Sunday, April 11, 2010

Big Banks Make the Case for Continuous Disclosure

We learned late last week that 18 of the largest banks (including, among others, Goldman Sachs, Morgan Stanley, J.P. Morgan Chase, Bank of America and Citigroup) displayed a pattern of temporarily lowering their debt levels at the end of each quarter, just in time for their quarterly reports, and then ratcheting their borrowings back up at the beginning of the next quarter. (See Wall Street Journal, April 9, 2010, p. C1). Their reported debt levels averaged 42% below the intraquarter peaks. Thus, their quarterly reports understated the risks they carried.

As we know from the Lehman bankruptcy examiner's report, Lehman used a transaction called "Repo 105" to understate its leverage. While it is unclear that other major banks engaged in Repo 105 trades, they evidently have other ways to achieve a similar result.

Let us ask: who's in the dark? Not management of the big banks. They should be and hopefully are monitoring leverage levels on a continuing basis throughout market hours (which are basically 24 hours a day, five days a week, because trading is global). Certainly, they'd have the data at their fingertips.

Federal banking regulators can easily find out any time how leveraged the big banks are. They have examiners stationed at each of the major money center banks, who can get information on the spot. So there can be a continuous flow of information to the feds--and we hope there is.

That leaves (you've probably guessed it): you, the public investor. You're the chump. It's understandable why management wouldn't want you to know how risky their operations are. You might lower the price you're willing to pay for the bank's stock. That's not conducive to a brontosaurus size executive bonus. By reporting lower quarter-end leverage than they hold most of the time, the big banks can maintain a higher stock price. It's likely the big banks' lawyers have cleverly included language in their public filings saying that bank leverage levels fluctuate. But there's a distinct possibility they didn't disclose that they typically ease leverage levels down at the end of each quarter and pump them back up at the beginning of the next.

All this reinforces the case to require banks, and other public companies, to make continuous disclosure. We've advocated the idea before. See Our earlier essay argued that with continuous disclosure, there would be less inside information and therefore probably less insider trading. Now, we can see that continuous disclosure would result in fairer pricing of stocks. It may well be that bank stocks are over-valued because investors didn't realize how risky they are.

Continuous disclosure isn't difficult. It's already made to management as a matter of course, and to federal banking regulators on demand. We're not talking about highly tentative or immaterial information; we're talking about the info management relies on to run the banks and keep them solvent. There is no technological impediment to continuous disclosure, and the cost is small, since the data is already collected, crunched and disseminated (to some). Certain accounting decisions tend to be made on a quarterly or annual basis. Asset writedowns, adding to or drawing down reserves, writing off bad debts, depreciation and depletion are examples. But that's because the current reporting regime requires quarterly and annual reports. There's no intrinsic reason why these decisions can't be made more frequently. Even if they can't be made every day, assets depreciate and deplete, reserves can be set aside or used, and bad debts become uncollectible all the time, not just at the ends of quarters or years.

The quarterly and annual reporting requirements evolved in the 1930s and 1940s, when accountants collected data and prepared financial statements using pencils, paper and mechanical desk calculators. With the enormous capabilities of modern computers, there is no reason except inertia to stick with a quarterly and annual reporting regime. Indeed, there already are continuous reporting requirements for a limited number of items on SEC Form 8-K. The agency recognizes the need for continuous reporting; the only question is how much information should be continuously reported.

Of course, public companies will oppose the idea. Financial reporting is all too often treated as a game, in which management tries to present the company in the best possible light without violating any controlling legal precedents. And sometimes management presents the company in a better light than that and goes to jail. With only a tiny handful of exceptions, public companies don't seem to think that giving the public investor the full picture is a priority. That's too bad, because many public investors--i.e., individual investors--are MIA from the current stock market rally. Numerous commentators have observed that the past year's bull market progressed on rather thin volume, with individual investors licking their 2007-08 wounds from the sidelines. Even though the market has gone up for something like seven of the last eight weeks, the individual investor still hunkers down.

Of course, revealing the higher actual leverage of banks would tend to push their stock prices down. Indeed, continuous disclosure could in the near term be a short seller's banquet. But let us remember that a small group of mostly anonymous short sellers were among the first to realize that the real estate and mortgage markets amounted to a greatly over-valued bucket of mashed potatoes. Management and federal banking regulators, who had much better access to the relevant data, stood right at the front bumper but failed to see the tractor-trailer bearing down on them.

Continuous disclosure would enhance market fairness and efficiency. When stock prices reach a truly fair level, investor trust can begin. If investors continue to feel the stock market is a casino where they're always betting against the house, they'll embrace federally insured bank accounts and money market funds that invest only in U.S. Treasuries. This is exactly what happened in Japan after its 1989-90 stock market cataclysm, and the favorite savings vehicle for the Japanese today is an account with their postal system. (As odd as it sounds, the Japanese postal system runs the largest bank in the world measured by deposits; but then again, the U.S. postal system offered savings accounts until 1967.) Numerous individual investors in Japan never found their way back to equities. Very possibly, for many Americans that will also be the road not taken.

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