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April 22, 2006

Behind Closed Doors
by Doug Wakefield

In bull markets, we often look for people to support our bullishness rather than those whose understanding of markets is far deeper than our own. We can either look to those who are experts in their field, or those who are experts at marketing their expertise. The following two book reviews are by a former SEC Chairman and a former Chairman and Director of the FDIC, respectively. If you have held these posts, I'd skip the rest of this article. If not, I hope these book reviews will give you the insight to which these leaders of our financial markets and banking system were privy.

In his book, Take on the Street, the insights and stories of, retired SEC Chairman, Levitt speak plainly of the culture that surrounds Wall Street. In a word: GREED. By proposing Regulation Fair Disclosure (FD), speaking out against Wall Street analysts' conflicts of interest, and setting forth legislation to require corporate options packages to be recorded as an expense to the company, Levitt sought to help the individual investor. Here, he summarizes the issues at hand.

"The web of dysfunctional relationships among analysts, brokers, and corporations would grow increasingly worse. For instance, many CEOs were paying more attention to managing their share price than to managing their business. Companies technically were following accounting rules, while in reality revealing as little as possible about their actual performance. The supposedly independent accounting firms were working hand in glove with corporate clients to try to water down accounting standards. When that wasn't enough, they were willing accomplices - helping companies disguise the true story behind the numbers. With 51 percent of accounting firm revenues coming from management consulting in 1999 it was hard not to conclude that auditors had become partners with corporate management rather than the independent watchdogs they were meant to be.

CEOs and their finance chiefs were trading important information about earnings and product development with selected analysts, who in return were writing glowing reports. Such selective disclosures got passed on to powerful institutional investors - mutual funds and pension funds - and to brokers who could be counted on to place a substantial number of shares in the accounts of individual clients. Analysts were often paid more to help their firms win investment banking deals than for the quality of their research. This unholy alliance was producing revenue for the analyst's firm but hardly any benefits for most of their clients.

Mutual funds and pension funds were getting far better information, and a lot earlier, than retail investors. Individual investors were unaware of this side of Wall Street. And yet they were the victims of these long-standing conflicts." [Pages 6-8]

In speaking about the many difficulties he encountered in trying to get legislation, which would benefit individual investors, passed Levitt writes of the symbiotic nature of Washington and CEOs.

"For the CEOs, the ability to have access to and rub shoulders with well-known people who represented America's political elite had an addictive allure. The politicians, in turn, used these meetings as an opportunity to raise funds. Once I started pursuing my agenda to require companies to count their options as an expense on the income statement, I saw a dynamic I hadn't fully witnessed before. The rule would have crimped earnings and hurt the share price of many companies, but it also would have revealed the true cost of stock options to unsuspecting investors. Dozens of CEOs and Washington's most skilled lobbyists came to my office to urge me not to allow this proposal to move forward. At the same time, they flooded Capitol Hill and the support of lawmakers. When we proposed new rules to make sure that auditors were truly independent of corporate clients, some fifty members of Congress promptly wrote stinging letters in rebuke. In the final days of negotiation over new independence rules, I was constantly on the phone with lawmakers who were trying to push the talks toward a certain conclusion, or threatening me if they didn't like the outcome." [Pages 10-12]

"Reg FD (full disclosure) would require companies to release important information to all investors at the same time, and not just to a favored few. Such 'selective disclosure' had gotten out of hand in the 1990s, and put small investors at a disadvantage to the analysts, brokers, and institutional investors who were routinely getting advance information on corporate earnings ahead of the rest of the market. That was wrong, plain and simple.

Never before had so many lined up against me. For the past year [prior to 2000], much of Wall Street and the corporate establishment fought to kill Ref FD. The agency was inundated with comments - more than six thousand in all, the highest in SEC history. It made a deep impression on me when I saw that the industry comments were almost uniformly negative while the public comments were almost uniformly positive." [Pages 87, 93]

Reg FD was passed in 2000.

Lastly, Levitt's comments about mutual fund companies appear just as pertinent today as the time he served as the SEC Chairman.

"A mutual fund's past performance, which is the first feature that investors consider when choosing a fund, doesn't predict future performance. Funds buy expensive ads in newspapers and magazines to tout their performance over the past one, three, five, and ten years. The mutual fund industry irresponsibly promotes this 'culture of performance,' even though it knows perfectly well that is misleads investors. When it comes to mutual funds, the past is not prologue." [Page 56]

Levitt's comments are similar to those Jim Chanos made in our research paper, Riders on the Storm, when he stated, "Wall Street is a giant positive reinforcement machine."

While I agree with much of Levitt's assessment of the incestuous relationships that exist throughout much of Wall Street, his suggestion that the solution is to buy an index fund seems to miss the mark. If the system has many problems and a good number of companies are using the system to benefit themselves to the exclusion of retail investors, investors would be better advised to look for money managers, and companies, with high ethical standards. Levitt also notes, "Investors should give greater weight to the recommendations of independent research analysts." [84] As such, rather than chasing the fad of indexing [64], investors would do better to invest with a manager who is tenacious enough to do his own independent research, and, "who considers his client's interest before his own," rather than one who, for the sake of his own livelihood, ends up, "taking an action which may not be appropriate or timely to take." [25]

If you are concerned by the greed, lack of transparency, and lack of regard for retail investors in the stock market, you are likely to be troubled by the recklessness that exists in our banking system today.

Most people look at the FDIC sticker on a bank's door and assume that they are safe and that if there ever is any problem, the government will always bail them out. Few realize the increase in the size and scope of FDIC bailouts since the U.S. came off of the gold-exchange standard in 1971. Fewer still realize that it is completely up to the FDIC's discretion to decide which banks it will bail out and which deposits it will insure and which ones it will not. Large U.S. banks are considered too big (to be allowed) to fail. Will a day come when these same banks will be too big, with too many bad debts, to rescue?

In his 1986 book, Bailout: An Insider's Account of Bank Failures and Rescues, former Chairman and Director of the FDIC, Irvine Sprague, who handled more bank failures than anyone else in U.S. history, recounts the three largest bank failures of his day, from 1972 through 1985. But, before we move on, let's pause and consider the FDIC's "guarantee" to bail out all banks. Sprague offers the reader some clarification:

"Many believe the FDIC should save all failing banks, a concept that is clearly beyond the law. Section 11(f) of the FDI Act provides that 'payment of the insured deposits shall be made by the Corporation as soon as possible.' This is the basic insurance law and FDIC is under no obligation to use any other procedure. It was very much at our discretion whether and when any person with more than $100,000 in a failed bank would receive any part of it. Particularly vehement were those newly educated the hard way - those people who had lost money in small-or medium-sized banks that we had handled without 100 percent protection for all depositors. Section 13(c)(4)(A) of the FDI Act gives the FDIC board sole discretion to prevent a bank from failing." [Pages 9, 23-24, x-xi, 27]

Banks most often failed for non-performing loans, taking other excessive risks, and making investments that moved against them (often bets on declining interest rates).

Commonwealth, the first billion-dollar bailout, took place in 1972.

"Parsons, Commonwealth [bank's] chairman, set off on a rampage of acquisition and parlayed a small financial stake and a lot of borrowed money into a $3-billion banking empire. Commonwealth's pattern, which was repeated at other banks, was to sell off the safe securities in the bank's portfolio and load up on low-grade securities that bore high interest rates. Interest rates not only continued up - they began to soar. The securities' value in the marketplace plunged. The banks were losing money just holding onto them but the banks would go broke if they sold those securities and took the market losses. The banks were squeezed in, illiquid, inflexible, and capital deficient. Deposits and stable funding sources had not kept pace with its burgeoning loan volume. Loans continued to go bad. The bank continued in its errant way until collapse became inevitable." [Pages 56-66]

With $9 billion, First Pennsylvania experienced similar problems. Sprague writes,

"First Pennsylvania was carrying $328 million in questionable loans. That was $16 million more than the bank's entire equity capital. Bunting [the bank CEO] sought to increase the bank's loan volume at a more rapid pace than the growth in the bank's core deposits would sustain. Loan quality was poor - problem loans rose from 10 percent of capital funds in 1967, to 32 percent in 1969, to 156 percent in 1976." [Pages 83-85]

At roughly $520 million, Penn Square was a smaller bank, but it set afloat more than $2 billion in loans on other banks' books, and the largest failure, the $41 billion dollar failure of Continental Illinois, was largely an outgrowth of this practice. As such, Penn Square reminds me of our banking system today, partly because of their loans on oil and gas, assets that were appreciating like real estate today, and partly because they sought to divest themselves of risky assets, similar to our current credit default swap (CDS) market today.

"Penn Square was plunging other banks' money into the risky oil and gas exploration business. Its mode of operations was to make large, high-priced but chancy loans to drillers [think credit cards and auto loans] and then to sell the loans, in whole or in part, to other banks wile pocketing a fee for the service [just like CDSs]. Such loan sales are called 'participations' and are a common practice in banking. The bank used the proceeds of its participations to funds more oil and gas loans; it would then turn around and sell these as new participations to other banks to obtain proceeds to finance still more loans.

Oil and gas prices finally began to falter [think housing] and decline after rampaging through the 1970s. The prospectors began missing payments on their loans. Drilling rigs used to secure loans had been worth millions. Now their worth added up to only dollars.

Penn Square was in terminal trouble when we met. The large participating banks were exposed, embarrassed, and threatened. Buying loan participations in enormous amounts were some of the country's leading, and supposedly, most sophisticated institutions. They seemed to have been ready, even eager, victims. They were buying risky oil and gas drilling projects secured with doubtful or, in some cases, no collateral at all. The acquiring banks neglected to undertake their own credit analysis. Now they were exposed to massive and potentially fatal losses." [Pages 111-113]

Before it was over the larger banks suffered greatly: one was sold to avoid failure, one lost its management and had to fight a hostile takeover, one was bailed out, and one late-comer escaped with less damage. Remember, these were the brightest and the best. [Page 113]

With $41 billion dollars, Continental Illinois had all the appearances of a sound financial structure. Yet, an article in a banking periodical, Penn Square's affect on its earnings, and other risks that Continental was taking caused the bank to suffer the loss of the public's confidence.

One article in a banking periodical stated that Continentals growth was less a matter of skill than being willing to lend to risky customers who would not qualify for other banks credit standards. An article in the Wall Street Journal corroborated the risk level of Continental's loans. When Penn Square collapsed, Continental, with $1 billion exposure to Penn Square's participations, was hit hard. Its stock dove 25 percent in three months, its credit ratings were downgraded, and its income plummeted two-thirds from the year prior - 1982. Continental also suffered from its exposure to another bank failure, corporate bankruptcies, and the Mexican and Argentinean debt crises. Outwardly, Continental still appeared strong and stable, and all remained quiet on the surface. [Pages 150-152]

"Until May. Then the run exploded." Concerns for Continental's stability began to flood the newswires. "Japanese money began leaving. As the sun rose in Europe, the European bankers also began to withdraw their funds. The run took hold domestically when a long-standing customer withdrew $50 million. Word of this defection moved promptly, and the panic was on. In the 10 days preceding FDIC assistance, the loss exceeded $6 billion. Inside the bank all was calm, the teller lines moved as always, and bank officials recall no visible sign of trouble - except the wire room. [Page 153]

Our planning had covered every contingency, except the failure of one of the small handful of multinational giants. The unthinkable had happened. All agreed that Continental could not be saved without 100 percent insurance by FDIC and unlimited liquidity support by the Federal Reserve. Regan and Volcker raised the familiar concern about a national banking collapse, that is, a chain reaction if Continental should fail. Volcker was worried about an international crisis." [Pages 163, 183, 255] (Emphasis mine)

Needless to say Continental was bailed out.

More than five separate times throughout this book Sprague speaks to the fact that others and he "feared the domino effect that could be started by failure of [a] large bank with extensive commercial loan business and relationships with scores of other banks. The problem was there was no way to project how many other institutions would fail or how weakened the nation's entire banking system might become." [Pages 53, 155]

Sprague notes that the dollar amounts increased from $1.5 to $9.1 to $41 billion. He also notes the increase in the number of failures. "In 1968, there were three small failures all year. In 1983, we handled six failures in one day. In 1985, there were seven failures over a weekend." He also notes the increased speed at which banks can fail. "On occasion, the failure of a bank comes with lightning speed. In cases of fraud or runs, the failure can be dramatically fast. Continental succumbed in days." [Pages 4, 10, 30, 149]

Sprague concludes that a "disregard for loan quality" and loans made "without adequate investigation and documentation" were the surface reasons for most bank failures. As to the foundational reason, Sprague states,

"The greed factor remains the major - often the only - reason for a bank's failure. Nothing much has changed, except now the numbers are quite a bit larger. There is no reason to think that the chain has been completed yet." [Pages 233, 245, x]

With our banking system's current exposure to low doc/no doc risky real estate loans, credit card, and auto loans, and with the credit default swap markets soaring, we would all do well to remember banks have not always been synonymous with safety.

To read some of our other book reviews, we welcome you to visit our website. If you are growing more and more convinced that an economic storm is in front of us, then I strongly encourage you to download a copy of our research paper, Riders on the Storm: Short Selling in Contrary Winds. You will find this available to those who sign up for our monthly newsletter, The Investors Mind: Anticipating Trends through the Lens of History, which is offered at no cost.

Doug Wakefield,
President
Best Minds Inc., A Registered Investment Advisor

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.

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