Why the big banks are a mess

October 18, 2012

The biggest U.S. banks have released their latest quarterly financials, and the results for the third quarter were, well, so-so. Shares of major financial companies are up a meager 1.2 percent since the start of earnings season.

But that “meh” picture of the health of the major banks masks some deep turmoil within. And what the reports have in common is that they show how the biggest global banks still haven’t figured out what their business should be in a post-crisis world.

The headlines during the past week of earnings reports have shown that basic problem playing out in a number of ways.

●Vikram Pandit resigned Tuesday as chief executive of Citigroup (or, by some accounts, was pushed out), after five years running the behemoth bank.

●Bank of America said Wednesday that it earned a measly $340 million in the quarter, dropping 95 percent from a year earlier, as it was dragged down by an expensive legal settlement over mortgage securities from its 2008 emergency acquisition of Merrill Lynch.

●JPMorgan Chase added an additional $700 million to its reserves for future litigation losses and faces a new lawsuit from the New York attorney general over bad mortgage securities sold by Bear Stearns.

●At the big investment banks, both Morgan Stanley (which reported results Thursday) and Goldman Sachs reported solid financial results, but both are cutting jobs. Goldman has slashed 1,600 jobs, 5 percent of its workforce, in the past year, and Morgan said its payroll is down 9 percent from a year ago.

All of these banks are still grappling with the costs of the bad lending during the boom years before the crisis. They also are trying to determine how big they ought to be in a world where they cannot rely on such a large ratio of borrowed money (thanks to Basel III capital requirements), run some lucrative side businesses (thanks to the Volcker Rule that tries to stop proprietary trading) or have regulators all up in their noses over their ability to manage risk in their sprawling financial empires (thanks to the Dodd-Frank act).

In the old days, running a giant bank was, at least as the markets perceived it, a boring business. For long stretches in 2005 and 2006, shares of companies such as Citigroup were only slightly more volatile than the stock market as a whole: Citi shares were only 8 percent more volatile than the Standard & Poor’s 500 over some 90-day periods in 2005. These days the stock is 2.7 times as volatile as the market.

Markets now take for granted something that, with hindsight, should have been clearer back then: Running a big bank is a hairy business, filled with all sorts of financial, legal and regulatory risks. Those weren’t apparent during the halcyon days before 2007 and even now are hard to tabulate.

Consider the ongoing legal settlements. The banks have long since written down the direct losses from the bad mortgages on their books. What few would have foreseen is the long tail that has stretched from those lawsuits over bad lending.

In other words, the banks have long since written down their losses on “collateralized debt obligations,” securities created from various pieces of other mortgage securities like a Frankenstein’s monster. They’ve written down their losses on “CDO-squared,” the even more complicated variation in which CDOs were formed from pieces of other CDOs. But they are just now reckoning with CDO-cubed: the legal exposure they face from selling all those CDOs and CDOs-squared that turned out to be worthless.

Ironically, as JPMorgan chief executive Jamie Dimon has often pointed out, strong banks are now paying the bill for actions taken by the weaker companies that they acquired in fire sales — often at the government’s strong encouragement — during the crisis. JPMorgan ended up with Bear Stearns and Washington Mutual in its fold, along with all their dirty laundry; Bank of America snapped up Merrill Lynch and Countrywide; and Wells Fargo bought up Wachovia.

“I’m going to say we’ve lost $5 billion to $10 billion on various things related to Bear Stearns now. And, yes, I put it in the unfair category,” Dimon said at a conference last week. “Would I have done Bear Stearns again knowing what I know today? It’s real close.”

In a way, though, this was foreseeable. The companies that got into trouble earliest during the crisis were the ones that had taken the most extreme risks, pushing the outer boundaries of the mortgage business in the pre-crisis days. They knew that one of those risks was long and expensive litigation. None of that changes the fact that the resulting mess has cast a layer of uncertainty over the banks today.

At least those consequences will eventually be resolved, though at what cost is anybody’s guess. But that leaves the banks with strategic challenges. Should Citigroup, a giant bank with $1.9 trillion in assets, split into one large bank that deals with corporate clients and complex international transactions and one or two others that handle its more consumer-oriented businesses such as credit cards and mortgage lending?

Even Sandy Weill, who created Citigroup through a series of mega-mergers in the 1990s, seemed to suggest such a move in a TV interview in July: “What we should probably do is go and split up investment banking from banking, have banks be deposit takers, have banks make commercial loans and real estate loans, have banks do something that’s not going to risk the taxpayer dollars, that’s not too big to fail,” Weill said on CNBC’s “Squawk Box.”

At what point do the increasing costs of being a mega-bank, including dealing with new regulation and trying to manage a far-flung empire, become too burdensome to handle? That is the question facing the boards and executives of those big banks, and their answers will shape Wall Street — and global finance — for decades to come. In the meantime, we can expect each quarter to bring a new round of boardroom drama and financial hand-wringing as they try to figure out what should come next.

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