10/30/13 – Scary Monsters Lurking in the Financial System

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Oct 30, 2013 10:43:38 AM

and tagged Market Updates, Commentary

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I’ve written before about the potential problems lurking in the financial system. LIBOR, for example, was something I started covering last year. Looking at the papers today, though, even I am surprised by the sheer number—not to mention magnitude—of the problems that are showing up.

In just one of today’s papers, the Wall Street Journal, we have the following articles:

  • A1 – “SAC to Plead Guilty to Securities Fraud”
  • C1 – “Rabobank Is Fined, CEO Is Out in Libor Settlement”
  • C1 – “Troubles for J.P. Morgan in Its Effort to Settle”
  • C3 – “Currency-Trading Probe Gains Momentum”
  • C4 – “NASDAQ Glitch Prompts Trading Halt in Some Markets”
  • C16 – “European Banks Trapped in Legal Limbo”

Let’s take a detailed look. The first article reports that SAC Capital, one of the largest and most successful investment firms, is going to plead guilty to criminal charges. The firm will also agree to shut down its investment management business, on top of paying $1.2 billion in fines. In my opinion, for such a firm to admit this kind of guilt and agree to these penalties, the evidence must be very strong. The core of the case is insider trading allegations.

The second article discusses how a major Dutch financial institution effectively admitted rigging the markets—again, insider trading. This is a civil settlement, but the article notes that criminal charges are likely. Rabobank, the fifth company to settle on LIBOR manipulation charges, will pay more than $1 billion in penalties.

The third article focuses on the well-known settlement J.P. Morgan was supposed to have reached with the government. That deal is apparently at risk over whether and how much criminal exposure will be preserved after the settlement, and whether any of the settlement costs can be passed along.

In the fourth article, we learn that two major global banks, UBS and Deutsche, are being investigated for market manipulation in foreign exchange—another form of insider trading. The fifth article is about another in a series of breakdowns in the U.S. equity markets. And the sixth details how European banks, in general, are stuck in a legal limbo that resembles, in many ways, the one J.P. Morgan is in.

Apart from the almost unavoidable conclusion that there’s a lot of risk exposure here for something that is, in principle, a pretty simple business, I think there are a couple of takeaways.

First, the regulators are back, and they’re not messing around. Criminal charges have been almost unheard of in the past, with the only significant example I can think of being Enron and Arthur Andersen, which was put out of business. Post-Madoff, the regulators are being tougher and have the political backing to stick with it. SAC, J.P. Morgan, Rabobank—all involve criminal charges against individuals and the firm, which will markedly change the calculations of both in taking future risks.

Arguably, the impact of any criminal charges could extend well beyond the immediate effects, just as it did with Andersen, possibly limiting a firm’s ability to operate in other areas subject to regulation—investment management, for example. If SAC can be forced out of the investment management industry, could J.P. Morgan be forced out as well? An interesting, if speculative, article in Forbes suggests it might. The fallout from these cases could be much more damaging to financial institutions than most people now expect.

Second, there’s the very real damage that’s been done to the public perception of the capital markets. When the largest and most successful institutions are being investigated—and admit to criminal wrongdoing—the average investor is going to think twice about trusting the markets, to the detriment of society as a whole.

Beyond that, the argument against regulation gets harder and harder to make the more problems are revealed in the system. When we get to a societal breakpoint, regulation will be seen as the only appropriate result, rather than something that is used as necessary.

I suspect that the financial industry has hit its peak for this generational cycle, and investors should consider that. Too big to fail is a buzzword that already has legs, and the addition of admitted criminal malfeasance will only make it easier to act to downside the industry. Lower economies of scale will result in higher costs, and more stringent regulations will result in lower risks—and lower profits.

None of this will be immediate, of course, but the trend seems to be clear. Just as so many other industries have been disrupted by changes in societal conditions, the financial industry will have to change, and, at this point, that change looks to be to a lower-risk, lower-return model.

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