Bethany McLean

In capital we trust. Capital is our savior, our holy grail, our fountain of youth, or at least health, for banks. Seriously, how many times have you read that more capital will save the banks from another Armageddon? Even the banks point to capital as a reason to have faith. “Financial institutions have also been working alongside regulators to make themselves and the financial system stronger, more transparent, more resilient and more accountable,” wrote Rob Nichols of the Financial Services Forum, which is made up of the chief executive officers of 19 big U.S. financial institutions. “Specifically, capital, which protects banks from unexpected losses, has doubled since 2009.” If you were a cynic — who, me? — you might say that the mere fact that the banks are pointing to capital is proof that capital is not all that.

Everyone seems to be ignoring the basic fact that capital isn’t a pile of cash. It’s an accounting construct. On his Interfluidity blog (which I found courtesy of Naked Capitalism), Steve Waldman writes, “Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital,’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank.” In other words, even if you give bankers credit for good intentions, the accounting that would truly capture “capital” may not exist. Or as Waldman writes, “Bank capital cannot be measured.” Layer in some real world realities. The next time things get tough, will regulators once again practice forbearance and allow firms to overstate their capital, which has the perverse effect of making no one trust reported capital? Let’s not forget Lehman, which according to Lehman had a very healthy Tier 1 ratio of 10.7 percent on May 31, 2008 and a total capital ratio of 16.1 percent. This didn’t matter, because no one believed Lehman’s capital was real.

On the list of cures for the sick financial system, the concept of “risk retention” ranks right behind capital — but there are a couple of neat little twists here. The narrative of the crisis is that because mortgages could be sold off to banks, who would turn them into securities and sell those on to investors, who thought they were buying triple-A paper courtesy of the rating agencies — well, no one had any incentive to care about credit quality. In a piece in the Wall Street Journal entitled “How to Create Another Housing Crisis,” MFS Investment Management’s former chairman Robert Pozen writes, “With ‘no skin in the game,’ the originators had little incentive to determine whether the borrower was likely to default.” As a result, one provision of Dodd-Frank requires securitizers of any asset, not just mortgages, to retain 5 percent of the risk of loss. Barney Frank has said that the risk retention rules are the “most important aspect” of the legislation that bears his name.

The first twist is how risk retention became risk liberation. The housing-industrial complex went to work. Into Dodd-Frank went a provision that certain “safe” mortgages, called qualified residential mortgages, or QRMs, would be exempt from the risk retention requirement. “Safe” was left to the regulators to define. Cue more lobbying. The rules finally proposed in late August would exempt, according to a Wall Street Journal piece by Alan Blinder, some 95 percent of mortgages from the risk retention requirement. In other words, the very asset that most people believed led to the credit crisis is also the asset that is pretty much exempt from the new rules! Classic. In the joint announcement on August 28, the regulators wrote, “The Commission acknowledges that QM does not fully address the loan underwriting features that are most likely to result in a lower risk of default. However, the agencies have considered the entire regulatory environment, including regulatory consistency and the possible effects on the housing finance market.” (That last bit is super scary.)

That said, the real twist here is that risk retention is no silver bullet. After all, firms like Countrywide, Washington Mutual, Merrill Lynch, AIG and Citigroup went under or almost went under precisely because they retained so much risk on their own balance sheets. Malevolence is only part of the problem with our financial system. The other problem is sheer stupidity.

Limbo. That’s the word most people use to describe the state of affairs in a critical part of our economy — housing finance. The government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, which were nationalized almost five years ago with the seemingly noble goal of eventually getting rid of them, now back some 90 percent of American mortgages. So much for good riddance!

But talk of reform finally seems close to action. Senator Bob Corker (R-Tenn.) and Senator Mark Warner (D-Va.) have proposed a bipartisan bill called, appropriately enough, Corker-Warner. Meanwhile, the House Financial Services Committee, led by Representative Jeb Hensarling (R-Texas), has produced its own bill, the more grandiosely entitled Protecting American Taxpayers and Homeowners, or PATH Act. Last Tuesday, during a speech in Phoenix, President Barack Obama weighed in. “Private lending should be the backbone of the housing market,” the president said. That same day there was also a housing policy forum at the George W. Bush Presidential Center in Texas, where, among others, Hensarling spoke.

Everyone (well, almost everyone) seems to agree with the president: Private lending should be the backbone of the housing market. But just how much private capital does that entail? Hensarling and most of the Republicans think the government should get out of the game entirely. American Enterprise Institute scholar Peter Wallison, a long-time critic of the GSEs, recently wrote a piece in the Wall Street Journal entitled “Competing Visions for the Future of Housing Finance,” in which he called any remaining government presence “faux reform.”

“Ex Goldman Trader Found Guilty for Misleading Investors.” “Bond Deal Draws Fine for UBS.” “JPMorgan Settles Electricity Manipulation Case for $410 million.” “Deutsche Bank Net Profit Halves on Charge For Potential Legal Costs.” “US Sues Bank of America Over Mortgage Securities.” “Senate Opens Probe of Banks’ Commodities Businesses.” “US Regulators Find Evidence of Banks Fixing Derivatives Rates.” “Goldman Sachs Sued for Allegedly Inflating Aluminum Prices.”

So goes a sampling of headlines about the banking industry from the past week — yes, just one week. We seem to be living in an era where bankers can do no right. I can’t put it any better than a smart hedge fund friend of mine, who upon reading the news about the $410 million that JPMorgan paid to make allegations that it manipulated energy markets go away, sent me an email. “I am a bank friendly type,” he said. But, he added, in typically terse trader talk, “Something structurally amiss when so much financial activity is borderline.”

By one measurement, the problem has gotten worse by an order of magnitude in recent years. In the annual letter he writes to shareholders, Robert Wilmers, the chairman and CEO of M&T Bank, has started keeping track of the fines, sanctions and legal awards levied against the “Big Six” bank holding companies. In 2011, those penalties were $13.9 billion. In 2012, they more than doubled to $29.3 billion. Wilmers writes that the past two years represent the majority of the cumulative $52 billion in charges, from 236 separate actions in eight countries, over the past 11 years. Wilmers also cites a study done by M&T, according to which the top six banks have been cited 1,150 times by the Wall Street Journal and the New York Times in articles about their improper activities. Perhaps not surprisingly, the biggest bank, JPMorgan, accounts for a sizable chunk of all this. According to a report by Josh Rosner, a managing director at independent research consultancy Graham Fisher & Co, JPMorgan has paid $8.5 billion in fines between 2009 and 2012, or about 12 percent of its net income over that period.

The government is cracking down on insider trading; isn’t that great news for you? Last Friday, the Securities and Exchange Commission charged hedge fund mogul Steve Cohen with failing to supervise two employees who themselves face insider trading charges; on Thursday morning the Justice Department filed criminal charges against his firm, SAC Capital. Earlier this summer, the news broke that New York’s attorney general, Eric Schneiderman, was investigating the early release (by Thomson Reuters, which publishes this column) of the University of Michigan’s widely-watched index on consumer sentiment to a group of investors. Faced with a court order, Thomson Reuters agreed to suspend the practice, while asserting that “news and information companies can legally distribute non-governmental data and exclusive news through services provided to fee-paying subscribers.”

In a statement, Schneiderman said that “the securities markets should be a level playing field for all investors.” Preet Bharara, who is the U.S. Attorney for the Southern District of New York, has also invoked the notion of fairness. He told CNBC’s Jim Cramer, “I think people need to believe that the markets are fair, and that the same rules apply to everyone…I don’t want to buy a stock because I have a feeling that someone knows more than I do.”

Let’s give both Schneiderman and Bharara credit for good intentions. What could be more desirable than a level playing field in the all-important game called our financial security? But the playing field isn’t level, it never has been, and I’m not sure it can ever be. If history is any evidence, attempts to level it have only tilted it all the more. So, maybe the real problem is the pretense of fairness.

So today is the day.  After weeks of near-constant coverage of the big decision — will JPMorgan Chase shareholders keep Jamie Dimon as chairman and CEO or relegate him to just CEO? — the verdict came at JPMorgan’s annual meeting in Tampa, Florida:  Dimon gets to keep both titles. The next question is whether the result will get as much press as the original question did.

The subject has gotten so much coverage in part because Dimon is so divisive. To his supporters, he’s the personification of everything that’s best about the financial system. Those who defend Dimon, like New York Times columnist Andrew Ross Sorkin, point out that JPMorgan Chase hasn’t lost money in any quarter while Dimon has been in charge. Others, including Warren Buffett, Jack Welch, Michael Bloomberg and Rupert Murdoch, praise Dimon, who is often called “America’s most famous banker,” for his management skills. But to detractors, he’s the personification of all that’s wrong with modern banking — the arrogance, the resistance to new regulation, the astronomical pay in the face of obvious mistakes. The way he acted — threatening to resign entirely if his chairmanship was taken away — is proof that he’s no more than a spoiled child.

But I wonder if the vote has gotten so much attention for another reason, which is that it’s easier to chew over Jamie Dimon than it is to think about the right structure for our financial system. Sure, the management, and the structure of that management, at JPMorgan matters.  But if I were a conspiracy theorist ‑ and really and truly, I’m not! ‑ I might even suspect that all the fuss about Dimon is supposed to make us “watch the birdie.”  It’s a distraction, meant to deflect attention from the real point, which is how we structure a financial system that best serves the needs of consumers and businesses in as safe a way as possible.

The government’s 119-page civil lawsuit against credit rating agency Standard & Poor’s for allegedly inflating the ratings it gave to residential mortgage-related securities, or RMBS, in the run-up to the crash has removed whatever lingering doubts (there weren’t many!) might have remained about just how problematic the ratings game is. But it also raises a question: Why, in cases of white-collar wrongdoing, is it often the cogs in the wheel that seem to pay the highest price?

Let’s stipulate that there are weird things about this case. To lower its burden of proof, the government is using a 1989 law that is supposed to protect taxpayers from frauds against federally insured financial institutions. The result, as Bloomberg columnist Jonathan Weil has pointed out, is that the government is claiming that some of the very banks — mainly Citigroup — that packaged the securities were also defrauded by the rating agencies.

Plausible? Well, yes, particularly for Citi, where the right hand often doesn’t know what the left hand is doing. And just because the banks fell for their own scam doesn’t mean it wasn’t a scam. But it’s still weird. It’s also weird that the government names some S&P executives but leaves others anonymous. And  it’s weird that the government has sued S&P but not Moody’s Investors Service, which at least in outward appearance was equally culpable. (S&P, for its part, has stated that it is “simply false” that it compromised its analytical integrity, and that it has a “record of successfully defending these types of cases, with 41 cases dismissed outright or voluntarily withdrawn.”)

According to the numbers, Apple’s battered stock is one of the best bargains of all time. Since hitting a high of almost $700 last fall, shares have plummeted 37 percent, to $442, including a 12 percent drop in late January after Apple posted flat year-over-year profits, which bitterly disappointed the Street. Apple now trades at just over 10 times last year’s profits and roughly eight times Wall Street’s estimate of next year’s earnings — well below the average of the Standard & Poor’s 500-stock index. Plus, Apple is set to begin paying a dividend of $10.60 a share, well above the yield on Treasuries.

Fortune estimates that 29 of 36 analysts covering Apple rate it some form of buy, with a median price target of $605 per share. One analyst, who dubbed the company the “trillion dollar baby” based on his belief that Apple will one day have a market value that exceeds $1 trillion, still maintains his price target of $880 per share.

Maybe so. But scratch beneath the surface, and there is an argument that Apple isn’t so much a great bargain as it is a classic “value trap” — a company whose stock price is depressed for good reason.

In the aftermath of the 2008 financial crisis, the most commonly heard complaint has been: “Why hasn’t anyone gone to jail?” This past May, Newsweek asked, “Why Can’t Obama Bring Wall Street to Justice?” and Forbes wondered, “Obama’s DOJ and Wall Street: Too Big for Jail?” Even Rupert Murdoch’s New York Post recently chided the president because “not a single Wall Street fat-cat has been charged with violations of securities laws in connection with the 2008 collapse.”

There are many explanations — and plenty of conspiracy theories — about why this is the case, but there’s a different, more important question that needs to be asked: Has sending people to jail fixed anything?

Think back to the post-Enron years. The government convicted roughly a dozen former Enron executives, including former CEOs Kenneth Lay, who died awaiting sentencing, and Jeffrey Skilling, who is serving a 24-year prison sentence, and took accounting firm Arthur Andersen to trial, resulting in its demise. During that era, former WorldCom CEO Bernie Ebbers, former Quest CEO Joe Nacchio and former Adelphia executives were also convicted for misdeeds.

Last week, New York Attorney General Eric Schneiderman, who is the co-chairman of the Residential Mortgage-Backed Securities Working Group – which President Obama formed earlier this year to investigate who was responsible for the misconduct that led to the financial crisis – filed a complaint against JPMorgan Chase. The complaint, which seeks an unspecified amount in damages (but says that investors lost $22.5 billion), alleges widespread wrongdoing at Bear Stearns in the run-up to the financial crisis. JPMorgan Chase, of course, acquired Bear in 2008. Apparently, this is just the beginning of a Schneiderman onslaught. “We do expect this to be a matter of very significant liability, and there are others to come that will also reflect the same quantum of damages,” Schneiderman said in an interview with Bloomberg Television. “We’re looking at tens of billions of dollars, not just by one institution, but by quite a few.”

The prevailing opinion seems to be, Yay! Someone is finally making, or at least trying to make, the banks pay for their sins. But while there is one big positive to the complaint, overall I don’t think there’s any reason to cheer.

Schneiderman’s case clearly lays out the alleged bad behavior at the old Bear Stearns. Although Bear promised investors it was doing due diligence on the mortgages it purchased, it wasn’t. Defendants “systematically failed to fully evaluate the loans, largely ignored the defects that their limited review did uncover, and kept investors in the dark about both the inadequacy of their review procedures and the defects in the underlying loans,” alleges the complaint. Even worse, Bear would make deals with the sellers of mortgages in which it would force them to make a payment for failed mortgages, but instead of taking the bad loan out of the trust, Bear would just keep the money – even though both Bear’s lawyers and its accountants (this is truly stunning), according to Schneiderman’s case, warned them that wasn’t OK.

From the wonder of the Olympics to the horror of Libor, there’s been plenty of news this summer. So maybe it’s not surprising that a 1,676-page bill called Moving Ahead for Progress in the 21st Century, which President Obama signed into law on July 6, has escaped attention. (Really? You’d rather watch Gabby Douglas win the all-around gold than read this bill? Shocking.) But buried within the bill, which is also known as the Highway Act, is a provision that matters to many Americans, a provision that sums up a lot of what’s wrong with Washington today, a provision that is not just bad finance but also reeks of the cronyism we should all fear.

The provision is called the Pension Stabilization Act, and really, it should be renamed the Pension Destabilization Act. Pensions are fairly unstable already, relying on markets of the future that smart prognosticators doubt are going to be as generous as the markets of the past. And yet, many pension plans are counting on similar rates of return anyway. In his August letter, Pimco’s Bill Gross pointed out that one of the country’s largest state pension funds says it will earn what sounds like a modest real rate of 4.75 percent. But as Gross notes, assuming a portion of that is in bonds yielding 1 to 2 percent, the pension would need stocks to return 7 to 8 percent after adjusting for inflation to hit its target. That is, as Gross writes, “very heavy lifting.” Nor are we heading into tough times with a cushion. Different sources put the funding deficit for large corporate pension plans at somewhere between $475 billion and $500 billion as of the end of 2011.

Given that, and given that corporate profit margins and cash balances are near all-time highs, you might think, or hope, that Congress would be cracking the whip. And it did, sort of, by passing the Pension Protection Act in 2006, which among other things generally required companies to fund their pension shortfalls over seven years.  But then the financial crisis hit, and companies begged for relief, and now, in 2012, we have the Pension Stabilization Act. While the math is complicated – Jim Moore, a managing director at Pimco, calls it a “Rube Goldberg contraption”– most people who have looked at it say that the overall effect is going to be, as JPMorgan put it in a recent piece, to “significantly reduce” the cash that companies are required to contribute to their pension plans in the next few years.  It does so, in essence, by increasing the discount rate that companies use to calculate their pension liabilities when they’re determining how much money they need to put in. Using a higher discount rate makes the liability look smaller, thereby decreasing the funding requirement.