Elliott R. Morss
Elliott R. Morss ©All Rights Reserved
In 1999, Sandy Weill, supported by a coterie of other bankers
and lobbyists, got the US Congress to repeal Glass-Steagall. That
Act had kept depository institutions safe since the '30s. With
restrictions removed, US banks purchased, packaged and traded
mortgages and their derivatives. In late-2008, the market for these
financial packages disappeared resulting in the US banking collapse
and the largest global depression since 1929.
Some claim there were other reasons for the '08 Depression.
that the banks losing track of what was actually in the mortgage
packages they were selling was the primary reason the market for
mortgage-backed securities suddenly disappeared. And this in turn
led to the bank collapse et al.
Were the banks that caused the collapse acting legally?
Apparently not. While the wheels of justice turn slowly, there have
recently been a number of large fines and settlements won by
governments and private firms against the largest banks. In most of
the settlements, the banks have not conceded wrong-doing. Hard to
believe - why would Bank of America (
) agree to pay the Feds nearly $17 billion if they did nothing
wrong? The answer: Bank of America committed numerous criminal
acts. But admitting it would open the bank up to even more lawsuits
and the Feds settled because they know how expensive lawsuits
against the big banks can be.
This article provides detail on big bank crimes along with some
thoughts on whether these large fines and settlements will be
adequate to keep the banks in check going forward.
The Crimes Committed
There is long list. The crimes generating the largest penalty
- Mortgage foreclosure abuses;
- Fraud - misleading information on mortgage-related
- Money laundering;
- Manipulating LIBOR and other prices; and
- Tax evasion.
a. Foreclosure Abuses
In frenzied efforts to make money on the trading of mortgage
securities, large banks lost track of who actually had title to
properties underlying mortgages they wrote, bought, packaged, and
sold off. Banks engaged in criminal acts when they initiated
foreclosures on properties they did not own or know who did.
Numerous settlements have been won against the large banks for
fraudulent misrepresentations of the mortgage security packages
they were selling. Goldman (
) actually urged its clients to buy mortgage packages while selling
off its own holdings of the same securities. And while the banks
were certainly at fault for fraud, it should be kept in mind that
the buyers should have known better. Many of these packages were
brought by the Federal Housing Finance Agency and its "offsprings"
Fannie Mae and Freddy Mac. The well-paid officers of the Federal
agencies buying this stuff should either have known or found out
what they were getting before making the purchases. The reality is
that as long as large commissions were made on these transactions,
neither buyers nor sellers cared about product quality.
c. Money Laundering
The US had financial sanctions in place against Burma, Cuba,
Iran, Libya, and Sudan. The sanctions said all banks doing business
in the US should not conduct transactions for customers in these
countries. The following banks got caught and the fines they agreed
to pay are: BNP Paribas (BNP.PA) (BNPZY) - $8.9 billion, HSBC (
) - $2 billion, ING (
) - $619 million, Credit Suisse (
) - $536 million, Lloyds TSB Bank - $350 million, Barclays (BCS) -
$298 million, and Standard Chartered (STAN.L) (SCDRF) - $227
d. Manipulating LIBOR and Other Prices
Large banks use depositors' monies to buy and sell huge blocs of
financial assets. And they have used these funds to cause prices to
rise and fall. Many have heard about the LIBOR scandal. But there
have been others. For example, JPMorgan (JPM) was fined $410
million for manipulating electricity prices in 2013.
e. Tax Evasion
For many years, Swiss banks aided Americans in avoiding US
taxes. In recent years, the Swiss authorities reluctantly agreed to
cooperate with the IRS on these matters. And not surprisingly, UBS
agreed to pay a US fine of $780 million in 2009 for tax evading
activities. But today, Switzerland is not alone. The Treasury
reports that the Cayman Islands rank third behind the UK and Canada
for US investments.
Table 1 provides data on the fines, penalties and settlements
levied against the big banks. The final column gives fines, etc.,
for the 2011-14 period as a percent of reported income for 2011-13.
There are several problems with these ratios
, but they are indicative of how significant the fines are relative
to each bank's income.
Table 1. - Fines, Penalties, and Settlements Levied
Against Large Banks
(in millions of US$)
(click to enlarge)
* Crimes: FA=Foreclosure Abuses; FR=Fraud; LIBOR = Manipulating
Interest Rates and Prices;
ML=Money Laundering; TA=Aiding in Tax Evasion;
** Banks are in negotiation with Federal housing agencies -
significant additional fines expected.
Sources: Newspaper reports and company SEC filings.
Do Fines Have Deterrent Effect?
There is no question that since the 2008 depression, a new
regulatory era has started. And part of that are much higher
penalties. But will they have the desired impact of reducing bank
crime? I talked recently to a senior executive in one of the big US
banks. He said: "Big banks are in the risk business. One of those
risks is that either governments or private firms will take us to
court. In deciding what to do, we have to consider that risk.
However, the returns on some activities are high enough to risk
lawsuits. And when they are, the penalties we incur will be viewed
as a cost of doing business."
Take another look at Table 1 where fines are compared to banks'
income. I don't care how large a bank is. When your fines exceed $1
billion, your stockholders will sooner or later take note. And the
fines are not the only costs that banks incur for illegal acts. In
2013, Bank of America paid $2.9 billion in "Professional Fees" (I
am sure a significant segment of this is for outside lawyers);
JPMorgan's tab for said fees was $7.6 billion!
How About The Volcker Rule?
Paul Volcker, the former Federal Reserve Chief, has for some
time argued that banks should not be allowed to trade using
depositor assets. He points out that the Glass-Steagall Act did not
allow it and we had no major bank problems while it was in force. A
significant feature of the "true" Volcker Rule is that banks cannot
sell off the loans/mortgages that they originated, but instead hold
them to maturity. The "incentive effects" of adopting the Volcker
Rule would be significant: instead of trying to maximize commission
income from the sale of loan/mortgage packages (the driving force
behind the 2008 collapse - nobody cared about the quality of
loans), banks would instead focus on making sound loans.
At one point, Volcker had some influence in the White House.
That ended when Larry Summers and Tim Geithner took over. Both
Summers and Geithner, looking for paychecks from the finance
industry in their next jobs, effectively eliminated Volcker's
influence. However, Barney Frank and others in Congress insisted
that the Dodd-Frank Bill does include a Volcker Rule.
Unfortunately, just how it would be defined was left to the
regulators. And the bank lobbyists have been at work. Open Secrets
estimates that banks spent more than $60 million on lobbying in
each of the last 3 years (2011-13).
So where are we today? I quote from the most recent JPMorgan
annual report to the Security and Exchange Commission:
"On December 10, 2013, regulators adopted final regulations to
implement the Volcker Rule. Under the final rules, "proprietary
trading" is defined as the trading of securities, derivatives, or
futures (or options on any of the foregoing) as principal, where
such trading is principally for the purpose of
resale, benefiting from actual or expected
price movements and realizing
arbitrage profits or hedges of such positions. In order to
distinguish permissible from impermissible principal risk taking,
the final rules require the establishment of a complex
compliance regime that includes the measurement and monitoring of
. The final rules
specifically allow market-making-related activity,
certain government-issued securities trading and certain risk
The banks' lobbyists have done a good job. The agreed-upon rule
only applies to a segment of short-term trading. And "a complex
compliance regime" that involves "seven metrics"? The banks will
just hire a few more accountants and lawyers and again befuddle the
regulators. And the banks have negotiated things so they will be
able to "hedge". In sum, the banks got just about what they wanted,
a very distant relative of the Volcker Rule.
In its SEC report, JPMorgan stated, "The Firm has ceased all
prohibited proprietary trading activities." This is intended to
convince the SEC and JPM's stockholders that the London Whale
incident will not be repeated: speculative trading by a staffer in
London that resulted in trading losses of $6.2 billion, and 2012
fines of $1 billion.
Senator John McCain made an apt comment on the incident:
"JPMorgan's chief investment office increased risk by mislabeling
the synthetic portfolio as a risk-reducing hedge when it was really
involved in proprietary trading".
So will the "watered-down" version of the Volcker Rule have a
meaningful impact? Table 2 provides data on the trading assets and
income of banks at the end of 2103. It remains a big business and
will continue as such.
Table 2. - Trading Assets and Income, Selected
Too Big To Fail - The Living Will Solution
Just after the 2008 bank collapse, there was considerable
concern expressed about certain banks being "too big to fail".
Congress's solution was to ask the big banks to write up plans for
"orderly bankruptcies" that would not set off wider panics. This
sounded like a dead-end, losing proposition from the start and it
has proven to be just that. The banks have submitted their initial
plans and the federal regulators have reacted. The Federal Deposit
Insurance Corporation has determined that the living wills were
"not credible." Thomas M. Hoenig, the vice chair of the FDIC,
concluded: "Despite the thousands of pages of material these firms
submitted, the plans provide no credible or clear path through
bankruptcy that doesn't require unrealistic assumptions and direct
or indirect public support."
The Only Thing That Will Make Banks Safe
We do not deposit money in banks so banks can gamble. We put
money in banks for safe keeping. Depository institutions should not
be allowed to trade any assets. Too risky. Let hedge funds, private
equity funds, and venture capital funds take the risks. The simple
and only solution that will make banks safe: limit FDIC insurance
to banks that hold their own loans to maturity and do not engage in
trading on their own accounts.
Investing in Big Banks
Given the bad press big banks have been getting, perhaps the
best way to view them is like sin/vice investments. For example,
the Vice Fund (VICEX)
only invests in tobacco, alcohol, defense, and gambling companies.
It has done well (5 year average return - 17.7%) .
There is an interesting literature on sin/vice investing
. In essence, the studies find that in the long run, sin stocks
outperform the overall market. Why? Because some institutional
investors shy away from sin stocks, sin industries have high entry
barriers, and companies within sin sectors often have considerable
However, you want to view large bank investments, I offer one
recommendation: before investing in a big bank, take a look at its
annual filing with the SEC. In particular, find and read the
"Litigation" note to its Consolidated Financial Statements. For
example, JPM's Litigation note appears on pg. 326-332 of its
2013 10-K Report to the SEC
. It describes 37 major actions that have been investigated with
numerous cases coming forth from them.
I end with a quote contained in JPM's Litigation note:
"The Firm has established reserves for several hundred of its
currently outstanding legal proceedings….During the years ended
December 31, 2013, 2012 and 2011, the Firm incurred $11.1
billion, $5.0 billion and $4.9 billion, respectively, of legal
expense. There is no assurance that the Firm's litigation
reserves will not need to be adjusted in the future."
1. The fines, etc. data reflect what has actually been settled
on, either in court or in out-of-court settlements. Just when, how
and if these fines, etc. will be collected remains uncertain. The
banks set aside reserves (and in so doing, reduce income) for what
they expect they will have to pay annually. That means their
incomes are somewhat lower than they would have been in the absence
of the fines, etc.
2. The "Vice Fund" was recently renamed the "USA Mutuals Barrier
3. See F.J. Fabozzi, K.C. Ma, and B.J. Oliphant, "Sin Stock
Returns", Journal of Portfolio Management, Fall, 2008, and H. Hong
and M. Kacperczyk, "The Price of Sin: The Effects of Social Norms
on Markets", Journal of Financial Economics, April, 2009.
The author has no positions in any stocks mentioned, and no plans
to initiate any positions within the next 72 hours. The author
wrote this article themselves, and it expresses their own opinions.
The author is not receiving compensation for it. The author has no
business relationship with any company whose stock is mentioned in
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