Triggering a Run on Deutsche Bank

By Roy C. Smith

In November 2009 President Obama established the Financial Fraud Enforcement Task Force (FFETF) at the Department of Justice “to hold accountable those who helped bring about the last financial crisis as well as those who would attempt to take advantage of the efforts at economic recovery.”

FFETF has been very busy for the past eight years, having obtained approximately $200 billion of settlements of possible criminal or civil charges against almost all of the major banks in the US and Europe. The settlements were made with the boards of directors of the banks that preferred to avoid jury trials, further bad publicity and to get the matters behind them.

But, despite extensive investigations, FFETF has yet to indentify a single individual officer or director of a bank to hold accountable for bringing about the financial crisis (or the failure of their own banks). Thus the settlements are for crimes or misdeeds that no one actually performed, but that did not make them any less popular with the public. 

The Senate and House hearings this week on Wells Fargo clearly demonstrate that bank-rage is still very popular with Congressional constituents. John Stumpf, who until last week was one of the country’s most respected financial executives as head of the best performing large bank in the United States, must have felt that he had been attacked by a lynch mob.

During the same week as the Wells Fargo hearings, a report that the FFETF had offered Deutsche Bank to settle charges of misconduct in its mortgage backed securities business ten years ago for $14 billion began a “run” on that bank’s stock and bond prices and credit worthiness. The run has continued – the bank’s market capitalization, which was only $20 billion when the announcement was made, has dropped to $17 billion.

Deutsche Bank is now experiencing a credit crisis similar to those faced by American banks and investment banks in 2008. Deutsche Bank survived the financial crisis without a bailout, but the subsequent years have been very difficult for Germany’s largest and most prominent capital markets player. John Cryan, a Brit, is the bank’s third CEO in eight years, and he is struggling to turn things around in a slow economy with a new, very heavy regulatory burden. The bank had reserved a much lesser amount for the FFETF settlement, but the news of the huge $14 billion offer to settle was enough to start the run.

The bank’s stock price (already down nearly 50% for the year) dropped further, as did the price of its “contingent capital” bonds (which convert to equity in the event of trouble). Counterparties cut their trading limits with the bank, institutional investors shied away from rolling over deposits or maturing money market instruments, hedge funds and others withdrew funds from prime brokerage accounts, and so a continuous downward spiral was triggered.

Such downward spirals befell Bear Stearns, causing it to be rescued by a $33 billion Federal Reserve-backed merger with JP Morgan, and Lehman Brothers, which was not rescued and went bankrupt and created a market panic that spread to other banks, including Goldman Sachs and Morgan Stanley that were saved from a similar spiral by the Fed’s converting them to into Bank Holding Companies.

Though Deutsche Bank is large and better capitalized than these other firms, and thus better able to sustain a run, runs can scale upwards to bring even the biggest banks down. The German government, led by an embattled Angela Merkel, does not want to bail out Deutsche Bank – the German public has no greater love for banks than the American public – but also cannot allow it to fail. The European Central Bank, however, has the authority and the resources to offer such “loans of last resort” as may be necessary to stabilize Deutsche Bank, but, even so, runs are very scary things that no government should want to risk on any “systemically important” bank.

The US government is clearly operating at cross-purposes. On one hand it is trying to generate jobs and economic growth, for which it must have healthy banks like Wells Fargo and all the other large US and European banks operating here. On the other hand, it needs to re-regulate the financial industry to prevent future crises, and to demonstrate that offending institutions will be punished.

But the government has gone too far in the regulatory and punitive direction, apparently to benefit politically from the popular anti-bank sentiment, and the result is an overly heavy regulatory burden on large banks that has threatened the viability of their businesses, and to let the FFETF loose to bring charges against the banks that they know will not have to be proved in court because they be settled for large sums to be paid by the shareholders of the banks that had nothing to do with the offenses alleged.

Healthy banks are essential to economic growth. Healthy banks need investors (shareholders) who believe in their futures and do not fear continuing attacks from the government. Increasingly, these investors are becoming scarce.

After ten years, it is time to for the government to end the public anger against banks, which it helped to foster, and help the industry to get back on its feet. Certainly the Obama administration and its FFETF will do nothing along these lines during its remaining months in office. Based on the campaign rhetoric so far, neither competing candidate seems to want to do so either.

So, until the rage burns off, we seem to be stuck with mob rule on banking matters.

Reacting to Wells Fargo

by Roy C. Smith

 

On Sept 8, 2016, Wells Fargo announced that it had agreed to pay $185 million to settle charges of abusing customers through overly aggressive sales practices.

Two weeks later, Wells Fargo CEO John G. Stumpf was called before the Senate Banking Committee where he received a severe public dressing down from Sen. Elizabeth Warren. According to Sen. Warren, Mr. Stumpf should be “criminally prosecuted,” after, that is, he has resigned and given back his bonuses for failing “to be accountable” for his “gutless leadership.”

Apparently others in the Senate and elsewhere agree with her.  It’s an easy case to pile onto to express outrage against the banks, still America’s number one villains.

But, it is always hard for laymen like us to know enough about the facts in cases like this to form hard-edged judgments. Only the plaintiff’s side of the story has been told publicly, and the defendants are restricted in what they can or want to say. But, based on the reporting on the matter so far, Sen. Warren and the rest of us do know some things.

According to Mr. Stumpf, the bank discovered that some employees in local branches beginning in 2011 secretly opened new accounts for customers without their consent. This was an unexpected response by a considerable number of low-level branch employees to a poorly designed incentive plan to reward them for cross-selling the bank’s products for which there were quotas. This way of gaming the system spread throughout the branch network. As soon as the problem was discovered, the bank closed the unauthorized accounts, offered restitution to affected customers, and began to fire the branch personnel responsible (5,300 were fired over five years out of 100,000 branch employees, or an attrition rate of 1% a year).  Mr. Stumpf said the bank should have found out about the falsified accounts earlier, and addressed the issue more quickly than it did, but it acted in good faith once it discovered the problem.

In 2013 the Los Angeles Times reported on some of such accounts and a local lawyer began to accumulate a list of as many as 1,000 affected customers, presumably for a class action suit. The Los Angeles City Attorney read the story and began an investigation that ended with a civil lawsuit for damages. At this point the Office of the Comptroller of the Currency, a bank regulator, and the Consumer Financial Protection Bureau, (CFPB) a federal agency originally proposed by Sen. Warren and created by the Dodd-Frank Act in 2010, joined the suit as the heavy muscle. The CFPB ended up with $100 million of the $185 million (Los Angeles got $50 million).

By the time of the lawsuit, the bank was already engaged in trying to clean up the problem - responsible parties were fired, and Price Waterhouse was hired to investigate the issue independently from the bank’s own managers. Price Waterhouse found that perhaps 1.5 million unauthorized deposit and 500,000 unauthorized credit card accounts were created on which modest amounts of fees were charged. Over the five years in which the unauthorized activity occurred, fees on the deposit accounts amounted to $2.2 million ($1.50 per account), and $400,000 on the credit cards ($0.80 per account).  Against these fees, the bank paid incentive bonuses, and then had to pay the considerable cost of cleaning up. Last year Wells Fargo reported net income of $22.9 billion, so the amounts involved were not material to the bank’s shareholders.

Some observers have questioned the bank’s policy of creating ambitious quotas for cross-selling, that may have put excessive pressure on some low-pay employees causing the misconduct, though it does appear that the vast majority of branch employees responded to the quotas and incentives without breaking the rules.  Others point to failures in the accounting and control area that did not confirm new accounts with customers, or otherwise identify the problem early enough to keep it from spreading as widely within the bank as it did.  The bank and its board of directors has also been criticized for being slow and passive in pursuing responsible members of management and holding them accountable through clawbacks or other disciplinary measures.

It is clear that there were management mistakes and subsequent failures in the case. But, there is no evidence that management intended this to happen, or tried to cover it up once informed of the problem. By any standard other than Senator Warren’s, the damage done to customers did not constitute what she called a “massive fraud.”

Nevertheless, it certainly has turned out to be an expensive event for the bank, far more expensive than one might think initially.  Right after the announcement, Wells Fargo’s stock price dropped 5% while the stock price of bank’s principal competitor, JP Morgan, rose by 3%. That 8% difference amounts to $20 billion in lost market capitalization.

The market may have overreacted – the customer damages were small and further legal costs are unlikely to reach anywhere near $20 billion.  But, cumulatively the costs to Wells Fargo will be far greater than what they seem to be so far.

After the Senate hearings we learned that three US Attorneys from the Justice Department have opened criminal investigations, and the SEC is looking into civil infractions. The $185 million settlement did not involve the Justice Department – this is its first appearance on the scene.  For criminal charges to be brought against a corporation, the evidence must clear several difficult hurdles set by the Justice Department, but according to James Stewart in the New York Times, the facts in this case may be enough to do so.  Wells Fargo would have no choice but to settle any criminal charges, if made, even for a very large additional sum.  Banks cannot remain in business if convicted of felonies.

There is also the possibility of a class action on behalf of bank customers who were affected by lowered credit ratings and other difficulties as a result of the bogus accounts, and perhaps by employees who were fired for failing to meet quotas or for similar reasons. Such suits first would have to get by customer agreements requiring the use of arbitration for disputes, but sometimes they can. A guilty verdict in  federal case would invite and encourage class action litigation.

The event has surely caused some so far invisible reputation damage to the entity that before this event surfaced was America’s most admired, least sullied, and most valuable bank. In January, Wells Fargo traded at 1.7 times book value and had a market capitalization of $282 billion, in contrast to the much larger JP Morgan, that then, at 1.1 times book value, was worth $247 billion.

Even the generally supportive Wall Street Journal has suggested that Mr. Stumpf may be lucky to keep his job. Public pressure on the Wells Fargo board can only get worse. Threats of criminal investigations by the NY Attorney General of Citigroup and AIG in the early 2000s cost both of them their powerful CEOs at the time, Sandy Weill and Hank Greenberg, respectively. Losing Stumpf and or other top executives could be a further disruption to the bank.

Wells Fargo may argue that its policies and business practices over the years have been exemplary, and that customers have benefitted greatly from its products and cross-selling efforts, but in competitive businesses operated at large scale, mistakes will happen and when they do, the bank will remedy them. This is what we expect “good” corporations to do: to compete hard to get our business with good new products, but also to stand behind them and never try to cheat us. 

Wells Fargo probably believes that it has lived up to that standard for a long time, and is entitled to some benefit of the doubt when an embarrassing mistake is made. But one of the first signs of reputation damage is the loss of the benefit of the doubt.

Sorry, Wells Fargo, it doesn't work that way anymore.

In Remembrance of Lehman Brothers

In Remembrance of Lehman Brothers

Paul H. Tice

Guest Contributor

Lehman Brothers, the fourth largest U.S. investment bank, filed for bankruptcy protection on September 15, 2008 to send a message to the markets.  Eight years later, we are still struggling to decode the message and draw the proper lessons from that catastrophic event.

Much has been written and said about the bankruptcy of Lehman Brothers over the intervening years, including government inquiries, forensic reports and countless case studies. Yet for all this accumulated body of work, we still seem to be missing some of the basic take-away points.

The first Lehman lesson should be an obvious one: in the modern age of integrated global finance, the bankruptcy of a major investment bank can never be orderly, much less therapeutic for the markets.  Lehman Brothers still ranks as the largest U.S. corporate bankruptcy to date, with $613 billion of total liabilities reported when it filed Chapter 11.  When the firm collapsed, it touched off a global financial crisis, seized up credit markets worldwide and deepened an already-gathering U.S. recession. 

The Lehman bankruptcy estate is now readying its eleventh distribution of cash to creditors, with no end in sight for the process.  Along the way, there has been an incredible destruction of economic value across the financial sector, both in terms of spent time and legal costs.

And yet, under the Dodd-Frank Act, it will be the same game plan going forward, with any future failing financial firm to be resolved through an “orderly liquidation” process. 

While all systematically-important financial institutions must now have “living wills” in place, these confidential company directives are more placebo than panacea, and do not abrogate the need for regulatory support and consistency to maintain liquid and functioning financial markets during periods of stress.

Even with the proper paperwork on file, there is little reason to expect different results the next go-round, especially in a repeat scenario of 2008 when a series of major bank bankruptcies would need to be orchestrated in the midst of a systemic crisis caused by a market-specific trigger.

Second, while some have argued for the re-instatement of the Glass-Steagall Act, the housing of securities underwriting and trading activities in larger commercial banks actually represents a source of stability for the financial system, not the reverse.

Most of the industry players that disappeared along with Lehman in 2008 were stand-alone investment banks with smaller balance sheets that were more exposed to mark-to-market accounting, due to their large trading books and collateralized agreements.  When these investment banks ran into trouble, the solution was to simply merge them with their stronger commercial bank brethren, accelerating an industry consolidation that started back in the 1990s.  With or without public financial support, such government-facilitated combinations were preferable to the Lehman Chapter 11 alternative.

Third, it was not a lack of regulations on the books, but rather regulatory uncertainty and a lack of supervisory oversight, that contributed to the 2008 financial crisis, both before and after Lehman’s bankruptcy filing. 

Nonetheless, the Dodd-Frank Act, with its companion Volcker Rule, has mandated a total of 390 new rulemakings for the financial sector.  Of this target, 274 major rules or 70% had been finalized by July 2016, according to the latest progress report prepared by Davis Polk.  Six years into it, Dodd-Frank has added roughly $36 billion of regulatory costs and 74 million man-hours in paperwork filing for the industry, based on numbers compiled by the American Action Forum.

While some regulatory changes have been positive—notably, central clearing requirements for credit derivatives—Wall Street banks are now consumed with legal compliance, as opposed to financial innovation, market-making and providing liquidity for investors.  In many ways, what has happened to the financial sector post-crisis is similar to the regulatory takeover of the U.S. electricity sector during the 1930s, with banks now functioning as the equivalent of public utilities.  The key difference, though, is that finance is much more complicated than just keeping the lights on.

Lastly, the antidote for the weak corporate governance and poor risk management demonstrated by Lehman Brothers and many of its peers in the run-up to 2008 would include a series of simple prescriptions—such as less-compliant boards, more-proactive auditors and improved balance sheet transparency—rather than the wholesale elimination of all risk-taking.

Since 2008, Federal Reserve policy has distorted the pricing of all risk assets, as interest rates have been kept too low for too long, undermining fundamental trade conviction and positioning appetite and amplifying price movements. These days, even a 25 basis point increase in interest rates from a zero starting point is enough to paralyze the markets.  Now, every extreme volatility event in the markets is casually referred to as a “Lehman moment,” which shows how much memories have faded over the past eight years.

As the industry currently stands, the likelihood of a recurrence of the 2008 financial crisis is arguably very low, but at what cost?  The U.S. economy continues to generate sub-par growth, and few question whether a key contributing factor is a moribund financial sector cowed by compliance, averse to risk and struggling to retain talent due to artificially-suppressed compensation levels.  Given the stigma attached to a career in finance these days, it is not surprising that the number of finance majors coming out of business school has fallen off dramatically in recent years.

When Lehman Brothers collapsed, it also altered the course of an American presidential election, and changed the direction of this country.  Since then, Wall Street has been pitted against Main Street, and bi-partisan criticism of Wall Street banks has devolved into antipathy towards big business and wealthy Americans.  More recently, it has led to atavistic attacks on free trade and global markets and charges that the entire U.S. capitalist system is “rigged.”

All of which, at some level, can be traced back to the failure to deal with the bankruptcy of Lehman Brothers in a frank and open manner.  By not learning the proper lessons from Lehman and 2008, we remain stuck re-litigating the past, unable to move on. 

Something to think about as everyone pauses today to remember where they were eight years ago when the world’s financial markets stood still.

15 September 20167. Paul Tice is an Executive-in-Residence at New York University’s Stern School of Business and spent 14 years of his Wall Street career at Lehman Brothers.