Former Chief Accountant of SEC takes on Wall Street's Opacity Protection Team

In her NY Times column, Gretchen Morgenson discusses the Fed's secret bailout of the banks as seen by Lynn E. Turner, a former chief accountant at the SEC.

Mr. Turner takes on Wall Street's Opacity Protection Team and calls for transparency to both prevent a repeat of the secret bailout and, more importantly, to change bankers' mindset so that they do not get in trouble in the first place.

In short, Mr. Turner endorses ultra transparency as proposed by your humble blogger.

The fact is, investors didn’t know how dire the situation was at these institutions. At the same time that these banks were privately thronging the teller windows at the Fed, some of their executives were publicly espousing their firms’ financial solidity. 

During the first three months of 2009, for example, when Citigroup’s Fed borrowing apparently peaked, Vikram Pandit, its chief executive, hailed the company’s performance. 

Calling that first quarter the best over all since 2007, Mr. Pandit said the results showed “the strength of Citi’s franchise.” 

Citi’s earnings release didn’t detail its large Fed borrowings; neither did its filing for the first quarter of 2009 with the Securities and Exchange Commission. Other banks kept silent on these activities or mentioned them in passing with few specifics. 

These disclosure lapses are disturbing to Lynn E. Turner, a former chief accountant at the S.E.C. Since 1989, he said, commission rules have required public companies to disclose details about material federal assistance they receive. The rules grew out of the savings and loan crisis, during which hundreds of banks failed and others received government help.

The rules are found in a section of the S.E.C.’s Codification of Financial Reporting Policies titled “Effects of Federal Financial Assistance Upon Operations.” They state that if any types of federal financial assistance have “materially affected or are reasonably likely to have a future material effect upon financial condition or results of operations, the management discussion and analysis should provide disclosure of the nature, amounts and effects of such assistance.” 

Given these rules, Mr. Turner said: “I would have expected some discussion in the management discussion and analysis of how this has had a positive impact on these banks’ operating results. The borrowings had to have an impact on their liquidity and earnings, but I don’t ever recall anybody saying ‘we borrowed a bunch of money from the Fed at zero percent interest.’ ”... 

Of course, there is stigma associated with a company tapping into federal assistance programs. This is the Fed’s main argument for keeping its operations under wraps. And companies want to avoid frightening investors by disclosing their reliance on this type of emergency cash, even if it is only temporary.

This argument is fundamentally flawed.

Prior to the introduction of deposit insurance in the 1930s, banks would routinely disclose 'all their accounts fit to print'.  This was a sign of a bank that could stand on its own two feet.

It is only with the arrival of the regulators that less information was made available to deposit holders and investors.

If banks were required to provide ultra transparency, market participants would know if they needed to use a Fed program and if the need was temporary or a reflection of a true solvency problem.

But keeping this information from shareholders is no way to engender their trust. And a lack of investor confidence often translates to depressed valuations among companies’ shares.

Actually, a lack of investor confidence often translates into a run on the bank.  One symptom of this is investors fleeing the bank's stock.

If investors doubt that a company is coming clean about its financial standing — the current worry is how exposed our banks are to European debt woes — its stock price will suffer. This is very likely one of the reasons that big bank stocks trade at such low price-to-earnings multiples today.

Today, investors know that banks are not coming cleaning about their financial standing.  The Fed's secret bailout was just one of the ways that bank financial statements were manipulated.

At the beginning of the financial crisis, regulators adopted a raft of programs to distort bank financial statements.  These include regulatory forbearance (extend and pretend on loans), suspension of mark to market accounting, and adoption of mark to myth accounting (management values securities based on hope rather than prevailing market prices).

It will be interesting to see whether the S.E.C. does anything to enforce its rules that companies disclose federal assistance in financial filings, either in the recent past or in the future.

Highly unlikely as the SEC is a card carrying member of Wall Street's Opacity Protection Team.

This blog has frequently documented how the SEC, despite its mandate to ensure that market participants have access to all the useful, relevant information in an appropriate, timely manner, has repeatedly endorsed opacity in the financial system.

For example, disclosure for structured finance securities is covered by SEC Regulation AB.  Under this regulation, investors only have access to the underlying loan performance information once per month.

This contrasts with the centuries old banking industry standard for monitoring a loan portfolio of looking on a daily basis for any observable events with the underlying loans.  An observable event includes a payment, delinquency, default or borrower filing for bankruptcy.

This regulation also legalized for Wall Street what was the equivalent of an insider's trading advantage.  They were able to trade on tomorrow's news today as Wall Street ran the firms that did the billing and collecting of the loans backing the structured finance securities and therefore had access to data on a daily basis.

You could certainly argue that requiring such disclosures is even more important nowadays, given that so many banks are considered too big to fail and that the taxpayer will undoubtedly be asked once again to rescue them from their mistakes.  

 “These banks and the Fed have never believed in transparency,” Mr. Turner said. “I actually think their thought process is sorely flawed. If the banks knew this stuff was going to be made public they’d behave differently. Instead of runs on the bank you’d have bankers doing things intelligently to avoid getting into trouble.” 

What an idea!

Yes, one that your humble blogger has frequently shared with regular readers.