Rogue Banks, Not Rogue Regulators

Includes: BAC, C, GS, JPM, MS, MTB
by: Tom Armistead

The Wall Street Journal recently featured an attack on bank regulators, entitled "Bankers Haven't Gone Rogue - Regulators Have." My own views on the topic have previously been expressed here on Seeking Alpaha - "Big Banks: A Rogue Industry." This article analyzes the data, sources and reasoning provided by George Melloan, the author of the WSJ opinion piece. Briefly, Mr. Melloan presents a collage of strident rhetoric, with little supporting data, and completely bypasses the articulate and balanced views of his first named source.

Here's where he mentions Robert Wilmers, CEO of M&T Bank (NYSE:MTB).

CEO Robert Wilmers of the northeast regional M&T Bank told his shareholders in March about an M&T study that showed that fines, sanctions and legal awards against the six largest U.S. based banks soared to $29.3 billion last year. This is more than double the $13.9 billion of 2011 and dwarfs the $9 billion of the 10 years preceding 2011.

The figures on fines, etc. are startling. Even more startling is Mr. Melloan's interpretion of the information. His take is that the "populists" don't have a plausible reason to label the banks as rogues, because "bankers are more likely to exercise extreme discretion in an era when they are being constantly reviled by leftist politicians, writers and placard-carriers in the streets."

More accurately, big banks exercised no discretion whatsoever during the run up to the financial crisis, when the complete lack of regulation gave them free rein to run a rigged casino at the heart of the US financial system. It's not that regulators started picking on big banks recently, it's that they have finally started to levy the fines, sanctions and penalties that are long overdue, for actions that pre-date the passage of Dodd-Frank.

Of course the $29.3 billion is dated information. Bloomberg recently prepared an analysis that shows $103 billion in legal costs, including restitution to injured parties. The figure doesn't include major European banks.

Making twisted arguments from Robert Wilmers' data, Melloan neglects his source's carefully thought out views on the cause of the financial crisis, the need for financial reform and the actual effect of such reforms as have been enacted.

Here's a selection of quotes, taken from Wilmers' letters to shareholders in the annual reports, as well as his prepared remarks at the M&TB shareholder meetings:

So it is that we need a new generation of regulation to extend the time-honored principles of safety, soundness and transparency to what has become a virtual casino of lending. All the players must be included. Investment banks, hedge funds and other investment vehicles - who are the ones who sparked the securitization boom - must be overseen. The rating agencies which enabled the lending casino to operate by certifying as top quality what turned out to be high-risk bonds, must operate under a new business model: they must be paid by those who might purchase bonds, not by those issuing them. They, too, must be regulated. Complex derivatives, such as credit default swaps - which ostensibly provided insurance for high-risk investments - must be brought out of the shadows, into a public clearinghouse, such that markets can know their magnitude and extent. (The market for credit-default swaps is estimated to have grown from $500 billion in 1998 to $54.6 trillion in 2008.) At the same time that huge flows of capital must come under a broader regulatory regime, so too, must all players. The activity of U.S. mortgage brokers, for instance - whose number increased from 9,000 in 1988 to 54,000 in 2005, played a key role in the subprime debacle and must have some sort of supervision.

We are neither fond of regulation nor quick to call for more of it. But it is neither consistent nor wise to subject banks to regulation that can only be called intrusive and excessive while the rest of the financial services sector operates in a Wild West environment. There is simply no justification for the exclusion from regulation of any major pools of capital which, if poorly managed, could threaten the smooth functioning of the financial system as a whole.

Let's start with Wall Street's most successful investment bank. It was in the forefront in creating, originating and selling derivative securities. As a result it made a lot of money. It made still more when, just before the market realized that these securities were of questionable value, it shorted the market for sub-prime mortgages and securities, betting that the value would fall.

The entrepreneurial spirit is what made us a great nation, but something must have been out of kilter when over two years, 2006 and 2007, the top five people in this one firm's management received total compensation of $503 million. The conversion of this once-great investment bank into a giant hedge fund-with huge payouts for executives went unchecked and largely unremarked upon by regulators, despite the fact that it constituted a radical change in our financial system. It hardly seems a coincidence that this same investment bank, from 1998 to 2008, spent $40.6 million on lobbying expenditures and campaign contributions.

In 2008 alone, this one investment bank spent $8,970,000 for those same purposes - almost 11% more than similar spending by the Financial Services Roundtable, the trade organization which represents the top 150 financial institutions. What's more, this same firm has consistently sent its top officials to Washington to serve at the highest levels of government, there, in fact, to oversee directly the current restructuring of the financial industry.

Briefly, an analysis of Wilmers' published writing and speeches supports the view that he is critical of the rein of lawlessness among the big banks on Wall Street, and supportive of regulation directed at eliminating the abuses and leveling the playing field. Not quoted here, he is equally articulate in his criticism of Dodd-Frank, and emphasizes the expense and inconvenience of responding to that complex piece of regulation.

Big banks sent an army of lobbyists to Washington while Dodd-Frank was being created. My take: their strategy was to make the legislation so cumbersome and convoluted, such a parody of regulation at its worst, that it would eventually self-destruct, or be repealed in its entirety.

Let us now turn to Melloan's inflammatory choice of words. He supports his reasoning by using terms such as "populist," "left-wing," "zealotry," "overkill," placard-carrier" and "assault." He sees the financial crisis as being blamed on "anyone who still wears a suit." These concepts are difficult to quantify, or verify. They shed no light. "Populist" and its variants get heavy use, occurring three times.

Here's his narrative:

Such populist thinking inspired the Clinton administration in the 1990s to campaign for "affordable housing." The Department of Housing and Urban Development lowered the standards under which Fannie Mae and Freddie Mac could insure loans, and regulators strong-armed banks into writing mortgages for applicants with low credit ratings. That led to a tsunami of mortgage-backed securities laced with subprime mortgages that flooded into world markets.

The 2008 financial crisis resulted after home prices peaked and began to decline when banks and other investors began to realize that the mortgage backed securities they were holding were poisoned by large numbers of mortgage loans with negative collateral and subject to default. The populist politicians who forced the banks into these investments blamed the banks. This set the stage for Dodd-Frank.

Briefly, this is the "devil-made-me-do-it defense." The satanic regulators, under this interpretation, actually forced the banks to issue mortgages to anyone who could sign the application.

Here's an alternative narrative, from the aforementioned Robert Wilmers:

There is no doubt in my mind that at the heart of the problem lie the complex, indeed opaque, derivative securities created not by Main Street but by Wall Street and done so - and this is just as important - with the passive complicity of regulators. Last year at this meeting, I described such activity as a "virtual casino"-and the passing of time has made the phrase no less apt. The key players were those who built what has come to be called the "shadow banking industry" that came to account for as much as two-thirds of all lending. Investment banks whose capital markets' divisions created, originated and sold an alphabet soup of derivative securities unleashed a flood of credit which caused a vast excess of housing to be built in a gold rush atmosphere. In the collapse that has followed, billions of dollars worth of mortgage-backed securities and their ilk have now been written off.

That's how it looks to a well-informed banker who is not part of the Wall Street club. He has also repeatedly expressed concern, as quoted above, with the lobbying expenses and campaign donations of the big banks. My conclusion: these contributions bought off politicians, who called off regulators. The problem with the devil-made-me-do-it defense is identifying who is standing in for the malevolent one.

Of course Dick Bove had to contribute to the dialogue here by labeling regulatory attention directed at JPMorgan (NYSE:JPM) as "McCarthyism." Soon enough, Jim Cramer put his two cents in, suggesting that regulators are treating JPM as a "piñata bank." Those who get too close to Wall Street lose understanding of basic concepts, such as cause and effect - in this case, crime and punishment. Admittedly, it was many quarters before the hens came home to roost. Nevertheless, the outcome is quite clear: the big banks broke the law, and they are being punished.

As a self-vowed populist, I offer my defense and explanation of what I regard as a common-sense approach to the regulation of the financial services industry, previously published here on Seeking Alpha:

Critics of Obama's efforts to re-regulate the financial system, including his most recent proposal to reinstate Glass-Steagall, have made numerous accusations that he is pandering to "populist rage" for political purposes. Populism has become something of a pejorative in this country, so much so that it serves as a useful shorthand argument and attack, a quick way of discrediting the opposing view.

Populists hail from some distant past: ignorant and unwashed, they band together outside the mansions of their betters, armed with torches and pitchforks. They are the peasants, the peons, the serfs. They come with vengeance in their eyes, motivated by murderous rage rising from imagined grievances against those more intelligent and refined than themselves.

As always with "isms" these terms accumulate a tremendous burden of assumption and stereotype, frequently deflecting discussion away from facts and into a never-never land of conflicting and irreconcilable ideologies. Populism, when properly understood, has genuine insights into the serious and as yet uncorrected problems that brought the economy and financial system to the brink of chaos.

Pragmatic Populism respects the power of greed, rationalization and self-deception. It recognizes that big business will abuse its powers, gouge its customers, stifle competition, and assiduously strive to create a monopoly. It notes that fraud, abuse and manipulation in financial markets lead to destructive cycles of boom and bust, creating fictitious wealth and then crushing poverty.

Populism ultimately unites the 98% of the population who are not among the elite sufficiently to achieve four important goals:

  1. Establish a cadre of elites who perform their function without unjustly enriching themselves or others.

  2. Establish (or re-establish) a rule of law and system of regulation that prevents the greedy from harming others in their pursuit of happiness or personal enrichment.

  3. Reduce the size and power of big business, big banks (and big government) to what is necessary to serve the common good.

  4. Prevent fraud, abuse and manipulation in financial markets from endangering the real economy

I look at the big banks. I consider the sheer magnitude of their transgressions as reflected in the staggering size of the judgments, fines and penalties that have been levied on them, their continued repeat offenses, their inability to acknowledge their wrongdoing, and their refusal to make restitution until they have exhausted all dilatory legal tactics, and I still see a rogue industry.

To quantify "staggering" the losses now exceed a full year's earnings for the banks involved. They also exceed five year's worth of dividends.

Let's be clear: "big banks" refersto Goldman Sachs (NYSE:GS), JPMorgan, Morgan Stanley (NYSE:MS), Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC) and Citigroup (NYSE:C).

Here's a final thought: Dodd-Frank is a fatally flawed approach to regulation. It's too cumbersome and convoluted, and doesn't address the need to adequately regulate the big banks. Instead, it makes it harder for the vast majority of ethical and responsible regional and local banks to serve the public.

It's possible that when management at these banks tallies up the final cost of lying, cheating and stealing to promote the issuance and sale of mortgages and derivatives, they will conclude it's not economically sound behavior. That will be evidence of effective regulation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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