Mrs. Warren Goes to Washington: Does the Market Mistrust Big Banks?

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Critics of the nation’s largest banks haven’t had very many friends in Washington lately, but that dynamic changed markedly in January, when Massachusetts Senator Elizabeth Warren — perhaps Big Finance’s most articulate gadfly — was sworn in and given a seat on the Senate Banking Committee. And last week, the committee held its first hearing of the new year to question regulators about the stability of the nation’s financial system, and to get a progress report on the implementation post-crisis financial reform.

Not surprisingly, it was the rookie Massachusetts Senator who stole the show, pointedly asking each member of the panel when the last time they had taken a large Wall Street bank to trial, where their misdeeds would be aired publicly. The implication was, of course, that regulators are either unwilling or unable to take big banks to trial, that they rely too much on mutually agreed upon settlements as penalties for misbehavior, and that this reluctance has created a dangerous culture of impunity on Wall Street. This folksy-yet-informed populism has gone over well, with three clips from Warren’s performance having garnered more than 1.1 million views on YouTube since last Thursday. Check out Senator Warren’s performance in the clip below:


But Warren’s second point is equally interesting, and perhaps more important to understanding what remains broken about the American banking system. She indicated that the majority of the nation’s big banks are “trading below book value.” The book value of a company is simply the total value of all the company’s listed assets minus its liabilities — in theory, that is, what shareholders would get by selling their company off for parts.

But most companies are worth much more than book value. That’s because most firms are more than just a sum of their parts — they possess institutional knowledge, for example, that enables them to turn their employees, equipment, and intellectual property into profits. But lately, the stock market is actually valuing large banks like Citigroup, Bank of America, and JPMorgan, below the value of the company’s stated assets minus liabilities. 

Let’s take the example of Citigroup, which according Yahoo Finance has a market capitalization of $135 billion. In other words, if you had $135 billion laying around, you could buy up all the outstanding shares of Citigroup and be the sole proprietor of one of the largest banks in the world. But here’s the rub: If you actually add up the stated value of Citigroup’s assets minus liabilities, the bank should be worth at least $190 billion. Theoretically, you could buy up Citi, chop it up, and sell it for parts, all the while making a tidy $55 billion in profit.

Of course, in a competitive market, this shouldn’t be. Something is amiss, and Senator Warren thinks there can only be two reasons: 1) Banks aren’t being honest about the value of their assets; or 2) The market believes that large banks are too big to manage effectively. In his response, Federal Reserve Board Governor Daniel Tarullo added that regulatory uncertainty may play a role in pushing down the values of bank stocks. But are these the correct explanations?

It would appear that a lack of trust in bank accounting is one culprit for the discrepancy. In a recent cover story for The Atlantic magazine, Frank Partnoy and Jesse Eisenger did a deep dive into Wells Fargo’s annual report to evaluate how effective federally-mandated financial disclosures are at describing a large, complicated bank’s financial health. They found that the vast majority of the assets on Wells Fargo’s books are securities like derivatives and mortgage-backed securities which aren’t traded often or on public markets. Because they aren’t traded often or openly, these securities are difficult to value, and therefore banks must use estimates when putting together their financial reports. But Partnoy and Eisenger lament that the byzantine complexity of these instruments, combined with the bank’s incentive to hide the true nature of the risk its shareholders are exposed to, causes big-bank financial statements to be effectively useless.

Barry Rithotz, CEO and director of equity research at Fusion IQ, commenting upon the article summed up investor’s skepticism in the banking sector succinctly:

Banks are essentially opaque black boxes; banks have purposefully concealed what’s on their balance sheets . . . they are not merely complex, but actually deceptive; investors have no idea what they are buying when they own one of the behemoth money centers like Citigroup, Bank of America, Wells Fargo, or JP Morgan.

So it would seem Senator Warren is on to something when she accuses large banks of being dishonest about the value of their investments. The large banks take umbrage at an accusation of deceit. (Politico’s Ben White has a nice write up of banking industry reaction to Thursday’s hearing.) But Warren isn’t accusing large financial institutions of outright fraud.  Surely these institutions are following the letter of law, and complying with every last accounting rule stipulated by the Financial Accounting Standards Board. But accounting isn’t an exact science, and given enough resources, firms can avoid conforming to the spirit of these rules while still technically being in compliance.

And, of course, you don’t need to take Warren’s word for it. Just take a look at the bank’s stock prices and decide for yourself. Bank representatives may argue that the $55 billion discrepancy between Citigroup’s market capitalization and book value are due completely to the fear that regulators will increase capital requirements, but does this explanation really pass the smell test?

Regulatory uncertainty may be a factor, but ultimately investors don’t understand what these banks have on their books — and don’t want to be holding the bag when we eventually find out. That would be all fine and good, except that it may be taxpayers who ultimately have to cover the costs if the market’s worst fears become a reality.