Big Banks Ready To Restore Confidence?

Includes: BAC, C, CS, DB, JPM, MS, WFC
by: Tom Armistead

The question is rhetorical: How can the market recover if the financials don't lead? Those who frame the question are talking about the big banks - Bank of America (NYSE:BAC), JP Morgan (NYSE:JPM), Goldman Sachs (NYSE:GS), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC).

When the FHFA sued 17 banks over PLS (private label securities) held by Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC), one response was that the timing is poor. Suing the big banks undermines confidence, holds back the market, and may damage the fragile recovery. According to this line of thinking, it would be better to defer litigation or continue to negotiate behind closed doors. Or even better yet, to pretend it didn't happen.

Proponents of this view include Dick Bove and Jim Cramer. Bove made it the topic of an interview on CNBC, while Cramer expressed his view in a sarcastic one liner, along the lines of "thanks U.S. government," implying the government had sabotaged the market with its inconsiderate and ill-conceived suits against the banks.

I hold a contrary view. I've been saying this for a long time. When MBIA (NYSE:MBI) first sued Countrywide over fraudulent MBS, I welcomed the beginning of a necessary cleansing process:

... a pet peeve – the use of the term "toxic waste" to describe mortgage assets. Home ownership is part of the American dream and mortgages issued for that purpose are non-toxic. What is toxic is the witch's brew of lies by the mortgage applicants, brokers, appraisers, mortgage companies, investment banks, etc., creating an endless quagmire where no-one wants to take responsibility for his own actions.

MBIA's action in suing Countrywide is part of the solution, painful but necessary. Every fraudulent transaction needs to be pushed back along the chain of perpetrators to its original source, if that person or entity can be located. As much as possible, those whose dishonesty caused the losses must bear them.

Investors don't like uncertainty, and tend to discount assets, or mark up liabilities, when their value is questionable. Under current conditions, any holder of MBS is questioned on the grounds of shaky assets. Similarly, any bank exposed to representations and warranties liability (R&W), is questionable. Mortgage based assets are a meaningful part of the financial structure of this country. As such, many of our financial institutions are built on weak and shifting sand. The problem is, they rest on the integrity of industry participants.

Tolling The Statute

The best and cleanest legal route to recovery is found in the Securities Act of 1933. However, there is a statute of limitations, and the offenses involved are now outside the time frame permitted. FHFA was given an extension by law when it took over the GSE's, but others who seek relief under the 1933 act are forced to rely on membership in various class actions that have been filed over the years since the financial crisis in order to stop the clock on the statute of limitations.

The dishonest and fraudulent acts were by their nature difficult to discover. The banks have actively concealed their role in the creation of the defective securities, by refusing access to the mortgage files involved. A group of CEO's sat before Congress and with great cheek and plausibility stated that it was impossible to foresee the fortuitous intervention of the financial crisis in destroying value.

It seems unfair and unjust that the statute of limitations should be invoked to protect banks that were actively concealing the nature of their offenses long after they occurred. Many of them were servicing loans that they securitized, and conveniently neglected to review the files in order to put them back under R&W.

A Congressional extension of the statute of limitations in the 1933 act would be a good idea.

Failing that, a resourceful and creative plaintiff's attorney might be able to forge some kind of exception to the statute of limitations, based on the bank's role in concealing their crime from the victims.

Accounting Solutions

There has been great variation in financial disclosures. My impression, reading financial statements of the banks involved over the past three years, has been that whatever the rules are, some banks bent them until they broke.

The easiest method of evasion is to assert that it's impossible to develop an estimate. A bank might say that it sold $200 billion into securitizations, and that it made representations and warranties about the quality of the collateral, but that it has no historical information as to the the frequency of putbacks on which to base an estimate. Somewhere there is a filing cabinet stuffed with putback demands that have been ignored.

One bank asserted that lack of communication with a potential claimant made it impossible to develop an estimate.

Claimant attorneys have developed reliable methods of sampling mortgage collateral for information on loan to value and occupancy discrepancies, using publicly available data. Perhaps a bank should be obligated to include the results of a third party sampling directed at ascertaining putback exposure. I don't see any reason why the SEC can't question banks very firmly about their accounting for R&W exposure.

Mortgage Assistance

Examining the complaints filed by FHFA, FHLB, MBIA (MBI), Ambak, Assured Guaranty (NYSE:AGO), Allstate (NYSE:ALL) and others, as well as the rescission rates notched by Radian and other mortgage insurers, it is evident that about 10% of mortgage applications misstated occupancy. Perhaps 20% contained exaggerated statements of income. Appraised values were a fantasy land. It's difficult to determine whether the applicants knew the values were bogus.

Mortgage applicants perpetrated a great deal of fraud. Many of them will defend themselves on the grounds that everybody was doing it, and that the banks actually encouraged it, coaching them on what the proper answers were, or filling in the applications without asking the questions.

Public policy may move in the direction of further relief for underwater homeowners. At a minimum, such relief should be denied to any applicant who made a material misstatement in applying for a mortgage.


Part of the process may involve public shaming and severe punishment of one or several industry members. Goldman Sachs (GS) comes to mind. Congress fingered them, the SEC fined them, Matt Taibbi has made the vampire squid moniker famous, and Lloyd Blankfein has hired a criminal attorney who specializes in the defense of publicly hated persons.

Dick Bove suggests that the government wants to break the big banks up into smaller and more manageable pieces. Market values may be depressed by what is seen as regulatory hostility. Bove feels the government is unfairly favoring more conservative banks, those that stick to pedestrian activities such as taking deposits and making loans. It should be noted those are the legitimate functions of banks.

On a strictly objective basis, crimes were committed. Corporations are not subject to capital punishment or imprisonment. However, if a corporation develops an ongoing culture of lawlessnes, at some point government has to intervene and put them out of business. It seems harsh to punish frontline employees who were only doing what management expected. Management if questioned will claim they didn't know what was happening.

Jamie Dimon is widely regarded as a fairhaired boy. Warren Buffett has a substantial stake in Wells Fargo, which may grant them some degree of immunity. Buffett's involvement with GS goes back to the depths of the crisis, and won't help them now. Buffett's seal of approval probably indicates BAC will survive.

CDOs: The Hall Of Mirrors

In the final desperate battle to offload defective mortgages, Merrill Lynch and others resorted to packaging and repackaging them in CDOs and CDO^2. Leftover collateral was recycled. In the case of Merrill Lynch the average number of iterations was awesome.

According to "The Story of the CDO Market Meltdown: An Emprical Analysis," a paper by Harvard student Anna Katherine Barnett-Hart, "on average Merrill Lynch's CDO assets were made of CDOs that had undergone 4.79 iterations of securitizaton."

Given the complexity of the structures that were developed by this process, it's a Herculean task to get to the bottom of it, best likened to the cleansing of the Augean Stables. Litigation has enjoyed spotty success. MBIA has managed to terminate its obligations as an insurer of a large number of CDOs, in some cases without making any payment, and in all cases without revealing the identity of the other party.

CDS: The Ultimate Hall of Mirrors

The role of CDS in exacerbating the severity of the financial crisis cannot be overstated. A majority of these insurance contracts are naked, not supported by an insurable interest, and as such ought to be illegal, classified as gambling contracts.

Nevertheless, CDS enjoy an exemption from regulation. They have served to obfuscate and obscure who holds the risk on numerous transactions, who has adequate capital, and have also spread losses far and wide, so that the impact of defaults is magnified.

It should be noted that many of the banks being sued are active in creating the market for CDS. CDS don't create jobs or provide funding for industry. To the contrary, they are financial weapons of mass destruction. To the extent the U.S. government is hostile toward big banks, it would be easier and more constructive to just limit the writing of CDS to cases where the protection buyer has an insurable interest.

Access To Capital

BofA CEO Brian Moynihan has repetitiously claimed the bank doesn't need to raise capital. But after Warren Buffett, playing financial Archimedes in his bathtub, shouted "Erueka" and called him to propose a deal, Brian was only too happy to accept.

What Basel III is really about is stuffing these banks with capital, because neither the assets nor the liabilities are transparently valued, and there are serious integrity problems on both sides of the ocean. Regulators are doing what investors do, they're applying a margin of safety to both sides of the ledger, because in their hearts they don't trust the bankers. Why should they?

Investors who were early to the game of recapitalizing banks took staggering losses. Think TPG and WaMu. There is no more sickening way of suffering a loss than to be cheated, to take a loss because someone else can't or won't tell the truth. This is a serious impediment to banking solvency, since they have very poor access to credit markets in the event the encounter liquidity problems.

Investment Implications

Investment decisions that rely on outcomes in litigation, or estimates of regulatory zeal or the lack thereof, are inherently speculative. The big banks are attractive on price/book or other common metrics, but are only suitable for investors who combine patience with risk tolerance. I'm on the other side, long MBI and Assured Guaranty (AGO), both of which have litigation pending against banks on R&W and/or fraud.

A number of European banks were among the 17 banks sued: SocGen (OTCPK:SCGLY), Credit Suisse (NYSE:CS) and Deutsche Bank (NYSE:DB) are already suspect due to holdings of sovereign debt. The potential losses from the FHFA suit make them even less attractive as investments.

Other financials seem to have been tainted by association, at least in the market's eyes. Insurance companies, and especially those that hold high quality fixed income assets, do not have the integrity and capitalization problems that banks do, and are a buy at current prices.

Because the process of cleaning up the bank's integrity issues is proceeding slowly, and may never be complete, confidence will recover grudgingly. The big banks will not be able to pull their weight. Bove and Cramer are wrong in asserting that it is inappropriate for the government to sue these banks. The only way to restore confidence is to restore integrity. It's a tall order.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here