Editor’s Note
Some people
think government regulation happens to protect the poor and the
innocent.
It does not.
It does not happen for
those reasons nor does it protect the poor and the innocent.
Regulation
happens in most cases to protect a well-connected crony business
group from competition.
Always look for who
benefits from the regulation.
Follow the money.
Another reason
it happens is collective guilt.
Observe the mass
movements to motivate politicians to pass regulation laws, and then
observe the collective guilt behind the mass movement.
And thirdly,
regulation happens because of the 97 pound weakling syndrome.
Years ago, in comic books
(do you remember them?); the back pages were full of ads promising
success.
Sometimes they pictured a
beach shot, with a pale, skinny kid (97 pound weakling) sitting down
and a bigger, healthier, tan kid kicking sand in the skinny kid’s
face.
The message was “buy my
product to become the big kid”.
And here this is
very important.
Politicians, bureaucrats
and other regulators can never be the heroes of business (the big
kids) because they are always the skinny 97 pound weaklings.
You know I am not talking
about good looks and physical size but am talking about intelligence
and successful productivity.
In a word, regulation
happens because of ENVY.
The Regulated States of America
Wall Street Journal - June 19, 2013 by
Niall
Ferguson
In "Democracy in America," published in
1833, Alexis de Tocqueville marveled at the way Americans preferred
voluntary association to government regulation. "The inhabitant of
the United States," he wrote, "has only a defiant and restive regard
for social authority and he appeals to it . . . only when he cannot
do without it."
Unlike Frenchmen, he continued, who
instinctively looked to the state to provide economic and social
order, Americans relied on their own efforts. "In the United States,
they associate for the goals of public security, of commerce and
industry, of morality and religion. There is nothing the human will
despairs of attaining by the free action of the collective power of
individuals."
What especially amazed Tocqueville was the
sheer range of nongovernmental organizations Americans formed: "Not
only do they have commercial and industrial associations . . . but
they also have a thousand other kinds: religious, moral, grave,
futile, very general and very particular, immense and very small;
Americans use associations to give fetes, to found seminaries, to
build inns, to raise churches, to distribute books, to send
missionaries to the antipodes; in this manner they create hospitals,
prisons, schools."
Tocqueville would not recognize America
today. Indeed, so completely has associational life collapsed, and
so enormously has the state grown, that he would be forced to
conclude that, at some point between 1833 and 2013, France must have
conquered the United States.
The decline of American associational life
was memorably documented in Robert Puttnam's seminal 1995 essay
"Bowling Alone," which documented the exodus of Americans from
bowling leagues, Rotary clubs and the like. Since then, the downward
trend in "social capital" has only continued. According to the 2006
World Values Survey, active membership even of religious
associations has declined from just over half the population to
little more than a third (37%). The proportion of Americans who are
active members of cultural associations is down to 14% from 24%; for
professional associations the figure is now just 12%, compared with
more than a fifth in 1995. And, no, FaceBook is not a substitute.
Instead of joining together to get things
done, Americans have increasingly become dependent on Washington. On
foreign policy, it may still be true that Americans are from Mars
and Europeans from Venus. But when it comes to domestic policy, we
all now come from the same place: Planet Government.
As the Competitive Enterprise Institute's
Clyde Wayne Crews shows in his invaluable annual survey of the
federal regulatory state, we have become the regulation nation
almost imperceptibly. Excluding blank pages, the 2012 Federal
Register—the official directory of regulation—today runs to 78,961
pages. Back in 1986 it was 44,812 pages. In 1936 it was just 2,620.
True, our economy today is much larger than
it was in 1936—around 12 times larger, allowing for inflation. But
the Federal Register has grown by a factor of 30 in the same period.
The last time regulation was cut was under
Ronald Reagan, when the number of pages in the Federal Register fell
by 31%. Surprise: Real GDP grew by 30% in that same period. But
Leviathan's diet lasted just eight years. Since 1993, 81,883 new
rules have been issued. In the past 10 years, the "final rules"
issued by our 63 federal departments, agencies and commissions have
outnumbered laws passed by Congress 223 to 1.
Right now there are 4,062 new regulations at
various stages of implementation, of which 224 are deemed
"economically significant," i.e., their economic impact will exceed
$100 million.
The cost of all this, Mr. Crews estimates,
is $1.8 trillion annually—that's on top of the federal government's
$3.5 trillion in outlays, so it is equivalent to an invisible 65%
surcharge on your federal taxes, or nearly 12% of GDP. Especially
invidious is the fact that the costs of regulation for small
businesses (those with fewer than 20 employees) are 36% higher per
employee than they are for bigger firms.
Next year's big treat will be the
implementation of the Affordable Care Act, something every small
business in the country must be looking forward to with eager
anticipation. Then, as Sen. Rob Portman (R., Ohio) warned readers on
this page 10 months ago, there's also the Labor Department's new
fiduciary rule, which will increase the cost of retirement planning
for middle-class workers; the EPA's new Ozone Rule, which will
impose up to $90 billion in yearly costs on American manufacturers;
and the Department of Transportation's Rear-View Camera Rule. That's
so you never have to turn your head around when backing up.
President Obama occasionally pays lip
service to the idea of tax reform. But nothing actually gets done
and the Internal Revenue Service code (plus associated regulations)
just keeps growing—it passed the nine-million-word mark back in
2005, according to the Tax Foundation, meaning nearly 19% more
verbiage than 10 years before. While some taxes may have been cut in
the intervening years, the tax code just kept growing.
I wonder if all this could have anything to
do with the fact that we still have nearly 12 million people out of
work, plus eight million working part-time jobs, five long years
after the financial crisis began.
Genius that he was, Tocqueville saw this
transformation of America coming. Toward the end of "Democracy in
America" he warned against the government becoming "an immense
tutelary power . . . absolute, detailed, regular . . . cover[ing]
[society's] surface with a network of small, complicated,
painstaking, uniform rules through which the most original minds and
the most vigorous souls cannot clear a way."
Tocqueville also foresaw exactly how this
regulatory state would suffocate the spirit of free enterprise: "It
rarely forces one to act, but it constantly opposes itself to one's
acting; it does not destroy, it prevents things from being born; it
does not tyrannize, it hinders, compromises, enervates,
extinguishes, dazes, and finally reduces [the] nation to being
nothing more than a herd of timid and industrious animals of which
the government is the shepherd."
If that makes you bleat with frustration,
there's still hope.
Mr.
Ferguson's new book "The Great Degeneration: How Institutions Decay
and Economies Die" has just been published by Penguin Press.
Back to top
Editor’s Note
This Apple article is right out of the pages
of Atlas Shrugged.
Here is the first truth.
Steve Jobs and Apple created a
revolution in small portable devices.
They made popular Internet music.
They along with Amazon and others
created mass e-books.
They were producers.
And none of the regulators or lawyers
in this article could qualify for a mail room job at Apple.
It is much easier to tear down the
great than it is to build greatness.
Again, Atlas Shrugged.
Here is the second truth.
Conservatives will always fail.
The author of this article is no doubt
a conservative.
They try to justify Apple’s position by
the standard conservative manta – “Well, the outcome was good for the
whole”.
How about justifying Apple’s position by
saying: “Apple had a right to charge whatever they wanted.
The Market will determine if they are
correct.”
All TTS readers might consider re-reading in
Atlas, Hank Rearden’s trial section.
I would drop dead if just one American
company would stand up at trial and say: “It is mine by right!”
Wall
Street Journal - June 13, 2013
Throwing the Book at Apple
Steve Jobs
is remembered as the Thomas Edison of Silicon Valley, but Washington's
trust busters would like to add one more legacy: That the Apple
cofounder tried to suppress competition as the "ringmaster" of a
conspiracy to fix digital book prices that nonetheless caused prices to
fall.
At least that's the legal theory behind the federal show trial against
Apple that got underway last week, which is incoherent even by the
standards of modern antitrust. The Justice Department contends that
Apple plotted with five publishers to artificially inflate the costs of
books in 2009-2010.
At the time, prior to the existence of the tablet device market that
Jobs created with the iPad, Apple did not sell e-books. Amazon sold nine
of every 10. Justice claims Jobs then forced Amazon and every other
e-book distributor to adopt a new e-book pricing model that harmed
consumers.
Yet the average retail price for "trade" e-books has since dropped to
$7.34 from $7.97, and Amazon's Kindle is still the industry leader with
Apple trailing in third. Over the same period readers bought 447% more
e-books, and they can choose from dozens of tablets for titles and other
media content.
Lower prices, more sellers and better products don't sound like a return
to the days of Standard Oil, so Justice's Antitrust Division conjured up
a complaint by looking at the prices for the digital versions of new and
bestselling books, which have jumped by a few cents. Justice blames this
on Apple's so-called "agency" sales model.
Much like Jobs had done earlier to (and for) music with iTunes, he
wanted the iBookstore to let content producers set retail prices within
simplified limits—songs for 99 cents, books capped at $12.99 or $14.99
depending on the category. Apple would take a fixed commission of 30%.
Historically the book business has operated on wholesale distribution,
with publishers charging a fixed price and retailers setting the
consumer sale price. Amazon was used to buying e-books wholesale and
selling them as loss leaders at $9.99, which the publishers worried was
erasing hardcopy sales and freezing consumers' digital price
expectations.
Justice sued the five publishers last year
claiming they colluded on behalf of agency pricing, and all have since
settled, including HarperCollins, which like this newspaper is owned by
News Corp. Macmillan CEO John
Sargent explained the capitulation best in an email to authors when he
cited the damages Justice sought: "I cannot share the breathtaking
amount with you, but it was much more than the entire equity of our
company."
Apple maintains its innocence, with important legal implications. The
Justice Department is trying to set a dangerous new theory of antitrust
liability, contrary to multiple legal precedents going back to the
1980s.
Normally non-merger investigations use a "rule of reason" standard to
weigh how business practices help or hurt competition. The government
wants the courts to declare Apple's pricing model a "per se" violation,
or inherently unlawful. (Think Standard Oil.) Retailer royalties have
long been upheld by the courts, but Justice's bizarre claim is that
creating an alternative e-books platform gave the publishers an
opportunity to gang up and coerce Amazon into raising prices, with Apple
as an accomplice. In other words, the still-dominant online retailer is
the victim because a rival entered the market. Yet despite the
publishers settlement, Amazon has itself largely switched from wholesale
to agency pricing, which helps explain why average e-book prices
continue to trend down.
The government's evidence is mostly out-of-context emails and innuendo.
A key exhibit is a Jobs email to James Murdoch, the News Corp.
executive: "Throw in with Apple and see if we can all make a go of this
to create a real mainstream e-books market at $12.99 and $14.99."
Justice didn't release the rest of the Jobs's email, which added that
"Heck, Amazon is selling this book at $9.99, and who knows maybe they
are right and we will fail even at $12.99. But we're willing to try at
the prices we proposed. We are not willing to try at higher prices,
because we are pretty sure we'll all fail."
That speaks to the other part of the Justice case, which is that Apple's
illegal intent can be inferred from the contracts that the company
offered separately to each publisher. The book publishers hated the
$14.99 cap Apple insisted on to maintain standard pricing across its
bookstore, but Justice cites these ceilings that constrain the ability
to raise prices in a case allegedly about raising prices.
So too for a "most favored nation" clause in the contract that said
Apple store e-books must match the cheapest market price. This is a tool
for keeping prices down. But Justice argues Apple forced the publishers
to force Amazon to switch, even though the contracts that they didn't
have to sign said nothing about their dealings with other retailers.
Amazon and Apple are both innovative, rich, ruthless companies, so this
case is hardly David versus Goliath—unless Goliath is the Justice
Department abusing its discretion to favor one over the other.
The larger spectacle is the Obama Administration attempting to dictate
how the book industry and online commerce must be structured in a way
that benefits an incumbent like Amazon in what is otherwise a fluid,
dynamic market. The case reveals how degraded antitrust law has become
as its lawyers search for reasons to justify their existence.
Back to top
Editor’s Note:
Here is a good one right from the pages of
Atlas Shrugged.
Ayn Rand did not write
predictions.
She wrote about the logical
conclusions of specific events.
The scenario below is classic.
Big investment banks are both the victims
of credit rating agencies and are pursued simultaneous by the government
as bad guys.
Only in the world of Alice in
Wonderland.
Additionally, only one bad credit rating
agency has been sued – S & P.
The very like kind agency
Moody’s has not been sued.
Obama friend, major contributor and
knee-jerk liberal, Warren Buffett, owns most of Moody’s.
Go figure.
Wall
Street Journal – April 25, 2013
Suddenly, Banks Are Victims
In their S&P lawsuit, the feds discover a new
crisis narrative.
Standard & Poor's on Tuesday asked a federal judge to dismiss a $5 billion
fraud lawsuit filed by the Justice Department. The judge ought to grant
S&P's motion for many reasons, not least because otherwise no one will
be able to sort Washington's list of victims and villains.
The lawsuit covers the years before the financial crisis of 2008. Justice
accuses S&P of claiming to be "independent" and "objective" and then—in
order to please clients—assigning Triple-A ratings to mortgage-backed
securities that S&P knew were more risky. S&P denies this.
In this latest Beltway telling of financial history, the alleged victims
include two bailed-out U.S. financial giants and a failed credit union.
Yet in other federal suits, all three have been charged as perpetrators
of the mortgage crisis.
Former executives of Western Federal Corporate
Credit Union, known as WesCorp, must be shocked to learn that Washington
now blames their troubles on somebody else. WesCorp bought a lot of the
mortgage paper at issue and its managers were fired and then sued by
regulators after the feds seized the failing credit union in 2009.
Few would argue that these managers were blameless. Last year WesCorp's
former chief economist Dwight Johnston described the problem to trade
publication Credit Union Journal. "Management was well aware the housing
bust was possible," said Mr. Johnston. "But from 2004 through 2007, no
one inside WesCorp really wanted to hear about it."
Actually it appears they did want to hear about it—but only as a source of
humor. The magazine reports that executives would laugh off Mr.
Johnston's housing warnings and then tease him for selling his home too
early in 2004.
Other alleged victims in the Justice lawsuit include divisions of
Citigroup and
Bank of America.
Now that's funny. These two received the biggest taxpayer bank bailouts
during the crisis. Given the reckless mortgage bets that Citi hid
outside its balance sheet before the panic, it seems absurd to cast the
giant bank as a victim. But there will be benefits for the White House
if Justice can airbrush the bank's crisis-era portrait. Citi
mortgage-investment veteran Jack Lew now serves as Secretary of the
Treasury, which is the funniest story of all.
BofA and Citi are presented in Justice's lawsuit as victims of overly
optimistic S&P ratings even on mortgage deals that these banks created.
To be consistent, how can the government keep suing these banks for
selling bad paper if the government argues in a separate suit that it
was all S&P's fault? An equally challenging question is how a bank can
be misled by an S&P report that relies on the bank's own data.
Then there's the Japanese bank Mizuho, which has already been sued and
settled a case in which the Securities and Exchange Commission claimed
that it was Mizuho that misled S&P. For those trying to keep score,
different parts of our government have now claimed that a firm was
defrauding investors while it was simultaneously being defrauded by
another firm on the same deal.
This legal blooper reel would not be complete without mentioning the
elephant in the courtroom. So far Justice is not suing Warren Buffett's
Moody's ratings service, even though Moody's rated many of these same deals,
often with identical ratings. Are we supposed to believe that Moody's
never suggested to anyone that it was independent and objective? Whether
Team Obama would ever dare to sue a company in which St. Warren is
invested, you don't have to be a cynic to wonder if the feds will first
wait and see whether Moody's downgrades U.S. Treasury debt the way S&P
did in 2011.
The truth is that S&P's ratings on mortgage
bonds, along with those issued by Moody's and Fitch, did inflict
terrible damage. But this was not because employees at these firms are
more stupid or unethical than those at other businesses. The damage
occurred because the same government that's now suing S&P required
financial institutions to use the ratings issued by S&P and the other
raters.
This doesn't make the investors blameless as they happily chased yield and
concentrated their bets in the residential mortgage market. But as we've
long argued, the crisis had several causes other than the greed that is
found at all times on Wall Street and every other street.
The Federal Reserve's loose money provided a subsidy for credit. The SEC
anointed the ratings agencies as the supreme judges of credit risk.
Various federal programs encouraged Americans to buy homes with borrowed
money, and
Fannie Mae
turbocharged housing finance. Basel bank rules exacerbated these policy
flaws. To avoid the next crisis, the U.S. needs true reform of these
policies.
But instead of reform, Washington is inventing lawsuits that require the
government to pretend that those who contributed to the crisis were
actually victims. Instead of suing the credit raters, Washington should
simply take away their power to do harm and for heaven's sakes stop
endorsing them.
Back to top
Editor's Note:
The following is a perfect example of overcoming
ObamaCare regulation and shrugging profitably. If you have a business with 50 or
more employees, study this idea carefully.
Wall Street Journal - January 28, 2013 by Paul
Christiansen
Outsmart ObamaCare, Go Protean
How big can a company get with just 50
employees? We're about to find out. Thousands of small businesses across the U.S. are
desperately looking for a way to escape their own fiscal cliff. That's because ObamaCare
is forcing them to cover their employees' health care or pay a fine “either of which
will cut into profits and stymie future investment and growth.
We've already seen many of America's
biggest companies respond to the new law by laying off employees, putting them on
part-time, or raising prices. But those are short-term solutions. Ultimately, these
corporations will have to innovate and restructure to thrive in the era of ObamaCare. If
small businesses follow their lead, they may even gain an advantage over their big
competitors.
In his 2009 book "The Future Arrived
Yesterday," veteran Silicon Valley journalist Michael S. Malone described a new
organizational model called a “Protean Corporation." Like a protozoan
single-cell organism, the protean corporation has the ability to "shape shift,"
rapidly adapting to internal and external forces in the market and the company. At the
heart of a true protean corporation is a tiny number of core employees surrounded by a
large cloud of resources, generally contracted or outsourced talent that does most of the
work.
While the concept has been used
successfully in large corporations like Intel, Microsoft MSFT it is bound to appeal to
smaller companies now. Such businesses have several ways to get their workforce under the
50-employee limit at which certain ObamaCare rules kick in. These include reducing
workers' hours to move full-time employees to part-time; laying off workers; and either
selling the company or closing down.
"Going protean" offers a better
strategy for many businesses. Owners of protean companies create a core of strategic
employees who manage the big-picture elements of the enterprise the culture, business
model, product mix, vision, strategy, etc. This core then outsources the business tasks to
other corporations.
Non-core tasks could include things like
accounting, marketing, product development, manufacturing, IT, PR, legal, finance, etc.
There is almost nothing that cannot be outsourced including even the CEO function (which
can already happen, e.g., when a company is in turnaround.)
To most business owners,
"outsourcing" means shipping jobs overseas. But in the protean sense, it means
having tasks performed in the context of a contractual relationship as opposed to an
employment relationship. It's not about replacing employees with contractors, but about
replacing employees with corporations.
These new contracts will be a mix of large
corporations, small businesses, micro-corporations and even nano-corporations (an
individual doing business as a corporation). But to be a protean solution, it must involve
a corporation-to-corporation relationship. Any substitute, a sole proprietorship is only a
time bomb because eventually the government will pressure you to turn any so-called 1099
contractors into employees.
In the context of ObamaCare, a small
business could go protean by offering current employees contracts for doing their current
work as a corporate entity instead of as an employee. Entrepreneurial employees will jump
at the chance to form a corporation and run their own business. Non-entrepreneurial
employees can choose to move on and find other work or work hard to join the core
company.
Going protean won't work without a massive
mental shift. A company no longer manages employees, but tasks and contracts instead a
quantum leap in management styles and process.
The biggest change is replacing
human-resources. Instead of writing position descriptions and managing employees, the
protean corporation writes contracts and scope-of-work documents and manages those.
There is another subtle but powerful shift.
Instead of relationships being vertical e.g., boss-employee the relationships are peer,
corp.-to-corp. Having your work done by people who own corporations will be completely
different than working with people with an employee mindset.
Perhaps the biggest change protean
corporations will experience is in the nature of their relationships with people. When a
person is an employee, he or she is, by definition, in partnership with the government the
Equal Employment Opportunity Commission, the Occupational Safety and Health
Administration, etc. and is subject to all the government's regulations. But when a
protean corporation enters into a relationship with that same person, now a corporation,
it is a purely contractual relationship with a fellow enterprise. As long as there is no
fraud or breach of contract, and the agreement is legal, the government really has nothing
to say.
In the years ahead, as government continues
to impose itself into the marketplace and reduce the freedom of the commercial sector
through statist programs like ObamaCare, businesses will have to look for creative
solutions to survive. Going protean is only one way, and others will emerge.
Yet as small enterprises approach 50
employees (or retreat back below that number), look for a significant number of them to
concentrate on growing in revenues without ever again growing in employees. The result can
be a wave of entrepreneurship, new company creation, business growth and economic freedom.
Not a bad result when you consider that it will be spurred by the government’s
bid to keep America's businesses under its thumb.
Mr.
Christiansen is an entrepreneur based in San Diego. He has owned an IT-training company
and an executive forum group and currently has a Web-design firm, Quorim.com
Back to top
Editor's
Note:
This is what I mean by Shrugging`. This young man is beating the regulators and the
crony business people at the same time.
Hooray
for him!
Wall Street Journal – January
26, 2013 by Andy Kessler
The Transportation Trustbuster
An interview with Travis Kalanick by Andy Kessler
San Francisco
I walk to the security desk in the lobby of
what could be any of this city’s downtown office buildings filled with lawyers,
architects and finance firms. "I'm here to see Travis Kalanick at Uber."
"You'll have to email him, they're
very secretive. And take a seat."
I sit down and send a note to say I have
arrived for the interview. Nearby, several middle-aged men, all wearing black suits,
white shirts and ties, listen to a young guy in jeans, orange socks and sneakers. He
is consulting a MacBook as he talks to them. "Your account is no longer active, due
to quality concerns from negative feedback," he says to one of the men. "You've
had 105 trips and your quality scores are low."
These are Uber drivers, I surmise, and one
of them is being given the heave-ho. The company is a hot San Francisco startup that
already has 25 outposts around the world for its simple, seductive service: on-demand
transportation. With an iPhone or Android app, you call up the Uber map, spot an available
town car or taxi, and summon it with a click. The fare and tip for a town car, or limo, is
maybe 50% higher than for a regular taxi ride and paid for through the service.
As the "no longer active" driver
might attest, the company puts a premium on customer satisfaction. Uber has been
successful enough that city bureaucrats across the country, eager to protect homegrown
taxi and limousine services, have thrown up regulatory roadblocks left and right.
An Uber staffer fetches me and I am taken
to meet Mr. Kalanick. The 36-year-old CEO isn't dressed in the usual geek-chic uniform.
Instead, he wears a light-gray Italian suit with a pink shirt, no tie. But the Uber
offices themselves have the usual Silicon Valley accouterments—as I walk with Mr.
Kalanick to a cluttered conference room, we pass a game room with a Foosball table, a
Pepsi-stocked fridge and two tapped beer kegs.
His background is also classic Silicon
Valley. Started coding in sixth grade. Studied computer engineering at
UCLA—"a great discipline on how to break down problems and put them back
together," Mr. Kalanick says. Founded a company in 1999 during his senior year, left
college without graduating.
The company, Scour.com, was like Napster, a
peer-to-peer search engine to find music and other content on the Web. He was sued for
$250 billion (yes, with a "b") by 30 or so media companies, filed for
Chapter 11, started another company with the same P2P technology, but this time he was
paid by media companies to move their content around cheaply. He ran out of money several
times, moved back home with his parents near Los Angeles and worried about his sanity.
Then the company, called Red Swoosh, finally started working, and in 2007 he sold it to
Akamai for $15 million.
Two years later, Travis and a friend,
Garrett Camp, who had made his fortune by selling the Web search tool StumbleUpon to eBay
in 2007, were in Paris for the Le Web conference. "We were jammin' on ideas,"
Mr. Kalanick recalls. "What's next, what's the next thing, and Garrett said, 'I just
want to push a button and get a ride.' And I'm like, 'That's pretty good.' He said
'Travis, let's go buy 10 Mercedes S-Classes, let's go hire 20 drivers, let's get
parking garages and let's make it so us and a hundred friends could push a
button and an S-Class would roll up, for only us, in the city of San Francisco,
where you cannot get a ride.' This wasn't about building a huge company, this was
about us and our hundred friends."
It took another year to get going as a real
company, even a small one. At one point early in 2010, Mr. Kalanick says, he asked
himself: "Do I really want to run a limo company?" He Googled "San
Francisco limousine" and started calling existing companies to try out the idea.
"Three of them hung up, four of them were 'maybe' and another three were super
pumped."
That was good enough to suggest that he was
onto something. Uber launched as an iPhone app in June 2010. The cars that iPhone users
summon are typically town cars owned by a limousine company but not on a call. Instead of
idly waiting for work, the nearest available driver answers the app call. Other cars are
simply privately owned vehicles whose drivers have been vetted by Uber.
The idea worked. How could Mr. Kalanick
tell? Four months after the launch in San Francisco, Uber was served with a "cease
and desist" order from the California Public Utility Commission and the San Francisco
Municipal Transportation Agency. "Given my background," Mr. Kalanick says,
alluding to being sued at Scour.com, "this was like homecoming." He verified
with his lawyers that what Uber was doing was indeed legal, then the company took its case
to the public through Twitter and email.
"Did you ever cease?" I asked.
"No." "Did you ever desist?" "No." "So you basically
ignored them?"
As he talks, Mr. Kalanick paces around the
conference room carrying a golf putter. The more wound up he becomes, the more he seems
likely to break a window than practice his stroke. "The thing is, a cease and desist
is something that says, 'Hey, I think you should stop,' and we're saying, 'We don't think
we should.' The only way to deal with that is to be taken to court, and we never went to
court."
But Uber did have to meet with the San
Francisco Municipal Transportation Agency, where the woman in charge of taxis "was
upset," Mr. Kalanick says. "Oh man, I've never. . . . She was fire and
brimstone, deep anger, screaming. But here’s the thing, SFMTA has no jurisdiction on
what we do. They regulate taxis. Every single limo company we work with is licensed
and regulated by the state of California."
Ultimately, he says, the question boiled
down to this: "Are we American Airlines or are we Expedia? It became clear, we are
Expedia."
When I suggest to Mr. Kalanick that Uber,
in the fine startup tradition, was using the "don't ask for permission, beg for
forgiveness" approach, he interrupts the question halfway through. "We don't
have to beg for forgiveness because we are legal," he says. "But there's been so
much corruption and so much cronyism in the taxi industry and so much regulatory capture
that if you ask for permission upfront for something that's already legal, you'll never
get it. There's no upside to them."
The crisis with the transportation agency
lasted a few days and then faded. Meanwhile, Uber was trying to perfect its model,
employing Ph.D.s to create algorithms to estimate demand and pricing to make the service
efficient.
Breaking their own rules and not wanting to
get screamed at, Uber met with the New York Taxi and Limousine Commission, briefing
commissioners on the company’s success in San Francisco. "They gave us their
blessing," Mr. Kalanick says, and Uber started operating in New York in May 2011.
Soon a prominent newspaper article appeared about the company, and "the minute it hit
the public, the taxi industry and black-car industry sees it and then the lobbyists get
working and then they try to shut us down." As he notes, in New York there are 13,000
taxis with medallions that trade for close to $1 million, implying a very profitable cash
flow from fares. That's a lot of assets to protect.
Uber met with New York officials and ended
up getting a memo saying they were legit, for limos anyway. "This speaks to New York,
they wanted to embrace innovation and they did," Mr. Kalanick says. That sounds like
a big change for the Big Apple. "You can trace this to [Mayor] Bloomberg. If anyone
gets technology disrupting an industry, he was there." As long as the drivers
don’t smoke or drink Big Gulps.
Uber also launched in Chicago, where
regulators tried to change the rules to block them, in Seattle with no problems, and in
Boston, where a cease and desist was issued because the state's Division of Standards
didn't have a standard for using GPS in commercial vehicles. The company ignored that one,
too.
Then, last year, came the clash with
regulators in the city where they order red tape by the truckload: Washington, D.C. A
month after Uber launched there, the D.C. taxi commissioner asserted in a public forum
that Uber was violating the law.
This time Uber was ready with what it
called Operation Rolling Thunder. The company put out a news release, alerted Uber
customers by email and created Twitter hashtag #UberDCLove. The result: Supporters sent
50,000 emails and 37,000 tweets. Mr. Kalanick says that Washington "has the most
liberal, innovation-friendly laws in the country" regarding transportation, but
"that doesn’t mean the regulators are the most innovative." The taxi
commission complained that the company was charging based on time and distance, Mr.
Kalanick says. "It's like saying a hotel can't charge by the night. But there
is a law on the books, black and white, that a sedan, a six-passenger-or-under, for-hire
vehicle can charge based on time and distance."
In July, the city tried to change the
law—with what were actually called Uber Amendments—to set a floor on the
company's rates at five times those charged by taxis. "The rationale, in the frickin'
amendment, you can look it up, said ‘We need to keep the town-car business from
competing with the taxi industry,' " Mr. Kalanick says. "It's
anticompetitive behavior. If a CEO did that kind of stuff—you'd be in jail."
He sits down and puts away the golf club.
"A lot of my job is taking those kinds of things—anticapitalist taxi
protectionism—and putting it in populist terms. What they're really saying when
they put a floor on prices is that only wealthy people are allowed to get into town
cars."
As an experiment, the company launched
UberTaxi in Chicago last year—another option in the app, to hail a taxi for a lower
fare than a town car. "If there is to be a low-cost Uber, Uber will be the low-cost
Uber," Mr. Kalanick says. Company reps met with the Chicago Taxi Commission,
which told them they needed a taxi-dispatch license. So Uber obtained a license and for a
while had no problems. The company's limo business in Chicago tripled and the taxi
business soon equaled the limo business. But in the course of one week in October, Uber
was sued by taxi and limousine companies, and Chicago regulators sent citations and filed
a class-action suit on behalf of passengers.
Rolling Thunder rolled out again, though
this time the company broke the email list into 10 parts and sent out one-tenth
every day, asking customers to let City Hall know what they thought. Mayor Rahm
Emanuel's office received a constant torrent of emails, tweets and phone calls and, lo and
behold, the regulatory threat went away. No permission, no plea for forgiveness.
The day that I spoke with Mr. Kalanick,
UberTaxi launched in Washington. Next month, a one-year trial of UberTaxi will start in
New York City. "We already know how the trial will come out," he says. "We
ran taxi dispatch in New York for six weeks. Drivers will make a lot of money."
Uber investors seem to think they're onto a
good thing too. The company raised $37 million in exchange for a 10% stake over a year ago
from Amazon CEO Jeff Bezos and others. Mr. Kalanick says that Uber currently has 170
employees, not including drivers, and he expects the total to reach 800-900 by the end of
2013, all without raising any more money. Uber sends work to tens of thousands of drivers,
who log hundreds of thousands of hours behind the wheel per week. Imagine, a company
stirring up all that economic activity without government stimulus money.
What has Mr. Kalanick learned so far from
his Uber experience? "The regulatory systems in place disincentive innovation. It's
intense to fight the red tape." His advice for others: "Stand by your
principles and be comfortable with confrontation. So few people are, so when the people
with the red tape come, it becomes a negotiation."
The resistance to regulatory interference
doesn't stem from a particular political stance. "My politics are: I'm a trustbuster.
Very focused. And yeah, I’m pro-efficiency. I want the most economic activity at the
lowest price possible. It's good for everybody, it's not red or blue.
“Mr. Kessler a former hedge-fund
manager, is the author most recently of "Eat People”.
Back to top
Editor's Note:
While The
Atlantic is not necessarily known as a hot bed of Objectivist thought, we are including
this article for very specific and important reasons.
The article discusses big banks (think Wall Street Investment banks, not
neighborhood retail banks) and the trouble they are still in. I think most of the authors’ facts are
essentially correct about the banks; their lack of disclosures and the high risk they
present.
However, the
authors’ conclusions are dead wrong.
They
want more regulation not less. They believe
with more regulation the risks the big banks exhibit would be less. Maybe or maybe not.
It depends on if think the cream of Wall Street is smarter than your average
bureaucrat. I would bet on Wall Street.
Our first
thought and conclusion was “So What.”
If
investment in these banks and their recommendations go south, who gets hurt? Just your ordinary Wall Street investor with at
least 6 figures to invest with a liquid net worth of 7 figures. Oh, and who has studied this market and hopes to
make a better than retail bank CD rate interest.
Also notice the
slippery regulation language they advocate. The regulators can make you guilty of
anything if the language is loose enough. Even banking and trading. Oh, my
gosh!
The beauty and
power of free market capitalism will always weed out the bad guys and allow the good ones
to flourish. It takes decades for a bank (or
any endeavor) to establish trust and a solid gold reputation for worthy investment. Regulations wipe that out using the sticker system. You know, the FDIC $250,000 safety sticker on banks
(and all the other related sticker systems in place).
Partnoy and
Eisinger don’t want to think.
But worse
they want to remove everyone’s thinking from one's own respective decision making
process. I truly believe they think Big
Government will protect them AND all of us.
These
two are grown men who still believe everyone needs a nanny! This is the soul of a
liberal (collectivist) standing naked.
The
Atlantic Jan / Feb 2013 issue by Frank Partnoy, and Jesse Eisinger
What’s Inside
America’s Banks?
The financial crisis
had many causes—too much borrowing, foolish investments, misguided
regulation—but at its core, the panic resulted from a lack of transparency. The
reason no one wanted to lend to or trade with the banks during the fall of 2008, when
Lehman Brothers collapsed, was that no one could understand the banks’ risks. It was
impossible to tell, from looking at a particular bank’s disclosures, whether it might
suddenly implode.
For the past four
years, the nation’s political leaders and bankers have made enormous—in some
cases unprecedented—efforts to save the financial industry, clean up the banks, and
reform regulation in order to restore trust and confidence in the American financial
system. This hasn’t worked. Banks today are bigger and more opaque than ever, and
they continue to behave in many of the same ways they did before the crash.
Consider
JPMorgan’s widely scrutinized trading loss last year. Before the episode, investors
considered JPMorgan one of the safest and best-managed corporations in America. Jamie
Dimon, the firm’s charismatic CEO, had kept his institution upright throughout the
financial crisis, and by early 2012, it appeared as stable and healthy as ever.
One reason was that
the firm’s huge commercial bank—the unit responsible for the old-line business
of lending—looked safe, sound, and solidly profitable. But then, in May, JPMorgan
announced the financial equivalent of sudden cardiac arrest: a stunning loss initially
estimated at $2 billion and later revised to $6 billion. It may yet grow larger; as of
this writing, investigators are still struggling to comprehend the bank’s condition.
The loss emanated
from a little-known corner of the bank called the Chief Investment Office. This unit had
been considered boring and unremarkable; it was designed to reduce the bank’s risks
and manage its spare cash. According to JPMorgan, the division invested in conservative,
low-risk securities, such as U.S. government bonds. And the bank reported that in 95
percent of likely scenarios, the maximum amount the Chief Investment Office’s
positions would lose in one day was just $67 million. (This widely used statistical
measure is known as “value at risk.”) When analysts questioned Dimon in the
spring about reports that the group had lost much more than that—before the size of
the loss became publicly known—he dismissed the issue as a “tempest in a
teapot.”
Six billion dollars
is not the kind of sum that can take down JPMorgan, but it’s a lot to lose. The
bank’s stock lost a third of its value in two months, as investors processed reports
of the trading debacle. On May 11, 2012, alone, the day after JPMorgan first confirmed the
losses, its stock plunged roughly 9 percent.
The incident was
about much more than money, however. Here was a bank generally considered to have the best
risk-management operation in the business, and it had badly managed its risk. As the bank
was coming clean, it revealed that it had fiddled with the way it measured its value at
risk, without providing a clear reason. Moreover, in acknowledging the losses, JPMorgan
had to admit that its reported numbers were false. A major source of its supposedly
reliable profits had in fact come from high-risk, poorly disclosed speculation.
It gets worse.
Federal prosecutors are now investigating whether traders lied about the value of the
Chief Investment Office’s trading positions as they were deteriorating. JPMorgan
shareholders have filed numerous lawsuits alleging that the bank misled them in its
financial statements; the bank itself is suing one of its former traders over the losses.
It appears that Jamie Dimon, once among the most trusted leaders on Wall Street,
didn’t understand and couldn’t adequately manage his behemoth. Investors are now
left to doubt whether the bank is as stable as it seemed and whether any of its other
disclosures are inaccurate.
The JPMorgan scandal
isn’t the only one in recent months to call into question whether the big banks are
safe and trustworthy. Many of the biggest banks now stand accused of manipulating the
world’s most popular benchmark interest rate, the London Interbank Offered Rate
(LIBOR), which is used as a baseline to set interest rates for trillions of dollars of
loans and investments. Barclays paid a large fine in June to avoid civil and criminal
charges that could have been brought by U.S. and U.K. authorities. The Swiss giant UBS was
reportedly close to a similar settlement as of this writing. Other major banks, including
JPMorgan, Bank of America, and Deutsche Bank, are under civil or criminal investigation
(or both), though no charges have yet been filed.
Libor reflects how
much banks charge when they lend to each other; it is a measure of their confidence in
each other. Now the rate has become synonymous with manipulation and collusion. In other
words, one can’t even trust the gauge that is meant to show how much trust exists
within the financial system.
Accusations of
illegal, clandestine bank activities are also proliferating. Large global banks have been
accused by U.S. government officials of helping Mexican drug dealers launder money (HSBC),
and of funneling cash to Iran (Standard Chartered). Prosecutors have charged American
banks with falsifying mortgage records by “robo-signing” papers to rush the
process along, and with improperly foreclosing on borrowers. Only after the financial
crisis did people learn that banks routinely misled clients, sold them securities known to
be garbage, and even, in some cases, secretly bet against them to profit from their
ignorance.
When we asked Ed
Trott, a former Financial Accounting Standards Board member, whether he trusted bank
accounting, he said, simply, “Absolutely not.”
Together, these
incidents have pushed public confidence ever lower. According to Gallup, back in the late
1970s, three out of five Americans said they trusted big banks “a great deal” or
“quite a lot.” During the following decades, that trust eroded. Since the
financial crisis of 2008, it has collapsed. In June 2012, fewer than one in four
respondents told Gallup they had faith in big banks—a record low. And in October,
Luis Aguilar, a commissioner at the Securities and Exchange Commission, cited separate
data showing that “79 percent of investors have no trust in the financial
system.”
When we asked Dane
Holmes, the head of investor relations at Goldman Sachs, why so few people trust big
banks, he told us, “People don’t understand the banks,” because “there
is a lack of transparency.” (Holmes later clarified that he was talking about average
people, not the sophisticated investors with whom he interacts on an almost hourly basis.)
He is certainly right that few students or plumbers or grandparents truly understand what
big banks do anymore. Ordinary people have lost faith in financial institutions. That is a
big enough problem on its own.
But an even bigger
problem has developed—one that more fundamentally threatens the safety of the
financial system—and it more squarely involves the sort of big investors with whom
Holmes spends much of his time. More and more, the people in the know don’t trust big
banks either.
After all the
purported “cleansing effects” of the panic, one might have expected big,
sophisticated investors to grab up bank stocks, exploiting the timidity of the average
investor by buying low. Banks wrote down bad loans; Treasury certified the banks’
health after its “stress tests”; Congress passed the Dodd-Frank reforms to
regulate previously unfettered corners of the financial markets and to minimize the impact
of future crises. During the 2008 crisis, many leading investors had gotten out of bank
stocks; these reforms were designed to bring them back.
And indeed, they did
come back—at first. Many investors, including Warren Buffett, say bank stocks were
underpriced after the crisis, and remain so today. Most large institutional investors,
such as mutual funds, pension funds, and insurance companies, continue to hold substantial
stakes in major banks. The Federal Reserve has tried to help banks make profitable loans
and trades, by keeping interest rates low and pumping trillions of dollars into the
economy. For investors, the combination of low stock prices, an accommodative Fed, and
possibly limited downside (the federal government, needless to say, has shown a
willingness to assist banks in bad times) can be a powerful incentive.
Yet the limits to
big investors’ enthusiasm are clearly reflected in the data. Some four years after
the crisis, big banks’ shares remain depressed. Even after a run-up in the price of
bank stocks this fall, many remain below “book value,” which means that the
banks are worth less than the stated value of the assets on their books. This indicates
that investors don’t believe the stated value, or don’t believe the banks will
be profitable in the future—or both. Several financial executives told us that they
see the large banks as “complete black boxes,” and have no interest in investing
in their stocks. A chief executive of one of the nation’s largest financial
institutions told us that he regularly hears from investors that the banks are
“uninvestable,” a Wall Street neologism for “untouchable.”
That’s an
increasingly widespread view among the most sophisticated leaders in investing circles.
Paul Singer, who runs the influential investment fund Elliott Associates, wrote to his
partners this summer, “There is no major financial institution today whose financial
statements provide a meaningful clue” about its risks. Arthur Levitt, the former
chairman of the SEC, lamented to us in November that none of the post-2008 remedies has
“significantly diminished the likelihood of financial crises.” In a recent
conversation, a prominent former regulator expressed concerns about the hidden risks that
banks might still be carrying, comparing the big banks to Enron.
A recent survey by
Barclays Capital found that more than half of institutional investors did not trust how
banks measure the riskiness of their assets. When hedge-fund managers were asked how
trustworthy they find “risk weightings”—the numbers that banks use to
calculate how much capital they should set aside as a safety cushion in case of a business
downturn—about 60 percent of those managers answered 1 or 2 on a five-point scale,
with 1 being “not trustworthy at all.” None of them gave banks a 5.
A disturbing number
of former bankers have recently declared that the banking industry is broken (this
newfound clarity typically follows their passage from financial titan to rich retiree).
Herbert Allison, the ex-president of Merrill Lynch and former head of the Obama
administration’s Troubled Asset Relief Program, wrote a scathing e-book about the
failures of the large banks, stopping just short of labeling them all vampire squids. A
parade of former high-ranking executives has called for bank breakups, tighter regulation,
or a return to the Depression-era Glass-Steagall law, which separated commercial banking
from investment banking. Among them: Philip Purcell (ex-CEO of Morgan Stanley Dean
Witter), Sallie Krawcheck (ex-CFO of Citigroup), David Komansky (ex-CEO of Merrill Lynch),
and John Reed (former CEO of Citigroup). Sandy Weill, another ex-CEO of Citigroup, who
built a career on financial megamergers, did a stunning about-face this summer, advising,
with breathtaking chutzpah, that the banks should now be broken up.
Bill Ackman’s
journey is particularly telling. One of the nation’s highest-profile and most
successful investors, Ackman went from being a skeptic of investing in big banks, to being
a believer, and then back again—with a loss of hundreds of millions along the way. In
2010, Ackman bought an almost $1 billion stake in Citigroup for Pershing Square, the $11
billion fund he runs. He reasoned that in the aftermath of the crisis, the big banks had
written down their bad loans and become more conservative; they were also facing less
competition. That should have been a great environment for investment, he says. He had
avoided investing in big banks for most of his career. But “for once,” he told
us, “I thought you could trust the carrying values on bank books.”
Last spring,
Pershing Square sold its entire stake in Citigroup, as the bank’s strategy drifted,
at a loss approaching $400 million. Ackman says, “For the first seven years of
Pershing Square, I believed that an investor couldn’t invest in a giant bank. Then I
felt I could invest in a bank, and I did—and I lost a lot of money doing it.”
A crisis of trust
among investors is insidious. It is far less obvious than a sudden panic, but over time,
its damage compounds. It is not a tsunami; it is dry rot. It creeps in, noticed
occasionally and then forgotten. Soon it is a daily fact of life. Even as the economy
begins to come back, the trust crisis saps the recovery’s strength. Banks can’t
attract capital. They lose customers, who fear being tricked and cheated. Their executives
are, by turns, traumatized and enervated. Lacking confidence in themselves as they grapple
with the toxic legacies of their previous excesses and mistakes, they don’t lend as
much as they should. Without trust in banks, the economy wheezes and stutters.
And, of course, as
trust diminishes, the likelihood of another crisis grows larger. The next big storm might
blow the weakened house down. Elite investors—those who move markets and control the
flow of money—will flee, out of worry that the roof will collapse. The less they
trust the banks, the faster and more decisively they will beat that
path—disinvesting, freezing bank credit, and weakening the structure even more. In
this way, fear becomes reality, and troubles that might once have been weathered become
existential.
At the heart of the
problem is a worry about the accuracy of banks’ financial statements. Some of the
questions are basic: How do banks account for loans? Can investors accurately assess the
value of those loans? Others are far more complicated: What risks are posed by complex
financial instruments, such as the ones that caused JPMorgan’s massive loss? The
answers are supposed to be found in the publicly available quarterly and annual reports
that banks file with the Securities and Exchange Commission.
The Financial
Accounting Standards Board, an independent private-sector organization, governs the
accounting in these filings. Don Young, currently an investment manager, was a board
member from 2005 to 2008. “After serving on the board,” he recently told us,
“I no longer trust bank accounting.”
Accounting rules
have proliferated as banks, and the assets and liabilities they contain, have become more
complex. Yet the rules have not kept pace with changes in the financial system. Clever
bankers, aided by their lawyers and accountants, can find ways around the intentions of
the regulations while remaining within the letter of the law. What’s more, because
these rules have grown ever more detailed and lawyerly—while still failing to cover
every possible circumstance—they have had the perverse effect of allowing banks to
avoid giving investors the information needed to gauge the value and risk of a bank’s
portfolio. (That information is obscured by minutiae and legalese.) This is true for the
complicated questions about financial innovation and trading, but it also is true for the
basic questions, such as those involving loans.
At one point during
Young’s tenure, some members of the Financial Accounting Standards Board wanted to
make banks account for loans in the same way they do for securities, by recording them at
current market values, a method known as “fair value.” Banks were instead
recording the value of their loans at the initial loan amount, and setting aside a reserve
based on their assumptions about how likely they were to get paid back. The rules also
allowed banks to use different methods to measure the value of the same kind of loans,
depending on whether the loans were categorized as ones they planned to keep for a long
time or instead as ones they planned to sell. Many accounting experts believed that the
reported numbers did not give investors an accurate or reliable picture of a bank’s
health.
After bitter
battles, turnover on the board, worries about acting in the middle of the financial
crisis, and aggressive bank lobbying, the accounting mandarins preserved the existing
approach instead of switching to fair-value accounting for loans. Young believes that the
numbers are even less reliable now. “It’s gotten worse,” he says. When we
asked another former board member, Ed Trott, whether he trusted bank accounting, he said,
simply, “Absolutely not.”
The problem extends
well beyond the opacity of banks’ loan portfolios—it involves almost every
aspect of modern bank activity, much of which involves complex investment and trading, not
merely lending. Kevin Warsh, an ex–Morgan Stanley banker and a former Federal Reserve
Board member appointed by George W. Bush, says woeful disclosure is a major problem. Look
at the financial statements a big bank files with the SEC, he says: “Investors
can’t truly understand the nature and quality of the assets and liabilities. They
can’t readily assess the reliability of the capital to offset real losses. They
can’t assess the underlying sources of the firms’ profits. The disclosure
obfuscates more than it informs, and the government is not just permitting it but seems to
be encouraging it.”
Accounting rules are
supposed to help investors understand the companies whose shares they buy. Yet current
disclosure requirements don’t illuminate banks’ financial statements; instead,
they let the banks turn out the lights. And in that darkness, all sorts of unsavory
practices can breed.
We decided to go on
an adventure through the financial statements of one bank, to explore exactly what they do
and do not show, and to gauge whether it is possible to make informed judgments about the
risks the bank may be carrying. We chose a bank that is thought to be a conservative
financial institution, and an exemplar of what a large modern bank should be.
Wells Fargo was
founded on trust. Its logo has long been a strongly sprung six-horse stagecoach, a fleet
of which once thundered across the American West, loaded with gold. According to the
firm’s official history, “In the boom and bust economy of the 1850s, Wells Fargo
earned a reputation of trust by dealing rapidly and responsibly with people’s
money.” People believed Wells Fargo would keep their money safe—the bank’s
paper drafts were as good as the gold it shipped throughout the country.
For a century and a
half, Wells Fargo stock was also like gold, which is what led Warren Buffett to buy a
stake in the bank in 1990. Since then, Buffett and Wells Fargo have been inextricably
linked. As of fall 2012, Buffett’s firm, Berkshire Hathaway, owned about 8 percent of
Wells Fargo’s shares.
Today, Wells Fargo
still prominently displays the stagecoach logo at branches, in advertising, on the
12,000-plus ATMs that dot the country, and even at the bank’s museum stores. There,
visitors can buy wholesome, family-friendly items: a stagecoach night light; stagecoach
salt and pepper shakers; a hand-painted ceramic stagecoach pillbox. These are more than
tchotchkes. They are emblems of the bank’s honest and honorable mission.
Buffett’s
impeccable reputation has rubbed off on the bank. Wells Fargo is widely regarded as the
most conservative of the nation’s biggest banks. Many investors, regulators, and
analysts still believe its financial reports reflect a full, fair, and accurate picture of
its business. The market value of Wells Fargo’s shares is now the highest of any U.S.
bank: $173 billion as of early December 2012. The enthusiasm for Wells Fargo reflects the
bank’s good reputation, as well as one seemingly simple fact: the bank earned solid
net income of nearly $16 billion in 2011, up 28 percent from 2010.
To find out
what’s behind that fact, you have to read Wells Fargo’s annual report—and
that is where we began our adventure. The annual report is a special document: it is the
place where a bank sets forth the audited details of its business. Although banks also
submit unaudited quarterly reports and other periodical documents to the SEC, and have
conference calls with analysts and shareholders, the annual report gives investors the
most complete and, supposedly, reliable picture.
(Today, big banks
have to answer to a dizzying litany of regulators—not only the SEC, but also the
Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit
Insurance Corporation, the Commodity Futures Trading Commission, the newly created
Consumer Financial Protection Bureau, and so on. The disclosure regimes vary, adding to
the confusion. Banks confidentially release additional information to these regulators,
but investors do not have access to those details. That regulators have these extra,
confidential disclosures isn’t much comfort: given the inability of regulators to
police the banks in recent years, one of the only groups that investors trust less than
bankers is bank regulators.)
Wells Fargo’s
most recent annual report, covering 2011, is 236 pages long. It begins like a book an
average person might enjoy: a breezy journey through a year in a bank’s life. On the
cover, that stagecoach appears. The first page has a moving story about a customer. The
next few pages are filled with images of guys in cowboy hats, a couple holding hands by
the ocean, cupcakes, and solar panels. In bold 50 point font, Wells Fargo reports that it
contributed $213.5 million to nonprofits during the year, and it even does the math to
make sure we appreciate its generosity: “$4.1 million every week or $585,000 every
day or $24,000 every hour.” The introduction’s capstone is this: “We
don’t take trust for granted. We know we have to earn it every day in our
conversations and actions with our customers. Here’s how we try to do that.”
The sheer volume of
“trading” at Wells Fargo suggests that the bank is not what it seems.
Fortunately for
Wells Fargo, most people do not read past the introduction. In the pages that follow, the
sunny faces of satisfied customers disappear. So do the stories. The narrative is replaced
by details about the bank’s businesses that range from the incomprehensible to the
disturbing. Wells Fargo told us it devotes “significant resources to fulfilling all
reporting requirements of various regulators.” Nevertheless, these disclosures
wouldn’t earn anyone’s trust. They are littered with language that says nothing,
at length. The report is riddled with progressively more opaque footnotes—the
financial equivalent of Dante’s descent into hell. Indeed, after the friendly
introduction, the report ought to bear a warning to the inquisitive reader intent on truly
understanding the bank’s financial positions: “Abandon all hope, ye who enter
here.”
The first circle of
Wells Fargo’s version of the Inferno, like Dante’s Limbo, merely hints at what
is to come, yet it is nonetheless unsettling. One of the main purposes of an annual report
is to tell investors how a company makes money. Along these lines, Wells Fargo splits its
businesses into two apparently simple and distinct parts—“interest income”
and “noninterest income.” At first blush, these two categories appear to
parallel the two traditional sources of banking income: interest from loans and customer
fees.
But here the descent
begins. Suddenly, this folksy mortgage bank starts showing signs of a split personality.
It turns out that trading activities, the type associated with Wall Street firms like
Goldman Sachs and Morgan Stanley, contribute significantly to each of Wells Fargo’s
two categories of income. Almost $1.5 billion of its “interest income” comes
from “trading assets”; another $9.1 billion results from “securities
available for sale.”
One billion dollars
of the bank’s “noninterest income” are “net gains from trading
activities.” Another $1.5 billion is income from “equity investments.” Up
and down the ledger, abstruse, all-embracing categories appear: “other fees earned
from related activities,” “other interest income,” and just plain
“other.” The income statement’s “other” catchalls collectively
amounted to $6.6 billion of Wells Fargo’s income in 2011. It will take the devoted
reader 50 more pages to find out that the bank derives a big chunk of that
“other” income from, yes, “trading activities.” The sheer volume of
“trading” at Wells Fargo suggests that the bank is not what it seems.
Some bank analysts
say these trading numbers are small relative to the bank’s overall revenue ($81
billion in 2011) and profit (again, $16 billion in 2011). Other observers don’t even
bother to look at these details, because they assume Wells Fargo is protected from trading
losses by its capital reserves of $148 billion. That number, assuming it is accurate, can
make any particular loss appear minuscule. For example, buried at the bottom of page 164
of Wells Fargo’s annual report is the following statement: “In 2011, we incurred
a $377 million loss on trading derivatives related to certain CDOs,” or
collateralized debt obligations. Just a few years ago, a bank’s nine-figure loss on
these sorts of complex financial instruments would have generated major headlines. Yet
this one went unremarked upon in the media, even by top investors, analysts, and financial
pundits. Perhaps they didn’t read all the way to page 164. Or perhaps they had become
so numb from bigger bank losses that this one didn’t seem to matter. Whatever the
reason, Wells Fargo’s massive CDO-derivatives loss was a multi-hundred-million-dollar
tree falling silently in the financial forest. To paraphrase the late Senator Everett
Dirksen, $377 million here and $377 million there, and pretty soon you’re talking
about serious money.
Even conservatively
run banks can be risky, as George Bailey learned in It’s a Wonderful Life. But
the Bailey Building and Loan Association did not earn money from trading. Trading is an
inherently opaque and volatile business. It is subject to the vagaries of the markets. And
yet in the past two decades, as profits from traditional lending and brokering activities
have been squeezed, banks have turned more and more to trading in order to make money.
Today, banks’
trading operations involve more leverage, or borrowed money, than in the past. Banks also
obtain a form of leverage by promising to pay money in the future if some event
doesn’t go their way (much like an insurance company must pay out a lot of money if a
house it covers burns down). These promises come in the form of derivatives, financial
instruments that can be used to hedge against various risks—like the possibility that
interest rates will rise or the likelihood that a company will default on its
debts—or simply to place bets on those same possibilities, hoping to profit. Because
many of these bets are both large and complex, trading carries the potential for
catastrophic losses.
The cryptic way
Wells Fargo describes its trading raises many questions. The bank breaks what it calls
“net gains from trading activities”—which doesn’t cover all of its
trading income, but is an important part—into three subcategories, leaving the
annual-report reader to play a kind of shell game.
Look first at
“proprietary” trading—activity a firm undertakes to make money for its own
account by buying or selling stocks, bonds, or more-exotic financial creations.
Self-evidently, this activity might involve big risks. When this shell is lifted, the
bank’s exposure seems reassuringly inconsequential: the reported loss is just $14
million. Still, there may be more under this shell than meets the eye: that $14 million
might not be indicative of the bank’s true exposure. Was Wells Fargo just lucky to
finish slightly down after a roller-coaster year of wild gambling with much bigger gains
and losses? Without more information about the size of the bank’s bets, it is
impossible to know.
A second subcategory
is “economic hedging.” An activity labeled “hedging” might sound
soothing. Wells Fargo says it lost an inconsequential $1 million from economic hedging in
2011. So maybe there is nothing to worry about under this shell, either. In its pure form,
hedging is supposed to reduce risk. A person buys a house and then hedges the risk of a
fire by purchasing insurance. But hedging in the world of finance is more complex—so
much so that it requires advanced mathematics and computer modeling, and still can be
little better than guesswork. It is difficult to anticipate how a portfolio of complicated
financial instruments will respond as variables like interest rates and stock prices go up
and down. As a result, hedges don’t always work as intended. They may not fully
eliminate large risks that banks think they’ve taken care of. And they may
inadvertently create new, hidden risks—“unknown unknowns,” if you will.
Because of all this complexity, some traders can disguise speculative positions as
“hedges” and claim their purpose is to reduce risk, when in fact the traders are
purposely taking on more risk to try to make a profit. That is what the traders within
JPMorgan’s Chief Investment Office appear to have been doing. Was Wells Fargo’s
“economic hedging” like buying straightforward insurance? Or was it more like
speculation—what JPMorgan did? Do the reported numbers suggest low risk when in fact
the opposite is true? The bank’s disclosures don’t answer these questions.
Finally we come to a
third shell—and there’s unquestionably something to see under this one. It
carries an innocuous label: “customer accommodation.” Wells Fargo made more than
$1 billion from customer-accommodation trading in 2011. How did it make so much money
merely by helping customers? This should be a plain-vanilla business: a broker sits
between a buyer and a seller and takes a little cut of the transaction. But what we
learned from the 2008 financial crisis, and what we keep learning from incidents such as
the JPMorgan scandal, is that seemingly innocuous activities that appear highly profitable
can be dangerous to a bank’s health—and to our economy.
Don’t look to
the annual report for clarity. Here is the bank’s definition: “Customer
accommodation trading consists of security or derivative transactions conducted in an
effort to help customers manage their market price risks and are done on their behalf or
driven by their investment needs.”
That might seem
safe, but the report notably fails to explain why this activity would be so profitable. In
fact, at many large banks, customer accommodation can be a euphemism for
“massive derivatives bets.” For Wells Fargo, the subcategory of “customer
accommodation, trading and other free-standing derivatives” included derivatives
trades of about $2.8 trillion in “notional amount” as of the end
of 2011, meaning that the underlying positions referenced in the bank’s derivatives
were that large then. By way of explanation: if we were to make a bet with you about how
much the price of a $70 share of Walmart would change this year—we pay you any
increase, you pay us any decrease—we’d say the “notional amount” of
the bet is $70.
Wells Fargo
doesn’t expect to gain or lose $2.8 trillion on its derivatives, any more than we
would expect the payment on our Walmart bet to be $70. Bankers generally assume that the
likely risk of gain or loss on derivatives is much smaller than their “notional
amount,” and Wells Fargo says the concept “is not, when viewed in isolation, a
meaningful measure of the risk profile of the instruments.” Moreover, Wells Fargo
reports that many of its derivatives offset each other, as yours might if you placed
several wagers that Walmart stock would go up, along with several other bets that it would
go down.
Yet, as investors in
bank stocks learned in 2008, it is possible to lose a large portion of the “notional
amount” of a derivatives trade if a bet goes terribly wrong. In the future, if
interest rates skyrocket or the euro unravels, Wells Fargo might sustain huge derivatives
losses, just as you might lose the full $70 you bet on Walmart if the company went bust.
Wells Fargo doesn’t tell investors how much of the $2.8 trillion it could lose in a
worst-case scenario, nor is it required to. Even a savvy investor who reads the footnotes
can only guess at what the bank’s potential risk exposure to derivatives might be.
One reason Wells
Fargo is trusted more than other big banks is that its notional amount of derivatives is
comparatively small. At the end of the third quarter of 2012, JPMorgan had $72 trillion in
notional amount on its books—about five times the size of the U.S. economy. But even
at Wells Fargo levels, the numbers are so large that they lose their meaning. And they put
Wells Fargo’s seemingly immense capital reserves—$148 billion, you’ll
recall—in a rather different light.
How much risk is the
bank actually taking on these trades? For which customers does it place a requested bet,
then negate its risk by taking an exactly offsetting position in the market, so that it is
essentially acting as an agent simply taking a commission? And for all these trades, what
risk is Wells Fargo taking on its customers? Many of these bets involve the
customers’ promises to pay Wells Fargo depending on how certain financial numbers
change in the future. But what happens if some of those customers go bankrupt? How much
money would Wells Fargo lose if it “accommodates” customers who can’t pay
what they owe?
We asked Wells Fargo
officials if we could talk to someone at the bank about its disclosures, including those
concerning its trading and derivatives. They declined. Instead, they suggested we submit
questions in writing, which we did.
In response, Wells
Fargo public-relations representatives wrote, “We believe our disclosures on the
topics you raised are comprehensive and stand on their own.” In answering our written
questions about the annual report, the representatives simply pointed us back to the
annual report. For example, when we inquired about the bank’s trading activities,
Wells Fargo responded: “We would ask you to refer to our discussion of ‘Market
Risk-Trading Activities’ on pages 80–81 in the Management Discussion and
Analysis section of the Wells Fargo 2011 Annual Report.”
Yet it was precisely
those pages that generated our questions about the bank’s various categories of
trading. When we specifically asked Wells Fargo to help us quantify the risks associated
with customer-accommodation trading, its representatives pointed us to those same pages.
But those pages don’t answer that question. Here is the most helpful of the
bank’s disclosures related to customer-accommodation trading:
For the majority of
our customer accommodation trading we serve as intermediary between buyer and seller. For
example, we may enter into financial instruments with customers that use the instruments
for risk management purposes and offset our exposure on such contracts by entering into
separate instruments. Customer accommodation trading also includes net gains related to
market-making activities in which we take positions to facilitate expected customer order
flow.
Bankers, and their
lawyers, are careful about the language they use in annual reports. So why did they use
the word expected in discussing customer order flow in that last sentence? Is Wells
Fargo speculating based on what one of its traders “expects” a customer to do,
instead of responding to what a customer actually has done? The language the bank pointed
to for answers to our questions only raises more questions.
Wells Fargo’s
annual report is filled with similarly cryptic declarations, but not the crucial
information that investors actually need. It doesn’t describe worst-case scenarios
for customer-accommodation trades, or even include any examples of what such trades might
involve. When we asked straightforward questions—such as “How much money would
Wells Fargo lose from these trades under various scenarios?”—the bank’s
representatives declined to answer.
Only a few people
have publicly expressed concerns about customer-accommodation trades. Yet some banking
experts are skeptical of these trades, and suspect that they hide huge risks. David
Stockman, who was the federal budget director under President Reagan, an investment banker
at Salomon Brothers, and a partner at the private-equity firm Blackstone Group, calls the
big banks “massive trading operations.” Stockman has become so disillusioned by
America’s financial system that he is now regarded, in some quarters, as a wild-eyed
heretic, but his expertise is undeniable. He recently told reporters for “The Gold
Report,” an online newsletter, “Whether they called it customer accommodation or
proprietary is a distinction without a difference.”
Bankers and
regulators today might dismiss warnings that customer-accommodation derivatives could
bring down the financial system as implausible. But a few years ago, they said the same
thing about credit-default swaps and collateralized debt obligations.
The penultimate stop
on our expedition through Wells Fargo’s annual disclosures brings us to one of the
most important concepts in bank reporting: fair value. It’s the topic that led Don
Young to conclude that he could not trust banks’ accounting after fighting about it
on the Financial Accounting Standards Board. Banks hold huge amounts of assets and
liabilities, including derivatives, and are supposed to record them at their “fair
value.” Fair enough? Not so fast.
Like other banks,
Wells Fargo uses a three-level hierarchy to report the fair value of its securities. Level
1 includes securities traded in active, public markets; it isn’t too scary. At Level
1, fair value simply means the reported price of a security. If Wells Fargo owned a
stock or bond traded on the New York Stock Exchange, fair value would be the closing price
each day.
Level 2 is more
worrisome. It includes some shadier characters, such as derivatives and mortgage-backed
securities. There are no active, public markets for these investments—they are bought
and sold privately, if at all, and are not listed on exchanges—so Wells Fargo uses
other methods to figure out fair value, including what it calls “model-based
valuation techniques, such as matrix pricing.” At Level 2, fair value is what
accountants would charitably describe as an “estimate,” based on statistical
computer models and what they call “observable” inputs, such as the prices of
similar assets or other market data. At Level 2, fair value is more like an educated
guess.
Many banks’
stocks are below “book value” today. This indicates that investors don’t
believe the stated value of the assets on banks’ books, or don’t believe banks
will be profitable in the future—or both.
Level 3 is
hair-raising. The bank’s Level 3 estimates are “generated primarily from
model-based techniques that use significant assumptions not observable in the
market.” In other words, not only are there no data about the prices at which these
types of assets have recently traded, but there are no observable data to inform the
assumptions one might use to generate prices. Level 3 contains the most-esoteric financial
instruments—including the credit-default swaps and synthetic collateralized debt
obligations that became so popular and prevalent at the height of the housing boom,
filling the balance sheets of Bear Stearns, Merrill Lynch, Citigroup, and many other
banks.
At Level 3, fair
value is a guess based on statistical models, but with inputs that are “not
observable.” Instead of basing estimates on market data, banks use their own
assumptions and internal information. At Level 3, fair value is an uneducated guess.
Surely, one would
assume, Wells Fargo’s assets would mostly reside on Level 1, with perhaps a small
amount on Level 2. It’s just a simple mortgage bank, right? And it seems
inconceivable that Wells Fargo would be loaded with Level 3 investments long after
regulators have supposedly purged the banks of toxic assets and nursed them back to
health.
Yet only a small
fraction of Wells Fargo’s assets are on Level 1. Most of what the bank holds is on
Level 2. And a whopping $53 billion—equivalent to more than a third of the
bank’s capital reserves—is on Level 3. All three categories include risky assets
that might lose value in the future. But the additional concern with Level 2 and Level 3
assets is that banks might have errantly recorded them at values that were inflated to
begin with. There is no way to check whether reported values are accurate; investors have
to trust the bank’s managers and auditors. Scholarly research on Level 3 assets
suggests that they can be misstated by as much as 15 percent at any given time, even if
the market is stable. If Wells Fargo’s estimates are that far off, the bank could be
sitting on billions of dollars of hidden losses.
Wells Fargo
discloses in a quiet footnote in small print on page 133 of the annual report that its
Level 3 assets include “collateralized loan obligations with both a cost basis and
fair value of $8.1 billion, at December 31, 2011.” In English, that means that the
bank is recording the value of some of its most complicated investments (composed of
packages of loans to companies) at exactly the price it paid for them (the “cost
basis”). Were these products bought a year ago? Two? Before the crash of 2008? Have
they actually retained their value? Don Young finds it curious that the fair value and
cost basis would be the same. “With interest rates much lower than most expected, why
didn’t the CLOs rise in value?” he asks. But he’s the first to admit that
he’s really in no position to say. Without more information about the composition of
the loan packages and when they were purchased, an outsider cannot determine what these
assets might be worth.
Accountants and
regulators insist that categorizing an investment as Level 1, 2, or 3 is better than
simply recording the investment’s original cost. But the current system permits
bankers to use their own internally generated estimates. Who oversees those estimates?
Auditors who are dependent on the bank for significant revenue, and regulators who are
endemically behind the curve. Such a setup erodes trust. And when that trust disappears,
so does any confidence in what the bank says its investments are worth.
The Level 3 issue
isn’t simply theoretical. One major problem during the 2008 crisis was that banks and
investors didn’t know what to trust about Level 3, so they panicked. We just suffered
through a crisis in Level 3 assets. We can’t afford another.
There is an even
lower circle of financial hell. It is populated with complex financial monsters once known
as “special-purpose entities.” These were the infamous accounting devices that
Enron employed to hide its debts. Around the turn of the millennium, the Texas
energy-trading firm used these newly created corporations to borrow money and take on
risks without recording the liabilities in its financial statements. These deals were
called “off-balance-sheet” transactions, because they did not appear on
Enron’s balance sheet.
Suppose a company
owns a slice—just a small percentage—of another company that has a lot of debt.
The first company might claim that it doesn’t need to include all of the second
company’s assets and liabilities on its balance sheet. Let’s say we owned shares
of IBM. We aren’t suddenly on the hook for all of the company’s liabilities. But
if we owned so many IBM shares that we effectively controlled it, or if we had a side
agreement that made us responsible for IBM’s debts, common sense dictates that we
should treat IBM’s liabilities as our own. A decade ago, many companies, including
Enron, used special-purpose entities to avoid common sense: they kept liabilities off the
balance sheet, even when they had such control or side agreements.
As in a horror film,
the special-purpose entity has been reanimated, and is now known as the variable-interest
entity. In the alphabet soup of Wall Street, the acronym has switched from SPE to VIE, but
the idea is the same. Big companies create these entities to borrow money and buy assets,
but—like Enron—they do not include them on their balance sheets. The problem is
especially worrisome at banks: every major bank has substantial positions in VIEs.
As of the end of
2011, Wells Fargo reported “significant continuing involvement” with
variable-interest entities that had total assets of $1.46 trillion. The
“maximum exposure to loss” it reports is much smaller, but still substantial:
just over $60 billion, more than 40 percent of its capital reserves. The bank says the
likelihood of such a loss is “extremely remote.” We can hope.
However, Wells Fargo
acknowledges that even these eye-popping numbers do not include its entire exposure to
variable-interest entities. The bank excludes some VIEs from consideration, for many of
the same reasons Enron excluded its special-purpose entities: the bank says that its
continuing involvement is not significant, that its investment is temporary or small, or
that it did not design or operate these deals. (Wells Fargo isn’t alone; other major
banks also follow this Enron-like approach to disclosure.)
We asked Wells Fargo
to explain its VIE disclosures, but its representatives once again simply pointed us back
to the annual report. We specifically asked about the bank’s own reported corrections
of these numbers (in one footnote, Wells Fargo cryptically says, “?‘VIEs that we
consolidate’ has been revised to correct previously reported amounts”). But the
bank would not tell us anything about those corrections. From the annual report, one
cannot determine which VIEs were involved, or how big the corrections were.
Don Young calls
variable-interest entities “accounting gimmicks to avoid consolidation and
disclosure.” The Financial Accounting Standards Board changed the accounting rules
that govern them in recent years, but the new rules, he says, are easy to manipulate, just
like the old ones were. The presence of VIEs on Wells Fargo’s balance sheet “is
a signal that there is $1.5 trillion of exposure to complete unknowns.”
These disclosures
make even an ostensibly simple bank like Wells Fargo impossible to understand. Every major
bank’s financial statements have some or all of these problems; many banks are much
worse. This is an untenable situation. Kevin Warsh, formerly of the Fed, argues that the
SEC should tell the biggest banks that their accounts are unacceptably opaque. “The
banks should give a full, fair, and accurate account of their financial positions,”
he says, “and they are failing that test.”
In the decades
following the 1929 crash, banks were understandable. That’s not because they were
financially simple—that era had its own versions of derivatives and special-purpose
entities—but because the banks’ disclosures were more straightforward and clear.
That clarity sprang from the fear of consequences. The law, as Oliver Wendell Holmes Jr.
said, is a prediction of what a court will do. And the broadly scoped laws of that time
gave courts wide latitude.
Going to jail for
financial fraud was a real risk back then, and bank executives worried that their
reputations would be destroyed if a judge criticized what they had done. Richard Whitney,
a broker who had been the president of the New York Stock Exchange, was sent to Sing Sing
prison in 1938 for embezzlement. “Sunshine Charlie” Mitchell, the president of
National City Bank, the predecessor to Citibank, was indicted for tax evasion after the
1929 crash and was also the first of many bankers to testify before the famous Senate
Pecora Committee in 1933. The Pecora investigation galvanized public opinion, and helped
usher in the landmark banking and securities laws of 1933 and 1934. The scrutiny and
continuing threat of prosecution convinced many bank executives that they should keep
their business simple and transparent, or worry about the consequences if they did not.
In the wake of the
recent financial crisis, the government has moved to give new powers to the regulators who
oversee the markets. Some experts propose that the banking system needs more capital.
Others call for a return to Glass-Steagall or a full-scale breakup of the big banks. These
reforms could help, but none squarely addresses the problem of opacity, or the mischief
that opacity enables.
The starting point
for any solution to the recurring problems with banks is to rebuild the twin pillars of
regulation that Congress built in 1933 and 1934, in the aftermath of the 1929 crash.
First, there must be a straightforward standard of disclosure for Wells Fargo and its
banking brethren to follow: describe risks in commonsense terms that an investor can
understand. Second, there must be a real risk of punishment for bank executives who
mislead investors, or otherwise perpetrate fraud and abuse.
These two pillars
don’t require heavy-handed regulation. The straightforward disclosure regime that
prevailed for decades starting in the 1930s didn’t require extensive legal rules. Nor
did vigorous prosecution of financial crime.
Until the 1980s,
bank rules were few in number, but broad in scope. Regulation was focused on commonsense
standards. Commercial banks were not permitted to engage in investment-banking activity,
and were required to set aside a reasonable amount of capital. Bankers were prohibited
from taking outsize risks. Not every financial institution complied with the rules, but
many bankers who strayed were judged, and punished.
Since then, however,
the rules have proliferated, the arguments about compliance have become ever more
technical, and the punishments have been minor and rare. Not a single senior banker from a
major firm has gone to prison for conduct related to the 2008 financial crisis; few even
paid fines. The penalties paid by banks are paltry compared with their profits and bonus
pools. The cost-benefit analysis of such a system tilts in favor of recklessness, in large
part because of the complex web of regulation: bankers can argue that they comply with the
letter of the law, even when they violate its spirit.
As rules have
proliferated, arguments about compliance have become more technical, and punishments have
been rare. Not one senior banker from a major firm has gone to prison for conduct related
to the 2008 financial crisis.
In an important call
to arms this past summer, Andrew Haldane, the Bank of England’s executive director
for financial stability, laid out the case for an international regulatory overhaul.
“For investors today, banks are the blackest of boxes,” he said. But regulators
are their facilitators. Haldane noted that a landmark regulatory agreement from 1988
called Basel I amounted to a mere 18 pages in the U.S. and 13 pages in the U.K. Likewise,
disclosure rules were governed by a statute that was essentially one sentence long.
Basel II, the second
iteration of global banking regulation, issued in 2004, was 347 pages long. Documentation
for the new Basel III, Haldane noted, totals 616 pages. And federal regulations governing
disclosure are even longer than that. In the 1930s, a bank’s reports to the Federal
Reserve might have contained just 80 entries. Yet by 2011, Haldane said, quarterly
reporting to the Fed required a spreadsheet with 2,271 columns.
The Glass-Steagall
Act of 1933, which Haldane said was perhaps “the single most influential piece of
financial legislation of the 20th century,” was only 37 pages. In contrast,
2010’s Dodd-Frank law was 848 pages and required regulators to create so many new
rules (not fully defined by the legislation itself) that it could amount to 30,000 pages
of legal minutiae when fully codified. “Dodd-Frank makes Glass-Steagall look like
throat-clearing,” Haldane said.
What if legislators
and regulators gave up trying to adopt detailed rules after the fact and instead set up
broad standards of conduct before the fact? For example, consider one of the most heated
Dodd-Frank battles, over the “Volcker Rule,” named after former Federal Reserve
Chairman Paul Volcker. The rule is an attempt to ban banks from being able to make
speculative bets if they also take in federally insured deposits. The idea is
straightforward: the government guarantees deposits, so these banks should not gamble with
what is effectively taxpayer money.
Yet, under constant
pressure from banking lobbyists, Congress wrote a complicated rule. Then regulators larded
it up with even more complications. They tried to cover any and every contingency. Two and
a half years after Dodd-Frank was passed, the Volcker Rule still hasn’t been
finalized. By the time it is, only a handful of partners at the world’s biggest law
firms will understand it.
Congress and
regulators could have written a simple rule: “Banks are not permitted to engage in
proprietary trading.” Period. Then, regulators, prosecutors, and the courts could
have set about defining what proprietary trading meant. They could have established
reasonable and limited exceptions in individual cases. Meanwhile, bankers considering
engaging in practices that might be labeled proprietary trading would have been forced to
consider the law in the sense Oliver Wendell Holmes Jr. advocated.
Legislators could
adopt similarly broad disclosure rules, as Congress originally did in the Securities
Exchange Act of 1934. The idea would be to require banks to disclose all material facts,
without specifying how. Bankers would know that whatever they chose to put in their annual
reports might be assessed at some future date by a judge who would ask one simple
question: Was the report complete, clear, and accurate?
The standard of
proof for securities-fraud prosecutions, meanwhile, could and should be reduced from
intent,
which requires that prosecutors try to get inside the heads of bankers, to
recklessness,
which is less onerous to prove than intention, but more so than negligence. The goal of
this change would be to prevent bankers from being able to hide behind legalese. In other
words, even if they did not purposefully violate the law, because they had some technical
justification for their conduct, they still might be liable for doing something a
reasonable person in their position would not have done.
Senior bank
executives should face the threat of prosecution the same way businesspeople do in other
areas of the economy. When a CEO or CFO sits holding a pen, about to sign a certification
that his or her bank’s financial statements and controls are accurate and adequate,
he or she should pause and reflect that the consequences could include jail time. If bank
directors and executives had to think through their institution’s risks, disclose
them, and then face serious punishment if the disclosures proved inadequate, we might
begin to construct a culture of accountability.
A bank seeking to
comply with the principles we’ve laid out wouldn’t need to publish a 236-page
report with appendices. Instead, it could submit a statement perhaps one-tenth as long,
something that a reader who made it through the introduction to Wells Fargo’s current
annual report might actually continue reading. Ideally, a lay reader would be able to
understand how much a bank might gain or lose based on worst-case scenarios—what
would happen if housing prices drop by 30 percent, say, or the Spanish government defaults
on its debt? As for the details, banks could voluntarily provide information on their Web
sites, so that sophisticated investors had enough granular facts to decide whether the
banks’ broader statements were true. As the 2008 financial crisis was unfolding, Bill
Ackman’s Pershing Square obtained the details of complex mortgages and created a
publicly available spreadsheet to illustrate the risks of various products and
institutions. Banks that wanted to earn back investors’ trust could publish data so
that Ackman and others like him could test their more general statements about risk.
Is this just a
fantasy? The changes we’ve outlined would certainly be difficult politically. (What
isn’t, today?) But in the face of sufficient pressure, bankers might willingly agree
to a grand bargain: simpler rules and streamlined regulation if they subject themselves to
real enforcement.
Ultimately, these
changes would be for the banks’ own good. Banks need to be able to convince the
most-sophisticated people in the markets—investors like Bill Ackman—that they
are once again “investable.” Otherwise, investors will continue to worry about
which bank will be the next JPMorgan—or the next Lehman Brothers. Today, Ackman says
the risk of investing in a big bank is too great: “I think the JPMorgan loss was a
really bad loss for confidence. If the best CEO in the industry has a loss like that, what
about the other banks?” he says. “If JPMorgan can have a $5.8 billion derivative
problem, then any of these guys could—and $5.8 billion is not the upper bound.”
The banks provide
“a ton of disclosure,” Ackman notes. There are a lot of pages and details in any
bank’s annual report, including Wells Fargo’s. But “it’s what you
can’t figure out that’s terrifying.” In the gargantuan derivatives-trading
positions, for instance, he says, “you can’t figure out whether the bank has got
it right or not. That’s faith.”
A combination of
clearer, simpler disclosure and stronger enforcement would help clean up the system, just
as it did beginning in the 1930s. Not only would shareholders better understand
banks’ businesses, but managers would have the incentive to run their businesses more
ethically. The broad cultural failure on Wall Street has arisen in part because disclosure
rules encourage the banks to be purposefully opaque. Today, their lawyers don’t judge
whether statements are clear and meaningful but rather whether they are on the bleeding
edge of legality. If bank managers faced real consequences when their descriptions proved
inaccurate or incomplete, they would strive to make those descriptions as clear and simple
as Strunk and White’s The Elements of Style.
Perhaps there is a
silver lining in the loss of sophisticated investors’ trust. The disillusionment of
the elites, on top of popular outrage, could foment change. Without such a mobilization,
all of us will remain in the dark, neither understanding nor trusting the banks. And the
rot will spread.
Frank Partnoy is
a law and finance professor at the University of San Diego and the author of
Wait: The Art and Science of Delay. Jesse
Eisinger is a senior reporter at ProPublica and a columnist for
The New York Times’ Dealbook section.
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