk management, the other “bug-in-the-coffee”, and financial control are not glamorous pursuits, especially when compared with the “jet pilots” of finance that were tossing around all sorts of money chasing narrow spreads with lots and lots of leverage. Performance over time, however, is closely related to an institution’s ability to successfully exert risk management and financial control.

We have to know what is going on in the banks and other financial institutions. The pressure needs to be stepped up to find out where things are. And, the sooner this pressure is exerted the sooner we will be able to find ways out of the mess we are in.

And this brings me to one final point. The Financial Times also had another headline on its front page that I found disturbing. The article cried out “AIG in derivatives spotlight:”

The unit that all but destroyed AIG has failed to sign up for the overhaul of the global derivatives market, which was given added impetus by the troubles at the US insurance group.

The government is involved with AIG—the government owns most of AIG. It is mind boggling to me that a government that supposedly wants to bring greater openness and transparency to the financial markets allowed this to happen!

Comments

[madmilker:]

not since 1912....

Apr 13 03:04 PM

[john s. gordon:]

sir, your advice is welcome & i hope the authorities pay attention to what you are saying.
> jack

Apr 13 03:05 PM

[rogersails:]

Isn't the "Act of Fraud" you speak of the same thing as not "marking to market" - the very act our leadership has muscled FASB into condoning ?

Apr 13 03:15 PM

[Alan Young:]

If anyone in the prior administration had cared to investigate fully before throwing money at these clowns, we might have learned something. But now, after so much political capital has been invested in persuading us that the bailout was just what we needed to get through the liquidity crisis, there's not much chance of anyone associated with the government saying, "oops! we just wasted hundreds of millions of dollars...."

So, I'm pretty sure we are going to hear more of the same, and be no closer to knowing the truth.

Apr 13 04:48 PM

[JohnAl:]

Sorry, but I'm skeptical that no matter what any bankster has done we'll see anything more from the government than a symbolic wrist slap, if that. At this point it should be obvious to everybody that they're in bed together. This "top cop" business is surely a sham.

Apr 13 05:57 PM

[dcb:]

I think it is impt to point out that what the top cop suggested should not be done with the toxic assets because such a system would be ripe for fraud is exactly what geitner and co. have decided to do. (also from Ft today). I feel like the banks having caught the house on fire are now attempting to run off with all the contents of the house before it burns down. the troubling thing is that our governemnt is making sure they can.

Apr 13 06:46 PM

[ed233:]

I agree with the author. I have for some time suggested on several occasions that the authorities have a duty to go into these institutions to conduct a thorough investigation. This has to be an independent team of auditors and lawyers to conduct an investigative inquiry so as to rout out the corruption and close down the zombie banks before the US government finds itself too far into trouble. This would be a good first step toward establishing transparency.

Apr 13 07:36 PM

[bthomas:]

If liquidity is the issue, and MTM of illiquid assets has somehow affected liquidity to the point that banks are insolvent then they were probably insolvent already. That being said, why continue the charade of securitizing the debt? Have this mess unbundled since there is no foreseeable market for it anyway. Don't abandon any semblance of oversight. Have all government agencies abdicated inherent responsibility? Or is America simply too soft and spineless for anyone to actually do the right thing to accomplish the task at hand? Let's hope Mr. Barofsky is up to the task, and can (is allowed to) exercise his authority.

Apr 13 08:39 PM

[Fitz919:]

Cooking the books is standard operating procedure for many financial institutions. They employ a huge bag of tricks. The 500 Trillion derivatives market is off balance sheet for example. Hard to value Mortgage Backed Securities "Toxic Assets" can now be valued as high as they want them to be under the relaxed mark to market rules. Now there is the goose that layed the golden egg as far as financial institutions are concerned. And there is no way they are going to sell their geese to the public/private partnerships. This means Geithner's big plan is DOA. Turning insolvency into a mere liquidity issue for the purpose of getting TARP money was child's play for these guys. Look at how far IndyMac Bank got with 10.5% of their loans not performing, and the FDIC didn't have a clue until there was a run on the bank. They hid their bad loans so that the regulator wouldn't see them on their books.

When Wells Fargo reported a $3 Billion profit, I immediately figured it was due to the relaxed mark to market rules. And the other big banks that reported profits in January and February, did so only after they had assurances that the mark to market rules would in fact be relaxed.

Apr 13 08:43 PM

[WayneinOregon:]

Until we get a Warren Commission type investigation of all the fraud involved in the financial meltdown, I will hesitate to trust either Wall Street financial institutions or a US government that allows them to keep covering their tracks.

Apr 14 01:47 AM

[holmesnmanny:]

Did you seriously just use the Warren Commission as a standard for a credible investigation?


On Apr 14 01:47 AM WayneinOregon wrote:

> Until we get a Warren Commission type investigation of all the fraud
> involved in the financial meltdown, I will hesitate to trust either
> Wall Street financial institutions or a US government that allows
> them to keep covering their tracks.

Apr 14 08:13 AM

[wakeup call:]

1 week ago the information on the linking of Goldman Sach's to the AIG bailout came to light in detail. Since that time there has been virtually zero follow-up. I guess Goldman is too powerful from both the perspective of being just about the only remaining investment bank(commercial bank when convient) and having its past executives so firmly intrenched in the federal government. AIG might be too big to fail but Goldman is too powerful to be investiated.

Apr 14 09:11 AM

[Lilguy:]

The banks covered up the fraudulent value of their assets on the way up; they are certainly covering up their toxic value on the way down. Most of these assets were never worth what the banks paid for them, much less what they claimed they were worth, and now things are just that much worse.

Apr 14 09:14 AM

[Tony Daltorio:]

What a great article! The problem with bank assets is one of solvency and not liquidity as Tim Geithner and others want everyone to believe. I feel sorry for anyone foolish enough to be buying financial stocks in this current rally.

Apr 14 09:27 AM

[john s. gordon:]

the warren commission was a whitewash job, we have to do do better this time around.
> jack

Apr 14 11:14 AM

[holmesnmanny:]

Exactly. Their job was to create a report that labeled Oswald as the sole assassin even though all evidence said it wasn't possible, even if that meant ignoring credible evidence and fabricate false evidence.


On Apr 14 11:14 AM john s. gordon wrote:

> the warren commission was a whitewash job, we have to do do better
> this time around.

Apr 15 06:30 AM

[reality chk:]

The banks and scheme financial institutions have Never told the truth about anything.
They state, they overstate, they understate and then the smoke and mirrors apear just like magic.

Apr 16 03:16 PM

[mktcycler:]

The AIG response makes sense if you apply the hypothesis that a large portion of their CDS exposure is mitigated by side letters.

Apr 21 05:30 PM