Felix Salmon

Jamie Dimon is wagging his finger from newstands across America this week, above the kind of headline his PR team can only dream of: “DIMON IS FOREVER: Why Jamie Dimon is Wall Street’s Indispensable Man”.

The story itself, by Nick Summers and Max Abelson, consists mainly of rich corporate insider types talking about how wonderful Jamie Dimon is, and how ridiculous it is that anybody might consider stripping him of the chairmanship of JP Morgan. Here’s a doozy:

Admiring rivals have been known to call Dimon “the sun god.” That cosmic aura has real use, says Kathryn Wylde, who served on the Federal Reserve Bank of New York’s board with Dimon until his term ended last year. “There’s no doubt that it helped the bank, because so much of that business is built on confidence.” The intrusion of shareholders, in the form of a vote on Dimon’s dual roles, she adds, is “indefensible if the company is performing well.”

Wylde is one of those great-and-good people who turn up on boards all over the place: not only the New York Fed, but also everything from the NYC Economic Development Corporation and the Manhattan Institute to the Lutheran Medical Center and the US Trust Advisory Committee. Her day job is serving as the president and CEO of the Partnership for New York City, a partnership made up exclusively of large companies and the rich people who lead them. JPMorgan is unshockingly among them. Her view of the role of shareholders in corporate governance is fascinating: it’s “indefensible” for them to care about such things so long as they’re getting paid.

But clearly shareholders do care about governance: both Institutional Investors Services and Glass Lewis, advisory firms paid to work out what is in the best interests of shareholders, have come to the entirely reasonable conclusion that Jamie Dimon should not keep his job as chairman of the board.

The battle line between princpals and agents has never been more clearly delineated than it is here. The shareholders of JP Morgan — the owners of the company — want a board which represents their interests, and which can control what the CEO does. The managers and captured professional board members, on the other hand — the CEO class — have rallied around Dimon in an impressive display of high-wattage solidarity. Bloomberg Businessweek quotes Bill Daley, John Mack, Jimmy Cayne, Phil Gramm, Dick Kovacevich, and “two dozen of Dimon’s peers and colleagues” in his defense; Andrew Ross Sorkin, for good measure, adds Barry Diller and Hank Paulson.

Will shareholders see this awesome display of PR firepower and decide that Jamie’s right, he should stay on as chairman after all? If they’re narrowly focused on the short-term future of the JP Morgan share price, then probably they will. After all, Dimon has petulantly threatened to quit if the motion goes through, which would be bad for the share price — and as all of these articles are at pains to point out, there’s not much evidence that splitting the chairman and CEO roles is likely to do any particular good for JP Morgan’s share price over the medium term. (It can help underperforming companies, but that effect disappears with respect to relatively strong ones.)

The cult of the CEO is still going strong: just look at the way Bloomberg has appointed the ex CEO of IBM to try to help the company recover from its recent data scandal. So maybe if you get enough CEOs supporting Dimon, their collective weight will help tip the balance. (Although it’s hard to believe that any shareholders particularly value the opinion of Jimmy Cayne on this issue.)

But the fact is that Dimon should not be chairman of JP Morgan, and shareholders can see exactly why just by looking right there at the cover of Bloomberg Businessweek. No one man should ever be indispensable, and it’s the job of the chairman to ensure that the company is in good solid health no matter what happens to the CEO.

A fuller, and quite wonderful, explanation has also been offered up by the Epicurean Dealmaker, who makes a few more salient points. He explains:

The entire point of separating the roles of Chairman of the Board and Chief Executive Officer is that they have different responsibilities and duties. They are different jobs. Now, perhaps at smaller companies with simple business models and uncomplicated objectives (grow revenues fast enough to meet payroll and pay the bank on time), there is no practical need to separate them. But the bigger a company gets—and I think we can all agree J.P. Morgan is about as big as a firm can get—the breadth and scope of duties each role properly possesses expands dramatically.

Even if Dimon is a great CEO, there’s really no evidence at all that he’s a great chairman, and JP Morgan’s shareholders have the right to install the best possible officeholder in each of those roles.

How do we know that Dimon is a bad chairman? Well, there’s the fact that there’s no good succession planning, for starters. And then there’s the board itself, which is basically a bunch of supine muppets, who do as they’re told rather than actually representing shareholders and holding the CEO to account.

Most intractably, there’s the question of shifting goalposts. As the Epicurean Dealmaker points out, Jamie Dimon is the very last person on the planet who should be in charge of judging whether Jamie Dimon is doing a good job as CEO. For instance: it’s impossible for a bank with $2.4 trillion in assets and 256,000 employees to stay out of regulatory trouble entirely. But how many fines is too many? As Businessweek points out, “the litigation section of the bank’s quarterly filings now runs to almost 9,000 words, or 18 single-spaced pages.” At what point does the litany of legal and ethical lapses become so long that the CEO has to take responsibility, and/or break up the company into small-enough-to-manage chunks? This is an important question, and Jamie Dimon cannot answer it. You need an independent board to do that — to set the goalposts — and JP Morgan’s board is not independent.

In theory, shareholders elect directors, who hire the CEO to run the company. In practice, the CEO picks the directors he wants, pays them a handsome stipend for doing nothing, and they in turn make no attempt to listen to what the company’s shareholders might desire. In fact, they’re quite offended when it’s suggested that they might want to do that at all.

The debate about this vote often seems as though it’s two groups of people talking at cross purposes to each other: the Dimon defenders are making it all about him personally, and what a good job he’s done running the company, while the good-governance types generally say nothing personally about Dimon at all, and instead insist that all they’re doing is standing on principle.

But in fact this is about Dimon personally: it’s about how much power one man can or should be allowed to have. Dimon has too much. It’s time to give him a boss.

How do you value a hedge fund? It’s impossible, really. You can see how much it earned in any given year, but past performance is a very bad guide to future results. In any case, all future income is reliant on both the investors and the managers sticking around, which means that the value of a hedge fund to its managers is always going to be higher than the value of a hedge fund to an outside investor with little ability to keep the managers in place.

Partly as a result, almost nobody buys and sells stakes in hedge funds as an investment. (As Peter Lattman recalls, Anthony Scaramucci tried to do that, and failed, before he became a fund-of-funds manager.) Indeed, there are precious few hedge funds where such stakes are even traded. If you want exposure to a certain manager’s alpha-generating abilities, then you’re better off just investing with her and paying 2-and-20.

This is bad news for banks forced to get rid of their hedge fund arms as a result of the Volcker Rule. If they just close them down, then they’ll lose money. But there also aren’t willing buyers for such things out there in the world. So Citi, for one, is doing the only thing it can. It spun off Citi Capital Advisors at the beginning of March; the firm is now called Napier Park Global Capital. It’s mostly owned by its managers, but Citi has retained a Volcker-compliant 25% stake, so if Napier Park does well on its own, Citi should be able to make something out of the deal.

Bloomberg’s Donal Griffin is not happy about this — not happy at all. He first wrote about the spin-off in January, when he found a hedge fund consultant, with the wonderful name of Ezra Zask, who was willing to say that Citi Capital Advisors was worth $100 million. Griffin managed to obtain “unaudited, internal CCA performance data” from the company, but he didn’t reveal the contents of that data — only that it had somehow managed to get extrapolated into the $100 million price tag.

Griffin’s story appeared under the headline “The Great Citigroup Hedge Fund Giveaway”, and quoted a professor at George Mason University asking why Citi wasn’t selling the unit. (Griffin didn’t bother to ask whether anybody on the planet would be willing to buy it, in such a deal.)

Griffin has now returned with another story on the same subject, and once again he has obtained confidential documents — this time “internal projections” of the fees it might make in future. Those fees are incredibly uncertain, of course: they rely on the company being able to raise new money from investors, as well as outperform the markets. But guess what, here’s Ezra Zask again, right at the top of the article:

Jonathan Dorfman and James O’Brien are among executives who got 75 percent of the investment firm for free when it broke off from Citigroup earlier this year. The business may be worth $360 million, according to hedge-fund consultant Ezra Zask.

Zask evinces no sheepishness about more than trebling his valuation for the company over the space of four months, and Griffin doesn’t explain why Napier Park is worth so much more today than he thought it was worth in January. He does, however, go get a few more estimates for how much the company might be worth: one said it “could be worth as much as $300 million by 2016 if the firm replaces Citigroup’s money with outside investment and attracts extra cash”, while another gave a range of somewhere between $61 million and $251 million. But those estimates are much lower down in the article: Zask’s highball estimate comes at the very top. And again, Griffin never bothers to explain who on earth would be willing to pay any such sum for a stake in the company.

There’s a reason that you don’t often see estimates for hedge funds’ valuations, as opposed to their assets under management: such numbers are generally hypothetical to the point of meaninglessness. But Griffin is convinced that since Citi has given away something very valuable, something smelly must be going on here.

It’s true that if Napier Park’s principals manage to turn the company into a success, then they will do very well for themselves. That’s the way that hedge funds work. But what I don’t see is what kind of choice Citi had in the matter. It can’t own the company any more, and it is being forced to withdraw the money it has invested there. So it really only had two choices: it could spin out the company, retain a minority stake, and hope that it manages to do well in the future — or it could just close it down entirely, and suffer a substantial loss. The former is clearly the more attractive option.

If Griffin is going to write a series of articles talking about Napier Park’s value, then it really does behoove him to explain what exactly he means by that. Was there a third option on the table? Could Citi have found a buyer for the business, who would have paid the bank some nine-figure sum for the privilege of owning it? If so, who might that buyer have been? And if not, in what sense do all these valuation figures mean anything at all?

Not all cash flows are created equal: an asset is worth, in the real world, only what someone else is willing to pay for it. Absent such a bidder, it seems to me that anybody talking about Napier Park’s valuation should start at zero, rather than with some academic discounted-cash-flow analysis.

There’s a lot of money and power at the nexus of banking and policymaking, home of the infamous revolving door and the natural habitat of people like Mike Froman, America’s new trade representative, who has shuttled back and forth between government and Citigroup and who, behind the scenes, helped pick all of Barack Obama’s initial economic team. And wherever there’s money and power, you’re sure to find turmoil. If Promontory is the big winner these days, there’s also bound to be a big loser. Let me introduce you to the IIF.

The Institute for International Finance describes itself as being “the most influential global association of financial institutions” — where by “influential” it means that it aspires to have the ability to persuade policymakers what to do. For most of its existence it was run by Charles Dallara, a former Treasury official who spent two years at JP Morgan before becoming head of the IIF in 1993. He stayed in that job for 20 years; in 2011, the last year we have numbers for, he was paid $3,955,381 for his efforts. That’s 20% of the IIF’s total payroll; the other 104 employees, between them, took home a slightly more modest, but still impressive, average of $153,870 each.

Dallara was replaced by Tim Adams, another former Treasury official — but “replaced” is not really the right word. The IIF was Dallara, and without him, it seems, the IIF is nothing. For all that it has 105 employees and prides itself on having a truly global membership, Dallara turned the IIF into what Adams calls, in a Powerpoint presentation circulated to the entire staff, a “founder-led, personality-driven” enterprise. (The presentation, entitled “An Era of Rapid Change, Repositioning and Renewal”, is essentially Adams’s buzzword-laden manifesto for keeping the IIF relevant.) Dallara was a notoriously tyrannical micro-manager; the not-so-secret of career success at the IIF was always to do everything and anything Dallara wanted, and nothing else. When Dallara left, his yes-men — and the IIF’s top execs are overwhelmingly men — had no idea how to react, and the Institute inevitably collapsed into a viper-pit of political infighting.

Already, there have been two high-profile casualties: the IIF’s long-standing chief economist, Phil Suttle, has been fired, as has its PR chief, Gary Mead. (Unsurprisingly, the IIF didn’t manage to respond to my requests for comment.) More worryingly, Bank of America has resigned its membership, and there seem to be questions over whether other big US banks might follow suit, with at least one of them allegedly hundreds of thousands of dollars behind on its membership fees. That’s very bad news for the IIF, which is nothing if it’s not a shop where the world’s most important policymakers can rub shoulders with senior executives of the world’s biggest banks. The IIF’s membership changes over time, but at its core is always the select global group of systemically-important financial institutions. If it’s losing the likes of BofA, it’s losing its raison d’être.

In recent years, the IIF has also become something of a ham-handed lobbying shop, to the point at which a capital-markets-friendly outlet like Euromoney will happily and openly dismiss its claims as so much self-interested claptrap. The change dates back to the global financial crisis, which caused a massive rise in demands for global financial institutions to be regulated much more assiduously. The institutions fought back, through the IIF, with 161-page report detailing the gruesome economic consequences of doing so. A taster, to take you back to the summer of 2010:

IIF Deputy Managing Director and Chief Economist Philip Suttle, who is the lead author of the new report, said the impact is not the same in each part of the world, given differences in each banking system and in the roles banks play in the broader economy. The analysis suggests that for the Euro Area a weaker recovery with real GDP some 4.3% less than otherwise might be the case and with new job creation, therefore, being potentially some 4.6 million lower over the 2011-2015 period than otherwise might be the case. The respective projections for GDP and for employment on this basis for the United States would respectively be 2.6% and 4.6 million. For Japan the projected numbers on this same scenario would be 1.9% and around 0.5 million jobs to 2015.

Suttle, here, was essentially saying that if the Basel Committee and others actually did their jobs and regulated the banks to the point at which they were significantly less likely to blow up the global economy, then the cost of doing so would be trillions of dollars and millions of jobs. The banks don’t like to be reminded of this report, partly because it was based on ludicrous assumptions, and partly because the reforms ended up happening anyway, and as a result the banks now need to claim, at least in public, that they’re fully supportive of their wise regulators.

As a result, Suttle got thrown under the bus — although the report came from the institution as a whole, and had the sign-off of a very high-powered board, including Dallara. The problem is that the IIF is still trying to have it both ways. Even as it tries to butter up policymakers, especially in central banks, it continues to talk about the enormous cost of proposed policies. And if the press doesn’t take its pronouncements seriously, policymakers are even less impressed: within serious institutions like the New York Fed, for instance, the IIF has become little more than a punchline to an unfunny joke.

Charles Dallara might have been, as I described him last year, an “amiable buffoon” — but at least he was an amiable buffoon with access. Since his departure to a Swiss private-equity shop, the IIF has not only been leaderless and rudderless; it has also been completely out of the loop on key issues such as the treatment of deposits in Cyprus. In a world where the financial services lobby has never been more sophisticated, the IIF feels like an anachronism, and Adams’s attempts to reinvent it are doomed to fail. If he were starting up a new association that would be hard enough, but given the quantity of entrenched dysfunction at the IIF, turning it around to be, in his words, “faster, shorter, sharper, relevant” is simply not going to happen. Adams may or may not have a clear vision of where he wants to go — his presentation is pretty vague and fluffy — but even if he does know where he’s going, there’s really no way of getting there from here.

The IIF won’t be missed, at least by anybody who isn’t a banker with a fondness for rubber chicken. But its fate should be salutary for any institution with a powerful chief executive. If that chief departs without some very clear succession planning in place, it can be extremely difficult for the institution to survive.

I feared this would happen. Peter Eavis has a column today about what his headline calls “Down Payment Rules”. Here’s his lede:

It seemed an easy fix to prevent the excesses of the housing market: make home buyers put more money down.

Read on, and you’ll find lots of talk about “down payment requirements”, “restrictions” on lenders, and whether “requiring a down payment” is a good idea or not, given that we want to both encourage homeownership and prevent systemic risk.

But the subject of Eavis’s column — something called the qualified residential mortgage, or QRM — was never designed to be “an easy fix to prevent the excesses of the housing market”. Rather, it was designed as a loophole to allow banks to wriggle out from an entirely sensible skin-in-the-game requirement.

I covered this subject in some depth back in June 2011, so go read that post if you want the details; nothing has really changed. (For even more on the subject, read Kevin Wack’s excellent treatment from a couple of months later.) But the basic story is simple: under Dodd-Frank, banks need to hold on to at least 5% of the loans that they make. The QRM is a loophole in that requirement — loans with high down payments are exempt from the law, and banks can sell the entire thing, rather than just 95%.

If low-down-payment loans are as safe as the critics of high down payments say they are, there shouldn’t be a problem. The bank will make the loan, will hold on to 5%, and will profit twice: first by selling the other 95% for a quick-flip gain, and secondly by getting a non-defaulting income stream from the remaining 5% of the loan.

Somehow, however, the loophole has expanded to encompass pretty much the entire mortgage market, so that high down payments are now considered an outright “requirement” for new loans, rather than just being a way for banks to avoid holding on to a tiny bit of the loan that they themselves are making.

Really, this whole debate is concentrating on entirely the wrong thing. The question about high down payment mortgages is a relatively arcane backwater of financial underwriting, and we can leave it to the statisticians and bond investors to decide just how much, if at all, such down payments reduce defaults. Instead, we should be concentrating on the banks here, the institutions which seem to be entirely unwilling to underwrite any mortgage at all, unless and until they’re allowed to flip the entire thing, 100%, to bond investors, for a quick, risk-free profit.

This violates common sense. If the bank is underwriting the loan, the bank should retain at least a tiny amount of the risk in that loan. Indeed, if I were a bond investor, I would as a matter of course require extra yield on any loans which were sold by a bank without any skin in the game at all. After all, there’s not much point in being assiduous about your underwriting if you’re just going to sell the entire loan anyway.

So instead of debating down payments, let’s hold the banks’ feet to the fire, a little bit, instead. “Banks do not like” rules requiring them to hold on to 5% of a loan, says Eavis. Why not? Until we get a good answer to that question, we shouldn’t even be talking about down payment “requirements” which aren’t really requirements at all.

Once again the question raises itself: what is the point of filing criminal charges against a bank — not a bank’s executives or employees, but the bank itself? The WSJ today says that the US wants RBS to plead guilty to such charges, in addition to paying the inevitable fine over Libor fixing. But only, it seems, insofar as such an admission wouldn’t have any visible practical consequences:

As part of UBS’s settlement last month, the Swiss bank’s Japanese unit pleaded guilty to wire fraud, a felony. Justice Department officials were heartened by the lack of a negative reaction in the markets and among regulators around the world to UBS’s guilty plea. Before the settlement deal, some officials had worried it could destabilize the bank. That has emboldened officials to pursue similar actions against banks like RBS.

Does “banks like RBS”, here, mean all of the banks which are going to settle Libor-rigging charges in the future? If so, it almost certainly includes US banks. And that in turn means that shareholders in such banks should be worried about potentially owning stock in a self-admitted criminal enterprise. On the other hand, maybe shareholders care only about the share price, and can take solace in the fact that Justice only seems to want to file criminal charges insofar as there’s a “lack of a negative reaction in the markets”.

The spectre everybody’s afraid of here is that of Arthur Andersen, which was prosecuted for obstruction of justice in the wake of the Enron scandal, went out of business as a result, and only later saw its conviction overturned by the Supreme Court. By that point it was too late: 25,000 jobs had been lost, and the accounting industry had become even more consolidated than it was before.

As a result, Justice seems to be treading very carefully here, prosecuting UBS — and, now, probably RBS as well — only with respect to activities in far-flung Asian outposts that no one cares much about. Think of it as the diametric opposite of the way that prosecutors went after Aaron Swartz: the US in this case is being minimally rather than maximally aggressive.

The problem is that this m.o. seems to violate a basic principle of justice — the principle that where there is a crime, there should be a punishment. Put the fines to one side: they will happen anyway, whether the bank admits to criminal activity or not. The criminal prosecution, in these cases, seems to be little more than a CYA move on the part of the administration, which can now have a slightly straighter face when saying that it’s being tough on the banks.

Still, maybe the markets should be more worried about such admissions than they’ve shown themselves to be until now. If a bank with a substantial US retail operation — JPMorgan Chase, say — admits to criminal misconduct, that doesn’t just open itself up to lawsuits from people who bought instruments linked to Libor, but also hands a whole new ammunition clip over to the opponents of big banks generally. Remember that most of the Dodd-Frank law still has yet to be written, including the details of the Volcker Rule; the worse the light the big banks are seen in, the tougher that regulators are going to allow themselves to get.

And then there’s the question of local prosecutors and regulators. The Justice Department might be very solicitous here, but that doesn’t mean that aggressive state attorneys general will follow suit. Once a bank has admitted criminal wrongdoing, its banking license in New York or any other state could surely be in jeopardy. And once a bank loses its banking license in New York, it’s basically dead in the water.

Justice, then, needs to ask itself what exactly it’s trying to achieve with these criminal admissions. In principle, I’m all in favor of holding criminal organizations to account for their actions. But only if doing so does more good than harm.

Yesterday saw the launch of Gobank, an exciting new bank from Green Dot. If you know about Simple, it’s at heart the same thing: mobile-first, no fees, very easy to use, and built by Real Internet People. (Green Dot acqu-hired Loopt for $43 million last March, giving it the requisite tech savvy to build Gobank; and indeed Green Dot itself was a Sequoia-backed startup, once upon a time.) At both banks, you basically do everything with either the app or your debit card — but although Green Dot is new to the bank-account space, it has been offering debit cards for many years, and so has pretty well-tested technology on that side of things.

Gobank does have some advantages over Simple. For one thing, as part of a large public corporation, it has more resources at its disposal, and is able to launch in fully-fledged form, with mobile check deposit, iPhone and Android apps, and the like. (At Simple, these things come slowly.) Gobank even offers you the ability to transfer money easily and directly from Simple, or any other checking account, straight into your Gobank account: you just type in your debit card number and your security code, and transfer as much money as you want. And because Green Dot has a lot of retail locations, it can offer something Simple will never have: free cash deposits.

More importantly, Gobank is, actually, a bank. (Simple, by contrast, is basically a smart front end built on top of Bancorp.) That means, at least in theory, that it can iterate more quickly than Simple, which needs to work with Bancorp in order to add features. And in terms of marketing, Gobank can sell itself as being a bank; Simple can’t.

Gobank is great news for consumers: it means that simple, no-fee, debit-card-based banking is really entering the mainstream, and might even get picked up by mid-sized commercial banks at some point. (It doesn’t make sense for banks with more than $10 billion of assets, because they can’t get the higher interchange revenue which makes Gobank and Simple workable.) It also means — I hope — that rip-off prepaid debit cards are going to become increasingly marginalized. Given the choice between a prepaid debit card and a Gobank account, it makes no sense at all to get the prepaid debit card: the bank account is superior, and cheaper, in all respects.

I asked Green Dot CEO Steve Streit about this yesterday, and he said that demand for prepaid debit cards rarely intersects with demand for checking accounts; he’s targeting Gobank at people who want a checking account, not at people who want a prepaid debit card. That’s fair enough. But as prepaid debit cards start looking more and more like bank accounts (think Suze Orman’s Approved card, or Amex’s Bluebird card, or Chase’s Liquid card), it’s pretty clear that they’re now going to have to start competing not only with other prepaid cards, but also with the likes of Gobank and Simple.

As far as Green Dot is concerned, Gobank is a big and important bet. Since its blaze-of-glory IPO in July 2010 at a first-day price of $44 per share, the company’s stock has gone steadily south. It rose yesterday, on the Gobank news, but gave up all those gains today: it’s now trading at just $13.30, which corresponds to a market capitalization of less than $500 million. I don’t know what Simple’s valuation is these days, but I’m sure that Green Dot would love to be credited with that kind of value, on top of its debit-card franchise.

I’m sure that Gobank will evolve over time: I don’t really understand the voluntary “membership fee”, for instance, and some of the gimmicks, like the “Fortune Teller” in the app which tells you whether you can afford a certain item, are not the kind of thing that people really want from their bank. But the technology looks solid, and it’s always encouraging when a company shows a willingness to cannibalize its existing customer base. (You can’t make free cash deposits onto a Green Dot prepaid debit card, for instance.)

So here’s hoping that Gobank is a big success, along with Simple and anybody else looking to enter this space. That’s really the best chance we have for the big banks to get forced to make their checking accounts much more user-friendly.

If you have a bit of time today, the official JP Morgan post mortem on the London Whale affair is well worth reading. The whole thing is 132 pages long, although the executive summary — which is very clearly written — is only 17 pages.

One thing the report certainly does is reinforce my conviction that you can’t hedge tail risk. The losses all took place in something called the Synthetic Credit Portfolio, which was described as a “Tail Risk Book” — something designed to make money “when the market environment moves more than three standard deviations from the mean based on predictions from a normal distribution of historical prices”. In other words, JP Morgan is well aware that market moves are not normally distributed, and therefore it has a whole derivatives book in place to protect itself against inevitable unexpected events.

The whole point about tail risk, however (a/k/a “black swans”) is that you can’t anticipate exactly what it’s going to look like before you see it. In this case, the biggest tail event was the publication of stories, in the WSJ and Bloomberg, talking about JP Morgan’s positions. Those stories had a massive effect on the mark-to-market valuation of JP Morgan’s positions At the beginning of the first trading day after the stories appeared, it looked as though JP Morgan might be facing a one-day loss of $700 million; in the event, the final official number was $412 million. Ina Drew, the person in charge of the portfolio, sent an email to JP Morgan’s CEO and CFO, in which she observed that the move was “an eight-standard-deviation event”.

The report doesn’t say how many eight-sigma events the CIO has ever seen: my guess is that this is the only one. But here’s an idea of how crazy eight-sigma events are: under a normal distribution, they’re meant to happen with a probability of roughly one in 800 trillion. The universe, by contrast, is roughly 5 trillion days old: you could run the universe a hundred times, under a normal distribution, and still never see an eight-sigma event. If anything was a black swan, this was a black swan. And it didn’t help JP Morgan’s “tail risk book” one bit. Quite the opposite.

Another thing the report does is show just how difficult it is for any large organization to actually implement what managers want. At JP Morgan, for instance — where the CEO has an unusually large degree of power and knowledge of what is going on — the whole firm was meant to be reducing its “risk-weighted assets”, or RWA, since the higher a bank’s RWA, the more capital it needs under Basel III. And yet somehow, by the time this directive trickled down to the London Whale, it had been watered down and misinterpreted to the point at which the office’s RWA actually went up — substantially — rather than down.

What’s more, there’s a constant theme running through the report of managers being told what they want to hear, rather than the truth, especially with regard to substantial losses. When those appear, no one wants to tell Ina Drew about them; instead, the traders do everything they can to try to either fudge the numbers or attempt to trade their way out of the position.

Interestingly, one way that numbers were fudged was to use the favorite tool of quants around the world, the Monte Carlo analysis. After the Bloomberg and WSJ stories appeared, for instance, one trader drew up an analysis of just how bad the position could get. He modeled nine extreme event like a “bond market crash” or a “Middle East shock”, and found that in six of them, the portfolio lost money, with the losses ranging from $350 million to $750 million. This analysis did not go down well:

This trader sent his loss estimates to the other on April 7. According to the trader who prepared the loss estimates, the other trader responded that he had just had a discussion with Ms. Drew and another senior team member, and that he (the latter trader) wanted to see a different analysis. Specifically, he informed the trader who had generated the estimates that he had too many negative scenarios in his initial work, and that he was going to scare Ms. Drew if he said they could lose more than $200 or $300 million. He therefore directed that trader to run a so- called “Monte Carlo” simulation to determine the potential losses for the second quarter. A Monte Carlo simulation involves running a portfolio through a series of scenarios and averaging the results. The trader who had generated the estimates did not believe the Monte Carlo simulation was a meaningful stress analysis because it included some scenarios in which the Synthetic Credit Portfolio would make money which, when averaged together with the scenarios in which it lost money, would result in an estimate that was relatively close to zero. He performed the requested analysis, however, and sent the results to the other trader in a series of written presentations over the course of the weekend. This work was the basis for a second-quarter loss estimate of -$150 million to +$250 million provided to senior Firm management.

In the event, of course, the portfolio ended up losing not $150 million, not even $750 million, but more like $6 billion, with some $800 million of those losses taking place in the six trading days leading up to April 30, long before the decision was made to liquidate the position. Which just goes to show how useful stress tests are. (Remember, the initial worst-case estimates were put together after the WSJ and Bloomberg stories appeared, which means that JP Morgan was acutely aware, at this point, of the risk that the market would move against them just because their positions were public.)

There is one big omission in the report — and that’s any discussion of how the ultimate losses in the portfolio grew to be so enormous. Where did the initial $2 billion estimate come from, and how did it grow to $6 billion by the time all was said and done? The report basically ends when the potential losses were made public, and doesn’t spend any time discussing how Jamie Dimon and his senior executives handled everything from there on in.

From the perspective of JP Morgan’s shareholders, there are two big things to worry about in this whole episode. The first is weaknesses in risk management, which the report goes into in great detail. The second is the way that senior management responds to a crisis, and whether it can do so while keeping its head and minimizing losses. On that front, the report is silent. Did a panicked reaction to the early losses result in a “dump everything immediately” response which ended up causing an extra $4 billion in damage? Who was responsible for those $4 billion in losses, and how avoidable were they? Those questions are never asked, let alone answered.

JP Morgan has looked in great detail at its crisis-prevention architecure: it’s time, now, too look at its crisis-response architecture, too. Because sometimes, it seems, the latter can cause more damage than the former.

Monday’s Counterparties email went out under the headline “QEBasel“, which may or may not have been an effective way to communicate that the latest relaxation of Basel rules was emphatically done with monetary policy in mind, rather than regulatory prudence. Under the new rules, it might take banks longer to get to a truly safe place, but at least those banks will (we fervently hope) lend more in the meantime, giving a much-needed boost to global growth.

Interestingly, the press reacted very badly indeed to the announcement, which means that Andrew Ross Sorkin, in defending the new rules, is fighting a lonely battle.

He doesn’t do so very well, it must be said. He quotes one John Berlau saying that implementation of Basel as written “almost certainly would have thrown the U.S. and other economies into a recession”, and then says that “Mr. Berlau is right”. Well, Mr Berlau is not right: according to the Basel timetable, very little has to be done this year — and in fact nothing with a 2013 deadline has actually changed at all. The problem with Basel III was never that it would cause some kind of sudden stop in capital flows from banks to borrowers, the minute that it started getting implemented.

And Sorkin also undermines his one genuinely good point. “The chances of a leverage-induced crisis from Wall Street banks right now is quite low,” he writes — and he’s right about that. Indeed, the chances of any leveraged-induced crisis any time before 2019 are very slim indeed. (For one thing, there isn’t enough time, between now and then, to get out of our present slump, find ourselves in a boom, watch the boom get out of control, and then see the boom spectacularly implode.) But here’s the problem: Basel’s leverage requirements haven’t actually changed at all. It’s the liquidity requirements which have changed. And while I’m not worrying about banks’ leverage, I am worrying about their liquidity.

Here’s the difference: leverage requirements protect banks against a sudden drop in the value of their assets. Liquidity requirements, on the other hand, protect banks against bank runs. And bank runs are all about trust and confidence. Banks, especially in the US, might have reasonably strong balance sheets these days. But no one trusts them, or their accounting. (If you don’t believe me, just read Jesse Eisinger and Frank Partnoy in the Atlantic, then you will.) When you don’t have trust, you need liquidity to make up for it — which is why the liquidity requirement is exactly the wrong place for the Basel committee to be fiddling.

What’s more, the Basel committee didn’t just delay the implementation of the liquidity requirements: they changed the requirements themselves. Liquidity is not a completely well-defined term, but it basically means money, or something very very close to it. But the Basel committee has now given up on saying that you need cash, or government bonds, to count against your liquidity requirement. Now, you can even use mortgage-backed securities, if you have enough of them: the rule is that $100 of mortgage-backed securities provide the same amount of liquidity as $50 of cash.

This is a bit silly. If you owe me $50, I’ll accept $50 in cash. In a pinch, I’ll accept $50 in government debt. But I’m not going to accept mortgage-backed securities, any more than the merchants in Times Square accepted a gold bar in lieu of fiat money. The point about liquidity is that it’s money, and mortgage-backed securities aren’t money, they’re securities, which may or may not be easily converted into money at any given point in time. During a liquidity crisis, it’s entirely possible that such things could lose their bid entirely, and that they would therefore be useless in during a bank run.

Another problem here is that the change was not communicated well at all. It was put forward as a significant change in the international system of bank regulation — which is exactly what it is. And as such, it clearly makes bank regulation weaker, and the chances of a crisis some tiny bit greater. But the regulators didn’t change the rules because they thought that the rules were too stringent before; they changed the rules because they wanted banks to lend more, and thereby boost the economy. They just didn’t effectively say what they were doing, with the result that the financial press took the announcement at face value, rather than greeting it as another heterodox way of trying to use central-bank policy to generate economic growth.

The central bankers certainly should have been up-front about what they were doing, because it has important implications. For one thing, they’re playing straight into the hands of the banking lobby. Every time anybody proposes a new bank regulation, no matter how small, the ABA and the IIF and other banking-industry lobbyists will start screaming that the new regulation will depress lending, which in turn will hurt the economy; the clear implication is that even if a regulation makes perfect logical sense from a safety-and-soundness point of view, authorities still shouldn’t implement it if it will reduce the flow of credit from banks into the economy at large. That’s just not true: safety should always come first. But the Basel committee seems to have implicitly accepted that the argument does have validity.

More generally, the committee has clearly determined that if you’ve run out of ammunition in terms of interest rates and quantitative easing, then when you’re searching around for some other monetary-easing tool, regulations are a reasonable place to look. And I really don’t like that precedent. Monetary policy should be entirely separate from bank regulation, even if central banks should properly perform both roles. With the ink barely dry on the Basel III agreement, now is no time to start diluting it for the sake of some hypothetical temporary future marginal boost to growth.

After all, we have no particular reason to believe this stunt will even work. Banks have more than enough liquidity already, to meet the requirements, and they don’t seem to be very keen to lend it out. Sure, the new rules will allow them to lend out that cash, if they want to. But the market right now is rewarding the conservative banks, and punishing those who lend to Main Street. Changing the liquidity rules won’t change that. It will just make banks that much riskier over the long term.

When JP Morgan’s London Whale blew up, one part of the collateral damage was the publication of a detailed Volcker Rule. The Whale was gambling JP Morgan’s money, and wasn’t doing so on behalf of clients — yet somehow his actions were Volcker-compliant. And when the blow-up revealed the absurdity of that particular loophole, the rule went back to the SEC for further refinement.

So we still don’t know exactly what will and what won’t be allowed under Volcker, if and when it ever comes into force. We do know, however, that Citigroup is selling off its internal hedge fund, Citi Capital Advisors. If by “selling off” you mean “giving away“: it’s spinning the fund out as an independent entity, to be owned 75% by its current employees. Citi will retain a Volcker-compliant 25% stake, and slowly reduce the $2.5 billion of its own money it has invested in the entity so that the managers can “diversify the client base away from Citi and to build a stand-alone firm”.

It’s incredibly difficult to value a hedge fund, especially a relatively small one without a long track record. The high-water point for such transactions was probably Citi’s acquisition of Vikram Pandit’s fund, Old Lane, in 2007. Old Lane managed $4.5 billion, and was sold for $800 million, but even then the markets appreciated that the buy was more of an “acqui-hire” of Pandit than a fair price for a young and volatile business.

A few years later, Citi was on the ropes and selling rather than buying; that’s when it unloaded its fund-of-funds, Citi Alternative Investments, to Skybridge Capital. Skybridge paid almost nothing up-front for the business, but agreed to remit a large chunk of the group’s management fees back to Citi for the first three years.

Bloomberg managed to find one consultant who valued Citi Capital Advisors, which manages about $3.4 billion, at $100 million. I, for one, wouldn’t buy in at that valuation: less than $1 billion of the assets under management constitute real money, as opposed to simply being a place where Citi parks a small chunk of its balance sheet. And as the Citi funds diminish, the chances of Citi Capital Advisors becoming a profitable standalone entity have to be pretty slim.

Which brings me to Multi-Strategy Investing, a small group of a dozen people within Goldman Sachs, who between them manage about $1 billion. As Max Abelson shows, MSI is unabashedly an internal hedge fund, concentrating on medium-term trades lasting a few months. (The idea is that if positions are held for longer than 60 days, that makes them Volcker-compliant.)

Abelson finds a lot of illustrious alumni of the MSI group; maybe the bank is keeping it on just for nostalgia’s sake. Because I can’t for the life of me see the point of it. Goldman Sachs has a trillion-dollar balance sheet; the $1 billion it has invested in MSI is basically a rounding error. And by the time you’ve shelled out annual bonuses to a dozen high-flying Goldman Sachs professionals, the contribution of MSI to Goldman’s annual profits has to be downright minuscule. (Let’s say the group generates alpha of 5%, or $50 million per year: that doesn’t go very far, split 12 ways at Goldman Sachs.)

Clearly, with a mere $1 billion under management, MSI doesn’t present Goldman with much in the way of tail risk. But by the same token, this really doesn’t seem like a particularly attractive business for Goldman to be in. As Abelson says, Goldman’s own CEO is adamant that the bank doesn’t make money trading for its own account: everything it does has to be for clients. Under that principle, MSI shouldn’t exist. And the profits from the group simply can’t be big enough to make it worth the regulatory and reputational bother.

Goldman should take a leaf out of Citi’s book, here, and spin MSI off as a standalone operation, if necessary retaining a 25% stake. If its principals can make a go of it, attracting real money from outside investors, great. If they can’t, no harm done. Alternatively, Goldman could just shut down MSI entirely, and put its valuable employees to work helping the bank’s clients, and making money that way. Either way, there doesn’t seem to be any point to keeping this small fund going as is.

The theme of the day, today, is nostalgia for the simple banking systems of yore, where the Bailey Building & Loan was run by simple, honorable men who had no problems complying with Basel I or its predecessors. If you have a large chunk of time today, you can start with the 9,500-word cover story in the Atlantic by Jesse Eisinger and Frank Partnoy, and then for dessert follow it up with Yalman Onaran’s 2,600-word explanation, for Bloomberg, that bank regulation these days is really complicated.

These are genuine problems. Once you’ve read the Atlantic article, which takes a deep dive into Wells Fargo’s 10-K and comes out convinced that it’s impossible to really know anything about the risks and assets in any big bank, you’ll understand why that’s a huge systemic problem:

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.

This paragraph is the heart and soul of the piece. (You’ve gotta love any article where the nut graf comes more than 2,000 words in.) We can’t trust the banks; but unless we can trust the banks, another major financial crisis is inevitable, since banks are built on trust, and without trust they are nothing.

This dynamic was central to what went wrong during the financial crisis, and a large part of the problem was the global system of bank regulation known as Basel II, which basically allowed the world’s biggest banks to simply make their own determination of what their risks were and how much capital it made sense to carry against those risks. Obviously, that didn’t work out very well. So, what can be done about this problem?

The answer of the global regulatory regime was something called Basel III. It was pushed through in something of a rush, and so it built on Basel II as a base: my metaphor is that it’s a bit like the way Windows was built on DOS. As a result, although it’s a clear improvement over Basel II, it is necessarily at least as complex as Basel II. And when complexity itself is part of the problem, extra layers of regulation are unlikely to constitute much of a solution.

That’s Onaran’s point, but I think he pushes it a bit too far. His headline is “Basel Becomes Babel as Conflicting Rules Undermine Safety”, and he talks at the very top about how “conflicting laws, divergent accounting standards and clashing rules” have “created new risks” in the banking system. But the shoe never drops: he doesn’t actually explain what these new risks are, or how Basel III undermines the safety of the baking system.

Partly, it’s a baseline game. Both the Atlantic and Bloomberg are essentially comparing Basel III to Basel I, and saying that everything is still far too complicated. By contrast, if you compare Basel III to Basel II, it’s a clear improvement. Onaran’s article is full of quotes from people saying that we should go back to a much simpler system. And the Atlantic actually lays out what such a system might look like:

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?

This is basically principles-based regulation, as opposed to rules-based regulation. Rather than forcing banks to comply with thousands of pages of abstruse regulation, keep things simple and deliberately vague: that’ll keep them on their toes, goes the argument, and force them to err on the side of caution.

If there were a real chance of doing this, I’d be all in favor. Principles-based regulation doesn’t always work: just look at what happened to the City of London. Banks ran rampant, committed massive Libor fraud, and required enormous bailouts; London is also, not coincidentally, the home of JP Morgan’s Chief Investment Office. Eisinger and Partnoy rightly use banks’ price-to-book ratio as an indicator of the degree to which anybody in the market understands or trusts what they’re doing; what they don’t say is that it’s hard to find a lower price-to-book ratio than Royal Bank of Scotland, which was regulated in the UK rather than the US, and which is owned not by out-of-control risk-loving capitalists, but rather by the much safer and much more risk-averse UK government.

And what neither article really admits is that regulators are painfully aware of all the problems they lay out — and many more. That’s why the UK government spent so much effort trying to lure Mark Carney over from Canada to run the Bank of England: he was one of the few regulators who managed to ensure that his national banking system didn’t implode during the crisis, or require any kind of bailout.

But the fact is that all regulation is, by its nature, path-dependent. In 1932 it was easy to install a simple system of bank regulation, because there was no existing system of bank regulation to replace or build on. Since then, as Eisinger and Partnoy write, “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.” That’s just the nature of things: complexity breeds further complexity, and with it much higher levels of endemic systemic risk.

The genius of Canada, and other countries with safe banking systems like India, is that they never allowed their banks to become highly complex in the first place. There are financial capitals like London, New York, and Frankfurt; those countries will have lots of capital flows and complexity and systemic danger. And then there are second-tier places like Toronto and Delhi, where financing can be much simpler. The problem is that you can’t turn New York into Toronto, or London into Delhi. Nor would any of the politicians in the US or the UK particularly want to do so: they get too much precious tax revenue from being global financial centers.

And it’s equally hard to take a multi-layered rules-based system, complete with a large and powerful and entrenched regulatory infrastructure, and tear it down to build something smaller and simpler. Accounting rules proliferated even during the era of deregulatory zeal in the 1990s; accounting rules will always proliferate, and it’s pretty much impossible to find an example of a regulatory system which has ever managed to go in the other direction, losing complexity, gaining constructive ambiguity, and reducing systemic risk in the process.

So while Eisinger and Partnoy and Onaran are absolutely right when it comes to diagnosing the problem, I think they’re either naive or way too optimistic when it comes to suggesting that all we need to do in terms of a solution is press some magic button and find ourselves with the banking system of the 1950s. We can’t — which is exactly why complexity and systemic risk are here to stay.

Basel III isn’t perfect, but it’s as good as we’re going to get, and is actually significantly better than most people dared hope when it first started being negotiated. And the technocrats who put Basel III together are not some group of knaves, deluding themselves that they’ve magically fixed all the problems with the banking system. They’re smart and well-intentioned regulators, who know full well what the problems are, and who are implementing the best set of patches and solutions that can be implemented in reality. Or if not the very best, then something damn close. They too would love to tear everything up and start from scratch with a much simpler system featuring much smaller banks. But, unfortunately, they can’t.

Call me naive, but after the Barclays revelations, I actually thought that I couldn’t be shocked about the extent of Libor manipulation. Boy, was I wrong. I could quote all 40 pages of the FSA notice fining UBS for Libor fraud: this is far, far worse than simply understating UBS’s borrowing costs so as to make investors think the bank was healthy. In fact, a lot of the fraud was designed to move Libor up rather than down: whatever the traders could make the most money manipulating.

The FSA concludes, quite explicitly:

UBS’s misconduct is, although similar in nature, considerably more serious than Barclays’ because it was more widespread within the firm, being exacerbated by the control failings, in particular the inherent conflict of interest in its submission function. More individuals, including Managers and Senior Managers, participated in or knew about the manipulation and there were more instances of individual manipulation, across more currencies. Furthermore, the extent to which UBS colluded with others was significantly greater and involved financial rewards being paid to Broker Firms.

The latter point is key: UBS didn’t just manipulate its own submissions, but actively attempted to manipulate other firms’ submissions as well. And at points the bribery was so explicit as to beggar belief that anybody would ever communicate such things on the record:

If you keep 6s [i.e. the six month JPY LIBOR rate] unchanged today … I will fucking do one humongous deal with you … Like a 50,000 buck deal, whatever … I need you to keep it as low as possible … if you do that …. I’ll pay you, you know, 50,000 dollars, 100,000 dollars… whatever you want.

A “50,000 buck deal” here does not mean a $50,000 deal: it means a $50 billion deal. If the broker on such a deal siphons off a fee of 0.0001%, that’s $50,000 right there.

The $1.5 billion that UBS is paying in fines here is enormous, but it’s not remotely enough: if the chairman and CEO of Barclays were forced to resign over much lesser Libor fraud, then we’re going to need to see heads roll at UBS too. And, with any luck, some individual criminal prosecutions of UBS executives, to boot.

That said, UBS has already taken the most drastic action it could: it has basically shut down its entire fixed-income business. That unit made enormous profits when things were going well — but it was staffed by rogue traders, who manipulated Libor rates around the world as a matter of course, and who on top of that contrived to lose mind-boggling amounts of money during the financial crisis.

Other fines, for other banks, are sure to follow this one — but if Barclays was dreadful and UBS was much worse than Barclays, it’s hard to imagine that anybody has clean hands here. You want to know why pretty much the entire financial sector is still trading at less than book value? This is why: the number of investors who trust the banks is now zero, and banking seems to have become a game of picking up fraudulent nickels in front of a relentless justice-department steamroller. (And for good measure there are all the civil suits as well: the $1.5 billion that UBS is paying today is just a down-payment on the all-in cost of its Libor fraud.)

The fixed-income department at UBS was the merged product of many storied firms: Swiss Bank, SG Warburg, Dillon Read, Paine Webber, Kidder Peabody, Phillips & Drew, and many others. And that’s the most depressing part of this whole story: there were good and honest managers at all those shops, and they all got pushed out by the fast-buck merchants. The inevitable conclusion: if you’re a senior fixed-income executive in the investment banking world, you’re necessarily suspect. Because this isn’t the kind of world where honest men live long.

Mark Gongloff is not a fan of the idea that corporations are people. Except, that is, when the corporation in question is HSBC: he’s extremely angry at the fact that the UK bank won’t face criminal prosecution as a result of its money-laundering shenanigans.

Gongloff’s take is pretty mainstream: the NYT editorial page said that the decision is “a dark day for the rule of law”, adding that “clearly, the government has bought into the notion that too big to fail is too big to jail”.

But here’s the thing: you can’t jail a bank, or any corporation; a criminal indictment of a corporation is a bit of a peculiar fish at the best of times. Even if the bank survived, which Gongloff thinks is possible but no one knows for sure, there would certainly be massive job losses — and we can be sure that somewhere between 99% and 100% of those job losses would fall on people who had absolutely nothing at all to do with the money laundering that HSBC was getting up to.

What’s more, it’s important to put HSBC’s crimes in context. The United States, in its role as global hegemon and guardian of the world’s only real reserve currency, has unapologetically taken the opportunity to use its economic power to push its geopolitical agenda. For instance, if you’re an Iranian business and you want to do business in dollars, the US is determined to make your life as difficult as possible. The US might have no jurisdiction over Iranian businesses, but it does have jurisdiction over nearly all the important banks in the world, since it’s impossible to be a global bank without having some kind of presence in the US. And — as Argentina is finding out right now in its court case against Elliott Associates — if you want to send dollars around the world, you basically have to send them through the USA.

To put it another way, the laws that HSBC broke were laws designed to bolster the international standing of the US relative to Iran and other countries: they were geopolitically motivated, and the intended target was not the international banking system, with which the State Department has no particular beef, but rather countries the State Department doesn’t like.

In general, the laws have had their intended effect: they have depressed commerce in the relevant countries. But after HSBC has been caught breaking the laws, is there really any point in then pursuing a scorched-earth criminal prosecution against the bank? Remember, the bank was not the real target of the laws in the first place — and what HSBC did was perfectly legal in, say, the UK.

The US certainly has the ability to criminally prosecute HSBC. But doing so would not particularly hurt Iran or any of America’s other state enemies. And the laws which HSBC broke were not laws against bad banking, they were laws against bad states.

Or, to put it another way: the US is the most powerful sovereign nation on the planet. With a flick of its Justice Department finger, it could wipe a globe-spanning bank off the face of the financial system. It has truly awesome power. And every single bank in America is well aware of just how much power the US has in this regard. The question isn’t whether to use that power, it’s why. To do so would be bullying, and capricious, and would punish thousands of innocent individuals, and would destroy hundreds of billions of dollars of value, all for the purpose of nothing much in particular. Just because the US can prosecute HSBC doesn’t mean that it should prosecute HSBC. And sometimes, forbearance isn’t a sign of weakness, it’s a sign of maturity.

Update: Contra EJ Fagan, this is not an argument against prosecuting individuals at HSBC who broke the law. And in the comments, a lot of people are making the point that HSBC’s crimes centered not on Iran but rather on Mexican drug cartels; again, the laws broken are all part of the US war on drugs. The question here is: do you destroy a bank as collateral damage in that war?

In the wake of Citigroup’s cost-cutting announcement yesterday, which hit the bank’s international branch network very hard, Bloomberg’s Christine Harper and Yalman Onaran have a very good overview of how international banking is becoming increasingly difficult and expensive. National regulators at both the subsidiary level and at the corporate-parent level are becoming much more aggressive, compliance costs are rising fast, and the whole business rapidly begins to look like it’s much more trouble than it’s worth. According to Citi’s press release, it will save about $1 billion of expenses per year by paring back, while reducing revenues by less than $300 million per year.

The potential problem here for Citi is that while the cost-benefit analysis undoubtedly makes a lot of sense on a branch-by-branch basis, there are second-order network-effect and reputational consequences which are much harder to quantify. Jeff Horwitz and Maria Aspan at American Banker have a story headlined “Citi’s Latest Cuts Target International Identity”, which cuts to the chase:

More than 6,000 of Corbat’s layoffs and reductions will fall on the global bank, which Citi has long argued hitched its success to those of affluent urbanites in emerging markets. The bank plans to limit or shutter its consumer operations in such places as Turkey, which posted an 8.5% GDP in 2011, and Uruguay, which grew by 5.6% last year. In Turkey, Citi will curtail a 37-year relationship; in Uruguay, almost a century of doing business.

The same is true in Paraguay, and Romania, and Pakistan, as well as second-tier locations in key markets like Hong Kong, Korea, and Brazil. And the result is that Citi risks losing much of its future.

Citi’s branches in far-flung parts of the world have massive long-term value to the bank in ways which can’t be found on any income statement. For one thing, they’re a constant reminder of the bank’s ubiquity. They’re a bit like The Economist like that: if you’re part of the international cosmopolitan classes, then wherever you go in the world, you’ll be able to find the British newsweekly at a local newsstand, and a branch of Citibank somewhere reasonably near your hotel. You might not buy that local copy of The Economist — you probably have it on your iPad — and you almost certainly won’t enter that Citi branch. But just seeing them, knowing that they’re there, targeted at people like you, is a very powerful brand message.

Part of that message is that the bank is so big and international that it’s a notch or three above any purely local institution. During the financial crisis, when Citigroup was insolvent, the vast majority of its $773 billion in deposits was uninsured, held outside the country. If those depositors were rational, they would have moved their money somewhere much safer. But they didn’t: Citi’s storied history and massive international branch network helped to reassure them that their money was safe, even when it really wasn’t. In many emerging markets, Citibank has had a banking relationship with a plurality of the most important local families for many generations: it’s a baked-in part of the architecture of power. That kind of thing ends up having value in all manner of places: when a scion rises up the corporate ranks in some other country entirely, he’ll still feel that in a weird way he has known Citi since before he was even born.

The world is changing, of course, but not as fast as you might think: emerging-market economies are often still dominated by old families, and rich Brazilians and Argentines still like to know that they have access to their bank in Uruguay, even if their main branch relationship has moved to Miami. And while it’s incredibly easy to make fun of former Citigroup CEO Vikram Pandit and his love of what he liked to call “globality”, the fact is that there are really only two banks in the world which can claim a genuinely global branch footprint. If Citi is shrinking, that leaves just one, and I can’t imagine that anybody would be well served by HSBC becoming a complacent and rent-seeking monopolist for the kind of people who don’t really consider themselves of any one nationality at all.

Pandit was right that you go to war with the army you have, and the only area where Citibank is clearly superior to nearly all of its competitors is in its history and international reach. Mike Corbat, who has spent most of his long Citi career working with non-US clients, knows this better than anyone, so I don’t think we’ll see a wholesale dismantling of the model. And I’m pretty sure that the two big national banks that Citi owns outside the US — in Poland and Mexico — are also safe. Citi is big enough to be able to shoulder the costs that the Bloomberg article talks about, and will be smart to do just that. But it has sold off its entire branch network in other countries, like Germany, and it hasn’t placed its entire brand identity behind its global status in the way that HSBC has. As US and international regulators continue to breathe down its neck, there will be continued temptation to keep on shrinking in far-flung nations. And it’s hard to do that without the risk of damaging Citi’s priceless long-term international franchise.

Tom Braithwaite, Michael Mackenzie and Kara Scannell of the FT have one of the wonkiest articles I can ever remember reading in any newspaper, trying to explain the mechanics behind the complaints that various former Deutsche Bank employees have taken to the SEC. Matthew Goldstein first reported on the whistleblower complaints last year, in pretty vague terms; the FT has now added a huge amount of detail.

I have sympathy with all three of the sides in this story: Deutsche Bank, the SEC, and the whistleblowers. The main whistleblower in the FT story is Eric Ben-Artzi, who joined Deutsche in 2010, when the actions in question were already in the past. An alumnus of Goldman Sachs, he was assiduous about finding and defining all the various exotic risks that can crop up in derivatives portfolios, and he ultimately came to the conclusion that during the crisis, Deutsche hadn’t been marking those risks properly to market.

Ben-Artzi, along with at least two other Deutsche whistleblowers, took his complaints to the SEC, which in turn heard them out but has not (as yet) accused the bank of any wrongdoing in the matter. These things are highly complex, and very hard to get a prosecution on, and frankly the SEC probably has more important things to do. Here’s how the FT story concludes:

By 2012, many of the trades have matured or have been unwound. With credit markets back to more normal levels, Deutsche’s dalliance with exotic derivatives is no longer life-threatening. A person familiar with the matter says that for all the sturm und drang over gap risk, at no time was the collateral jeopardised.

But the three former employees told the SEC that this outcome does not mean the allegations should be forgotten. “If Lehman Brothers didn’t have to mark its books for six months it might still be in business,” says one of the men. “And if Deutsche had marked its books it might have been in the same position as Lehman.”

The “gap risk” here needs a little bit of explanation. Simplifying a bit, let’s say that Deutsche Bank bought $130 billion of protection from some Canadians, but the Canadians, in turn, only put up $1.3 billion of collateral. Deutsche never actually called on that collateral — but there was a risk that something catastrophic would happen, and that it would demand much more than $100 million. In that event, the Canadians would probably have just walked away, leaving their $1.3 billion behind, but also leaving Deutsche on the hook for potentially enormous losses.

The question then becomes: what is the value of the protection that Deutsche bought from the Canadians? And the answer depends in part on what Deutsche did to hedge the risk that the Canadians would walk away. Deutsche hedged that risk — the “gap risk” in various ways at various times — first it applied a “haircut” to the valuation of the trades, then it used a reserve account, and finally it bought put options from Warren Buffett.

None of these hedges was remotely perfect, however, and Ben-Artzi, who came from a bank which was notoriously aggressive in such matters, came to the conclusion that the $130 billion of protection had actually been worth roughly $10 billion less than that, if you marked its value to, um, “market”. One problem with this, of course, is that at the height of the financial crisis, the ability of Deutsche Bank to sell $130 billion of leveraged super-senior derivatives was exactly zero. There was no real liquid market to mark to, and what Ben-Artzi was really doing here was “marking to model”.

In the end, what the whistleblowers seem to be complaining about here was that Deutsche didn’t aggressively write down its assets so far that “it might have been in the same position as Lehman.” And why on earth should it have done such a thing? Well, an equally aggressive SEC could surely try to make the case that US GAAP required them to. But let’s take a step back here.

The whole point of banks is that they lend money for the long term, “through the cycle”, and make money over the long terms as well. Sometimes defaults spike, but if you can get through those tough periods, then banking can be a profitable business overall. Now that’s not the way that Goldman Sachs thinks. At Goldman, everything is marked to market every day, and the bank competes on fighting as hard as it can for daily profits. There’s no delusional marking-to-par at Goldman: it’s far more disciplined than that.

But if everybody behaved like Goldman, the result would be a disaster. Specifically, it’s fair to say that if you have a broad economic crisis and there’s not much liquidity in the credit market, then if you assiduously marked every asset to market, the entire banking system would be insolvent. Indeed, a common-or-garden cyclical recession can sometimes come close to having the same effect. If one or two investment banks mark their balance sheets to market every day, that’s fine. But if every bank in the system were to do such a thing, there would never be a bank in the country more than a decade or two old. After all, as even some Goldman executives will now quietly admit, no amount of clever counterparty hedging can protect a bank against the risk that the global financial system collapses.

Deutsche was not selling its super-senior portfolio during the crisis, it was holding on to it. Should it have marked the value of that portfolio down by $12 billion, on the grounds that mark-to-market rules required it to do so? I have no idea: the whistleblowers think it should have, while Deutsche Bank is adamant that it has investigated the allegations and found no particular cause for concern.

But here’s a certainty: seeing Deutsche Bank take a $12 billion writedown at the height of the crisis would have been almost as bad for the system as a whole as seeing Lehman go bankrupt. The time for kitchen-sink writedowns is when you can afford them, not when you can’t. And while there’s a convenient fiction that quarterly accounts are simply the product of following clear and simple rules, no one really believes it — especially not in the ultra-complex world of derivatives accounting.

It’s pretty clear that the world is a better place for Deutsche Bank not having taken a gratuitous writedown on the grounds that even though it had billions of dollars of collateral from the Canadians, that might not be enough to cover what they owed if the crisis got even worse. I remember those crisis days vividly; they were characterized by policymakers on every continent doing everything they possibly could to boost the liquidity and confidence in the financial system. (Well, except for maybe Sheila Bair.)

The whistleblowers say that when Deutsche Bank reported record profits at the end of the first quarter of 2009, it was reporting fiction, because there should have been enormous charges related to derivatives valuation. But I’m happy that Deutsche managed to find a way to keep its accounts in shape during those most dreadful months. Here’s the FT again, talking about early 2009:

In an investor call that February, Mr Ackermann said he would provide “as much clarity as we can on all the positions” to refute the suggestion that banks such as his had “hidden losses, and one day that will pop up, and then . . . we need more capital.”

Ackerman’s performance paid off: his share price rallied, and soon the worst of the crisis was behind us. If he had taken an eleven-figure charge in the first quarter of 2009, that would have been the absolutely worst possible time to do so, both for his bank and for the financial system as a whole. Deutsche Bank survived, the positions turned out to be healthy, and when you see situations as unique and exceptional as this one, there’s a strong case to say “no harm, no foul”.

No good would have come of Deutsche doing what the whistleblowers say it should have done; instead, its profits helped to restore badly-needed confidence in the system as a whole. It’s not exactly a shining precedent. But given how unique and terrible this crisis was, I’m inclined to give Deutsche a pass.

(Picture from Stephen Foley)

“When it comes to natural disasters,” says Rob Cox today, “there’s no such thing as too much preparation.” He then goes on to extend the analogy:

In advance of Sandy’s march through Manhattan, thousands of sandbags have been stacked in front of the downtown headquarters of Goldman Sachs. It is a picture whose metaphorical value should not be lost on regulators, policymakers, shareholders and the bankers themselves: when the flood comes, there can never be too many sandbags, or capital, to prevent a wipeout.

There are a few problems with this line of argument. Firstly, of course there is such a thing as too much preparation when it comes to natural disasters. Cox praises New York mayor Mike Bloomberg for evacuating Zone A — the lowest parts of the city which are most susceptible to storm surges. But an evacuation of all of Long Island, for instance, or all of Manhattan, would surely be way too much.

At the same time, three’s a good reason why Goldman Sachs needed to get in thousands of sandbags: it’s in that very-high-risk Zone A.

A brief history of Manhattan skyscrapers: they were first built in Lower Manhattan, at the highest possible points around there. Look at the Woolworth Building, say, or the New York Stock Exchange, or the Bank of New York building, or City Hall, or even Chase Manhattan Plaza: all of them are on or near Broadway, which runs up the highest part of Lower Manhattan, which means that all of them are in Zone C. And as skyscraper construction moved north in the 1930s, the same thing held true: the Empire State Building, the Chrysler Building, and all the midtown skyscrapers are all well outside the reach of any storm surge.

But then skyscraper building became more high-tech and scientific, and very tall buildings started to be constructed in Zone A, very close to the water. The architects did lots of clever mathematics, or the actuaries did lots of clever sums, and soon there were dozens of huge buildings in the Manhattan flood zone; the Goldman Sachs headquarters at 200 West Street is merely the most recent.

Now, with a Frankenstorm approaching, the decision to build so close to the water is coming home to roost, and firms like Goldman Sachs are scrambling to try to protect themselves. Hence the sandbags. Which aren’t really preparation; they’re more like a desperate last-ditch attempt to save a multi-billion-dollar headquarters building from very nasty flooding.

And the fact is that Goldman’s sandbags, along with all the other sandbags being deployed up and down the east coast (including in my very own apartment building), are very unlikely to be any use at all. They’re meant to be trying to protect property against a huge storm surge, which could reach 11 feet; the chances have to be very slim indeed that the surge will be big and powerful enough to reach the sandbags, but small and weak enough that the sandbags will suffice to keep it at bay.

Or, to put it another way: when big tail events happen, the old models get broken, and you can’t rely on them any more. That’s true when it comes to building skyscrapers, and it’s also true when it comes to financial crises. In fact, it’s even more true when it comes to financial crises.

Hurricane Sandy is a known unknown: it’s approaching New York, and the only real question is how high the storm surge is going to get. It could be six feet, it could be nine feet, it could be 12 feet. Bank capital, by contrast, is something which disappears in a much less linear fashion. A bank’s capital is just the difference between two huge numbers: its assets, and its liabilities. Its liabilities are fixed; its assets are loans, and derivatives, and other financial instruments which can fluctuate in value dramatically, especially in a crisis. What’s more, assets which banks think of as being ultra-safe — “quadruple-A”-rated super-senior CDO tranches, for instance — turn out to be precisely the assets which implode in value when a crisis comes along, turning banks insolvent overnight.

And that’s just the solvency problem: the bigger issue is liquidity, in a world where banks roll over billions of dollars of debt every day. You can protect yourself as much as you like, but if your lenders for whatever reason stop rolling over your debts, you’re toast. Let’s say you needed to sell lots of US stock today, for instance. Well, thanks to Sandy, you can’t: the stock market is closed. When liquidity dries up, everybody, no matter how prepared they are, is affected, and either central banks manage to step in to save the day, or they don’t. No mere mortal, without a printing press, can hold out.

Financial crises are similar to storms: they require humility, not hubris. Being prepared can be helpful at the margin, but ultimately it doesn’t matter how good your liquidity management teams and risk ledgers and counterparty hedging operations are: if everybody else is blown over by forces beyond their control, then you will be too.

That’s why skyscrapers always used to be built well above the water level, and that’s why we used to have dumb regulations like Glass-Steagal and Basel I, which weren’t very sophisticated, but which generally did the trick. Buildings like 200 West are a bit like Basel III: they’re built with models, so that they can withstand certain forces. But if an unprecedented storm arises, they’re still more at risk than, say, Trinity Church, built more than 150 years earlier. Sometimes, simple common sense (high ground is safer, huge books of complex derivatives can blow up in unpredictable ways) does a lot more good than any amount of sophisticated preparation.