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Why 'Too Big To Fail' Banks Remain A Disaster Waiting To Happen

Includes: BAC, C, JPM
by: Lenny Grover

Bank of America’s accounting error is merely the latest big bank stumble.

Big banks’ low P/B ratios may be the product of “distorted” balance sheets.

Big banks’ management of counterparty risk “fails to meet expectations”.

High leverage ratios, inadequate risk management practices, and overstated asset values are a potentially lethal cocktail.

On Monday, Bank of America (NYSE:BAC) reported that it had $4 billion less in regulatory capital than initially reported to the Federal Reserve. While the company was forced to suspend its dividend and buyback, and there was a flurry of initial media reports, Bank of America's "oops" moment seems to have passed without much consequence for investors; the share price seems to have stabilized only ~5-8% below its prior levels. More importantly, yet another big bank "oops" moment has passed without prompting the existential questions that are appropriate for "too big to fail" institutions that seem to be "too big to manage."

Citigroup's (NYSE:C) second failed Federal Reserve stress test in March marked yet another moment that should have prompted soul searching among big bank investors and regulators. As reported by DealBook, the Federal Reserve criticized the "overall reliability of Citigroup's capital planning process" and "it had concerns about the bank's 'ability to project revenue and losses under a stressful scenario for material parts of the firm's global operations.'"

JPMorgan (NYSE:JPM) was also confronted by a situation in which even the company's top executives seemed to lack a firm grasp on the firm's financial condition. In 2012, JPMorgan CEO Jamie Dimon initially described its "London Whale" trading losses as a "tempest in a teapot" in an attempt to reassure investors. However, those losses ultimately totaled over $6 billion (plus an additional $920 million fine assessed by regulators)-hardly inconsequential.

The enormous complexity inherent in banks with balance sheets carrying over a trillion dollars each of assets and liabilities make such mistakes understandable. However, when an organization becomes too large and complex to effectively manage, it is appropriate to ask whether it should be broken up. Given that US taxpayers are providing an implicit backstop on these "too big to fail" institutions, that question is consequential even to Americans who choose not to invest in the banks directly.

While bargain hunters may be attracted to the banks' low Price-to-Book ratios, that ratio is only meaningful when the book value is a good proxy for the market value of the firm's assets and its true liabilities. However, FAS 159, an accounting rule that governs how to prepare banks' balance sheets, can be problematic. The CFA Institute even has a blog post on how the revaluation of liabilities can distort the banks' reported results. In one extreme example, Bloomberg reported that, in Q1 2008, Citi was allowed to report a $12.65 billion gain by virtue of its outstanding debt losing value as it became less creditworthy.

More important, in my opinion, is the fast-tracked FAS 157 rule change (FAS 157-d) that was explicitly designed to prop up the banks' financial position at the height of the financial crisis. It gives firms significantly more discretion when valuing the illiquid securities that are commonly found on bank balance sheets. Whether it is wise to allow such discretion (commonly called "mark to myth" or, as Wikipedia puts it, "mark to make believe") to be extended to the same banks that nearly blew up the global financial system has never really been subject to public debate. Here's how it works…

Let's say that a bank holds a position in an impaired, illiquid, security which has a very large bid-ask spread. In other words, the price sellers are willing to sell it for is far higher than what buyers are willing to pay for it. Rather than forcing the bank to value the security at the then-current bid price (or the midpoint between the bid and ask, etc.), the bank is given discretion as to how to value that security. Under FAS 157-d, the bank is supposed to value it at "the price that would be received by the holder of the financial asset in an orderly transaction that is not a forced liquidation or distress sale at the measurement date." However, such guidance allows it to ignore the then-current quotes and make its own assumptions about what a future "orderly" sale of the asset would see it worth.

The problems with FAS 157-d are not merely hypothetical. A 2009 IMF working paper, Accounting Discretion of Banks During a Financial Crisis, which has been cited over 80 times according to Google Scholar, found that "banks use[d] accounting discretion to overstate the value of distressed assets.... Our results indicate that banks' balance sheets offer a distorted view of the financial health of the banks."

Perhaps even more frightening is that even the banks, themselves, do not seem to fully understand their risks. A 2014 Financial Stability Board Senior Supervisors Group report found, "five years after the financial crisis, firms' progress toward consistent, timely, and accurate reporting of top counterparty exposures fails to meet both supervisory expectations and industry self-identified best practices." In other words, the banks, themselves, do not even have a robust understanding of their counterparty risks.

As Mayra Rodriguez Valladares wrote this week in DealBook, "the market is buying banks' bonds and stocks on faith." High leverage ratios, inadequate risk management practices, and overstated asset values are a potentially lethal cocktail. Personally, I don't see enough potential upside (for investors or taxpayers) to justify this risk.

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.