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American Dream Betrayed

Why No One Believes The Banks

By almost any measure, Morgan Stanley is fine.

Look at this impressive rundown of the bank's critical numbers and ratios compiled by Paul Gulberg, an investment-banking analyst with the independent research firm Portales Partners.

Morgan Stanley has much more capital and lower leverage than it did at the height of the financial crisis, which I like to think of as 9/08. It has almost $60 billion in common equity, compared with $36 billion before September 2008, and its ratios are stronger. Its trading book - which is volatile and where any bank can take sudden, large losses - is smaller than it was. Morgan Stanley has more long-term debt and higher deposits, both of which stabilize its finances. The bank has more cash available in case there's a crunch and a smaller amount of Level III assets, which don't have an independently verifiable value and so must be estimated by the bank. Hedge funds have parked a smaller amount of assets at Morgan Stanley. That's good because in the financial crisis, they pulled them from the bank.

Yes, Morgan Stanley by any measure is a safe and solid investment bank. Except for one: The amount of trust people have in the whole financial and political system. It's just about zero.

That's why the bank's shares are down 42 percent this year. That's why all the big bank stocks have double-digit dips.

True, they start their next round of quarterly reporting in a matter of days. Morgan Stanley is scheduled to report its third-quarter earnings on Oct. 19, and its earnings may calm fears temporarily.

But the essential problem will still be there, a slow burn beneath the global financial system that flares up at the worst moments. Banks don't have faith in other banks, investors are deeply scarred and wary, and nobody believes that the governments around the world could grapple with the magnitude of the problems, even if they wanted to.

Three months ago, the Belgian bank Dexia passed the European stress tests. By that measure, it was fine. Then it collapsed.

This weekend France, Belgium and Luxembourg swooped in to save Dexia and pledged to figure out how to recapitalize European banks as a whole.

So investors had a moment of euphoria on Monday: Governments will save institutions!

While they probably won't hesitate to wipe out equity holders in failed financial institutions and will perhaps force the value of bondholders' investments to be trimmed, they will do everything they can to protect counterparties so that the system doesn't melt down.

That's the hope, at least, and it has a rational basis. Almost universally, regulators and political leaders believe that letting Lehman fail in the fall of 2008 was a disastrous mistake. Its downfall cascaded throughout the global financial world, collapsing money markets, terrifying lenders to banks and accelerating the implosion of multiple financial institutions.

So investors and policy makers, burned by the recent crisis, are all supposed to be acting more prudently and forcefully.

Yet, the moment one examines almost any detail of the global financial system, faith falters once again. Take the uncertainty about the derivatives markets. Morgan Stanley has a face value of $56 trillion in derivatives. That's really nothing. JPMorgan Chase has more - amounting to the G.D.P. of large countries - a face value of $79 trillion in derivatives. If something goes wrong with just one-tenth of 1 percent of those trades, it's kablooie.

Now those are gross numbers. Many people would dismiss those totals as ridiculous and misleading. Anyone who brings them up is merely displaying ignorance. The banks' derivatives portfolios are full of off-setting trades that net out at a smaller number.

Derivatives can be dismissed as a popular bugaboo, but they really are just a symbol of the larger problem. A litany of daily stories reveals all kinds of reasons that banks don't trust each other. To take just one news item, almost at random: Bloomberg News reported the other day that a Danish bank was refusing French sovereign debt as collateral.

Nobody really knows how much exposure the American banks have to the European financial and political crisis, with the Treasury Department minimizing the issue while other outlets raise the specter of catastrophic problems.

So trust, naturally, is the casualty. "If you get in a period of stress, everyone starts questioning whether the hedges will hold up and whether the collateral is good enough," said Mr. Gulberg, the banking analyst.

Surely no bank would be so reckless as to accept dodgy collateral these days. It would hold out for something unassailable, like, say, Triple A mortgages on American homes. Wait, scratch that. It would accept sovereign debt, perhaps from some European realm that has been around for centuries. Whoops, no, no. Well, O.K., maybe United States Treasuries - and we'll agree to ignore that one of the country's two major political parties was willing to plunge the United States into default to achieve its aims.

So there's concern about the collateral. But what about the hedges? Of course, they wouldn't hedge with some bank like Dexia, which at year-end had $700 billion worth of loans, undrawn commitments, financial guarantees and the like. Some financial institutions have to be on the other side of Dexia's commitments. Some might even be those supposedly strong and prudent banks that were supposed to have learned so much from the financial crisis. Did Morgan Stanley learn its lesson from the crisis?

You begin to see the problem.

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Comments welcome.



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Posted on October 13, 2011


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